TR17-R18 Asset Allocation

Reading 18
Asset Allocation
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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
Example 4: Applying the safety-first criterion
3.4 Behavioral Influences on Asset Allocation
If client displays… Investment advisor should…
Loss aversion  increasingly greater Incorporate appropriate short-fall risk objective

risk to overcome losses
Mental accounting Pyramid approach:

High risk
Medium risk
Low risk
Sensitivity to regret  holding on to

winners and losers too long
Example 5
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
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
4.2 The Inclusion of International Assets
(Developed & Emerging Markets)
Add new asset class if…
Risk, Costs, and Opportunities of International Assets
• Risk of International Assets

Home country bias
 Currency risk
 Political risk
• Costs of International Assets
• Opportunities
Increased correlation
 Potentially better valuation than domestic markets in global equity
 Diversification markets
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
4.3 Alternative Investments
5. The Steps in Asset Allocation
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
6.1 The Mean-Variance Approach
Unconstrained MVF
Sign-Constrained MVF
Exhibit 11.
UK Capital
Market
Expectations
Understanding
Corner
Portfolios
Corner portfolios define segment where
1) Portfolios hold identical assets
2) Rate of change of asset weights is
constant
As MVF passes through a corner portfolio, an

asset weight either changes from 0 to + or
from + to 0.
GMV portfolio is a corner portfolio irrespective

of its asset weights
What are the asset class weights in an efficient portfolio with an expected return of 7%?
Do rest of Example 8
What are the asset class weights in an efficient portfolio with an expected return of 7%?
Do rest of Example 8
General points related to Efficient Frontier
• Asset allocations are highly sensitive to small changes in input data… which in turn are hard
to estimate!
– Most important input is expected return which is the most difficult to estimate
• Are T-bills really risk free?
• Tangency point  highest Sharpe ratio
• Capital Allocation Line
• Extensions to the Mean-Variance Approach

– Exhibit 18
• Do Examples 9 and 10
6.2 The Resampled Efficient Frontier
• Efficient frontier is very sensitive to inputs; REF tries to
address this problem
• REF is based on simulation and data set of historical
returns
• Advantages
– Portfolios resulting from REF tend to be more diversified
– Stable relative to portfolios from MVO approach
• Disadvantages
– Lack of theoretical underpinning for the method
– Relevance of historical return data
6.3 Black-Litterman Approach
• Overall objective is to come up with efficient portfolios
– Quantitative approach to deal with the problem of estimation error
– Unconstrained Black Litterman (UBL)
– Black Litterman (BL)
• UBL
– No constraints on assets weights  negative weight (short position) is possible
– Start with market weight of a global index and make adjustments based on
expectations
• BL
– Can not short an asset class
– Curriculum focuses on this approach
Exhibit 21
Exhibit 22: Equity market weights of five major markets across the world
Covariance matrix + capitalization weights  Equilibrium expected returns
Exhibit 23
Exhibit 24. Efficient

Frontier with Equilibrium
Returns
What is the impact of
your view on the relative
weights?
Exhibit 28. Efficient Portfolio
Weights with BL View-Adjusted
Returns
Exhibit 15. Efficient Portfolio

Weights Using Raw Historical
Mean Returns
Summarizing BL Benefits…
• Efficient allocations along frontier are more diversified compared
with those resulting from MVO using historical mean returns
• Combining investor’s views with equilibrium returns helps

dampen the effect of any extreme views the investor holds
• Anchoring estimates to equilibrium returns ensures greater

consistency across estimates
6.4 Monte Carlo Simulation
Scenarios for investment returns Range of possible investment

