CFA 2018 r16 introduction to asset allocation

Level III Introduction to Asset Allocation www.ift.world Graphs, charts, tables, examples, and figures are copyright 2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Contents and Introduction Introduction Asset Allocation: Importance in Investment Management The Investment Governance Background to Asset Allocation The Economic Balance Sheet and Asset Allocation Approaches to Asset Allocation Strategic Asset Allocation Implementation Choices Rebalancing: Strategic Considerations www.ift.world 2 Asset Allocation: Importance in Investment Management Identify and articulate asset owner’s objectives Document objectives and constraints in the IPS Identify changes in economic balance sheet, objectives and constraints Structure Portfolio Strategic asset allocation Active risk budgets Manager selection Security selection Execution of portfolio Develop capital market expectations for the planning horizon Monitor prices and markets Evaluate progress towards achieving objectives and compliance with IPS Investment Governance www.ift.world 3 The Investment Governance Background to Asset Allocation • Investment governance is the structure which helps ensure that assets are invested to achieve the asset owner’s investment objectives within the asset owner’s risk tolerance and constraints ▪ Includes organization of decision-making responsibilities and oversight activities ▪ Investment actions must comply with laws and regulations • Good governance  good investment performance This section covers: Governance Structures Articulating Investment Objectives Allocation of Rights and Responsibilities Investment Policy Statement Asset Allocation and Rebalancing Policy Reporting Framework The Governance Audit www.ift.world In this reading, governance structures are discussed in the context of defined pension benefit plans; however, the lessons learned here also apply to other types of investors 3.1 Governance Structures • Governance and management are separate but related functions ▪ Governance: clarify the mission, create a plan, and review progress ▪ Management effort is focused on outcomes: execution of the plan to achieve agreed-on goals • A common governance structure in an institutional investor context will have three levels 1) governing investment committee 2) investment staff and 3) third-party resources Effective governance models perform the following tasks: Articulate the long-term and short-term objectives of the investment program Allocate decision rights and responsibilities among the functional units in the governance hierarchy effectively, taking account of their knowledge, capacity, time, and position in the governance hierarchy Specify processes for developing and approving the investment policy statement that will govern the dayto-day operations of the investment program Specify processes for developing and approving the program’s strategic asset allocation Establish a reporting framework to monitor the program’s progress toward the agreed-on goals and objectives Periodically undertake a governance audit www.ift.world 3.2 Articulating Investment Objectives Long-term and short-term objectives clarify what an investor is trying to achieve and give context to the return requirement • Determine and communicate risk tolerance • Consider cash inflows and outflows characteristics • Consider liquidity needs • Find the best risk-return trade-off, given constraints and risk tolerance 3.3 Allocation of Rights and Responsibilities • Rights and responsibilities necessary to execute the investment program are generally determined at the highest level of investment governance • Resource availability  scope and complexity of investment program • Individuals must have the necessary knowledge and expertise • Next slide reproduces Exhibit 2: Allocation of Rights and Responsibilities www.ift.world Investment Activity Investment Committee Investment Staff Third-Party Resource Mission IPS Asset allocation policy Craft and approve Approve Approve with input from staff and consultants Delegate to investment staff; approval authority retained for certain service providers n/a Draft Draft with input from consultants n/a Consultants provide input Consultants provide input Research, evaluation, and selection of investment managers and service providers Consultants provide input Delegate to outside managers, or to staff if sufficient internal resources Execution if assets are managed in-house Execution by independent investment manager Investment manager and other service provider selection Portfolio construction (individual asset selection) Monitoring asset prices & portfolio rebalancing Risk management Delegate to staff within confines of the Assure that the sum of all sub-portfolios equals the desired overall portfolio investment policy statement positioning; approve and execute rebalancing Approve principles and conduct Create risk management infrastructure oversight and design reporting Consultants and custodian provide input Investment manager manages portfolio within established risk guidelines; consultants may provide input and support Consultants and custodian provide input Investment manager monitoring