T3 Asset Allocation

Question 1

What are the FOR arguments supporting AAA?

Answer 1

1. mispricing in the mkt (short run Rs don’t reflect LT risk prems, comes from mkt participant’s uncertainty re: many variables e.g. growth and inflation in Aus and global economy, commodity prices, currencies, govt spending, corporate earnings growth, tax systems, regulatory requirements etc. );

2. overreaction (knee-jerk sharp sell off risky assets, correction at a future date);

3. expectations - mkt participant’s mere interpretation of a situation can drive mkt movement e.g. bond price falls (expect higher bond yield) due to inflation scare after data release projecting strong economy growth.

Question 2

Which 3 inputs will always be on the horizon when estimating pf E(R) and E(risk)?

Answer 2

1. Expected mean
2. Expected volatility
3. Correlation bewteen asset classes.

Normal distribution of asset class Rs are assumed.

Question 3

What is asset modelling and what is asset-liability modelling?

Answer 3

Asset modelling involves no explicit liabilities, investment streategy can be developed solely on asset modelling.

Whereas asset-liability modelling is appropriate where the fund has explicit liabilities, and an asset-liability model is needed to test how investment strategy impacts the fund’s net position over a specific time period.

Question 4

How does inflation generally impact Rs on asset classes?

Answer 4

Generally, rising inflation reduces purchasing power of investments. So Pf must beat inflation over med-long term. In terms of inflation impact:

1. High inflation causes PE ratio to contract as investors would demand higher compensation to offset the high inflation impact and associated investment risk.
2. PE also contracts if inflation is too low (1-2%) as this indicates the economy is heading for recession, causing investors to lose willingness to pay a high price for company earnings.
3. high inflation causes govt to raise interest rate to combat the impact of high inflation. As a result, the cost of debt capital for companies rises and company earnings fall due to the higher cost of capital.
4. When inflation falls from high to normal, PE ratio and company earnings rise and shares generally perform better.
5. Falling inflation are best for bonds as bond ylds and interest rates fall with inflation fall, causing bond prices to rise as a result.

Question 5

Historically, higher long-term Rs come with the cost of higher volatility. However, longer the investment time horizon, smaller the probability of negative Rs. This is not always true, explain why?

Answer 5

Because effect of exchange rate and gearing introduce additional uncertainty/volatility to Rs even if the investment time horizon is very long.

Question 6

What generally determine(s) the method for AAA?

Answer 6

Generally, we need to assess E(R)s from various asset classes prior to performing AAA. This can be quantitatively structured or derived from judgemental exercises by committee or individual professionals, subject to investor’s time horizon for holding investments, manager’s styles (topdown/bottomup/both). Different managers make diff AAA decisions.

Question 7

What % of pf does an institutional investor typically allocate to Alternatives? And what are the general benefits of investing in Alternatives?

Answer 7

15-20%; Alternative as an asset class is generally expected to produce higher R with lower corr to traditional assets.

Question 8

What factors essentially help us decide if a particular SAA as a crucial part of an investment strategy will likely achieve investment objectives?

Answer 8

Expected risk and expected return for each asset class under consideration.

Question 9

3 main points that make SAA the determinant of the long term risk and return characteristics of a portfolio

Answer 9

1. SAA accounts for approx. 80% of the fund Rs
2. Can be regarded as a risk-control measure
3. Forms part of the pf investment strategy

Question 10

SAA has a benchmark AA for each asset class. What is a typical tolerance range per asset class?

Answer 10

+/- 2-10%

Question 11

Describe the general sequence of steps to carried out in constructing a portfolio?

Answer 11

1. Determine the AA that aligns with long term risk and return objectives
2. Determine investment management arrangement which may involve selecting external investment managers and should reflect if the pf is to be passively or actively managed
3. Select actual investments. Note large instituional investors with in-house investment teams save fees by bypassing investment managers and invest directly into assets.
4. Implement AA. This is no set and forget scenario. Tolerance bands will be set for each asset class.
5. Finally, AA is to be reviewed annually or preferably quarterly as investment performance is monitored. Objectives and strategies are reviewed 1-3 years to ensure they remain suitable to the fund’s circumstances. Should the objectives change, AA will be reviewed and changed accordingly.