Monte Carlo
inflation and other relevant results for given asset allocation
Simulation
variables over investor’s time horizon
Monte Carlo simulation contrasts and complements MVO
MVO is an analytical, one-period model
Monte Carlo is a statistical method which allows you model real-world constraints (such as
taxes) which are difficult to model analytically
Monte Carlo can help us project portfolio values in a multi-period scenario
Exhibit 29 Refresher on log scale:
Log scale
6.5 Asset Liability Management
• Mean-variance surplus optimization extends traditional MVO to
incorporate investor’s liabilities  surplus efficient frontier
MSV = Minimum Surplus Variance
Exhibit 31
Funding Ratio = Plan Assets/Plan Liabilities
Review examples
preceding Examples 14
and 15; and material
preceding examples
ALM with Simulation
• Determine the surplus efficient frontier and select a limited set of efficient
portfolios, ranging from the MSV portfolio to higher-surplus-risk portfolios,
to examine further.
• Conduct a Monte Carlo simulation for each proposed asset allocation and
evaluate which allocations, if any, satisfy the investor’s return and risk
objectives.
• Choose the most appropriate allocation that satisfies those objectives.
6.6 Experience Based Approaches
• Use tradition, experience and rules of thumb in making SAA
recommendations
1. Use 60/40 as neutral starting point allocation
2. Increase bond allocation with increasing risk aversion
3. High time horizon  increase stock allocation
4. Stock allocation = 100 - Age
Summary of Optimization Models
Methods Comments
Mean Variance Identify portfolios with maximum return for a given level of risk
Optimization (MVO) Corner portfolios
Theoretically pleasing (will see this in all books on PM)
Major issue: EF is very sensitive to input data
Resampled Efficient Based on simulation and historical returns
Frontier (REF) REF relatively less sensitive to input data and portfolios more diversified
Not as theoretically elegant as MVO
Black Litterman Aproach Start with diversified market portfolio and work backwards do determine
(BL) expected returns; incorporate your view; recreate EF
Less sensitive to input data
Portfolios more diversified relative to MVO
Monte Carlo Simulation Run MLS based on scenarios for investment returns inflation and other
(MLS) relevant variables  range of outputs
Complements MVO; determine portfolio values in multi-period environment
Asset Liability Explicitly model liabilities
Management (ALM)
Experience-Based Use tradition, experience and rules of thumb
Approaches www.irfanullah.co 45
Passive Investing Active Investing Semi-Active Investing
tracking portfolio of market portfolio of market securities that tracking portfolio of market
securities—whether self-managed, a reflects the investor’s perceived securities that permits some under-
separately managed account, an special insights and skill and that also or overweighting of securities
exchange-traded fund, or a mutual makes no attempt to track any asset- relative to the asset-class index but
fund— designed to replicate the class index’s performance with controlled tracking risk
returns to a broad investable index
representing that asset class; derivatives-based position (such as derivatives-based position in the
cash plus a long swap) to provide asset-class plus controlled active risk
derivatives-based portfolio consisting commodity-like exposure to the in the cash position (such as actively
of a cash position plus a long asset class plus a market-neutral managing its duration)
position in a swap in which the long–short position to reflect active
returns to an index representing that investment ideas
asset class is received;
derivatives-based portfolio consisting

of a cash position plus a long
position in index futures for the asset
class
Methods are not mutually exclusive…
Currency Risk Management Decisions
When investing in non-domestic assets we need to worry about currency risk
To hedge or not to hedge?
Asset allocation and currency hedging jointly optimized or separate?
Rebalancing to the Strategic Asset Allocation
Adjust portfolio because asset price changes have moved portfolio weights away
from target weights
Rebalancing can be done on calendar basis or percentage of portfolio basis
8. Strategic Asset Allocation for Individual Investors
Asset allocation must account for:
the part of wealth flowing from current and future labor income, and the
changing mix of financial and labor-income-related wealth as a person
ages and eventually retires
any correlation of current and future labor income with financial asset
returns
the possibility of outliving one’s resources
tax situation
8.1 Human Capital Financial Capital and
Human Capital with Age
• Ability and willingness to bear risk depends on

– Personality makeup
– Current and future needs
– Current and anticipated future financial situation
Investors with safe labor income (thus safe human capital) will invest more of their financial portfolio
into equities. A tenured professor is an example of a person with safe labor income; an at-will
employee in a downsizing company is an example of a person with risky labor income.
Investors with labor income that is highly positively correlated with stock markets should tend to
choose an asset allocation with less exposure to stocks. A stockbroker with commission income is
an example of a person who has that type of labor income.
The ability to adjust labor supply (high labor flexibility) tends to increase an investor’s optimal
allocation to equities
8.2 Other Considerations in Asset Allocation for Individual Investors
Mortality risk is the risk of loss of human capital if an investor dies prematurely. Of
course, it is the investor’s family that bears the effects of mortality risk. Life insurance
has long been used to hedge this risk.
Longevity risk is the risk that the investor will outlive his or her assets in retirement.
Mitigate using life annuity which guarantees monthly income for life
Fixed annuity
Variable annuity  payments vary depending on underlying investment portfolio
Equity-indexed annuity  fixed return + participation in stock market return
Example 16
9. Strategic Asset Allocation for Institutional Investors
• Defined Benefit Plans
• Foundations and Endowments
• Insurance Companies
• Banks
9.1 Defined-Benefit Plans
• Regulatory constraints
– Denmark: 60% minimum in domestic debt
• Liquidity constraints
– High liquidity requirement  low allocation of illiquid assets
• ALM
Exhibit 47
Example 17
9.2 Foundations and Endowments
• High long-term return to spending and inflation
– Recognize appropriate inflation rate
• SAA partly depends on resources available
– Smaller endowments will generally have a constrained opportunity set (long only) and
a relatively low percentage in alternative investments
• Example 18: Constructing an IPS and deciding on an asset allocation
9.3 Insurance Companies
An insurer’s strategic asset allocation must complement and coordinate with the insurer’s
operating policy. Investment portfolio policy thus seeks to achieve the most appropriate mix of
assets
1) to counterbalance the risks inherent in the mix of insurance products involved and
2) to achieve the stated return objectives
The insurer must consider numerous factors in arriving at the appropriate mix, the most
important of which are
1) asset/liability management concerns
2) regulatory influences
3) time horizons
4) tax considerations
Portfolio segmentation:
(Life insurance companies)
Advantages of portfolio segmentation
provides a focus for meeting return objectives by product line
provides a simple way to allocate investment income by line of business
provides more-accurate measurement of profitability by line of business. For example, the insurer
can judge whether its returns cover the returns it offers on products with investment features such as
annuities and guaranteed investment contracts (GICs)
aids in managing interest rate risk and/or duration mismatch by product line
assists regulators and senior management in assessing the suitability of investments.
Example 19. Sample Asset Allocation for a Life Insurance Company
9.4 Banks
Bank’s securities portfolio plays an important role in:
1) managing the balance sheet’s overall interest rate risk  ALM Approach
2) managing liquidity (assuring adequate cash is available to meet liabilities)
3) producing income
4) managing credit risk
Banks’ portfolios of loans and leases are generally not very liquid and may carry substantial credit
risk. Therefore, a bank’s securities portfolio plays a balancing role in providing a ready source of
liquidity and in offsetting loan-portfolio credit risk.
Example 20. Sample Asset Allocation for a Commercial Bank
10. Tactical Asset Allocation
• Deliberately underweighting or overweighting asset classes relative to their
target weights in the policy portfolio in an attempt to add value
• Active management at the asset-class level
• Based on short-term expectations and perceived disequilibria
• Frequently based on the following three principles

