Revised Asset Allocation

Question 1

What is investment governance?

Answer 1

This is the structure that is expected to ensure that assets are invested to achieve asset owners investment objectives within risk tolerances and constrains

Question 2

Draw the framework that connects the IPS, capital market expectations, and the SAA

Answer 2

Draw

Question 3

What are the three levels of investment governance structure?

Answer 3

1. Governing investment committee
2. Investment Staff
   3) Third party resources

Question 4

What are the 6 common traits that make an investment governance model effective?

Answer 4

1. Articulate long and short-term objectives (returns, liabilities, liquidity, etc)
2. Allocate decision rights and responsibilities among functional units - who does what? why?
3. Specify the process for developing and approving the IPS
4. Specify the process for development and approval of SAA - typically the investment committee
5. Establish a reporting framework - where are we now relative to goals? What value has been added?
6. Periodically audit - independent 3rd party

Question 5

What are the different elements of the IPS

Answer 5

1. Purpose
2. Objectives
3. Duties
4. Guidelines
5. Reporting

Question 6

What are the extended assets and liabilities listed on an economic balance sheet?

Answer 6

1. Human capital (PV of earnings)
2. PV of pension income
3. PV of expected inheritance
4. PV of future consumption

Question 7

What are the investment objectives of asset only, asset-liabilities, and goal based mandates?

Answer 7

Asset based typically MVO on the assets, does not consider liabilities. This goal is to maximize sharpe ratios.
Asset liabilities are typically using mean variance optimization including the correlation and values of liailities. The goal is to fund liabilities, MVO for excess
Goal based involves sub portfolios each with risk, time horizon, and other constraints. The goal is to maximize the probability of success for each goal.

Question 8

What are the relevant risk measures for asset based, asset-liabilitie based, and goal based strategies?

Answer 8

Asset - variance, downside risk (VaR, Sortino), monte carlo
A-L - risk of shortfall, volatility of cont
Goal based - overall risk of not achieving, overall portfolio risk

Question 9

What are the three super asset classes?

Answer 9

1. Capital assets (source of value)
2. Consumable or transformable - commodities
3. Store of value - currency, art, gold

Question 10

What are the three criteria for specifying asset classes?

Answer 10

1. homogenous within class
2. Mutually exclusive
3. Diversifying
4. Must be large, global, and widely investable
5. Capacity to absorb meaningful part of portfolio

Question 11

What are the risk factors that can describe equity investing? Fixed Income?

Answer 11

1. GDP growth
2. Volatility
3. Currency
4. Value
5. Liquidity
6. Momentum
7. Size
8. Inflation

Fixed Income
1. Inflation*
2. Capital structure
3. Volatility*
4. Currency*
5. Real rates
6. Convexity
7. Default risk
8. Duration
9. Liquidity*
More overlap means more correlation

Question 12

What are the steps to selecting an asset allocation?

Answer 12

1. Quantify objectives
2. Establish risk tolerance
3. Determine time horizon
4. Determine other constraints
5. Determine asset allocation approach
6. Specify asset classes and expectations
7. Develop range of choices for consideration
8. Test

Question 13

Why are risk factor models more relevant for liability driven mandates?

Answer 13

They have funding goals and hold more fixed income

Question 14

What is the difference between tactical and dynamic asset allocation?

Answer 14

tactical is short term, dynamic is longer term

Question 15

What are the strategic considerations for rebalancing strategies?

Answer 15

1. Transaction costs for different asset classes
2. Risk aversion makes for tighter rebalancing ranges
3. Less correlated assets will have tighter ranges
4. Do you believe in momentum?
5. Illiquidity
6. Derivative use
7. Taxes - more likely to rebalance on the downside

Question 16

What is the objective function for MVO?

Answer 16

Max utility U = E(r) - 0.005*lamda*Var
Find the asset class with the highest utility
Higher lamda will result in more conservative portfolios
Lamba = 0 means you are risk neutral
Lamba = 4 means moderately risk averse

Question 17

What is the global minimum variance portfolio?

Answer 17

This is the portfolio that has the highest slope on the efficient frontier

Question 18

What is the safety first criteria and what does it measure?

Answer 18

SF = E(r) - Lowest Required Return/SD
This measures (subject to z scores) the probability of hitting a goal

Question 19

What are the criticisms of MVO?

Answer 19

1. Very sensitive to changes in inputs
2. Concentration - could use reverse optimization or constraints
3. Investors care about more than mean and variance
4. Sources of risks may not actually be diversified (use factor instead)
5. Does not concern itself with liabilities
6. Single period framework

Question 20

What is reverse optimization?

