12-1 overview of asset allocation
1 introduction
2 asset allocation:
importance
in investment
management
4 the economic
balance sheet
and asset allocation
5
approaches
to asset
allocation
relevant
objectives
revevant
risk
concepts
modeling asset
class risk
asset allocation is a strategic decision in portfolio construction
the strategic asset allocation decision determines return level
the alignment of asset allocation with the asset owner's investment objectives, constraints and overall financial condition
also linked to other facets of portfolio management - risk management and behavioral finance
an investment process in asset owner's best interest rests on a foundation of good investment governance - the assignment of decision-making responsibilities to qualified individuals and oversight of processes
the portfilio management proces must reconsile/balance investor objectives with the possibilities offered by the investment opportunity set
an economic balance sheet
conventional assets and liabities
( financial assets and financial liabilities )
extended
portfolio
assets and
liabilities
human capital
PV of pension income
PV of expected inheritances
PV of future consumption
human capital roughly
30% equity-like
and 70% bond-like
significant variation
among industries
reflec increasing allocation
to bonds as human capital
declines to age 65
three broad approaches
asset-only
liability-relative
to the objective of funding liabilities
liability-driven investing LDI
goals-based: sub-portfolios aligned to specified goals
goals-based investing GBI
mean-variance optimization MVO
surplus optimization: MVO applied to surplus
constructing a liability-hedging portfolio focused on funding liabilities
and for any remaning balance of assets, a risky-asset portfolio
important distinctions between
for institutional and individual
liabilities of institutional are legal obligations ro debts
institutional liabilites are uniform in nature
liabilities of institutional of given type often be forecast with confidence
MVO asset-ony
to max expected portfolio return per unit of portfolio volatility over time horizon - sharpe ratio
liability-relative
to ensure payment of liabilities when due
asset-only
volatility of portfolio returan
regularly augmented by monte carlo simulation
risk relative to benchmarks - tracking risk / tracking error
downside risk:
semi-variance / peak-to -trough max drawdown / value at risk
liability-relative
shortfall risk - having insufficient assets to pay obligations due
the volatility of contributions needed to fund liabilities
goals-based
the max acceptable probability of not achieving a goal
overall portfolio risk is the weighted sum of the risks associated with each goal
three super classes of assets
capital assets
consumable/transformable assets
store of value assets
interest or devidens valued by net PV
commodities
currencies and art
realized through sale or exchange
effectively
specifying
asset classes for
the purpose of
asset allocation
assets withinn an asset class should be relatively homogeneous similar attributes
asset classes should be mutually exclusive
overlapping reduce effectiveness
asset classes should be diversifying
a pairwise correlation above 0.95 undesirable
the asset calsses as a group should make up a preponderance of world investable wealth
asset classed selected should have capacity to absorb a meaningful proportion of investor's portfolio
liquidity and transaction costs significant considerations
lists of
asset
classes
global public euiqty
global private equity: venture capital / growth capital / leveraged buyputs
global fixed income: +cash and short-duration securities
real assets - provide sensitivity to inflation
private RE equity / private infrastructure / commodities
*more sub-asset classes defined, less distinctive the sources of risk for more broadly defined, better distinguished
asset classed exhibit
some overlaps in
sources of risk
common factor
exposures accross
asset classes
US equity
US corporate bonds
gdp growth / volatility / currenct / value / liquidity / momentum / size / inflation
inflation / capital structure / volatility / currency / real rates / convexity / default risk / duration / liquidity
→multifactorial risk models - to bear on the issue of controlling systematic risk exposures in asset allocation - factor-based asset allocation
→ risk factor exposures
inflation: going long nominal treasuries and short inflation-linked bonds
real interest rates: inflation-linked bonds
US volatility: VIX futures
credit spread: going long high-quility credit and short treasuries / government bonds
duration: going long 10+ year treasuries and short 1-3 year treasuries