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Asset allocation real world constraints (Tax considerations (Rebalancing =…
Asset allocation real world constraints
Asset size
Too small or too large
May limit the opportunity set:
scale needed to invest successfully in certain asset classes
available of investment vehicles necessary to implements (alt investments limit smaller investors)
Liquidity
Liquidity needs of the asset owner - vary by goals and time horizon
Liquidity characteristics of the asset classes in the opportunity set
Time horizon
As time passes, allocations must reflect shortening horizons (changing HC as time passes, changing character of liabilities)
Nature of liability or goal will affect the allocation (lower risk/return with shorter goal/liabiliies
Regulatory/other external constraints
may hold for regulatory purposes/tax purposes
credit-worthiness constraints
-cultural/religious factors constraints
Tax considerations
Pre tax and after tax risk/return characteristics of each asset class can be materially different
After tax optimization = adjust each asset class E(r) and SD for expected tax
taxes reduces the expected return AND mutes the SD
correlations between asset classes remain the same
Rebalancing
= frequent rebalancing exposes taxable asset owner to realized taxes that could have been deferred
Rebalancing ranges for a taxable portfolio can be wider than tax exempt
(reduce the freq of trading)
Strategies to reduce tax impact
tax loss harvesting
tax location (place less tax efficient assets in accounts with favorable tax treatments
- low tax assets > taxable accounts
- high tax assets/high turnover -> tax exempt & tax deferred
Revising the SAA
Trigger by change in:
Goals
- changes in business conditions/expected CFs
Constraints
- Time, Liquidity, Asset size, Legal
Beliefs
- changes in CMAs, change in committee/trustees
also naturally (glide paths) at specific milestones
Short term shifts in SAA
TAA
= increase risk-adjusted return by taking advantage of short term market conditions
usually done at asset class level and asset-only approach
1.
Discretionary TAA
: manager skills in prediciting timing short term market moves
Systematic TAA
: based on technical analysis/market signals (look for asset class level return anomalies - value/momentum/valuation/trend-following)