1. Chapter 5

2.  Summarize the function of strategic asset allocation in portfolio management  Discuss the role of strategic asset allocation in relation to exposures to systematic risk  Compare and contrast strategic and tactical asset allocation  Appraise the importance of asset allocation for portfolio performance

3.  Explain an advantage and a disadvantage of implementing a dynamic versus a static approach to strategic asset allocation  Discuss and interpret the specification of return and risk objectives in relation to strategic asset allocation  Evaluate whether an asset class or set of asset classes has been appropriately specified  Select and justify an appropriate set of asset classes for an investor  Evaluate the theoretical and practical effects of including an additional asset class such as inflation- protected securities, international developed markets or emerging market securities, or alternative assets in an asset allocation

4.  Formulate the major steps in asset allocation  Determine and justify a strategic asset allocation, given an investment policy statement and capital market expectations  Critique and revise a strategic asset allocation, given an investment policy statement and capital market expectations  Determine and justify tactical asset allocation (TAA) adjustments to asset-class weights given a description of a TAA strategy and expectational data

6.  Integrated asset allocation ◦ capital market conditions ◦ investor’s objectives and constraints  Strategic asset allocation ◦ constant-mix  Tactical asset allocation ◦ mean reversion ◦ inherently contrarian  Insured asset allocation ◦ constant proportion

7.  Strategic asset allocation combines investor’s objectives and constraints with long-term capital market expectations into IPS- permissible asset classes  Purpose is to satisfy investor’s objectives and constraints  Process leads to a set of portfolio weights called the policy portfolio

8.  Strategic asset allocation aligns portfolio’s risk profile with investor’s objectives  Investors expect compensation for accepting non-diversifiable (systematic) risk  Distinct asset classes have distinct risk exposures  Strategic asset allocation effectively controls systematic risk exposures  Strategic asset allocation also provides the investor with a set of benchmarks for appropriate asset mix and long-term risk tolerance

9.  Strategic allocation sets investor’s long- term exposures to systematic risk  Tactical asset allocation (TAA) involves short-term adjustments to asset weights based on short-term predictions of relative performance  TAA is an active and ongoing investment discipline, whereas strategic asset allocations are revisited only periodically or when the investor’s circumstances change

10.  Some studies have indicated that asset allocation explains the vast majority of portfolio returns, far outweighing timing and security selection  Cross-sectional studies have shown asset allocation to explain much less (though still a very significant amount) of portfolio returns  However, other studies have shown that the dispersion of results can vary more due to security selection than asset allocation, and thus indicate that skillful investors would gain more from security selection

11.  Selecting an allocation method depends on: ◦ Perceptions of variability in the client’s objectives and constraints ◦ Perceived relationship between the past and future capital market conditions  importance of asset allocation ◦ Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance? ◦ Ibbotson and Kaplan FAJ Jan/Feb 2000

12.  Asset/Liability Management (ALM) models future liabilities and adopts an asset allocation best suited to funding those liabilities  Asset-only approach does not explicitly model liabilities  Dynamic Approach ◦ Asset allocation, actual returns and liabilities in one period directly affect the optimal decision for the following period  Static Approach ◦ Does not consider links between time periods ◦ Less costly and complex to model and implement

13.  Return objective ◦ Qualitative objectives describe fundamental goals ◦ Quantitative objectives specify return needed to achieve goals ◦ Compounding must be considered through geometric return and multiplicative rather than additive formulations  Risk objective ◦ Qualitative (below average or above average) ◦ Quantitative  numerical risk aversion measured through interview  Acceptable level of volatility  Shortfall/downside risk  Safety-first criterion  Behavioral biases

14. 1. Assets within a class should be relatively homogeneous 2. Asset classes should be mutually exclusive 3. Asset classes should be diversifying 4. Asset classes as a group should comprise the majority of world investable wealth 5. Asset class should have the capacity to absorb a significant fraction of the investor’s portfolio without compromising liquidity

15.  domestic common equity  domestic fixed income  international common equity  international fixed income  real estate  cash and cash equivalents  others to consider: ◦ alternative – real estate often considered part of this along with private equity, commodities, currencies, and investment strategies of hedge funds ◦ TIPS

17.  Assets should be considered in a portfolio if they improve the portfolio’s mean-variance efficient frontier  This occurs if the asset class Sharpe ratio exceeds the product of the existing portfolio’s Sharpe ratio and the correlation between the asset class return and the portfolio’s return  For example, an asset with a Sharpe ratio of 0.2 and a correlation of 0.9 to the return of a portfolio with a Sharpe ratio of 0.15 should be added because 0.2 > 0.15(0.9) = 0.135

