CFA III - Asset Allocation

Problems In Forecasting - limitation to using economic data due to

time-lag, revisions

Problems In Forecasting - data measurement and bias

transcription error (misreporting), survivorship bias, smoothed appraisal data

Problems In Forecasting - limitations of historical estimates

non stationary data due to regime changes

Problems in forecasting - ex post data

using ex post data to determine ex ante risk and return

time period bias

one period pattern driving results

Intertemporal inconsistency

Time horizon used to model is different from actual forecasting investment horizon

Cross-section inconsistency

Using one asset class to forecast anotherr

Problems with using using asynchronous data

outdated or missing values leading to risk and correlation biased downward

Name The Problems In Forecasting

Time lag, data measurement error, limitation of historical estimates, use of ex post data, non-repeating data patterns, failing to account for conditioning information, misinterpretation of correlation, model uncertainty

Seven steps to formulate capital market expectations

Step 1: determine investors preferences, step 2: asset historical performance evaluation, step 3: identify valuation model used, Step 4: collect data, step 5: interpret current investment conditions, Step 6: formulate expectations, Step 7: monitor performance and refine process

Name the cognitive psychological biases

anchoring, confirmation, prudence, availability

Name the emotional psychological biases

status quo, overconfidence

anchoring bias

first information received is overweighted, due to framing

Prudence bias

overly conservative forecast to avoid regret

availability bias

overweighting events that are more extreme/easiest to remember

Key to determining exogenous shocks

usually shocks unanticipated by markets

Over the long term, ___ is key for equity growth

nominal GDP

Forecasting Approach: Econometric Analysis - What is it

statistical methods/structural models

Advantage of Econometric models

Produces reasonably reliable output, can incorporate many variables, based on consistent set of relationships, can quantify the impact of exogenous shocks

Disadvantage of econometric models

complicated, time intensive, bad at predicting turning points

Forecasting approach - Economic indicators - advantages?

easy to interpret, can be tailored to specific needs

Forecasting approach - Economic indicators - disadvantages?

can appear to forecast better than it actual did

Forecasting approach - Checklist approach - describe

most subjective out of the three and considers a series of questions

Forecasting approach - Checklist approach - advantage

can be changed overtime

Forecasting approach - Checklist approach - disadvantage

can’t model complex relationships

Business Cycle - Initial Recovery - Rates, Yields, Stock prices?

Low rates, bottoming yields, rising stocks

Business Cycle - Early Expansion - Rates, Yields, Stock prices, credit spreads and slope?

Rising rates, rising yields, rising stocks, stable spreads

Business Cycle - Late Expansion - Rates, Yields, Stock prices?

Rates rises, yields rise, rising/peaking stock prices

Business Cycle - Slowdown - Rates, Yields, Stock prices?

Rates peak, yields peak or fall, stocks fall

Business Cycle - Contraction - Rates, Yields, Stock prices?

rates fall, yields fall, stocks increase in later stages

Impact of on-trend inflation for cash, bonds, equity, and real estate

cash earn real rate of interest, bonds have more volatility in short term than long term, neutral for equity and real estate

Impact of accelerating inflation on cash, bonds, equity, real estate

Positive for cash, bonds have more longer term volatility, negative for equity, positive for real estate

Impact of below-expectations inflation on cash, bonds, equity

negative for cash, bond yield decrease, neutral for equity

Impact of deflation on cash, bonds, equity, and real estate

neutral for cash, positive for bonds, negative for equity and real estate

Disadvantage and advantage of negative interest rates

net fee to invest in short term instruments, but benefit of low transfer fee outweigh cost of holding them at negative rates

When both fiscal and monetary policy are stimulative, the shape of the yield curve is

sharply upward sloping

When both fiscal and monetary policy are restrictive, the shape of the yield curve is

inverted

When fiscal restrictive, and monetary policy are stimulative, the shape of the yield curve is

upward sloping but less steep

When fiscal stimulative, and monetary policy are restrictive, the shape of the yield curve is

flat

Benefits of pegging interest rates to another country

more stable exchange rates

Cost of pegging interest rates to another country

Limits monetary and fiscal policy freedom

If Macaulay duration of a bond > investor horizon, bond yield rise means return is ___ than YTM, bond yields fall means return is ___ than YTM

lower, higher

If Macaulay duration of a bond < investor horizon, bond yield rise means return is ___ than YTM, bond yields fall means return is ___ than YTM

higher, lower

DCF Model advantage?

correct emphasis on future cash flows, can back out required return, suitable for long term valuation

Liquidity premium is lower for bonds that are ___ (name 6)

close to par, new, large, by frequent issuer, simple, higher credit quality

For EM countries, low risk if: real gdp growth rae > X, deficit to GDP ratio < X, debt to GDP ratio < X, foreign debt level to GDP < X, current account deficit < X, debt level < X of current account receipts, foreign exchange reserves should be at least X of short term debt

