CFA 2018 level 1 CFA 2018 level 1 CFA level 3 schweser practice ExamCFA level 3 quest bank CFA level 3 summary NotesCFA level 3 study NotéCFA level 3 r18 asset allocation with real world constraints

Level III Asset Allocation with Real-World Constraints 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 Constraints in Asset Allocation Asset Allocation for the Taxable Investor Revising the Strategic Asset Allocation Short-Term Shifts in Asset Allocation Dealing with Behavioral Biases in Asset Allocation www.ift.world 2 Constraints in Asset Allocation Asset Size Liquidity Time Horizon Regulatory and Other External Constraints www.ift.world 2.1 Asset Size Portfolio might be too small to efficiently capture the returns of certain asset classes and strategies such as hedge funds, private equity and real estate Reasons: Economies of scale not achieved • No enough resources for sophisticated governance • High management fee relative to AUM • Low negotiation leverage Too small to effectively diversify across asset classes Minimum investment requirements Portfolio might be too large to efficiently capture the returns of: • asset classes with low market capitalization • certain active strategies Reasons: • Asset class not large enough • Large trades  high price impact • Liquidity issues • Overexposure to some fund managers • Fund managers might be forced to make investments outside area of expertise • Organizational hierarchies slow down decision making Workaround: comingled vehicles www.ift.world Exhibit Asset Size and Investor Constraints Asset Class Cash and money market funds Investor Constraints by Size No size constraints Large-cap developed market equity Small-cap developed market equity Emerging market equity Developed market sovereign bonds Investment-grade bonds Non-investment-grade bonds Private real estate equity Alternative Investments Hedge funds Private debt Private equity Infrastructure Timberland and farmland Generally accessible to large and small asset owners, although the very large asset owner may be constrained in the amount of assets allocated to certain active strategies and managers Generally accessible to large and small asset owners, although to achieve prudent diversification, smaller asset owners may need to implement via a commingled vehicle May be accessible to large and small asset owners, although if offered as private investment vehicles, there may be legal minimum qualifications that exclude smaller asset owners The ability to successfully invest in these asset classes may also be limited by the asset owner’s level of investment understanding/expertise Prudent diversification may require that smaller asset owners implement via a commingled vehicle, such as a fund of funds, or an ancillary access channel, such as a liquid alternatives vehicle or an alternatives ETF For very large funds, the allocation may be constrained by the number of funds available www.ift.world Embedded Examples An asset owner with an investment portfolio of US$25 billion is seeking to make a 5% investment in global small-cap stocks: • The median total market capitalization of the stocks in the S&P Global SmallCap is approximately US$555 million • Assume a small-cap manager operates a 50-stock portfolio and is willing to own 3% of the market cap of any one of its portfolio companies Their average position size would be US$17 million, and an effective level of assets under management (AUM) would be on the order of US$850 million Beyond that level, the manager may be forced to expand the portfolio beyond 50 stocks or to hold position sizes greater than 3% of a company’s market cap, which could then create liquidity issues for the manager • Now, our US$25 billion fund is looking to allocate US$1.25 billion to small-cap stocks (US$25 billion × 5%) They want to diversify this allocation across three or four active managers—a reasonable allocation of governance resources in the context of all of the fund’s investment activities The average allocation per manager is approximately US$300 to US$400 million, which would constitute between 35% and 50% of each manager’s AUM This exposes both the asset owner and the investment manager to an undesirable level of operational risk Where Asset Size Constrains Investment Opportunity As of early 2016, the 10 largest sovereign wealth funds globally each exceed US$400 billion in assets For a fund of this size, a 5% allocation to hedge funds (the average sovereign wealth fund allocation) would imply US$20 billion to be deployed The global hedge fund industry manages approximately US$2.8 trillion in total; 73% of the funds manage less than US$100 million The remaining 27% of the funds (roughly 3,000) manage 72% of the industry’s AUM; their implied average AUM is therefore US$670 million If we assume that the asset owner would want to be no more than 20% of a firm’s AUM, we can infer that the average investment might be approximately US$130 million With US$20 billion to deploy, the fund would need to invest with nearly 150 funds to achieve a 5% allocation to hedge funds Sources: Sovereign Wealth Fund Institute, BarclayHedge, Eurekahedge (2016) www.ift.world Example 1: Asset Size Constraints in Asset