Asset Allocation Flashcards
Explain the function of strategic asset allocation in portfolio management.
Strategic asset allocation combines capital market expectations with the investor’s risk, return, and constraints (from the IPS). Strategic asset allocation is long term in nature, and the weights are called targets and the portfolio represented by the strategic asset allocation is a policy portfolio, or target portfolio, or benchmark.
Discuss the role of strategic asset allocation in relation to specifying and controlling the investor’s exposures to systematic risk.
Each asset class has its own quantifiable systematic risk, and strategic asset allocation is a conscious effort to gain the desired exposure to systematic risk via specific weights to individual asset classes. Each asset class represents relatively similar investments (e.g., long-term corporate bonds) with similar systematic risk factors. Exposure to specific asset classes in specific proportions enables portfolio mangers to effectively monitor and control their systematic risk exposure. In other words, strategic asset allocation reflects the investor’s desired systematic risk exposure.
Compare strategic and tactical asset allocation.
Tactical asset allocation is the result of active management wherein managers deviate from the strategic asset allocation to take advantage of any perceived short-term opportunities in the market. Hence, tactical asset allocation introduces additional risk, which should be justified by additional return, often called alpha.
What is dynamic asset allocation?
Dynamic asset allocation takes a multi-period view of the investment horizon. It recognizes that asset (and liability) performance in one period affects the required rate of return and acceptable level of risk for subsequent periods. Static asset allocation ignores the link between optimal asset allocations across different time periods. Investor who undertake the asset-liability approach to strategic asset allocation typically prefer dynamic asset allocation to static asset allocation.
Asset classes have been appropriately specified if:
- Assets in the class are similar from a descriptive as well as statistical perspective.
- They are not highly correlated so they provide the desired diversification.
- Individual assets cannot be classified into more than one class.
- They cover the majority of all possible investable assets.
- They contain a sufficiently large percentage of liquid assets.
Using mean-variance analysis, how would you decide whether to include an additional asset class in an existing portfolio?
Using a decision rule based on the the new investment’s Sharpe ratio, the current portfolio Sharpe ratio, and the correlation of the returns on the two. If the Sharpe ratio of the new investment is greater than the Sharpe ratio of the current portfolio multiplied by the correlation of the new investment’s returns with the portfolio’s returns, adding the investment to the portfolio will improve the portfolio Sharpe ratio.
What does empirical research suggest about the standard deviation of currency vs. the standard deviation of stocks.
The standard deviation of currency is only about half the standard deviation of stock prices. It is the less important determinant of risk.
Compare the volatility of an investor’s position in non-domestic assets with the sum of the volatility of the local market return (LMR) and the local currency return (LCR)
The correlation of LMR and LCR is generally less than +1.0. Therefore, the volatility of the investor’s position will be less than the sum of the volatility of the LMR and LCR. The more the correlation of LMR and LCR approach -1.0, the lower the volatility of the investment for the investor.
What are the cost in international assets?
- Transaction cost.
- Tax witholding may not be fully offset by tax treaties.
- Free-float can be an issue.
- Inefficient market infrastructure.
What may explain the rise in correlation with international assets during financial crises?
- Markets becoming less segmented and more integrated.
2. Industry factors becoming more important than country factors in determining a company’s risk and return.
What are the benefits of international diversification?
- Foreign markets could be undervalued and, thus, offer better expected returns.
- While the investor’s home market may have had the best returns in the past, that is not a reliable indicator of future returns.
- Even if correlations rise in the short run during crises, the long-run benefits of diversification can remain.
- Correlations among bond markets tend to be lower than among equity markets. Adding international bonds to domestic-only portfolios can be particularly beneficial in reducing risk for risk averse investors.
What is one explanation against the notion that correlations rise during financial crises.
Part (but not all) of the rising correlation can be explained away by technical issues in the way correlation is calculated; the mathematics of calculating correlation bias the statistic upward as standard deviations rise.
What are the special considerations of emerging market investing?
- Investability: Liquidity & free float can be limited.
- Non-normal return distributions which are inconsistent with mean-variance assumptions.
- Strong economic growth may not benefit existing shareholders: Share dilution, high share prices, weak corporate governance, opportunities allocated by the government.
