Portfolio Management and Wealth Planning【Reading 21】 techniques, investment, allocation

hinsafdar

Carl Allen and Cliff Hanes are analysts for Tacticon Advisory (Tacticon). Allen and Hanes have been assigned the task of documenting some of Tacticon’s 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 firm’s proprietary asset allocation process.
Ridley wants Allen and Hanes to record the specifics of Tacticon’s 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 investor’s 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, “I’m 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) establishes a portfolio’s long-term asset class exposures by integrating each element of investment policy with capital market expectations.

B) sets a portfolio’s asset class exposures to unsystematic risk.

C) involves short-term variations from an investor’s normal asset mix.

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Strategic asset allocation establishes a portfolio’s 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) both are correct.

B) both are incorrect.

C) only one is correct.

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ALM and asset-only approaches are used for strategic not tactical asset allocation. With ALM an investor’s 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.

prashantsahni

Lynette Kelly is a principal with Beta Asset Advisors. Traditionally, the firm has always invested with an extremely long time horizon; however, Kelly’s outlook is for generally flat returns for the market over the next 5 to 7 years. In an effort to generate stronger returns for clients, Kelly believes the firm needs to make tactical allocation adjustments to client portfolios in order to achieve higher returns. Kelly is not very familiar with tactical asset allocation, so she asks Jacob Cannon, an analyst with the firm to prepare a report on tactical asset allocation. Cannon’s report contains the following points:

Point 1:	The most common way to implement tactical asset allocation is through a derivative overlay.
Point 2:	Tactical asset allocation is only performed at the asset class level.
Point 3:	Tactical asset allocation can only be performed at regular intervals (i.e., monthly or quarterly).
Point 4:	In order to effectively implement the tactical asset allocation changes, our firm should hire additional personnel so that there will be internal experts on staff.

After reading Cannon’s report, Kelly should agree with:

A) Point 1 only.

B) Points 1 and 4 only.

C) all of the points in the report.

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Point 1 is correct. Tactical asset allocation can be accomplished through trading assets or through a derivative overlay, but as a result of cost savings and saving time, a derivative overlay tends to be a more common approach. The other three points are incorrect. Tactical asset allocation can be performed at the asset class, sector, industry, or in some cases, asset level. Also, tactical asset allocation can be performed at regular intervals (part of a regular program) or sporadically as market conditions warrant. Because of the flexibility of tactical asset allocation, it could be performed by internal personnel or by outside firms that specialize in tactical allocation.

prashantsahni

Reid Williams is responsible for training new analysts and portfolio managers for Grames Investment Advisors. Since Grames specializes in institutional clients, Williams wants to make sure that his new trainees know the needs of various institutional investors. Reid gives an assignment to all of his trainees to identify general differences in asset allocations for different types of institutional investors. One of Williams’ trainees, Phil Nagy, turns in his assignment with the following statements.

Statement 1:	A bank is likely to hold more bonds than an insurance company’s surplus portfolio.
Statement 2:	An endowment is likely to hold more equities than the portfolio that funds an insurance company’s fixed annuities.
Statement 3:	An endowment is more likely to hold more emerging market equities than an insurance company’s surplus portfolio.
Statement 4:	A private foundation is likely to have higher cash needs than a pension fund with a low ratio of retired to active lives.

When grading the papers, Williams gives his trainees 25 points for each correct statement. Given the grading criteria, Nagy’s grade on the paper is most likely:

A) 50%.

B) 75%.

C) 100%.

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Three of Nagy’s four statements were correct, for a score of 75%. Statement 1 is correct – a bank’s portfolio is concerned with funding liabilities, and therefore requires more fixed income instruments, while an insurance company’s surplus portfolio is focused on growth. Statement 2 is also correct – the portfolio that funds an insurance company’s fixed annuities is likely to rely more on fixed income securities, while the endowment has more of a total return focus. Statement 3 is incorrect – an insurance company’s surplus portfolio is very aggressive and should therefore have more emerging market equities than an endowment that likely spends a portion of its portfolio each year. Statement 4 is correct – the private foundation has an annual spending requirement and therefore is likely to have higher liquidity needs than a pension fund with a small number of retired employees relative to working employees.

prashantsahni

Constrained optimization usually involves an additional constraint that:

A) asset class weights add up to 1.

B) all asset class weights are non-negative.

C) all asset class weights are positive.

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The weight of all asset classes adding up to one is part of un-constrained optimization. Constrained optimization has an additional constraint that the weights of all the asset classes should be non-negative.

prashantsahni

Constrained optimization usually involves an additional constraint that:

A) each asset class weight should be positive.

