1
Q
Effective Investment Governance Models
A
- Express short-and long-term objectives.
- Allocate decision rights and responsibilities.
- Establish processes for developing the IPS
- Establish processes for developing and approving the SAA.
- Establish framework for reporting and monitoring progress toward objectives and goals.
- Periodically perform a governance audit.
2
Q
The Extended Portfolio Assets and Liabilities
A
- Extended Portfolio Assets: Is the present value of future income, pension income, intellectual property, royalties, inheritance, and minerals or resources
- Extended Liabilities: The expected present value of future expected consumption or payouts
3
Q
Human Capital vs Financial Capital due to Age
A
- When individual is younger human capital is high, financial capital is low
- When individual is older human capital is low, financial capital is high
4
Q
Types of Asset Allocation Approaches
A
- Asset-Only Approach
- Liability-Relative Based
- Goals Based
5
Q
Asset Only (AO)
A
- Making asset allocation decision based only on the investor’s assets on the balance sheet.
- Liabilities are not modeled.
- Relevant Risk Measures: The volaility and corelations of the portolfio returns.
6
Q
Liability Relative
A
- Accounts for the liability-side of the balance sheet
- Mainly for institution investors, but can be used by individual investors
- Designed to create allocation decisions for when a liability comes due
- Relevant Risk Measures: Not having enough assets in the portfolio when the liabilities come due
7
Q
Goals Based
A
- Asset allocation to sub-portfolio (mostly individuals).
- Common goals are retirement, college, charitable gifts, life-style expenses
- Each sub-portfolio will have its own unique asset allocation to meet a specific goal
- The sum of the sub-portfolios is the Strategic Asset Allocation (SAA)
- Potential risk not being able to meet or achieve the investor goal(s)
- Portfolio risk will be a weighted-average of each having its own probabilities associated with them
8
Q
What Constitutes an Asset-Class
A
- Homogenous: The asset should have similar attributes from a descriptive and statical perspective
- Mutually Exclusive: Asset cannot be classified in more than one asset class
- Diversification: An asset class should not be highly correlated
- Asset Classes should cover all possible investable assets as a group and should make up a preponderance of the world investable wealth
- Asset classes should contain a sufficiently large amount of liquid assets that has the capacity to absorb a significant fraction of an investor’s portfolio without seriously affecting the liquidity
9
Q
Strategic Asset Allocation (SAA)
A
The long-term strategic plan
Has to be Based on:
* Objectives
* Constraints
10
Q
Tactical Asset Allocation (TAA)
A
Is an active management strategy that uses a specific sub-asset class short-term deviation to exploit a specific opportunity in the market
Key Issues: cost benefit approach
* Need to incur additional trading and monitoring cost
* May incur capital gains taxes
11
Q
9 Steps Needed to Select a SAA
A
- Determine investors objectives, goals, what are they trying to achieve
- Determine the investors risk tolerance
- What is the investment horizon to be used to measure an investors risk requirement and tolerance
- What is the investor tax situation and/or constraints
- Select the asset allocation approach appropriate for the investor
- Specify the asset classes determine the CME
- Develop the potential asset allocation for the investor to consider
- Simulate the results to see if they meet the needs of the client
- Continue until the optimal allocation is determine
Note:
* It needs to monitored regularly to make sure it’s consistent with the client’s IPS.
* Any change in the long-term are incorporated back into the model for potential revision.
12
Q
Global Market Portfolio
A
- Represents a highly diversified asset allocation
- Serves as a baseline in an asset-only approach.
- Reflects the supply and demand across world markets.
- Investors can invest in a risk-free asset, a risky asset, and a combination between
- Once we institute the risk-free asset into the efficient frontier there will no longer be a curve linear anchor at the risk-free rate of return
- We can create capital allocation lines series anchored at the risk-free rate, then cut the original efficient frontier at different points
- The slope of any capital allocation line would be the Sharpe ratio
- Market portfolio: The highest part of the line tangent to the efficient frontier
13
Q
Types of Strategic Choices
A
- Indexing: Low costs, with some transaction costs (buy/sell, called, defaults). Follows a passive strategy.
- Enhanced Indexing: Cell matching primary risks factors but with fewer securities (in numbers)
- Full Active: Tracking error will increase, but also expected active return, can outperform the index
14
Q
Strategic Implement Choice
A
- Available investments.
- Scalability of active strategies.