Allocation (1/3) Akkarat Aromdee is the recently retired President of Alpha Beverage, a producer and distributor of energy drinks throughout Southeast Asia Upon retiring, the company provided a lump sum retirement payment of THB880,000,000 (equivalent to €20 million), which was rolled over to a tax-deferred individual retirement savings plan Aside from these assets, Aromdee owns company stock worth about THB70,000,000 The stock is infrequently traded He has consulted with an investment adviser, and they are reviewing the following asset allocation proposal: Global equities Global high-yield bonds Domestic intermediate bonds Hedge funds Private equity 40% 15% 30% 10% 5% Describe asset size constraints that Aromdee might encounter in implementing this asset allocation Discuss possible means to address them www.ift.world Example 1: Asset Size Constraints in Asset Allocation (2/3) The CAF$40 billion Government Petroleum Fund of Cafastan is overseen by a nine-member Investment Committee The chief investment officer has a staff with sector heads in global equities, global bonds, real estate, hedge funds, and derivatives The majority of assets are managed by outside investment managers The Investment Committee, of which you are a member, approves the asset allocation policy and makes manager selection decisions Staff has recommended an increase in the private equity allocation from its current 0% to 15%, to be implemented over the next 12 to 36 months The head of global equities will oversee the implementation of the private equity allocation Given the asset size of the fund, formulate a set of questions regarding the feasibility of this recommendation that you would like staff to address at the next Investment Committee meeting www.ift.world Example 1: Asset Size Constraints in Asset Allocation (3/3) The Courneuve University Endowment has US$250 million in assets The current allocation is 65% global largecapitalization stocks and 35% high-quality bonds, with a duration target of 5.0 years The University has adopted a 5% spending policy University enrollment is stable and expected to remain so A capital spending initiative of US$100 million for new science buildings in the next three to seven years is being discussed, but it has not yet been approved The University has no dedicated investment staff and makes limited use of external resources Investment recommendations are formulated by the University’s treasurer and approved by the Investment Committee, composed entirely of external board members The new president of the University has stated that he feels the current policy is overly restrictive, and he would like to see a more diversified program that takes advantage of the types of investment strategies used by large endowment programs Choosing from among the following asset classes, propose a set of asset classes to be considered in the revised asset allocation Justify your response • Cash equivalents and money market funds • Non-investment-grade bonds • Large-cap developed market equity • Private real estate equity • Small-cap developed market equity • Hedge funds • Emerging market equity • Private debt • Developed market sovereign bonds • Private equity • Investment-grade bonds www.ift.world 2.2 Liquidity Liquidity Needs of Asset Owner Liquidity Characteristics of Asset Classes Investment Opportunity Set Time horizon Liquidity needs under high market stress Governance capacity Consider particular circumstances, financial strength and resources beyond investment portfolio: • A foundation whose mission supports medical research in a field in which a break-through appears imminent may desire a higher level of liquidity to fund critical projects than would a foundation that supports ongoing community efforts • An insurance company whose business is predominantly life or auto insurance, where losses are actuarially predictable, can absorb more liquidity risk than a property/casualty reinsurer whose losses are subject to unpredictable events, such as natural disasters • A family with several children nearing college-age will have higher liquidity needs than a couple of the same age and circumstances with no children www.ift.world 10 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 22 Example 6: Revising the Strategic Asset Allocation (1/3) Auldberg University Endowment Fund (AUE) has assets totaling CAF$200 million The current asset allocation is as follows: • CAF$100 million in domestic equities • CAF$60 million in domestic government debt • CAF$40 million in Class B office real estate AUE has historically distributed to the University 5% of the 36-month moving average of net assets, contributing approximately CAF$10 million of Auldberg University’s CAF$60 million annual operating budget Real estate income (from the University’s CAF$350 million direct investment in domestic commercial real estate assets, including office buildings and industrial parks, much of it near the campus) and provincial subsidies have been the main source of income to the University Admission is free to all citizens who qualify academically Growth in the Cafastan economy has been fueled by low interest rates, encouraging excess real estate development