tycoon

Carl Allen and Cliff Hanes are analysts for Tacticon Advisory (Tacticon). Allen and Hanes have been assigned the task of documenting some of Tacticons asset allocation techniques. After receiving accolades in a recent trade magazine article featuring investment firms with innovative trading strategies, their supervisor, Amos Ridley, decides it is time the firm began formally documenting the firms proprietary asset allocation process.

Ridley wants Allen and Hanes to record the specifics of Tacticons investment process for internal use. He also wants them to compile a document explaining a variety of allocation techniques to be used by the marketing staff and portfolio managers when working with prospects and clients.

At their first meeting after receiving the assignment, a discussion of strategic and tactical allocation commences. Allen and Hanes feel confident about the distinction between the two, but are less certain about the differences between asset-liability management (ALM) versus asset-only approaches to asset allocation.

Hanes states ALM and asset-only approaches are used for strategic asset allocation. With ALM an investors optimal asset allocation is directly related to explicit liability modeling. On the other hand, with asset-only strategies, liabilities only indirectly impact the return objective.

Allen replies, Im not so sure. I thought that tactical, asset-only approaches like immunization and cash flow matching are more precise than ALM for controlling risk.

Strategic asset allocation:

A) involves short-term variations from an investors normal asset mix.

B) sets a portfolios asset class exposures to unsystematic risk.

C) establishes a portfolios long-term asset class exposures by integrating each element of investment policy with capital market expectations.

D) refers to the purchase of specific investment vehicles to serve as asset class proxies.

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Answer and Explanation

Strategic asset allocation establishes a portfolios long-term asset class exposures by integrating each element of investment policy with capital market expectations. It affords an investor the ability to control systematic risk exposures by aligning their risk and return objectives with the actual portfolio of investments. Tactical asset allocation involves adjustments away from the strategic mix to take advantage of short-term projections of relative asset class performance.

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Concerning the discussion between Hanes and Allen about ALM versus asset-only allocation approaches:

A) Hanes is incorrect; Allen is incorrect.

B) Hanes is correct; Allen is incorrect.

C) Hanes is incorrect; Allen is correct.

D) Hanes is correct; Allen is correct.

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Answer and Explanation

ALM and asset-only approaches are used for strategic not tactical asset allocation. With ALM an investors optimal asset allocation is directly related to explicit liability modeling. With asset-only strategies, liabilities only indirectly impact the return objective. Asset-only approaches are less precise than ALM for controlling risk. Immunization and cash management are ALM approaches.