CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 r16 introduction to asset allocation summary

Level III Introduction to Asset Allocation Summary Graphs, charts, tables, examples, and figures are copyright 2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Elements of Effective Investment Governance and Investment Governance Considerations in Asset Allocation 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 day-to-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 The Economic Balance Sheet and Implication for Asset Allocation • An economic balance sheet includes: ▪ Conventional (financial) assets and liabilities ▪ Extended portfolio assets and liabilities • For individual investors, extended portfolio assets/liabilities include: ▪ Assets: human capital, PV of pension income, PV of expected inheritances ▪ Liabilities: PV of future consumption • For institutional investors, examples of extended portfolio assets/liabilities include: ▪ Assets: underground mineral resources, PV of future intellectual property royalties ▪ Liabilities: PV of prospective payouts for foundations • Extended portfolio assets and liabilities should be considered in making asset allocation decisions www.ift.world Investment Objectives of Asset-Only, Liability-Relative and Goals-Based Asset Allocation Approaches Asset Allocation Relation to Economic Approach Balance Sheet Typical Objective Does not explicitly model Maximize Sharpe ratio for Asset only liabilities or goals acceptable level of volatility Typical Uses and Asset Owner Types Liabilities or goals not defined and/or simplicity is important • Some foundations, endowments • Sovereign wealth funds • Individual investors Liability relative Models legal and quasiliabilities Fund liabilities and invest excess assets for growth Penalty for not meeting liabilities high • Banks • Defined benefit pensions • Insurers Goals based Models goals Achieve goals with specified Individual investors required probabilities of success www.ift.world Relevant Risk Concepts Asset Allocation Relation to Economic Approach Balance Sheet Asset only Relevant Risk Concepts Does not explicitly Primary risk measure is volatility of portfolio returns which depend model liabilities or goals on asset class volatilities and correlation Risk relative to benchmark (tracking error) Downside risk Monte Carlo simulations Liability relative Models legal and quasiliabilities Shortfall risk: risk of having insufficient assets to pay obligations when due Goals based Risk of failing to achieve goals Models goals Risk limits: maximum acceptable probability of not achieving goals Overall portfolio risk is the weighted sum of the risks associated with each goal www.ift.world Use of Asset Classes to Represent Exposure to Systematic Risk and Criteria for Asset Class Specification Asset class: “a set of assets that bear some fundamental economic similarities to each other, and that have characteristics that make them distinct from other assets that are not part of that class.” Criteria for Asset Class Specification Assets within an asset class should be relatively homogeneous Asset classes should be mutually exclusive Asset classes should be diversifying The asset classes as a group should make up a preponderance of world investable wealth Asset classes selected for investment should have the capacity to absorb a meaningful proportion of an investor’s portfolio Sources of risk for broadly defined asset classes (equity versus debt) are better distinguished than sources of risk for narrowly defined subgroups (large cap versus small cap equity) Even broadly defined asset classes (US equity and US Corporate Bonds) have some common risk factor exposures  non-zero correlation between asset classes Risk factors are associated with non-diversifiable (systematic)  expected return premium www.ift.world Use of Risk Factors in Asset Allocation and their Relation to Traditional Asset Class-Based Approaches US Equity US Corporate Bonds At times an investor’s goals and objectives cannot be met through traditional asset classes Risk factor approaches to asset allocation focus on assigning investments to the investor’s desired exposures to specified risk factors Examples of how risk factor exposures can be achieved: • Inflation Going long nominal Treasuries and short inflation-linked bonds isolates the inflation component • Real interest rates Inflation-linked bonds provide a proxy for real interest rates • Credit spread Going long high-quality credit and short Treasuries/government bonds isolates credit exposure www.ift.world Select and Justify an Asset Allocation Based on Objectives and Constraints Asset Allocation Approach Asset only Typical Uses and Asset Owner Types Liabilities or goals not defined and/or simplicity is important Liability relative Suitable for: some foundations, endowments, sovereign wealth funds, individual investors Penalty for not meeting liabilities high Goals based Suitable for: banks, defined benefit pensions, insurers Suitable for some individual investors GPFC Sovereign Wealth Fund • Consideration: 1) Expected return in relation to volatility 2) volatility and 3) VaR GPLE DB Pension Plan • Plan assets = 1.25 billion; PV of pension obligations = 1.087 billion Lee Family www.ift.world Use of Global Market Portfolio as Baseline Portfolio in Asset Allocation Global market-value weighted portfolio should be the baseline asset allocation • • Represents all investable assets  minimizes non-diversifiable risk Investing in the global market portfolio helps mitigate investment biases such as home country bias Investing in the global market portfolio is done in two phases: • • Allocate assets in proportion to the global portfolio of stocks, bonds, and real assets Disaggregate each broad asset class into regional, country, and security weights using capitalization weights Implementation hurdles: • • • Size of each asset class on a global basis can’t be precisely determined Not practical to invest proportionately in residential real estate Private commercial real estate and global private equity assets are not easily carved into pieces of a size that is accessible to most investors Proxies for the global market portfolio are often based only on traded assets, such as portfolios of exchange-traded funds (ETFs) www.ift.world Strategic Implementation Choices in Asset Allocation • Passive/active management of asset class weights ▪ Passive strategy: stick to strategic asset allocation (SAA) ▪ Active strategy: allow deviation from SAA ➢ Called tactical asset allocation (TAA) • Passive/active management of allocations to asset classes ▪ Passive strategy: each asset class based on relevant benchmark ▪ Active strategy: deviate from asset class benchmark • Risk budgeting: which risks to take and to what extent Factors impacting active vs passive investment decision: • Available investments • Scalability of active strategies being considered • Feasibility of investing passively given constraints • Beliefs concerning market informational efficiency • Cost-benefit trade-off • Tax status ▪ Can be stated in absolute or relative terms ▪ 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 10 Strategic Considerations in Rebalancing Asset Allocations 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 and who is responsible for rebalancing Calendar rebalancing versus 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? • • • • • • • 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 11 ... traditional asset classes Risk factor approaches to asset allocation focus on assigning investments to the investor’s desired exposures to specified risk factors Examples of how risk factor exposures... 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... tactical asset allocation (TAA) • Passive/active management of allocations to asset classes ▪ Passive strategy: each asset class based on relevant benchmark ▪ Active strategy: deviate from asset