2018, Study S ession # 8, Reading # 16 “INTRODUCTION TO ASSET ALLOCATION” Invst = Investment SAA = strategic asset ASSET ALLOCATION: IMPORTANCE IN INVESTMENT MANAGEMENT allocation MVO = mean variance optimization A&L = assets & liabilities THE INVESTMENT GOVERNANCE BACKGROUND TO ASSET ALLOCATION Investment Governance: a structure to attain asset owner’s investment r elated objectives within his risk tolerance & c onstraints 3.1 Governance Structures 3.2 Articulating Investment Objectives 3.4 Investment Policy Statement 3.3 Allocation of Rights & Responsibilities A typical governance structural has three levels: Invt Committee: Invt Staff: rd 3 -‐party resources: Governance structure performs six tasks i Articulate s hort & long-‐term objectives ii Allocate rights & duties iii Specify IPS r elated methods iv Specify SAA r elated methods v Establish a reporting framework vi Periodic g overnance a udit Typically, settled at the committee level Identify primary objective and return requirement within investor’s resource constraints and risk tolerance 3.5 Asset Allocation & Rebalancing policy • Invst c ommittee, grant approval of asset allocation decision • Rebalancing can be performed by i nvst committee, staff or external c onsultant A typical IPS includes: Introduction Invst objective statement Invst c onstraints Statement of decision, rights & duties • Invst guidelines • Frequency & nature of reporting • • • • Copyright © FinQuiz.com All rights reserved 3.6 Reporting Framework An effective framework enables: • overseers to assess program’s progress quickly & clearly • advisors to comply with the guidelines 3.7 The Governance Audit The governance rd auditors (3 party) examine the documents, assess firm’s execution capacity & portfolios’ performances 2018, Study S ession # 8, Reading # 16 THE ECONOMIC BALANCE SHEET & ASSET ALLOCATION • Asset allocation s hould c onsider i nvestor’s economic balance sheet -‐ full range of assets a nd liabilities (A&L) • An economic balance s heet includes financial (A&L) a nd extended (A&L) Investor Extended Assets include: Extended Type Liabilities include: Individuals Human capital, PV of PV of future pension income, PV of consumption expected inheritance etc Institutions Resources, PV of future PV of prospective intellectual property payouts royalties etc APPROACHES TO ASSET ALLOCATION Asset-‐only approaches focus only on the asset-‐side of investor’s balance-‐sheet such as MVO Liability-‐relative approaches are intended to fund liabilities such as surplus-‐optimization, liability-‐hedging portfolio c onstruction etc 3.1.3 Forward Rate Pfarity Goal-‐based approaches, primarily or individuals or families, involve specifying asset allocation to s ub-‐portfolios 5.2 Relevant Risk Concepts 5.1 Relevant Objectives Primary risk measures for: Asset-‐only investors: v olatility, semi-‐variance, VaR, etc Liability-‐relative approaches: shortfall risk Goal-‐based approach: failure to attain agreed-‐on s ub goals 5.3 Modeling Asset Class Risks Three ‘super classes’ for assets i capital assets ii consumable/transferable assets iii store of value assets Modern four types of asset classes in practice: Global public equity Global private equity Global fixed income Real-‐assets Five criteria for effectively s pecifying asset classes are: Homogenous assets within a n asset class: Mutually exclusive asset classes: Diversifying asset classes: Asset classes as a group s hould c omprise the majority of w orld investable w ealth: Capacity to absorb a significant proportion of investor’s portfolio without s eriously affecting liquidity of portfolio: Copyright © FinQuiz.com All rights reserved 2018, Study S ession # 8, Reading # 16 STRATEGIC ASSET ALLOCATION 6.1 Asset-‐only • focuses on portfolios with the highest sharpe ratio • It is r ecommended to allocate in global market-‐value w eighted portfolio’ (GMP) as a baseline GMP allocation has two phases Phase 1: Allocate assets in the same proportion as i n the GMP Phase 2: Sub-‐divide broad asset classes into r egional, country & security