CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 r18 asset allocation with real world constraints summary

Level III Asset Allocation with Real-World Constraints Summary Graphs, charts, tables, examples, and figures are copyright 2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Constraints in Asset Allocation Asset size: a portfolio could be: • too large for some asset classes and certain active strategies • too small for complex asset classes like hedge funds and private equity and where there is a minimum investment requirement Time horizon Two major aspects: • Changes in human capital • Changing character of liabilities In the real world the investment opportunity set is influenced by several constraints Liquidity constraint has two dimensions: Liquidity characteristics of asset class Liquidity needs of asset owner • Time horizon • Liquidity needs under high market stress • Governance capacity Regulatory and Other External Constraints • Allocations to certain asset classes might be constrained by regulator • Tax incentives • Need to maintain certain financial ratios www.ift.world After-Tax Portfolio Optimization Portfolio optimization should be based on after-tax return and risk • rat = rpt(1 – t) or rat = pdrpt(1 – td) + parpt(1 – tcg) • σat = σpt(1 – t) • Correlations are not impacted by taxes Impact of taxes on asset allocation depends on the riskiness of the portfolio Tax inefficient asset class are still important in an after-tax context when correlation with other asset classes is low Rebalancing  realized capital gains  taxes • Trade-off between benefits of tax minimization (which calls for less rebalancing) merits of maintaining target asset allocation (frequent rebalancing) • After-tax volatility < before-tax volatility  larger asset class movements to materially alter risk profile of taxable portfolio  wider rebalancing ranges for taxable portfolios relative to tax exempt portfolios Strategic asset location: place less tax efficient assets in tax-exempt or tax-deferred accounts; place tax efficient assets (low tax rates and/or deferred capital gains) in taxable accounts www.ift.world Revising the Strategic Asset Allocation SAA should be reviewed periodically even if there is no change in investor circumstances Circumstances that might trigger a special review of the asset allocation policy include: • Change in goals Glide path: anticipate changes in risk ▪ Business conditions appetite and implement pre-established ▪ Investor’s circumstances changes to asset allocation in response • Change in constraints ▪ Size ▪ Liquidity needs ▪ Time horizon ▪ Regulatory or other external constraints • Change in beliefs ▪ Change in economic environment  change in capital market expectations ▪ Change in trustees or committee members www.ift.world Short-Term Shifts in Asset Allocation Tactical asset allocation (TAA) allows short-term deviations from SAA based on cyclic variations and temporary price dislocations in capital markets • TAA assumes that returns in the short-run are predictable • Success of TAA decisions should be evaluated ▪ Compare Sharpe ratio realized under the TAA with Sharpe ratio under SAA ▪ Evaluate information ratio ▪ Plot the realized return/risk of the TAA versus the realized return of SAA’s efficient frontier • Downside of TAA: higher trading costs, higher taxes and higher concentration of risk relative to policy portfolio Discretionary TAA is based on manager skill in predicting short-term market movements and considers, large number of data points such as valuations, credit spreads, monetary and fiscal policy, GDP growth, economic sentiment indicators, market sentiment indicators, etc Systematic TAA seeks to exploit asset class level return anomalies that have been shown to have some predictability and persistence such as value factor and momentum factor www.ift.world Dealing with Behavioral Biases in Asset Allocation Bias Implication Mitigation Representativeness Bias Overweight importance of most recent observations and information (recency bias) Return chasing  overweight in asset classes which have performed well recently Objective asset allocation process and strong governance framework Availability Bias People take a mental shortcut when estimating the probability of an outcome based on how easily the outcome comes to mind Outcomes that come to mind easily are considered more likely Familiarity Bias Home Bias Use global market portfolio as starting point Strong governance framework Investor’s choice of asset allocation may be influenced by the manner in which the riskreturn tradeoff is presented Present possible asset allocation choices with multiple perspectives on risk/reward trade-off; present risk in terms of shortfall probability, VaR, CVaR, etc Framing Bias Answer question differently based solely on how it is asked (framed) www.ift.world Bias Implication Mitigation Loss Aversion People dislike losses more than they like gains; prefer avoiding losses over achieving gains Might interfere with ability to maintain chosen asset allocation during periods of negative returns Goal-based investing: Frame risks in terms of shortfall probability Fund high-priority goals with lowrisk assets Illusion of Control Tendency to overestimate one’s ability to control events based on superior knowledge, skills and/or resources Exacerbated by overconfidence and hindsight biases Alpha-seeking behavior Excessive trading Concentrated positions Underexposure to asset classes which are a significant part of the global market portfolio Use global market portfolio as starting point in developing global asset allocation Formal asset allocation process based on long-term forecasts Mental Accounting Treat one some of money differently from another sum based on the mental account the money is assigned to Failure to consider correlations between assets assigned to different mental accounts  suboptimal overall portfolio Goals-based investing; if each subportfolio is on the same efficient frontier  optimal overall portfolio www.ift.world .. .Constraints in Asset Allocation Asset size: a portfolio could be: • too large for some asset classes and certain active strategies • too small for complex asset classes like... In the real world the investment opportunity set is influenced by several constraints Liquidity constraint has two dimensions: Liquidity characteristics of asset class Liquidity needs of asset. .. Impact of taxes on asset allocation depends on the riskiness of the portfolio Tax inefficient asset class are still important in an after-tax context when correlation with other asset classes is