Reading 12: Overview of Asset Allocation Flashcards
Strategic Asset Allocation
Strategic asset allocation analysis is usually done whenever the investor’s circumstances change significantly and is often done as frequently as yearly. It is based on long-run capital market conditions, and requires transactions to rebalance the mix periodically. It is typically a constant mix strategy. Refers to desired systematic risk (monitor and control).
Economic Balance Sheet
Target date funds alter the allocation toward risk as the investment horizon shortens and the required income generation increases. Within an economic balance sheet the extended portfolio assets and liabilities vary such that the appropriate asset allocation must adapt in an effort to meet this dynamic. This is similar to how target date funds are designed. Human capital decreases through time. The ratio of financial capital to human capital ideally should increase as an investor ages. Economic assets and liabilities includes the traditional accounting balance sheet assets and liabilities as well as extended portfolio assets and liabilities that are not included on traditional balance sheets.
Dynamic Asset Allocation
Dynamic asset allocation takes a multi-period view of the investment horizon while static asset allocation does not. Both dynamic and static asset allocation approaches consider more than one asset class.
Asset Classes
The asset classes used should explain a large part of portfolio return variability, and it should be easy to construct a bogey portfolio for each class. Heteroskedasticity refers to a non-constant variance of the error terms in a regression, which makes the regression model unreliable. Do not include two asset classes that are highly correlated (duplication of risk). Asset classes should be homogenous. Assets cannot be in more than one asset class. Asset classes cover all possible assets. Asset classes should hold sufficiently large percentage of liquid assets.
Risk Factor Asset Allocation
Risk factors describe the sources of risk for an asset class not the other way around. The objective of risk factors is to determine the systematic sources of risk of all asset classes and then construct an asset allocation around desirable exposures to these risk factors. Risk factors are often not investable (i.e., inflation). A multi factor model can be used.
Rebalancing
Rebalancing is part of managing risk but not necessarily part of the risk budgeting approach to portfolio management. Traditional rebalancing triggers include calendar (time), relative deviations from targets, and absolute deviations from target. Rebalancing rules are heavily dependent on the underlying liquidity of the assets and the associated cost of transacting and includes level of discretion (momentum).
Extended Portfolio Assets & Liabilities
Include PV of expected earnings (human capital), PV of pension income, PV of intellectual property royalties, PV of expected consumption, PV of future expected foundation payouts (institutional).
Approaches to Asset Allocation
Asset only: mean-variance optimisation (MVO) incorporate expected return, volatility, and correlation of asset classes. Objective is to maximise expected return per unit of risk. Only considers investors assets.
Liability relative: typically for insto investor with strict obligations. Focuses on surplus optimisation and ability to fund liabilities.
Goals-based: similar to liability relative approach but for individual investors where withdrawals are lifestyle goal (less obligatory). Includes sub portfolios with unique asset allocations.
Risk Concepts
Asset based: standard deviation, relative risk, downside risk. Monte Carlo can compliment mean-variance optimisation.
Liability based: risk of not being able to fund liabilities, standard deviation of surplus.
Goals based: weighted sum of risk attached to each goal.
Sub Asset Classes
Having too many can cause granularity. The sub asset classes can be used for tactical asset allocation. They will be more correlated.
Global Market Portfolio
Contains all available risky assets, minimises diversifiable risk, found on efficient market frontier by drawing a line from the risk free asset that is tangent to the efficient frontier (capital market line).
Optimal Width of Corridor
Correlations: higher correlated asset allocation will lead to less rebalancing (they move together).
Momentum: if trend will continue use wider, if it will revert to mean use tighter.
Volatility: higher volatility most likely causes for narrower widths to control risk but can cause more frequent rebalancing needs (argument for wider).