B) short sales are not allowed.

C) the weights of all asset classes add up to 1.

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The weight of all asset classes adding up to one is part of un-constrained optimization. Constrained optimization has an additional constraint that the weights of all the asset classes should be non-negative or that there be no short sales. The weight of asset classes can be zero or positive.

prashantsahni

Which of the following does NOT accurately reflect a statement describing the resampled efficient frontier?

A) A single portfolio with specific asset class weights at each level of return.

B) At each level of return the most efficient of the simulated efficient portfolios is at the center of a distribution.

C) A portfolio may be considered statistically equivalent if the manager’s portfolio is within a 90% confidence interval of the most efficient portfolio.

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A single portfolio with specific asset class weights at each level of return describes traditional mean variance optimization. The other answer choices describe the resampled efficient frontier where Monte Carlo simulation is used to create an efficient frontier at each return level and run thousands of times resulting in an efficient frontier that is the result of an averaging process. The efficient frontier becomes a blur rather than a single sharp curve. At each level of return, the most efficient of the simulated efficient portfolios is at the center of the distribution.

prashantsahni

Any mean-variance efficient portfolio has the:

A) lowest standard deviation and the highest expected return.

B) lowest standard deviation for a given level of expected return.

C) highest return among all other portfolios.

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A mean-variance efficient portfolio has the lowest standard deviation for a given level of expected return. Note that the lowest standard deviation portfolio and the highest return portfolio are just two of the infinite number of efficient portfolios.

prashantsahni

The first step in the portfolio construction process is called:

A) strategic asset allocation.

B) tactical asset allocation.

C) capital market expectation.

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The steps in the asset allocation process are:

• Determine the investor's risk, return, and constraints.
• Formulate long-term capital market expectations.
• Determine the mix of assets (allocation) that best meets the objectives of the IPS.
• Monitor the portfolio.
• Adjust the portfolio as necessary for strategic or tactical asset allocation.

Strategic asset allocation is the first step in the portfolio construction process which is step 3 above. Tactical asset allocation is the subsequent deviation from the strategic asset allocation based on short-term capital market expectations. Capital market expectations are used for the generation of the efficient frontier used in step 2 above which occurs before the portfolio construction takes place.

prashantsahni

Paul Kelley and Marie Dascenzo are portfolio managers for Myers and Schmolenberger Investment Advisors. Kelley and Dascenzo are discussing the asset allocation process that their firm should follow for its clients. Kelley states, “The asset allocation process should always start with determining the risk tolerance and return objective for each client.” Dascenzo replies, “While about half of the steps of the asset allocation process is the responsibility of the portfolio manager, the other half of the asset allocation process is the responsibility of the client.”

With regard to their statements about the asset allocation process:

A) Kelley is incorrect; Dascenzo is incorrect.

B) Kelley is correct; Dascenzo is incorrect.

C) Kelley is correct; Dascenzo is correct.

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Kelley’s statement is correct. The asset allocation process starts with identifying the investor’s return requirement and risk tolerance. From there, the portfolio manager must identify capital market expectations, select the appropriate asset classes, and monitor and adjust the allocation as necessary. Dascenzo’s statement is incorrect – each of the steps in this process is the responsibility of the portfolio manager.

prashantsahni

Sarah Berndt recently hired Phil Ruyle as a new portfolio manager with her firm, Private Wealth Consultants. Ruyle spends his first day with the firm shadowing Berndt and learning about her process. During the day, Berndt makes two statements regarding the asset allocation process:

Statement 1:	“The downside to the strategic asset allocation process is that if the long-term capital market expectations that formed the basis of the strategic asset allocation change dramatically, the client’s long-term returns are likely to suffer significantly.”
Statement 2:	“Tactical asset allocation has no role in the formal asset allocation process.”

  
With regard to the statements made by Berndt:

A) Statement 1 is correct; Statement 2 is correct.

B) Statement 1 is incorrect; Statement 2 is incorrect.

C) Statement 1 is correct; Statement 2 is incorrect.

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Both of Berndt’s statements are incorrect. Once the strategic asset allocation has been implemented, it should be monitored regularly and include a “feedback loop” such that changes in long-term market factors are incorporated back into the process and an assessment can be made to determine whether adjustments to the strategic allocation are justified. The key point here is that asset allocation is a flowing, flexible process. Also, if identified market changes are only short-term in nature, the manager should consider implementing tactical asset allocation measures which have been approved in the IPS. Tactical asset allocation definitely has a role in the formal asset allocation process.