Question 12

What are the 5 main approaches to calculating Expected Asset Returns? Explain each briefly.

Answer 12

1. Use economic and financial variables - it’s a process of forecasting the values of economic and financial variables in order to derive expected returns of sectors and asset classes. Difficult to achieve consistency and accuracy.
2. Use historical averages - using the backward looking performance data can be helpful for identifying irrational exuberance and unwarranted pessimism to unearth investment opportunities. However, history doesn’t necessarily repeat itself
3. Work out implied future returns by current market prices using Gordon (constant growth model) - assumes long term trend in both the CF (divs, coupons, rent) and grwoth rate of CF (note: growth rate g can be estimated using the nominal GDP growthe rate assuming business grows at the same rate as the overall economy. However, for some periods, the ratio of corporate profits to GDP varies.
4. Work out implied future returns using the Bogle model - the model for equity return forecasting is given by current div yld + long term growth rate of the divs + [( reversion PE/current PE ) to the power of 1/n (n=the time to reversion usually 10 yrs) -1]
5. Use the risk premium approach. - start with Rf (inflation prem + duration/term prem i.e. forgoing current consumption in exchange for future consumption) then add one or more risk prems aka building blocks to derive E(R) for each asset class: default/credit risk prem, illiquidity prem, equity risk prem (ERP), style (value, size, low volatility etc.) prem . The main idea is that investor would expect to be compensated for extra risk taken (interest rate risk, credit risk, illiquidity risk, equity risk, style risk…)

The risk premium approach can be used to check if current investment Rs offered by the market is reasonable compensation for the risks involved.

Question 13

What else must managers assess apart from economic inputs to perform AAA?

Answer 13

Key market indicators are also inputs to AAA. Market indicators affect equities, FI, REITs, and other asset classes in how they react to the economic outlook, and hence how AAA decisions should be made e.g. global credit crisis causing an upheaval in equity mkts.

Question 14

What are the arguments AGAINST AAA?

Answer 14

There has been strong evidence the average manager does not add val through AAA. Even the ones that did, there is **no conclusive evidence if that’s due to skill rather than luck.**

Question 15

What really drives a PF’s volatility?

Answer 15

Pf Beta (weighted average of beta of each asset class in the Pf). Diversification (adding alternative growth assets like infrastructure, hedge funds) may increase E(R) but the PF volatility is more or less unchanged if inclusion of new assets had little impact on the overall PF beta.

Question 16

Name 6 traditional asset classes.

Answer 16

Cash/cash equivalent
fixed income
equity - large and small cap
property - listed and direct
commodity
alternative - can be either growth or defensive, and covers infrastructure, hedge funds, private equity

Question 17

What are the 8 economic inputs a manager needs to assess in order to perform AAA?

Answer 17

1. Economic growth - measured by GDP which averages expenditure, production and income
2. Inflation expectations - affects fixed income (e.g. bond) and property mkts
3. Currency outlook - affects international equity and domestic coys with offshore earnings.
4. Monetary policy - setting short term interest rates which affects whoever that borrows e.g. equity mkts where firms are heavily geared
5. Fiscal policy - supply of securities, tax changes - impacts equity, FI and property.
6. External factors - offshore security holders/owners impacting pricing of the foreign-owned in aus mkt)
7. Balance of payments - e.g. aus running acct deficit -> outstanding foreign debt impacting bond and forex mkts.
8. Forthcoming events - elections, financial events, budgets etc.

Question 18

What is Return-to-Risk ratio?

Answer 18

By way of example, let’s say E(R) = 9.8% , stdev = 5.5%, then ratio = 9.8/5.5 = 1.78 this is the z-score corresponding to a p-value 0.0375, meaning return will be negative about once every 1/0.0375 = 27 yrs

Question 19

What is the role of an active asset allocator/market timer?

Answer 19

S/he must determine the best mix, based on investor’s/fund’s objectives and the inv oppo avail., balancing incremental return against incremental risk relative to a strategic benchmark.

If adding new alternative asset classes, must be strategic in nature and provide a specific level of the new classes.

