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CFA CFA level 3 volume III applications of economic analysis and asset allocation finquiz smart summary, study session 8, reading 16

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  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

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