R18 asset allocation
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Reading 18
Asset Allocation
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Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute. Reproduced
and republished with permission from CFA Institute. All rights reserved.
Overview
1. Introduction
2. Asset Allocation
3. Asset Allocation and the Investor’s Risk and Return Objectives
4. The Selection of Asset Classes
5. The Steps in Asset Allocation
6. Optimization
7. Implementing the Strategic Asset Allocation
8. Strategic Asset Allocation for Individual Investors
9. Strategic Asset Allocation for Institutional Investors
10. Tactical Asset Allocation
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2. What is Asset Allocation
Strategic Asset Allocation: Investor’s return objectives, risk tolerance, and
investment constraints are integrated with long-run capital market expectations to
establish exposures to IPS-permissible asset classes
Read Example 1: Making Asset Allocation a “Horse Race”
Appropriate asset mix under long-term or “normal” conditions
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Strategic vs. Tactical Asset Allocation
Tactical Asset Allocation: Short-term adjustments to asset class weights based on short-term
expected relative performance among asset classes
TAA creates active risk: variability of active returns
Example 2: Expectations and the Policy Portfolio
Importance of Asset Allocation
Classic empirical study by Brinston, Hood and Beebower:
Asset allocation explained 93.6% of variation of returns
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3. Asset Allocation and Investor’s Risk and Return Objectives
3.1 Asset Only and Asset/Liability Management Approaches to Strategic Asset
Allocation
3.2 Return Objectives and Strategic Asset Allocation
3.3 Risk Objectives and Strategic Asset Allocation
3.4 Behavioral Influences on Asset Allocation
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Asset-Only and Asset/Liability Management Approaches to
Strategic Asset Allocation
• AO approach does not explicitly involve modeling liabilities
• ALM approach involves explicitly modeling liabilities
– Cash-flow matching approach
– Immunization approach: assets match weighted average duration of
liabilities
• Dynamic approach: actual returns affect optimal decision for
next period
• Static approach
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ALM approach favored when…
Investor has below average risk tolerance
Penalties for not meeting liabilities are high
Market value of liabilities are interest rate sensitive
Risk taken in the investment portfolio limits the investor’s ability
to profitably take risk in other activities
• Legal and regulatory requirements and incentives favor holding
fixed-income securities
• Tax incentives favor holding fixed-income securities
•
•
•
•
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3.2 Return and Strategic Asset Allocation
Qualitative return objectives…
exceed rate of inflation in the long term
Additive vs. multiplicative method for calculating required return
Example 3
Update strategic asset allocation to reflect significant shifts in return and risk requirements
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3.3 Risk Objectives and Strategic Asset Allocation
Risk tolerance: below average, above average, average
Risk aversion
Note: return and risk aversion in %
If investor has a numerical
risk aversion of 4, which
allocation will he prefer?
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Downside risk: risk related to losses or worse than expected outcomes only
Short-fall risk
Safety first ratio
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Example 4: Applying the safety-first criterion
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3.4 Behavioral Influences on Asset Allocation
If client displays…
Investment advisor should…
Loss aversion increasingly greater
risk to overcome losses
Incorporate appropriate short-fall risk objective
Mental accounting
Pyramid approach:
High risk
Medium risk
Low risk
Sensitivity to regret holding on to
winners and losers too long
Example 5
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4. Selection of Asset Classes
4.1 Criteria for Specifying Asset Classes
4.2 The Inclusion of International Assets
(Developed & Emerging Markets)
4.3 Alternative Investments
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4.1 Criteria for Specifying Asset Classes
• Assets within an asset class should be relatively homogeneous
• Asset classes should be mutually exclusive
• Asset classes should be diversifying
• Asset classes as a group should make up a preponderance of world
investable wealth
• Asset class should have capacity to absorb a significant fraction of investor’s
portfolio without seriously affecting portfolio’s liquidity
Example 6
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4.2 The Inclusion of International Assets
(Developed & Emerging Markets)
Add new asset class if…
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Risk, Costs, and Opportunities of International Assets
• Risk of International Assets
Home country bias
Currency risk
Political risk
• Costs of International Assets
• Opportunities
Potentially better valuation than domestic markets
Diversification
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Increased correlation
in global equity
markets
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Risk, Costs and Opportunities of International Assets
• Conditional Return Correlations
Correlations appear to depend on global volatility which reduces
international diversification benefits
• Investment Characteristics of Emerging Markets
Higher returns, higher stand-alone risk, lower correlations
But there are several issues and risks:
Investability
Non-normality of returns
Growth illusion
Contagion
Currency issues
Changes from market integration
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4.3 Alternative Investments
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5. The Steps in Asset Allocation
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6. Optimization
6.1 The Mean-Variance Approach
6.2 The Resampled Efficient Frontier
6.3 The Black-Litterman Approach
6.4 Monte Carlo Simulation
6.5 Asset Liability Management
6.6 Experience-Based Approaches
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6.1 The Mean-Variance Approach
Unconstrained MVF
Sign-Constrained MVF
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Exhibit 11.
UK Capital
Market
Expectations
Understanding
Corner
Portfolios
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