19.  Investor Specific ◦ Consider investor’s net worth and risk attitudes ◦ Apply a risk tolerance function ◦ Determine the investor’s risk tolerance  Capital Market Situation ◦ Identify capital market conditions ◦ Implement a prediction procedure ◦ Generate expected returns, risks and correlations  Combined Investor-Market Relationship ◦ Use an optimizer to determine allocation given investor’s risk tolerance ◦ Select asset mix ◦ Actual returns determine feedback for process

20.  As an investor you want to maximize the returns for a given level of risk.  Your portfolio includes all of your assets and liabilities  The relationship between the returns for assets in the portfolio is important.  A good portfolio is not simply a collection of individually good investments.

21. Given a choice between two assets with equal rates of return, most investors will select the asset with the lower level of risk.

22.  Many investors purchase insurance for: Life, Automobile, Health, and Disability Income. The purchaser trades known costs for unknown risk of loss  Yield on bonds increases with risk classifications from AAA to AA to A….

23. Risk preference may have to do with amount of money involved - risking small amounts, but insuring large losses

24.  Quantifies risk  Derives the expected rate of return for a portfolio of assets and an expected risk measure  Shows that the variance of the rate of return is a meaningful measure of portfolio risk  Derives the formula for computing the variance of a portfolio, showing how to effectively diversify a portfolio

25.  For an individual asset - sum of the potential returns multiplied with the corresponding probability of the returns  For a portfolio of investments - weighted average of the expected rates of return for the individual investments in the portfolio

26. Standard Deviation

27.  For two assets, i and j, the covariance of rates of return is defined as: Cov ij = sum{[R i - E(R i )] [R j - E(R j )]p i }  Correlation coefficient varies from -1 to +1

29. Standard Deviation of Return E(R) R ij = +1.00 1 2 With two perfectly correlated assets, it is only possible to create a two asset portfolio with risk- return along a line between either single asset

30. Standard Deviation of Return E(R) R ij = 0.00 R ij = +1.00 f g h i j k 1 2 With uncorrelated assets it is possible to create a two asset portfolio with lower risk than either single asset

31. Standard Deviation of Return E(R) R ij = 0.00 R ij = +1.00 R ij = +0.50 f g h i j k 1 2 With correlated assets it is possible to create a two asset portfolio between the first two curves

32. Standard Deviation of Return E(R) R ij = 0.00 R ij = +1.00 R ij = -0.50 R ij = +0.50 f g h i j k 1 2 With negatively correlated assets it is possible to create a two asset portfolio with much lower risk than either single asset

33. Standard Deviation of Return E(R) R ij = 0.00 R ij = +1.00 R ij = -1.00 R ij = +0.50 f g h i j k 1 2 With perfectly negatively correlated assets it is possible to create a two asset portfolio with almost no risk R ij = -0.50 Exhibit 7.13

34. Efficient Frontier A B C Figure 8.9 E(R) Standard Deviation of Return

36.  The efficient frontier represents set of efficient portfolios at various levels of risk ◦ part of the minimum variance frontier which represents portfolio with the smallest variance of return for its level of expected return ◦ MVF has a global minimum variance portfolio which is the smallest variance of all minimum variance portfolios ◦ represents feasible set of investment opportunities  find an efficient portfolio with combination of risk and return that is appropriate for investor ◦ use mean-variance optimization (or other processes to determine asset class weights)

37.  Investors should choose from efficient portfolios consistent with the investor’s risk tolerance  Unconstrained: asset class weights must sum to one  Sign-constrained: no short sales (negative weights)  quality of inputs ◦ recommended asset allocations are highly sensitive to small changes in inputs  estimation error in expected returns is about 10 times as important as estimation error in variances and 20 times as important as estimation error in correlation (covariance)

38.  Capital market theory extends portfolio theory and develops a model for pricing all risky assets  Capital asset pricing model (CAPM) is early attempt at determining the required rate of return for any risky asset ◦ problems with this model in part due to unrealistic assumptions ◦ current research attempts to find “true” asset pricing model but no one accepted model ◦ concepts from CAPM used in practice even though model has problems  for example, beta as a measure of systematic risk

39.  An asset with zero variance  Zero correlation with all other risky assets  Provides the risk-free rate of return (RFR)  Will lie on the vertical axis of a portfolio graph  asset class of cash and cash equivalents

40. Covariance between two sets of expected returns is *instead of (/n), multiply by probability if calculating covariance of expected returns Because the returns for the risk free asset are certain, Thus R i = E(R i ), and R i - E(R i ) = 0 Consequently, the covariance of the risk-free asset with any risky asset or portfolio will always equal zero. Similarly the correlation between any risky asset and the risk-free asset would be zero.