Performance evaluation and reporting Oversight Ongoing assessment of managers Oversight Evaluate manager’s continued suitability for assigned role; analyze sources of portfolio return Consultants and custodian provide input Governance audit Commission and assess Responds and corrects Investment Committee contracts with an independent third party for the audit www.ift.world 3.4 Investment Policy Statement The investment policy statement (IPS) is the foundation of an effective investment program • Introduction • Statement of investment objectives • Investment constraints • Duties and responsibilities • Investment guidelines • Frequency and nature of reporting 3.5 Asset Allocation and Rebalancing Policy • IPS should contain ‘general orienting information relevant to rebalancing’ • IPS should specify who is responsible for defining the rebalancing policy www.ift.world 3.6 Reporting Framework Reporting should allow overseers to evaluate progress of investment program; it should address : • Where are we now? • Where are we relative to the goals and objectives? • What value has been added or subtracted by management decisions? Reporting framework should address performance evaluation, compliance with investment guidelines, and progress toward achieving the stated goals and objectives Benchmarking, management reporting, governance reporting 3.7 The Governance Audit • Ensures that the established policies, procedures, and governance structures are effective • Should be performed by an independent third party • Auditor examines fund’s governing documents, assesses the capacity to execute effectively, and evaluates the existing portfolio for its “efficiency” given the governance constraints • Good governance seeks to avoid decision-reversal risk www.ift.world Example 1: Investment Governance, Case In January 2016, the Cafastan Office Workers Union Pension (COWUP) made the following announcement: “COWUP will fully exit all hedge funds and funds of funds Assets currently amounting to 15% of its investment program are involved Although hedge funds are a viable strategy for some, when judged against their complexity and cost, hedge fund investment is no longer warranted for COWUP.” One week later, a financial news service reported the following: “The COWUP decision on hedge funds was precipitated by an allegation of wrongdoing by a senior executive with hedge fund selection responsibilities in COWUP’s alternative investments strategy group.” Considering only the first statement, state what facts would be relevant in evaluating whether the decision to exit hedge funds was consistent with effective investment governance In light of both statements, identify deficiencies in COWUP’s investment governance www.ift.world 10 Assets Financial assets Investment portfolio Real estate Extended assets Human capital 25 Total 44 Goal Lifestyle—minimum Lifestyle—baseline Lifestyle—aspirational Education Trust Charitable 16 Liabilities and Net Worth Financial liabilities Margin debt Mortgage Extended liabilities David’s education Museum gift Special needs trust PV of future consumption Economic net worth Required Probability of Achieving Extremely high Very high Moderate Very high High Moderate www.ift.world 1 0.25 0.75 20 18 44 Time Horizon Short to distant Short to distant Distant Short Long Short 32 Example 7: Goals-Based Asset Allocation The Lees are presented with the following optimized asset allocations: Asset Allocation A B Cash 40% 10% Global Bonds 50% 30% Global Equities 10% 45% Diversifying Strategies 0% 15% Assume that a portfolio of 70% global equities and 30% bonds reflects an appropriate balance of expected return and risk for the Lees with respect to a 10-year time horizon for most moderately important goals Based on the information given: What goal(s) may be addressed by Allocation A? What goal(s) may be addressed by Allocation B? Goal Lifestyle—minimum Lifestyle—baseline Lifestyle—aspirational Education Trust Charitable Required Probability of Achieving Extremely high Very high Moderate Very high High Moderate www.ift.world Time Horizon Short to distant Short to distant Distant Short Long Short 33 Example 7: Goals-Based Asset Allocation Because of her industry connections in the life sciences, Ivy Lee is given the opportunity to be an early-stage venture capital investor in what she assesses is a very promising technology What insights does goals-based asset allocation offer on this opportunity? Goal Lifestyle—minimum Lifestyle—baseline Lifestyle—aspirational Education Trust Charitable Required Probability of Achieving Extremely high Very high Moderate Very high High Moderate www.ift.world Time Horizon Short to distant Short to distant Distant Short Long Short 34 Implementation Choices Passive/Active Management of Asset Class Weights Passive/Active Management of Allocations to Asset Classes Risk Budgeting Perspectives in Asset Allocation and Implementation www.ift.world 35 7.1 Passive/Active Management of Asset Class Weights • Passive strategy: not deviate from strategic asset allocation (SAA) • Tactical asset allocation (TAA): deliberate short-term deviations from the strategic asset allocation ▪ Deviations generally kept within a certain range