4%, 4%, 70%, 50%, 4%, 200%, 100%

DCF model disadvantage

don’t account for current market conditions

Disadvantage for forecasting using P/E growth

ignores that P/E may not always grow infinitely linearly

Advantage of Singer-Terhaar Model

adjust for market segmentation

Cap rate is positive related ___, negatively related to ____

long term interest rates and vacancy rates, availability of credit and debt financing

Name the risk premiums that investors need to add to real estate (4) and why

term-premium for holding longer term assets, Credit premium to compensate for the risk of tenant non payment, Equity risk premium for fluctuation in real estate values, leases, vacancies, Liquidity risk premium to consider inability of selling asset quickly

Public-Traded Real Estate like REITs is correlated with ___ in the short term and ___ in the long term

equities, direct real estate

When comparing public real estate to directly held real estate returns, one must first

unleverage public real estate

Purchasing Power Parity states that country with higher inflation will see their currency value ___

decline

When there are capital restrictions, exchange rate sensitivity increase to

current account, especially if persistent

When there’s sudden capital mobility in an EM country, their currency will__ and then ___

appreciate, reverse

When a country becomes an increasing share of global GDDP, their currency exchange rate tends to ___

weaken

Advantage of factor based Variance-Covariance (VCV) versus sample VCV

Required fewer observations

Disadvantage of factor based Variance-Covariance (VCV)

will be misspecified, biased, and inconsistent

When can you use sample VCV with large sampling error, and when can you use VCV with low sampling error

when sample size > number of asset classes, when sample size > 10* number of asset classes

What does shrinkage estimates do for VCV?

Reduce estimation error and result in more precise data

How do you adjust for smoothed returns in VCV?

take weighted average of current true returns and previously observed returns

What does ARCH model address?

Volatility clustering

Strategic Asset Allocation Characteristics

combines capital market expectations and investor IPS, long term, specify target percentage of asset allocation, reflect investor desired systematic risk exposure

Out of the common asset allocation approaches, which ones can be used only for SAA?

ALM and asset-only

Tactical Asset Allocation (TAA) Characteristics

Short term deviations from SAA to exploit mispricing, specify a range of asset allocation

What does TAA assume?

constant risk tolerance

What do target date funds do?

alter allocations towards risk as investment horizon shortens and required income generation increases

Describe Asset-only approach

manage risk and return of asset, liabilities are indirect objective

asset-only approach defines risk as

standard deviation of portfolio return or deviation from benchmark

Describe Liability-Relative Approach

Focus directly on managing assets in relation to quantifiable liabilities

How does liability-relative approach define risk

shortfall risk, need for additional contributions, of volatility of surplus

Describe Goal-based approach

view asset made up of separately managed sub portfolios for each goal, achieve goals for individual investors

How does goal-based approach define risk?

Probability of not meeting the goal

Liability-relative approach is good for _ investors with _

institutional investors with constant goals and predictable liabilities

SAA vs. TAA - who focus on higher granularity of asset classes?

TAA

The baseline portfolio for asset allocation is

global market portfolio

What is the global market portfolio, which risk does it minimize, how can it be represented?

contains all investable risky assets, eliminate diversifiable risk, portfolio of ETFs

What asset approach is MVO commonly used for?

asset-only

List the inputs of traditional MVO

expected return, standard deviation, and correlation between asset classes

What does MVO output?

efficient frontier- portfolios with highest expected return for each level of risk

Limitation of MVO

No short selling

List criteria of asset classes

homogenous, mutually exclusive, not highly correlated, liquid, cover most investable assets

Including non-marketable asset in MVO?

Can include human capital and personal residence as fixed allocation

Three fix about less liquid assets in MVO

exclude them, use expected characteristics of specific holdings, base it off on other available asset class data

Name four criticisms of MVO

produce highly concentrated asset allocations from the math, assumes normal distribution, diversification not by risk source, single period and ignore taxes, transaction costs, and inflation

Approaches to select optimal EF (5)

utility max, safety-first, sharpe ratio, acceptable return, acceptable risk

Two ways of addressing concentrated asset criticism of MVO

Reverse optimization (Black-litterman) and resampling

Process of reverse optimization (from input to EF)

input using weights of asset classes in world market portfolio, solve for expected returns, use consensus return to determine EF

How does black-litterman reverse optimization work?

start with consensus return estimates and adjust those return based on weights

Advantages of Reverse Optimization in MVO

results are less dependent on initial return estimates

Describe Resampling to address MVO

start with baseline market assumptions, generate multiple MVO EFs, average the weighting from these EFs, then resample the frontier from the average weighting

Pros of resampling in MVO

more asset classes that are less concentrated

Cons of resampling in MVO

over-diversified, little theoretical foundation

How to address the MVO criticism that it doesn’t provide diversification by risk source

Factor-based allocation

Describe process of factor-based allocation in MVO

determine sensitivities to risk factors, use risk premium, standard deviation, correlations of risk factors to generate EF

Are all risk factors investable? If so, how?

Not all, but if so by forming a series of zero-dollar long/short portfolio

Can risk factors be used as a unit of analysis?

Yes

Multi-factor models isolate __ risk

systematic risk (aka nondiversifiable risks)

Quasi-legal liabilities

Cash flows essential to the mission of the institution like university funds or endowments