Reading 3.4 Flashcards
Strategic asset allocation is
long-term target asset allocation based on investor objectives and long-term risk-return expectations
Tactical asset allocation is
making short-term portfolio decisions to change a portfolio’s systematic risks to generate alpha. Most investment managers also make tactical decisions
Modern portfolio theory (MPT), which was pioneered by the economist Harry Markowitz (Markowitz 1952), states that
Based on the principle of _____, MPT suggests that allocation choices in perfect markets are mean-variance efficient portfolios which means?
assets that are less than perfectly correlated can be combined to
maximize return for a given level of risk.
diversification
optimal portfolios that maximize expected return given a risk aversion level
To create a mean-variance efficient portfolio (under the MPT theory), investors do the following:
combine the risk-free asset and the market portfolio
Why is applying MPT to alternative investments is challenging?
What is the solution to dealing with the issue?
due to the lack of quality data
A “satisficing” approach is used (coined by the economist Herbert Simon) = searching through available alternatives until an acceptable (good enought) solution is identified
probability-weighted expected return & probability-weighted standard deviation of returns may be expressed as
Asset owners’ risk-return preferences may be stated in terms of their utility, which is measure of
satisfaction gained from investment wealth or return.
Utility function U(*) describes what?
An investor’s utility may be expressed as a function of wealth W as
the relationship that converts an investment’s wealth or return into the investor’s level of utility
U(W)
Expected utility is the ___
probability-weighted average utility over all possible outcomes.
An investor’s expected utility with two potential outcomes to wealth, W1 and W2, may be expressed as
Risk-averse investors (i.e., those who demand higher expected return to bear risk) have concave utility functions. What does it mean?
Risk-averse investors do not typically take risks on investments with ___
increasing at a decreasing rate
no expected payoffs
investment’s expected utility may be expressed in terms of its expected return μ and its variance of returns o2 (st dev) as:
assumed investor preferences are that
most investors dislike variance and kurtosis and like positive skewness
Expected UTILITY FUNCTIONS WITH HIGHER MOMENTS (formula)
Expected utility may be expressed using value at risk (VaR) as the risk measure instead of variance
The degree of risk aversion, may be expressed as the ratio of the optimal portfolio’s expected excess return to its variance, formula:
MEAN-VARIANCE OPTIMIZATION (MVO); The return Rp on a portfolio of N risky assets and one riskless asset may be expressed as:
Efficient Frontier is a graph of
Portfolios on the efficient frontier represent portfolios with the ____ for a given ____
expected returns and standard deviations of risk-averse investors’ optimal portfolios
highest expected return
standard deviation (SD)
In general, MVO does not generate ____
realistic weights
hurdle rate is the ____
The hurdle rate for a new asset may be expressed as:
minimum expected return that an asset must earn to add value to an optimal portfolio (to be included in the portfolio)
if an analyst overstates an asset’s mean return, then an optimization model’s
suggested weight for the asset is likely to be ___ than would be considered reasonable.
Alternatively, if the asset’s mean return is understated, other assets would be _____.
larger
largely omitted from the portfolio
The mean-variance optimization (MVO) process may be described as follows:
- The portfolio manager estimates the mean return and the variance and covariance of returns for all assets.
- The optimizer produces an extreme portfolio allocation (which is unrealistic) = Extremely large allocations are made to seemingly attractive assets with high mean returns and low return volatilities, and little or no allocations are made to seemingly less desirable assets with low mean returns.
- To generate more reasonable portfolio allocations, the portfolio manager subjectively adjusts the model by adding constraints or changing the inputs (e.g., mean return).
Accuracy of estimated variance and covariance measures can be improved using _____ data. However, this data is not available for most ____.
Furthermore, assets that lack ____tend to be illiquid, with reported prices/returns typically based on ____
higher frequency
alternative assets
high-frequency prices
appraisals
Anson (2016) empirically analyzes the effects of unsmoothing private equity and venture capital returns on asset allocation. He finds that unsmoothing results in:
1) considerably higher volatility estimates (twice those of smoothed returns)
2) considerably higher estimated return correlations of private equity and venture capital with equities, credit, and government bonds.
3) better estimates of higher moments (e.g., skew and excess kurtosis)