1. Market prices tell explicitly what returns are available
2. Relative expected returns reflect relative risk perceptions
3. Markets are rational and mean reverting
1. Market prices tell explicitly what returns are available
2. Relative expected returns reflect relative risk perceptions
3. Markets are rational and mean reverting
Other factors:
1. changes in assets’ underlying risk attributes
2. changes in central bank policy
3. changes in expected inflation
4. position in the business cycle
Examples 21 and 22
Conclusion
• Learning objectives
• Summary
• Examples
• Practice problems

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Reading 18

Strategic Asset Allocation: Investor’s return objectives, risk tolerance, and

Read Example 1: Making Asset Allocation a “Horse Race”

Appropriate asset mix under long-term or “normal” conditions

TAA creates active risk: variability of active returns

Example 2: Expectations and the Policy Portfolio

Importance of Asset Allocation

Asset allocation explained 93.6% of variation of returns

3.1 Asset Only and Asset/Liability Management Approaches to Strategic Asset

3.2 Return Objectives and Strategic Asset Allocation

3.3 Risk Objectives and Strategic Asset Allocation

3.4 Behavioral Influences on Asset Allocation

• ALM approach involves explicitly modeling liabilities

• Dynamic approach: actual returns affect optimal decision for

exceed rate of inflation in the long term

Additive vs. multiplicative method for calculating required return

Risk tolerance: below average, above average, average

Note: return and risk aversion in %

If investor has a numerical

Safety first ratio

Loss aversion  increasingly greater Incorporate appropriate short-fall risk objective

Mental accounting Pyramid approach:

Sensitivity to regret  holding on to

4.1 Criteria for Specifying Asset Classes

4.2 The Inclusion of International Assets

4.3 Alternative Investments

• Asset classes should be mutually exclusive

• Asset classes should be diversifying

• Asset classes as a group should make up a preponderance of world

• Asset class should have capacity to absorb a significant fraction of investor’s

Add new asset class if…

• Risk of International Assets

• Costs of International Assets

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

As MVF passes through a corner portfolio, an

GMV portfolio is a corner portfolio irrespective

• Are T-bills really risk free?

• Tangency point  highest Sharpe ratio

• Capital Allocation Line

• Extensions to the Mean-Variance Approach

Exhibit 24. Efficient

Exhibit 15. Efficient Portfolio

• Combining investor’s views with equilibrium returns helps

• Anchoring estimates to equilibrium returns ensures greater

Scenarios for investment returns Range of possible investment

Monte Carlo simulation contrasts and complements MVO

MVO is an analytical, one-period model

Monte Carlo can help us project portfolio values in a multi-period scenario

MSV = Minimum Surplus Variance

Funding Ratio = Plan Assets/Plan Liabilities

• Choose the most appropriate allocation that satisfies those objectives.

derivatives-based portfolio consisting

When investing in non-domestic assets we need to worry about currency risk

To hedge or not to hedge?

Asset allocation and currency hedging jointly optimized or separate?

Rebalancing to the Strategic Asset Allocation

Rebalancing can be done on calendar basis or percentage of portfolio basis

Asset allocation must account for:

the possibility of outliving one’s resources

• Ability and willingness to bear risk depends on