Question 20

How do you determine how much to deviate from neutral position for each asset class in the AAA process?e.g. underweight/overweight equity

Answer 20

Firstly forecast E(R)s from asset classes based on economic inputs and key mkt indicators. Relative Rs estimated are valuation signals because they signal relative values the asset classes may bring to pf. But if scenario testing (changing key assumption values) lead to drastically diff AA in worst and best scenarios, then AAA faces some risk, forecast of asset class E(R)s may have to be reviewed prior to positioning the pf. So scenario-testing lets you know how confident you can be with the E(R) forecasts, hence you’d know how much to deviate from neutral position for each asset class in the AAA process.

Question 21

Describe the general process of asset-liability modelling?

Answer 21

Liabilities are projected for a number of years e.g. 20 yrs. Stochastic modelling is used (where variables like wage growth, interest rates, inflation, asset returns are considered randomly distributed). Probability of outcome is estimated within a forecast to predict what conditions are like under diff situations e.g. very high interest rates. Asset-liability modelling then brings asset and liability together to simulate how the pf’s financial position evolves year after year into the future.

Output of this process is usually a graph. Outcomes are compared under diff trial PFs. Through elimination, the PF promising set of outcomes that most likely meet client’s objectives is chosen. This PF will then be sensitivity-tested (to see how PF changes with any change in the modelling assumptions). Then this PF becomes the basis for long term inv Strat for the fund.

Stochastic modelling project probability distributions of A and L of the fund based on stochastic Inv Rs and inflation rates; usually at least 1000 simulations to be performed . Once the probability distributions of As and Ls are created, estimating risk of failing inv objectives is manageable.

Question 22

What is the difference b/w Active Management and AAA?

Answer 22

Active management is seeking excess return relative to a benchmark within an asset class like equity; active AA is dynamically tilting between asset classes to take max advantage of short term mkt movements considering perceived investment outlook and investor’s/fund’s predefined inv obj., position and ranges.

Question 23

What percentage of a normal distribution falls within -1 x stdev ~ +1x stdev?

Answer 23

2/3 (so you can say 2 out of 3 years, the E(R) will be between mean-std and mean+std)

Question 24

What are the shortcomings of MPT framework/mean-variance optimisation to decide on AA?

Answer 24

mean-variance optimisation requires judgemental exercise/subjective decisions projecting E(R)s, volatilities and corrs that feed into the model, even in the presence of historical data, so if used sensibly mean-variance optimisation can set appropriate AA. However the shortcomings of this framework are:

• optimal asset weightings can be very unstable. Can impose high transaction costs or constrain weightings to a set of benchmark weightings to stabilise the optimal pf, but it’d limit the usefulness of the model results.
• symmetrical definition of risk not always appropriate (hardly anyone cares about upside risk, right?)
• easy to work with when allocation is made to asset classes instead of securities as there are about 2000 listed equities in Aus only which will make the optimisation process computationally expensive and cumbersome.
• Var and Cov are not stable over time
• Data only avail for historical risks and returns whereas MPT framework uses E(R) and E(risk)
• no data for newly listed secs.
• Risk is not only about volatility, there is also risk of capital loss. Buying cheaper shares (or value-investing, as opposed to buying over-priced shares) reduces risk of capital loss, but share price falls come with volatility rises, so allocating more to cheaper shares doesn’t necessarily reduce pf volatility, might even increase it.

Question 25

What are the limitations of asset-liability modelling?

Answer 25

The assumptions (re: risk and return on asset classes, corrs) are the limitation of asset-liability modelling. Nevertheless, the asset-liability modelling process provides insight into how objectives and corresponding strategies are set.

Question 26

What are the main points to consider when deciding if to add assets into the mix as part of a pf investment strategy?

Answer 26

The if/not decision depends on:

1. the availability of the market in the assets
2. skills of the manager in managing these assets
3. the ability to value the asset accurately
4. the availability of a right market index to measure asset performance against

Question 27

What is the typical frequency of review for SAA?

Answer 27

SAA is typically reviewed annually unless there are some major circumstantial changes that require more frequent/early review.