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Flashcards in Asset Allocation Deck (34)
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1
Q

Asset Allocation

A
  • Process and Result
    Two types:
    Strategic
    Tactical
2
Q

Strategic Asset Allocation (SAA)

A

Investor’s IPS elements are integrated with long term capital market expectations to establish exposure to IPS permissible asset classes
- Process with well defined steps which leads to having weights for asset classes
- Starting point

3
Q

Tactical Asset Allocation

A

-Short term adjustments to asset class weights based on short term expectations

4
Q

Role of SAA in relation to systematic risk

A
  • Specifies the investors desired exposure to systematic risk
  • SAA exercises and controls the systematic risk exposure
  • Sets a benchmark
  • Appropriate asset mix to be held under long term normal conditions
5
Q

SAA VS TAA

A

SAA/TAA
Long Term/Short Term
/Active management choice
Reviewed periodically/

6
Q

Empirical Importance of Asset Allocation

A
  • Fraction of variation in returns over time attributable to asset allocation
  • Proportion of variation among funds’ performance explained by funds’ different asset allocation –> Cross sectional importance
7
Q

Approaches to SAA

A
  • Asset Only
  • Asset Liability Management
8
Q

Asset Liability Approach

A
  • Modelling liabilities and adopting optimal asset allocation in relation to funding those liabilities
    Used for those who have future liabilities (DB plans) or Quasi Liabilities
9
Q

Quasi Liabilities

A

Future income needs

10
Q

Asset Only

A

-No modelling of liabilities
- Much less precision in controlling risk related to funding liabilities

11
Q

Approaches to ALM

A
  • Risk minimizing
  • Accepting surplus risks to be benefit from surplus return
12
Q

Risk Related approaches

A
  • Cash flow matching approach
  • Immunization
13
Q

Cash flow matching approach

A
  • Invests in bonds to match future liabilities/quasi liabilities
14
Q

Immunisation

A
  • Structures investment in bonds to offset the weighted average duration of liabilities
  • More risk than cash flow matching approach
  • To better manage risk, managers match both convexity and duration
15
Q

Other approach to ALM

A

Static
Dynamic

16
Q

Dynamic Approach

A
  • Actual asset allocation and actual asset return and liability in given period affect the optimal decisions that will be available in the next period
  • Worth it for ALM approach
17
Q

Static Approach

A
  • Does not consider links between optimal decisions at different times
18
Q

Difference of asset allocation between ALM and AO approach

A
  • ALM results in higher allocation to fixed income securities
19
Q

Investors who prefer ALM approach

A
  • Below average risk tolerance
  • penalties for not meeting the liabilities or quasi liabilities are high
  • MV of liabilities or quasi liabilities are interest rate sensitive
  • risk taken in the investment portfolio limits the investors ability to profitably take risk in other activities
  • legal and regulatory requirements and incentives favour holding fixed income securities
  • tax incentive favour holding fixed income securities
20
Q

Return Objective and SAA

A
  • Returns both quantitative and qualitative
  • Should have a quantitative return objective stated for SAA
  • Return = Spending rate , inflation, cost to earn the rate and the compounding effect
  • If an arithmetic mean rate is given it should be compounded upward
  • Multistage period to be considered - dynamic is a better approach
21
Q

Risk objective and SAA

A
  • Risk aversion
  • Standard deviation
  • Short fall risk
  • Downside risk
22
Q

Risk aversion

A
  • Ability and willingness to take risk
  • High risk tolerance - lower risk aversion
    Measuring the utility using risk aversion
    Uofm=E(Rofm)-0.005R(av)variance of(m)
23
Q

Standard deviation

A
  • accepting certain level of volatility measured by standard deviation
24
Q

Shortfall risk

A
  • Type of downfall risk
  • risk that the portfolio’s value will fall below the minimum acceptable level
  • Roy’s safety first criterion
25
Q

Roy’s safety first criterion

A
  • SFration = E(Rp)- R(l)/standard deviation of P
  • Choose a portfolio with higher SFration
26
Q

Behavioural Influences on Asset allocation

A
  • loss aversion
  • mental accounting
  • regret avoidancw
27
Q

Loss aversion

A
  • Worry more about avoiding losses than gaining
  • Risk-seekers when faced with situations of substantial loss
  • Dealing with these investors:
    a. short fall risk approach
    b. ALM approach
28
Q

Mental accounting

A
  • Investors put mone in different buckets without considering the correlation between them and hence no effecient - no overall perspective taken into consideration.
  • Suggested approach: multistrategy goal based asset allocation.
  • Criticism of the approach: Ignores correlation
    Time consuming and expensive to optimize
29
Q

Regret aversion

A

Implications
- psychological factor promoting diversification
- regret avoidance may limit divergence from peer’s avg asset allocation

30
Q

Asset Class - Criteria

A
  • Homogenous
  • Mutually Exclusive
  • Diversifying
  • Make up a preponderance of world investable wealth
  • Capacity to adopt a significant fraction of portfolio’s without affecting liquidity
31
Q

Traditional Asset Classes

A
  • Domestic Common Equity
  • Domestic Fixed Income
  • Non-domestic Common Equity
  • Non-domestic Fixed Income
  • Real Estate
  • Cash and cash equivalents
32
Q

The inclusion of International Assets

A

A new asset class should be added if the following condition is met
E(Rnew-Rf)/std. dev of new is greater than [E(Rp-Rf)/std. dev of p))*Corr(Rnew,Rp)]

The above criteria is not valid if the distribution of the proposed assets class return in non-normal

Issues to consider:
1. Currency risk
2. Increased correlation in time of market crashes
3. Emerging Market Concerns - limited free float of shares, nondomestic ownership - limited, quality of company info, non-normality of returns

33
Q

Alternative Investments

A
  • lack of correlation between the different assets within the alternative investment class
  • lack of information like equity and bond
  • Fees and expenses related are higher
34
Q

Steps in Asset allocation

A
  • Diagram in Text: Pg 230