weights and alter/tilt with regards to asset-‐owner’s c oncerns 6.3 Goal-‐based 6.2 Liability-‐relative • uses economic and fundamental factors to link liabilities and assets • Fixed income assets play key role for this approach • Liability Glide Paths, a technique typically, where allocation gradually shifts from return-‐ seeking assets to liability hedging assets • Risk-‐factors (duration, inflation, credit risk) based modelling can improve performance of liability hedging assets • uses economic & fundamental factors to link A&L • helps investors holding optimal portfolios by usefully systemizing ‘mental accounting’ • goals can be classified into various dimensions Two of those classifications are: Classification 1 1) Personal goals 2) Dynastic goals 3) Philanthropic goals Classification 2 Personal risk bucket-‐ (safe heaven investing) Market risk bucket-‐ (investing in avg risk-‐adjusted market returns) Aspirational risk bucket-‐ (risky investing) Drawbacks: • Sub-‐portfolios add c omplexity • Goals may be ambiguous or may ∆ overtime IMPLEMENTATION CHOICES 7.1 Passive/Active Management of Asset Class Weights Strategic Asset Allocation (SAA)-‐ incorporates i nvestor’s long-‐term, equilibrium market expectations Tactical Asset Allocation (TAA)-‐ deliberate temporary tilts away from the SAA • TAA, exploits short-‐term capital market opportunities • Costs are main hurdle for an effective TAA Dynamic Asset Allocation (DAA)-‐ deviations from SAA, usually driven by long-‐term valuation models or economic views 7.2 Passive/Active Management of Allocation to Asset Classes Passive m anagement approach does not respond to ∆ in market expectations or to info on individual investments Active m anagement approach reacts to ∆ in capital market expectations or individual investment insights Blend of active & p assive investing Factors that influence active/passive investing: • Investment availability: • Scalability of active strategies: • Feasibility of investing passively along with asset-‐owner’s specific constraints: • Belief regarding market informational efficiency: • Incremental benefits relative to incremental costs & risk c hoices: • Tax Status 7.3 Risk Budgeting Perspective in Allocation & Implementation Risk Budgeting: budget for risk taking (in absolute/relative terms expressed in $ or %) Risk budgeting approach to asset allocation purely focuses on risk, regardless of asset returns, Active Risk Budgeting quantifies investor’s capacity to take benchmark-‐relative Two levels of active risk budgeting: At the level of Active risk r elative to 1) Overall asset SAA benchmark allocation 2) Individual asset Asset Class Benchmark allocation Copyright © FinQuiz.com All rights reserved 2018, Study S ession # 8, Reading # 16 REBALANCING STRATEGIC CONSIDERATIONS Rebalancing: aligning portfolio’s weights with the i nvestor’s target allocation 8.1 A Framing for Rebalancing • Calendar rebalancing: rebalancing a portfolio to target weights on periodic basis • Percent-‐range rebalancing involves setting r ebalancing threshold or trigger points as % of portfolio’s value, around the target allocation 8.2 Strategic Considerations for R ebalancing Factors that suggest tighter rebalancing include: • More risk averse investors • Less c orrelated assets • Belief in mean variance or mean reversion Factors that suggest wider rebalancing range l include: • Higher transaction c osts • Higher taxes • Illiquid assets • Belief in momentum and trend Copyright © FinQuiz.com All rights reserved ... 20 18, ? ?Study S ession # ? ?8, ? ?Reading # ? ?16 THE ? ?ECONOMIC BALANCE SHEET & ? ?ASSET ? ?ALLOCATION • Asset ? ?allocation s hould c onsider i nvestor’s ? ?economic balance... 5 .3 Modeling Asset Class Risks Three ‘super classes’ for assets i capital assets ii consumable/transferable assets iii store ? ?of value assets Modern four types ? ?of ? ?asset. .. liquidity ? ?of portfolio: Copyright © ? ?FinQuiz. com All rights reserved 20 18, ? ?Study S ession # ? ?8, ? ?Reading # ? ?16 STRATEGIC ? ?ASSET ? ?ALLOCATION 6.1 Asset- ‐only