or within risk budget ▪ Stock-bond-cash allocation versus comprehensive multi-asset approach • Deviating from SAA represents a source of risk ▪ Potential outperformance versus tracking error ▪ Trading costs, higher short-term capital gains taxes www.ift.world 36 7.2 Passive/Active Management of Allocations to Asset Classes • Passive management: portfolio composition does not react to changes in the investor’s capital market expectations • Active management: portfolio composition does react to changes in the investor’s capital market expectations; objective: achieve positive excess risk-adjusted returns relative to a passive benchmark www.ift.world 37 Factors that influence where to invest on the passive/active spectrum • Available investments • Scalability of active strategies being considered • The feasibility of investing passively while incorporating client-specific constraints • Beliefs concerning market informational efficiency • The trade-off of expected incremental benefits relative to incremental costs and risks of active choices • Tax status www.ift.world 38 Example 8: Implementation Choices (1) Describe two kinds of passive/active choices faced by investors related to asset allocation An equity index is described as “a rules-based, transparent index designed to provide investors with an efficient way to gain exposure to large-cap and small-cap stocks with low total return variability.” Compared with the market-cap weighting of the parent index (with the same component securities), the weights in the low-volatility index are proportional to the inverse of return volatility, so that the highest-volatility security receives the lowest weight Describe the active and passive aspects of a decision to invest an allocation to equities in ETFs tracking such indices Describe how investing in a GDP-weighted global bond index involves both active and passive choices www.ift.world 39 Example 9: Implementation Choices (2) Describe characteristic(s) of each of the following investors that are likely to influence the decision to invest passively or actively See Exhibit for Questions 1–3 and Example for Question Cafastan sovereign wealth fund GPLE corporate pension The Lee family Auldberg University Endowment www.ift.world 40 7.3 Risk Budgeting Perspectives in Asset Allocation and Implementation Risk budgeting: which types of risks to take and how much of each to take Risk budgets can be stated in absolute or in relative terms and in money or percent terms Asset allocation can be done based on a risk budgeting approach Active risk budgeting: how much benchmark-relative risk an investor is willing to take in seeking to outperform a benchmark; two levels of active risk budgeting • Overall asset allocation level • Individual asset class level www.ift.world 41 Rebalancing: Strategic Considerations Rebalancing: discipline of adjusting portfolio weights to more closely align with the strategic asset allocation Without rebalancing the overall portfolio risk rises IPS should specify: • Rebalancing policy • Who is responsible for rebalancing www.ift.world 42 8.1 A Framework for Rebalancing • Calendar rebalancing • Percent-range rebalancing ▪ How frequently is the portfolio valued? ▪ What size deviation triggers rebalancing? ▪ Is the deviation from the target allocation fully or partially corrected? www.ift.world 43 8.2 Strategic Considerations in Rebalancing • • • • Higher transaction costs for an asset class imply wider rebalancing ranges More risk-averse investors will have tighter rebalancing ranges Less correlated assets have tighter rebalancing ranges Beliefs in momentum favor wider rebalancing ranges, whereas mean reversion encourages tighter ranges • Illiquid investments complicate rebalancing • Derivatives create the possibility of synthetic rebalancing • Taxes discourage rebalancing and encourage asymmetric and wider rebalancing ranges www.ift.world 44 Example 10: Different Rebalancing Ranges The table shows a simple four-asset strategic mix along with rebalancing ranges created under different approaches Explain why the international equity range is wider than the domestic equity range under proportional ranges using the cost–benefit approach Asset Class Domestic equity International equity Emerging markets Fixed income Strategic Target 40% 25% 15% 20% Fixed Width Ranges 35%–45% 20%–30% 10%–20% 15%–25% www.ift.world Proportional Ranges (±1,000 bps) 36%–44% 22½%–27½% 13½%–16½% 18%–22% Cost–Benefit Ranges 35%–45% 19%–31% 12%–18% 19%–21% 45 Conclusion • Learning objectives • Summary • Examples • Practice problems www.ift.world 46 ...Contents and Introduction Introduction Asset Allocation: Importance in Investment Management The Investment Governance Background to Asset Allocation The Economic Balance Sheet and Asset Allocation. .. duration exposure being targeted Factor Models in Asset Allocation The interest in using factors for asset allocation stems from: • The desire to shape the asset allocation based on goals and objectives... Strategic Asset Allocation Strategic asset allocation or policy portfolio: asset allocation that is expected to be effective in achieving investment objectives given investment constraints and risk tolerance