- The feasibility of investing passively while incorporating client-specific constraints.
- Beliefs concerning market informational efficiency.
- The trade-off of benefits relative to costs and risks of active investing.
- The management costs, trading costs, and turnover-induced taxes in active investing
- Tax status
15
Q
Rebalancing
A
May be necessary under 2 conditions:
* Changes to the policy portfolio because of changes in an investor’s investment objectives and constraints, or in long-term capital market expectations.
* Adjusting the actual portfolio to the SAA because asset price changes have moved portfolio weights away from the target weights beyond tolerance limits.
16
Q
Rebalancing Approaches
A
- Calendar-based: Rebalances the portfolio to target weights on a periodic basis, such as quarterly.
- Range-based: Sets rebalancing thresholds (trigger points) around target weights.
17
Q
Corridor
A
“Rebalancing Range”
Wider:
* Transaction Costs
* Risk Tolerance
* Correlations with the rest of the portfolio
Narrower:
* Greater volatility
* Correlation
* Risk tolerance
18
Q
Mean Variance Optimization (MVO)
A
- Single period framework on the efficient frontier
- The objective is to maximize the return for a unit of risk (Sharpe Raito, MVO)
- Issues: might not be the best for multi-period rebalancing issues
- Does not take into account the liability approach
- Assume investors are risk adverse.
- Can be complemented it with Monte Carlo Simulation (MCS)
- A portfolio manager can start by using MVO and then use MCS to generate many different paths overtime
- MVO can lead to concentration portfolio with zero allocation to certain asset classes
19
Q
Efficient Frontier
A
- Curvy-Linear, should include all risky assets, but not the risk-free asset
- All portfolios on the line are considered efficient
- All analyst is based on the investor’s constraints
- To find the optimal point is to find the investors indifference direct (utility curves)
20
Q
What are Some of the Criticisms of MVO
A
- Garbage-In; Garbage-Out (GIGO): MVO is really sensitive to the inputs used
- Any portfolio on the efficient frontier is an efficient, but that portfolio is not a well-diversified portfolio
- Assumes all portfolios are normally distributed; it does not take into account skewness & kurtosis and portfolios that’s are not normally distributed
- Risk Diversification: Not diversified by the sources of risk (risk factors)
- Ignores liabilities
- Operates in a single period framework.
It doesn’t take into account:
* Interim cash flow
* Serial correlation of assets returns from one period to the next
* Rebalancing
* Taxes
21
Q
Black-Litterman Model
A
Estimation Error Specifically
* Fixes the problem with expected return and high sensitivity of MVO
* Allows for short-selling and negative inputs
* Takes into account the portfolio manager views which can adjust the portfolio
* Reserve optimization whereby MVO and the portfolio managers views are put together
* Can be used to calculate the market consensus expectations of returns
Items to Consider:
* Less sensitive to change in inputs
* Less likely to produce asset class concentration
22
Q
Resample MVO
A
- The major drawback to the efficient frontier is the sensitivity to any change in the inputs
- Simulation Approach: Using historical metrics and combined them with the CME
- This technique is a Monte Carlo Simulation (MCS).
- Will not be a smooth shape curve
- Levels above and below will have a distribution of different portfolios with different asset classes
- No single exact portfolio that will be optional, any average will be more stable than just one
23
Q
Advantage and Disadvantages of Resample MVO to Regular MVO
A
Advantage:
* Uses an average period creates an efficient frontier that is a lot more stable
* Better diversified than regular MVO which can have concentrated positions
* Can have an existing portfolio to see if the asset mix is within the range and is acceptable
Disadvantages:
1. Lacks sounds theoretical basis, there is no reason to say that an average will be better
2. A lot of the inputs are based on historical data which, can be lacking.
24
Q
Monte Carlo Simulation (MCS)
A
- Simulations will be ran 1000s of times and creates efficient portfolios at each different level of returns
- To address the limitations of MVO as a single period model and incorporate rebalancing and taxes in a multiperiod framework
- Try to explain the likelihood of an outcome to see what are the possibilities.
