Module 5: Asset Allocation with Real-World Constraints

Discuss constraints on asset allocation such as asset size, liquidity needs, time horizon, and regulatory considerations

• Asset size: some smaller funds lack the expertise and governance structure to invest in complex strategies, so they can’t achieve adequate diversification. Larger portfolios generally access greater management expertise in the governance capacity. As fund size increases, per-participant cost of internal governance decreases, giving the fund access to private equity, hedge funds, and infrastructure investing. At the same time, funds that are too large may not be able to take advantage of asset classes that lack the capacity to absorb large amounts of funds.

Discuss constraints on asset allocation such as asset size, liquidity needs, time horizon, and regulatory considerations

• Liquidity needs: some owners require extremely high levels of liquidity and hence typically invest in high-quality, short-term, liquid assets.

For example:

• Banks: high liquidity needed to support day to day operations and stand ready to repay deposits

• Sovereign wealth funds, endowments, pension plants, foundations: longer time horizons and lower liquidity needs

• Property and casualty insurance: relatively high liquidity due to unpredictability of claims

• Life and auto insurance: Relatively low due to predictability of claims

• Individuals: varies by individual circumstance

The possibility of extreme market conditions should also be considered when planning liquidity needs, as it can change your position.

Discuss constraints on asset allocation such as asset size, liquidity needs, time horizon, and regulatory considerations

• Time Horizon: a portfolio’s time horizon is defined by a liability to be paid or a goal to be funded at a future date. Asset allocations must consider the horizons defined by each goal. the time horizon is also associated with the ability to take on risk. Portfolios with longer time horizons are often invested in assets with higher risk.

Discuss constraints on asset allocation such as asset size, liquidity needs, time horizon, and regulatory considerations

Regulatory and other considerations: different for each type of portfolio

• Insurance companies: local legislations often limit the allocation insurance companies make to asset classes as such equity, private equity, or high-yield bonds, as these companies must meet the claims of policyholders

• Pension funds: Local legislation often caps allocation to certain asset classes, and places a wide range of tax, accounting, reporting and funding constraints on pension funds. There may be also tax incentives to invest in domestic assets, and accounting rules may allow deferred recognition of losses.

• Endowments and foundations: these are both assumed to have infinite time horizon and are subject to very few regulatory constraints, which allows them to invest in risky assets.

• Sovereign wealth funds: typically have minimum investment requirements in socially or ethically acceptable assets, and maximum investments in risk assets such as alternative investments, and limits on investing in certain currencies.

Discuss tax considerations in asset allocation and rebalancing

• Interest income is usually taxed at a higher rate than dividends or capital gains (might lead you to prefer preferred stock over bonds)

• Certain investment accounts may be tax deferred or tax exempt. The least tax-efficient (most heavily taxed) assets should be placed in the most tax-advantaged accounts.

For rebalancing, all portfolios are periodically rebalanced to maintain the SAA. Taxable asset owners will realize taxable gains at each rebalancing, so they must balance the need to maintain the SAA with the desire to avoid taxable gains through frequent rebalancing.

There are two strategies that can be employed to reduce the impact of taxation

• Tax loss harvesting: deliberately realizing losses to offset gains elsewhere

• Strategic asset location: making the most efficient use of tax-advantaged accounts

Recommend and justify revisions to an asset allocation given the chafes in investment objectives or constraints

• Changes in goals which may be triggered by business cycle downturns, or changes in employment status for individuals

• Changes in constraints such as government regulations requiring increased distributions to maintain tax-exempt status

• Changes in constraints such as increased funding requirement for the beneficiary of an endowment

• Changes in constraints such as forced early retirement of an investor due to illness

• Changes in beliefs such as the portfolio guiding principles

Discuss the short-term shifts in asset allocation

• Long term asset allocation is specified in the investment policy statement and know as the SAA Strategic Asset Allocation this represents the target asset weightings in the portfolio

• Short-term deviations are known as TAA Tactical Asset Allocations, and are typically used to take advantage of cyclical conditions in the market or a perceived mispricing in a given asset class

TAA

The objective of TAA is to increase risk-adjusted returns by exploiting these short-term opportunities

• The success of the TAA should be judged against the benchmark of the SAA

• Drawbacks: additional trading costs and taxation in the case of taxable investors

Identify behavioural biases that arise in asset allocation and recommend methods to overcome them

1. Loss aversion: is a bias in which investors dislike losses more than they like gains

2. Illusion of control: is a tendency to overestimate the ability to control events

3. Mental accounting: involves separating assets and liabilities into different “buckets” based on subjective criteria, which can lead to suboptimal asset allocations.

4. Representative bias, or recency bias: occurs when investors attach more importance to recent data than old data.

5. Framing bias: occurs when the way information is presented affects the resulting decision.

6. Availability bias: occurs when personally experienced or more easily recalled events disproportionately influence decisions.