There is a strong probability that the economy will soon go into recession, negatively impacting both the property values and the income potential of the University’s real estate holdings Gizi Horvath, a University alumnus, has recently announced an irrevocable CAF$200 million gift to AUE, to be paid in equal installments over the next five years AUE employs a well-qualified staff with substantial diverse experience in equities, fixed income, and real estate Staff has recommended that the gift from Ms Horvath be invested using the same asset allocation policy that the endowment has been following successfully for the past five years They suggest that the asset allocation policy should be revisited once the final installment has been received Critique staff’s recommendation, and identify the case facts that support your critique www.ift.world 23 Example 6: Revising the Strategic Asset Allocation (2/3) The Government Petroleum Fund of Cafastan (GPFC) is operating under the following asset allocation policy, which was developed with a 20-year planning horizon Target weights and actual weights are given: Global equities Global high-yield bonds Domestic intermediate bonds Hedge funds Private equity Target Asset Allocation 30% 10% 30% 15% 15% Current Asset Allocation 38% 15% 25% 15% 7% When this asset allocation policy was adopted years ago, the petroleum revenues that support the sovereign wealth fund were projected to continue to grow for at least the next 25 years and intergenerational distributions were expected to begin in 20 years However, since the adoption of this policy, alternate fuel sources have eroded both the price and quantity of oil exports, the economy is undergoing significant restructuring, inflows to the fund have been suspended, and distributions are expected to begin within years What are the implications of this change in the liquidity constraints for the current asset allocation policy? www.ift.world 24 Example 6: Revising the Strategic Asset Allocation (3/3) O-Chem Corp has a defined benefit pension plan with US$1.0 billion in assets The plan is closed, the liabilities are frozen, and the plan is currently 65% funded The company intends to increase cash contributions to improve the funded status of the plan and then purchase annuities to fully address all of the plan’s pension obligations As part of an asset allocation analysis conducted every five years, the company has recently decided to allocate 80% of assets to liability-matching bonds and the remaining 20% to a mix of global equities and real estate An existing private equity portfolio is in the midst of being liquidated This allocation reflects a desired reduction in the level of investment risk O-Chem has just announced an ambitious US$15 billion capital investment program to build new plants for refining and production The CFO informed the Pension Committee that the company will be contributing to the plan only the minimum funding required by regulations for the foreseeable future It is estimated that achieving fully funded status for the pension plan under minimum funding requirements and using the current asset allocation approach will take at least 10 years What are the implications of this change in funding policy for the pension plan’s asset allocation strategy? www.ift.world 25 Short-Term Shifts in Asset Allocation • SAA represents long-term investment policy targets • Tactical asset allocation (TAA) allows short-term deviations from SAA based on ▪ Cyclic variations ▪ 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 and risk of the TAA portfolio versus the realized return and risk of portfolios along the SAA’s efficient frontier • Downside of TAA ▪ Higher trading costs and higher taxes ▪ Higher concentration of risk relative to policy portfolio • Two types of TAA: Discretionary and Systematic www.ift.world 26 5.1 Discretionary TAA 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, etc • Economic sentiment indicators • Market sentiment indicators 5.2 Systematic TAA Systematic TAA seeks to exploit asset class level return anomalies that have been shown to have some predictability and persistence • Value factor ▪ Valuation ratios for equities ▪ Yield and carry in currencies, commodities, and/or fixed income • Momentum factor www.ift.world 27 Example 7: Short-Term Shifts in Asset Allocation (1/2) The investment policy for Alpha Beverage Corporation’s pension fund allows staff to overweight or underweight asset classes, within pre-established bands, using a TAA model that has been approved by the Investment Committee The asset allocation policy is reflected in Exhibit 10, and the output of the TAA model is given in Exhibit 11 Using the data presented in Exhibits 10 and 11, recommend a TAA strategy for the pension fund and justify your response SAA Policy Investment-grade bonds High-yield bonds Developed markets equity Emerging markets equity Investment-grade bonds High-yield bonds Developed markets equity Emerging markets equity Current Weight 45% 10% 35% 10% 12-Month Return 4% –2% 5% –10% Target Allocation 40% 10% 40% 10% Upper Policy Limit 45% 15% 45% 15% Lower Policy Limit 35% 5% 35% 5% Risk-Free Return 1% 1% 1% 1% Excess Return 3% –3% 