25
Illiquid Assets in the MVO Approach
Illiquid Assets are Difficult to be Included in the MVO Approach:
* Not many indexes that will track the illiquid investment
* If there is an index they are not consider to be able to passively invest in
* The risk-return characteristics of these investments will be very different
How to address the illiquid asset classes:
* Exclude the asset class when running the MVO
* You can include the asset class in MVO and model the inputs in your specific investments
* Use index that are highly diversified asset class as an input using MVO
26
Difference of Contribution of Risk
* **Marginal Contribution of Risk:** The change in the total portfolio risk as measured by standard deviation from a small change in the allocation to a specific asset class
* **Absolute Contribution to Total Risk:** Specific asset class contribution to the overall risk of the portfolio
27
Liability Relative Allocation
3 Approaches
1. Surplus Optimization Approach
2. 2-Portfolio Approach
3. Integrated Asset Allocation Approach
28
Surplus Optimization
* An extension of MVO where the efficient frontier is based on the standard deviation or volatility
* It is a measure of risk change in the value from the change in the liability
* We do the same approach as the asset only approach, but now add the liabilities
29
The Steps Involved in the Surplus Optimization Approach
* Select asset categories and determine the planning horizon.
* Estimate expected returns and volatilities for the asset categories, and estimate liability returns.
* Determine any constraints on the investment mix.
* Estimate the expanded correlation matrix and the volatilities.
* Compute the surplus efficient frontier and compare it with the asset-only efficient frontier.
* Select a recommended portfolio mix.
30
2 Sperate Asset Portfolio
**Partitions Assets into 2 Groups:**
1. Hedging Portfolio: Assets are expected to produce a good hedge to cover required cash outflows from the liabilities.
2. Return-Seeking Portfolio: Can be managed independently
**Things to Keep in Mind:**
* Most appropriate for conservative investors
* The idea is to use MVO to maximize the satisfaction or utility and to find the ideal return risk trade-off
* Popular with insurance companies, or pension plans
31
Limitations Sperate Asset Portfolio
1. Cannot be used if the funding ratio is <1; will be difficult to hedge the portfolio’s liabilities completely
2. Cannot be used when a true hedging portfolio is unavailable (earthquakes, floods, disasters).
32
Integrated Asset Allocation Approach
* Primary used by bank, insurance companies, and hedge funds that typically have short positions
* These companies have to make decision of the structure of their liabilities at the same time when they are making their asset allocation decisions
33
Goals-Based Approach
* Is really useful for individual investors.
* The overall portfolio needs to be divided into sub-portfolios.
* Both taxable and tax-exempt investments are important.
* Probability-adjusted and horizon-adjusted expectations are used.
* The minimum expectations are the minimum return expected to be earned over the investment horizon to achieve a given probability of success.
* The size/amount you need today is the present value of the future goal discounted at the expected rate of return.
34
Goals-based Asset Allocations have 2 Fundamental Parts
* **Creation of portfolio modules:** Are based on capital market assumptions and should cover a wide spectrum of the investment universe, across essentially all asset classes and risk factors.
* **Identifying clients’ goals and matching the goals to appropriate sub-portfolios and modules:** Considerations are placed on the urgency and/or priority, time horizon, success probability, liquidity, intra-asset class allocation, and risk-return trade-off.
35
Heuristic Approach
Experienced based techniques no real math involved
* 120 – Your Age
* 60-40: Equities to fixed income
* Endowment or Yale Model:
* Risk Parity: Focuses on risks not on expected returns
* Naïve diversification (1 ÷ N)
36
Inputs and Outputs of Regular and Reverse MVO
**Regular:**
* Inputs: Expected Returns, Covariance, and Risk Aversion Coefficient
* Outputs: Asset Allocations Weights
**Reverse:**
* Inputs: Asset Allocations Weights, Covariance, and Risk Aversion Coefficient
* Outputs: Expected Returns (using CAPM)
37
Change in Constraints
Relates to material changes in constraints, such as time horizon, liquidity needs, asset size, and regulatory or other external constraints.
38
Change in Goals
A change in an investor’s personal circumstances that may alter their risk appetite or risk capacity
39
Change in Beliefs
A change in the investment beliefs or principles guiding an investor’s investment activities. This could include a manager’s market perceived change.
40
Leveraged vs Unleveraged Portolfio(s)
* The leveraged strategic asset allocation offers lower expected volatility than the unleveraged allocation to achieve the required return.
* If no leverage is used, to achieve the required return you would use a combination of Portfolios.
* If leverage is used, a single Portfolio can be combined with borrowing to achieve rate required return. The resulting Sharpe ratio would be of that Portfolio which is higher than combined portfolios. This means the volatility is lower for the leveraged portfolio.
CFA Exam Level 3
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