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Why is strategic asset allocation important?
Strategic asset allocation is the first element of the portfolio management process to focus on selecting investments.
It’s a bridge to the execution step of portfolio management but at the broad level of asset classes.
Strategic asset allocation is a starting point for portfolio construction and a step of the portfolio management process on which many investors expand considerable thought and effort
SAA sets an investor’s desired long-term exposures to systematic risk.
What are ALM strategies?
ALM strategies run from those that seek to minimize risk w.r.t. net worth or surplus (asset minus liability)
Two matching approaches in ALM
Cashflow matching (A cashflow matching approach structures investment in bonds to match future liabilities or quasi-liabilities)
Immunization (An immunization approach structures investments in bonds to match the weighted average duration of liabilities)
What types of investors gravitate to an ALM approach
The investor has below average risk tolerate
The penalties for not meeting the liabilities and quasi liabilities are very high
The market value of liabilities or quasi-liabilities are interest rate sensitive
Risk taken in the investment portfolio limits the investors’ ability to profitably take risk in other activities
Legal and regulatory requirement and incentive favor holding fixed income securities
Tax incentives favor holding FI securities
Why recommend this portfolio
Is efficient
Is expected to satisfy the return requirement
Is expected to meet his risk objective
Has the highest expected sharpe ratio among the efficient portfolio that meet his return objective
Is the most consistent with the IPS statement concerning minimizing losses with any other investment typpe
Implementation choices of SAA
Passive investing
Active investing
Semi-active investing or enhanced indexing
Some combination of the above
Insurers are taxable enterprises, in contract to defined benefit pension plans, endowments and most foundations.
Therefore, insurers focus on after tax return
TAA
A second major type of asset allocation is tactical asset allocation (TAA), which involves making short-term adjustments to asset-class weights based on short-term expected relative performance among asset classes.
Dynamic approach vs. static approach
A dynamic approach recognizes that an investor’s asset allocation and actual asset returns and liabilities in a given period affect the optimal decision that will be available next period. The asset allocation is further linked to the optimal investment decisions available at all future time periods.
In contrast, a static approach does not consider links between optimal decisions at different time periods.
Advantage of dynamic approach over static approach
The advantage of dynamic over static asset allocation applies both to AO and ALM perspectives. With the ready availability of computing power, institutional investor that adopt an ALM approach to strategic asset allocation frequently choose a dynamic rather than static approach.
A dynamic approach, however, is more complex and costly to model and implement
The ALM approach to strategic asset allocation characteristically results in a higher allocation to fixed-income instruments than an AO approach. Fixed-income instruments have prespecified interest and principal payments that typically represent legal obligations of the issuer. Because of the nature of their cash flows, fixed-income instruments are well suited to offsetting future obligations.
Quantify investors’ risk aversion
Um = the investor’s expected utility for asset mix m
E(Rm) = expected return for mix m
RA = the investor’s risk aversion
σ2m= variance of return for mix m
Five criteria that will help in effectively specifying asset classes
Assets within an asset class should be relatively homogenous
Asset classes should be mutually exclusive
Asset class should be diversifying
The asset class as a group should make up a preponderance of world investable wealth
The asset class should have the capacity to absorb a significant fraction of the investor’s portfolio w/o seriously affecting the portfolio’s liquidity
When investing in international asset classes, investors should consider the following risks
currency risk
increased correlation in times of stress
emerging market concerns
Resampled efficient frontier
To mitigate this instability, the resampled efficient frontier uses multiple simulations of the input data. By creating many alternative efficient frontiers based on these resampled datasets, the resulting portfolios are averaged to form a more stable and diversified efficient frontier
Safety first ratio (SF ratio), also known as Roy’s safety-first criterion
Which is a risk management approach used in investment decisions. It helps investors choose a portfolio that minimizes the probability of returns falling below a minimum acceptable threshold
re = Expected return on the portfolio
rm = Minimum required return set by the investor
σp = Standard deviation of the portfolio returns
SFratio = (re-rm)/σp
By using this ratio, investors can compare different portfolios and select the one with the highest SFRatio, which indicates the lowest probability of falling below the desired return
Optimization
Mean variance approach
The resampled efficient frontier
The black litterman approach
Monte Carlo Simulation
ALM
Experience based approaches
Steps in BL model
Define equilibrium market weights and covariance matrix for all asset classes
Back solve equilibrium expected returns
Express views and confidence for each view
Calculate the view adjusted market equilibrium returns
Run mean variance optimization
Advantages of incorporating equilibrium returns in BL model
Incorporating equilibrium returns has two major advantages. First, combining the investor’s views with equilibrium returns helps dampen the effect of any extreme views the investor holds that could otherwise dominate the optimization. The result is generally better-diversified portfolios than those produced from a MVO based only on the investor’s views, regardless of the source of those views. Second, anchoring the estimates to equilibrium returns ensures greater consistency across the estimates.
Monte Carlo simulation
Monte Carlo simulation imitates an asset allocation real world operations in an investments laboratory, where the investment advisor incorporates his best understanding of the set of relevant variables and statistical properties
ALM with simulation
Monte Carlo simulation can help confirm that the recommended allocation provides sufficient diversification and to evaluate the probability of funding shortfalls, the likelihood of breaching return threshold and the growth of assets w and w/o disbursements form the portfolio
A simple asset allocation approach that blends surplus optimization with Monte Carlo simulation follows these steps
• 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.
ALM risk penalty function
The monte carol simulation produces a frequency distribution for the future values of asset mix, plan liabilities and NetWorth or surplus
Experience based approaches
A 60/40 stock/bond asset allocation is appropriate or at least a starting point for an average investor’s asset allocation.
The allocation to bonds should increase with increasing risk aversion.
Investors with longer time horizons should increase their allocation to stocks.
A rule-of-thumb for the percentage allocation to equities is 100 minus the age of the investor (This rule of thumb implies that young investors should adopt more aggressive asset allocations than older investors)
Portfolio segregation in insurance company
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.
Outline
Behavioral influences on asset allocation
Loss aversion
Mental accounting
Regret avoidance
Signed constrained optimization
In practice, MVO, including the constraints that the asset-class weights be non-negative and sum to 1. We call this approach a sign-constrained optimization because it excludes negative weights, and its result is the sign-constrained minimum-variance frontier.
Corner portfolio
Advantages of segmentation
Focus for meeting return objectives by product line / line of business
Easily allocate investment income by LoB
More accurate measurement of profitability by LoB
Better management of interest rate risk by product line
Assist senior management in assessing the suitability of investments
Establishes multiple acceptable asset allocations that are appropriate
Promote competitive crediting rates for each segment