Answer 20

This is similar to MVO but instead you solve for returns rather than weights. You would take starting weights, calculate Beta’s, use covariances with each other and find what the market is implying returns of each asset class would be.

Question 21

What is the black-litterman model?

Answer 21

This is a modified method of reverse optimization. You can specify the differences you see vs the return results generated by the reverse optimization and then use MVO to see how you should adjust weights.

Question 22

What is resampled MVO?

Answer 22

This is a monte carlo method where you actually simulate the efficient frontier and then average the results

Question 23

How can we include less liquid assets in the MVO process?

Answer 23

1. Optimize one section and reserve the other section for the illiquid asset
2. Include but attempt to model returns (factor based)
3. Include and use publically traded data to estimate returns (violates asset class exclusivity)

Question 24

What is the marginal contribution to total risk?

Answer 24

This is the marginal change in risk for a small chance in asset class weighting. This is the Beta (sensitivity of asset class to return in the portfolio) * Portfolio SD desired at that level

Question 25

What is the absolute contribution to total risk?

Answer 25

This is the actual contribution to risk. This is the weighting * marginal contribution to risk. Summed these will equal total volatility of the portfolio

Question 26

Based on the absolute contribution of marginal risk, how do you optimize asset class weightings?

Answer 26

You know that this is optimized when the Expected return of the asset - risk free weight/Marginal contribution to risk is equal across all assets. Summed, these will equal the sharpe ratio.

Question 27

What is the objective of risk budgeting in general?

Answer 27

The purpose is to efficiently allocation risk. For a given level of risk, you would want to construct a portfolio that achieves the maximum return.

Question 28

What are the different characteristics of liabilities?

Answer 28

1. Fixed vs contingent 2. Legal vs Quasi 3. Duration and convexity 4. Value of liabilities compared to size of org (under vs over funded) 5. Factors driving value of future liability 6. Timing considerations 7. Regulations

Question 29

What is the basic premise of surplus optimization?

Answer 29

This is an extension of MVO where you take all assets over liabilities and optimize.

Question 30

What is the utility function for asset liability portfolios and how does it differ from traditional utility curves?

Answer 30

The utility function is normal, however expected return is measured as the expected return on surplus (Change is surplus or deficit)/MV assets beg. period.

Question 31

What would we expect the difference in optimized portfolios to be between asset based vs A/L based for a low level of risk?

Answer 31

They would be much different, as the A/L will be overweight any hedging assets. Higher risks will look very similar

Question 32

What is the basic premise of a hedging/return seeking portfolio? What are the two types?

Answer 32

This is a two portfolio approach where you create one hedging portfolio and the rest you will invest in a return seeking portfolio. 1. Type one is the basic which you would use if you have a surplus, are very conservative, or have a liability that could wipe out the firm. you would fully hedge the liabilities and and only invest excess 2. type 2 is the variant where you only partially hedge the liabilities. You would use this if you are not conservative, have a current deficit, or have a massive firm that can take on more risk You can make this dynamic if you choose

Question 33

What is the basic premise of an integrated A/L approach?

Answer 33

This is typically used by banks, insurance companies, where the level of liability is directly affected by the type of assets.

Question 34

How does being a small firm affect your investment opportunities?

Answer 34

1. You may not meet minimum investment requirements | 2. You may not have governance capacity or enough knowledge

Question 35

How does being a big firm affect investment opportunities?

Answer 35

1. your desired minimum investment may be too big for managers to handle

Question 36

How do liquidity constraints in the real world affect asset allocation decisions?

Answer 36

1. The liquidity needs of asset owners will vary by goals, time horizon, and regulatory factors 2. The liquidity characteristics of assets may not align with your goals

Question 37

How does time horizon in the real world affect asset allocation decisions?

Answer 37

1. Changing human capital | 2. Changing character of liabilities

Question 38

What should cause you to revisit the SAA?

Answer 38

1. Changes in goals 2. Changes in constraints (time horizon, liquidity, etc) 3. Changes in beliefs

Question 39

What are the two approaches to TAA?

Answer 39

1. Discretionary | 2. Systematic

Question 40

What are the behavioural biases you need to deal with in AA?

Answer 40

1. Loss aversion - scared to stick to SAA during hard times 2. Illusion of control - excessive trading, leverage 3. Mental accounting - goals based will actually incorporate 4. Representative bias - return chasing 5. Framing bias - how do you present risk to a client? 6. Availability bias - home bias