4% –11% Signal Long Short Long Short www.ift.world 28 Example 7: Short-Term Shifts in Asset Allocation (2/2) One year later, the Investment Committee for Alpha Beverage Corporation is conducting its year-end review of pension plan performance Staff has prepared the following exhibits regarding the tactical asset allocation decisions taken during the past year Assume that all investments are implemented using passively managed index funds Evaluate the effectiveness of the TAA decisions Asset Class Investment-grade bonds High-yield bonds Developed markets equity Emerging markets equity Asset Allocation 45% 5% 45% 5% Calendar Year Return 3.45% –6.07% –0.32% –14.60% 12-month return Risk-free rate Standard deviation Sharpe ratio www.ift.world Policy Portfolio –0.82% 0.50% 5.80% –0.23 Realized Results 0.38% 0.50% 6.20% –0.02 29 Dealing with Behavioral Biases in Asset Allocation Several behavioral biases might influence asset allocation; an effective asset allocation process should recognize and address these biases Loss Aversion Illusion of Control Mental Accounting Representative Bias Framing Bias Availability Bias www.ift.world 30 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 31 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 32 Framing Bias Example Return Std Dev VaR (5%) CVaR (5%) P1 3.2% 3.9% –3.2% –4.8% P25 4.9% 7.8% –8.0% –11.2% P50 6.0% 11.9% –13.6% –18.5% P75 7.0% 15.9% –19.3% –25.8% P100 8.0% 20.0% –25.0% –33.2% Effective Investment Governance Six critical elements of effective investment governance are: clearly articulated long- and short-term investment objectives of the investment program; allocation of decision rights and responsibilities among the functional units in the governance hierarchy, taking account of their knowledge, capacity, time, and position in the governance hierarchy; established processes for developing and approving the investment policy statement that will govern the day-today operation of the investment program; specified processes for developing and approving the program’s strategic asset allocation; a reporting framework to monitor the program’s progress toward the agreed-upon goals and objectives; and periodic governance audits www.ift.world 33 Example 8: Mitigating Behavioral Biases in Asset Allocation Ivy Lee, the retired founder of a publicly traded company, has two primary goals for her investment assets The first goal is to fund lifetime consumption expenditures of US$1 million per year for herself and her husband; this is a goal the Lees want to achieve with a high degree of certainty The second goal is to provide an end-of-life gift to Auldberg University Ivy has a diversified portfolio of stocks and bonds totaling US$5 million and a sizable position in the stock of the company she founded The following table summarizes the facts Annual consumption needs Remaining years of life expectancy Diversified stock holdings Diversified bond holdings Concentrated stock holdings Total portfolio US$1,000,000 40 US$3,000,000 US$2,000,000 US$15,000,000 US$20,000,000 Assume that a 60% equity/40% fixed-income portfolio represents the level of risk Ivy is willing to assume with respect to her consumption goal This 60/40 portfolio offers an expected return of 6.0% (For simplicity, this illustration ignores inflation and taxes.) The present value of the expected consumption expenditures is US$15,949,075 This is the amount needed on hand today, which, if invested in a portfolio of 60% equities and 40% fixed income, would fully fund 40 annual cash distributions of US$1,000,000 each The concentrated stock has a highly uncertain expected return and comes with significant idiosyncratic (stock-specific) risk A preliminary mean–variance optimization using three “asset classes”—stocks, bonds, and the concentrated stock—results in a zero allocation to the concentrated stock position But Ivy prefers to retain as much concentrated stock as possible because it represents her legacy and she has a strong psychological loyalty to it Describe the behavioral biases most relevant to developing an asset allocation recommendation for Ivy Recommend and justify an asset allocation for Ivy given the facts presented above www.ift.world 34 Diversified stocks Diversified bonds Funding of lifestyle goal Concentrated stock Total portfolio Beginning Asset Allocation US$3,000,000 US$2,000,000 US$15,000,000 US$20,000,000 www.ift.world Recommended Asset Allocation US$9,600,000 US$6,400,000 US$16,000,000 US$4,000,000 US$20,000,000 35 Conclusion • Learning objectives • Summary • Examples www.ift.world 36 ... 45% 10 % 35 % 10 % 12 -Month Return 4% –2% 5% ? ?10 % Target Allocation 40% 10 % 40% 10 % Upper Policy Limit 45% 15 % 45% 15 % Lower Policy Limit 35 % 5% 35 % 5% Risk-Free Return 1% 1% 1% 1% Excess Return 3% ... intermediate bonds Hedge funds Private equity Target Asset Allocation 30 % 10 % 30 % 15 % 15 % Current Asset Allocation 38 % 15 % 25% 15 % 7% When this asset allocation policy was adopted years ago, the petroleum... Introduction Constraints in Asset Allocation Asset Allocation for the Taxable Investor Revising the Strategic Asset Allocation Short-Term Shifts in Asset Allocation Dealing with Behavioral Biases in Asset