- Contagion.
- Currency devaluation.
- Inefficient markets
Explain the effects on share prices, expected returns, and return volatility as a segmented market becomes integrated with global markets.
- Equity share prices rise: Investability increases allowing capital inflow and declining stand alone risk.
- Expected returns increase as capital flows into the market but then declines after the initial inflow to be consistent with the now higher stock prices and lower risk..
- Long-run volatility should decline as the markets become more efficient.
- Diversification benefits decline as correlation and covariance with the world market increases.
- Market microstructure and efficient improve.
- Capital cost fall with high stock prices and lower risk.
What is the mean-variance frontier?
The outer edge of a graphical plot of all possible combinations of risky assets.
What is the efficient frontier?
The portion of the mean variance frontier that contains portfolios with the highest expected return at each level or risk.
What is the mean-variance optimization approach (MVO)?
MVO is a static 1-period model and assumes that inputs will remain constant over time. MVO identifies at each level of return the portfolio with the lowest standard deviation and the asset allocation for that portfolio. The efficient frontier then starts with the portfolio with the lowest standard deviation and rises to the right.
Is there a risk-free rate and how does it lead to the concept of CALs and CMLs?
Over a single, discrete time period it is generally possible to identify a risk-free asset with a know return, zero standard deviation, and correlation to other asset returns of zero. The CAL is a line between the risk-free asset and the tangency portfolio (portfolio with the highest Sharpe Ratio) while the CML is the line between the risk-free asset and the market portfolio of risky assets. If an investor can borrow and lend at the risk-free rate the investor can construct any portfolio on the CML and these optimal portfolios dominate the otherwise optimal portfolios on the efficient frontier (EF).The market portfolio is the only portfolio common to the CML and EF.
What are the conceptual and practical problems with using the CML to construct an SAA?
- For the multiple and often ongoing time periods of a typical portfolio there is not risk-free asset. The single period government security will have a changing return over time and a standard deviation of the return.
- Even if a risk-free asset existed for a client concerned only with a single period, there are practical problems if the client is seeking a return higher than the market; the CML would require borrowing on an ongoing basis to take a leveraged position in the market. Generally borrowing creates risk and imposes restrictions that are unacceptable for most investors as a long-term strategy.
What is a significant drawback to generating an efficient frontier through traditional mean-variance optimization?
The sensitivity of the frontier to changes in the inputs. Especially since the inputs themselves are estimates.
What is the resampled efficient frontier (REF)?
A simulation approach utilizing historical means, variances, and covariances of asset classes, combined with capital market forecast. The resampling technique is based on a Monte Carlo simulation that draws from the distributions to develop a simulated efficient frontier. Because the simulation is run thousands of times, the efficient portfolio at each return level, and hence the resulting efficient frontier, is the result of an averaging process. Rather than a singe, sharp curve, the resampled efficient frontier is a blur. There can be many different combinations (by varying weights) of a given set of assets that will yield the same expected return and standard deviation, so the computer is asked for many sets of mean-variance efficient portfolios (a resampled efficient frontier) using the same set of returns and standard deviations. The average weight for each asset are used to represent the weights of the asset in the resampled efficient frontier.
What advantages does resampling have over the traditional MVO?
- It utilizes an averaging process that generates a more stable efficient frontier. Small changes in inputs only result in small changes in the resampled efficient frontier.
- Portfolios generated through resampling tend to be better diversified.
- Because there are multiple portfolios on the resampled efficient frontier for a level of risk it is possible that the current portfolio lies within the boundaries of what is acceptable leading to less portfolio turnover and lower transaction costs.
What are the disadvantages of the resampled efficient frontier?
- Its lack of a sound theoretical basis. There is no theoretical reasoning to support the contention that a portfolio constructed through resampling should be superior relative to another constructed through traditional mean-variance analysis.
- The inputs are often based on historical data that could lack current relevance.
Give a general description of the Black-Litterman model (BL).
It starts with the weighs of asset classes from a global index. Applying a Bayesian process, the manager increases or decreases the weights based upon her views of expected asset class returns and the strengths of those views. Unconstrained allows for short sales (negative weights).