41.  Under CAPM, in equilibrium each asset has nonzero proportion in M  All assets included in risky portfolio M ◦ All investors buy M ◦ If M does not involve a security, then nobody is investing in the security ◦ If no one is investing, then no demand for securities ◦ If no demand, then price falls ◦ Falls to point where security is attractive and people buy and so it is in M

42.  CML represents new EF ◦ all investors have the same EF but choose different portfolios based on risk tolerances (with homogeneous investors - assumption of CMT) ◦ investor spreads money among risky assets in same relative proportions and then borrows/lends  separation theorem ◦ optimal combination of risky assets for investor can be determined without knowledge of investor’s preferences toward risk and return  investment decision  financing decision

44. The decision of both investors is to invest in portfolio M along the CML (the investment decision) M CML PFR B A

45. Figure 9.3 Standard Deviation of Return Number of Stocks in the Portfolio Standard Deviation of the Market Portfolio (systematic risk) Systematic Risk Total Risk Unsystematic (diversifiable) Risk

46.  The existence of a risk-free asset resulted in deriving a capital market line (CML) that became the relevant frontier  An asset’s covariance with the market portfolio is the relevant risk measure  This can be used to determine an appropriate expected rate of return on a risky asset - the capital asset pricing model (CAPM)

47.  The relevant risk measure for an individual risky asset is its covariance with the market portfolio (Cov i,m )  This is shown as the risk measure  The return for the market portfolio should be consistent with its own risk, which is the covariance of the market with itself - or its variance:

48. In equilibrium, all assets and all portfolios of assets should plot on the SML Any security with an estimated return that plots above the SML is underpriced Any security with an estimated return that plots below the SML is overpriced A superior investor must derive value estimates for assets that are consistently superior to the consensus market evaluation to earn better risk-adjusted rates of return than the average investor

49.  Stability of Beta  Comparability of Published Estimates of Beta ◦ Number of observations and time interval used in regression vary ◦ Value Line Investment Services (VL) uses weekly rates of return over five years ◦ Merrill Lynch (ML) uses monthly return over five years ◦ There is no “correct” interval for analysis ◦ Weak relationship between VL & ML betas due to difference in intervals used ◦ Interval effect impacts smaller firms more  Market portfolio

50.  Specify the risk in microeconomic terms using certain characteristics of the underlying sample of securities extension of Fama-French 3-factor model includes a fourth factor that that accounts for firms with positive past return to produce positive future return - momentum

51.  60/40 stock/bond asset allocation is appropriate or at least a starting point for an average investor’s asset allocation  the allocation to bonds should increase with increasing risk aversion  investors with longer time horizons should increase their allocation to stocks  a rule-of-thumb for the % allocation to equities is 100 minus the age of the investor

52.  implementation choices ◦ investment approach and instruments to execute  passive  tracking portfolio of securities – self-managed, ETF or fund - designed to replicate returns of broad index  cash plus long position in either swap or futures for particular asset class  active  portfolio reflecting investor’s perceived special insights or skills with no attempt to track any broad index  derivatives-based position that reflects active investing ideas  semi-active (enhanced indexing)  tracking portfolio that permits some under- or over- weighting of securities relative to the index but with controlled tracking risk  derivatives-based position in asset class along with some controlled active risk mgt (i.e., actively managing duration)

53.  implementation choices  currency risk management decisions ◦ need to decide what part of exposures to hedge  passively manage  actively manage  currency overlay manager  rebalancing to target weights ◦ calendar basis ◦ percentage-of-portfolio basis  rebalancing threshold / trigger point

54.  Taxable  Human capital – present value of future income – must be considered but is not readily tradable ◦ Safer labor income permits a higher equity allocation ◦ Human capital correlations with stock market (stockbrokers, etc) should result in lower equity allocations ◦ Labor flexibility should permit higher equity allocations  Mortality risk – family loses human capital with early death – can be hedged with insurance  Longevity risk – outlive assets in retirement – annuity products help reduce this risk

55.  Active management at the asset class level  Often takes place after strategic allocation decision but before decisions on managing specific asset classes  Overlay strategy makes strategic allocations and adjusts asset class weights using derivatives

56.  Market prices explicitly describe the returns available (cash yield approximates future returns)  Relative expected returns reflect relative risk perceptions  Markets are rational and mean reverting