CFA III SS 8 Asset Allocation

  1. Dynamic vs static asset allocation
    • Dynamic: risk and return in one period affects performance in subsequent periods; difficult and costly; preferred for ALM
    • Static: ignores correlation among periods
  2. Behavioral biases associated with asset allocation
    • loss aversion
    • mental accounting
    • fear of regret
  3. Difference in calculating individual vs institutional return requirement
    • individual has shorter time horizon (usu) so can use additive
    • for institutional or longer term horizons, multiply (1+infl)(1+spend)(1+mgmt fees)
  4. Investors utility from asset mix
    • Image Upload 1
    • Note: variance, not standard deviation
    • equation is for whole percentages
    • if use decimals, including std dev in decimal form, change to 0.5
    • A = investors risk aversion score from 1-10, 1-3 is low risk aversion, 7-10 is high
  5. shortfall risk
    • semivariance
    • target semivariance
    • shortfall risk: risk of exceeding a maximum acceptable dollar loss
    • semivariance: variance calculated using only returns below the expected return
    • target semivariance: semivariance below some target minimum return (as opposed to expected return)
  6. Roy's safety first measure
    • Image Upload 2
    • Rmar = minimum acceptable return
    • IF Rmar < Rf, use Rf
  7. Five criteria for an asset class
    • 1. Assets are homogenous with high positive correlation
    • 2. Asset classes are mutually exclusive
    • 3. Asset classes are diversifying with low correlation
    • 4. The classes include most of the world's investable assets
    • 5. Asset classes are sufficiently liquid to allow investment
  8. Determine if an asset class will add value to the portfolio
    if Image Upload 3 AND asset is permissible by the investor's constraints, then asset should be added
  9. Risks of international investments
    • Currency
    • Home country bias
    • Political
    • Costs - less liquid; higher transaction costs; free float (market cap greater than investable shares); lack of information; infrastructure and facilities create high clearing and custody fees
    • Contagion - correlations are higher in a crisis, when diversification is most needed; could use two correlation matrices, one for normal periods and one for crisis
  10. Integration of markets pros and cons
    • Pros: higher capital flow into market could drive up prices; beta becomes the risk rather than standalone risk, which is usually higher; volatility declines; lowers cost of capital, increasing prices and liquidity
    • Cons: decreases diversification benefit
  11. Six approaches to asset allocation
    • 1. mean-variance optimization (MVO)
    • 2. resampled efficient frontier
    • 3. black-litterman
    • 4. monte carlo simulation
    • 5. asset-liability management
    • 6. experienced-based 
  12. mean-variance optimization description and cons
    • E(r), stnd dev, and correlation are estimated, then put into a model to optimize risk for each return level - aka efficient frontier
    • Can be unconstrained (allow short sales) or constrained (only positive weights
    • Constrained is more practical as unconstrained can lead to strange/unrealistic weights
    • Cons: frontier is unstable - highly sensitive to inputs; maintaining weighting is costly
  13. resampled efficient frontier definition; pros and cons
    • like MVO, but inputs have associated probabilities and run through monte carlo
    • efficient frontier is more like a blur
    • optimal allocation for a single resampled portfolio is the average of possible allocations
    • Pros: generates more stable asset allocations; addresses inability to know true input values
    • Cons: no statistical rationale for the process; historical initial data may not be indicative of future values
  14. black-litterman definitions; pros and cons
    • manager inputs global asset weights and covariances, and reverse optimizes for implied returns by asset class
    • manager can adjust returns based on his outlook on the economy
    • final results can be put into an MVO model, or start with the global portfolio and adjust weights based on views
    • Pros: by starting with global portfolio, generally produces well diversified portfolios; reduces bias input as returns are anchored to current returns
    • Cons: complex and uses historical values that may not reflect future performance
  15. Monte carlo pros and cons
    • Pros: overcomes the static nature of MVO; used for ALM analysis
    • Cons: complex; expensive; dependent on quality of inputs
  16. ALM definition; pros and cons
    • uses MV analysis to optimize growth of surplus in relation to volatility of surplus
    • surplus = present value assets (PVA) - PVL
    • plot efficient frontier of surplus with far left point being Minimum Surplus Variance (MSV)
    • vertical axis of efficient frontier graph is (PVA-PVL), horizontal is standard deviation
    • Pros: considers allocation of assets with respect to liabilities; can assess probability of meeting liabilities
    • Cons: estimation bias; must be incorporated with another approach (ex monte carlo) to address multi-period concerns
  17. experienced based technique three heuristics; pros and cons
    • Use heuristics, such as
    • 1. Long time horizons increase ability to bear risk
    • 2. Neutral allocation for the average investor is 60/40
    • 3. Subtract investors age from 100 to determine preferred allocation to equities
    • Pros: generally consistent with more sophisticated techniques; simple and cheap
    • Cons: not based on sound investment theory; allocation rules may be too simple for some investors
  18. Corner portfolio theorem (no Rf)
    • use small number of corner portfolios to approximate the efficient frontier
    • only applies for sign constrained portfolios
    • corners are when the weight of an asset go to or from 0 as move from left to right along efficient frontier
    • linear combination between corners for desired return, and linear combination to determine final portfolio standard deviation
  19. Addition of Rf to corner portfolio theorem
    • Create capital allocation line (CAL) between Rf and portfolio with highest Sharpe ratio
    • CAL dominates all other portfolios, other than the tangency portfolio
    • Note must be able to short Rf to gain higher return than tangency portfolio
  20. Tactical Asset Allocation
    Deviate from the optimal allocation to take advantage of mispricings and add alpha
Card Set
CFA III SS 8 Asset Allocation