Reading 25: Asset Allocation－LOS a investor, function, strategic, management, allocation

tycoon

CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 7: Asset Allocation
Reading 25: Asset Allocation
LOS a: Summarize the function of strategic asset allocation in portfolio management and discuss its role in relation to specifying and controlling the investor's exposures to systematic risk.

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.

---

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.

---

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.

---

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.

tycoon

Strategic asset allocation reflects what systematic risk exposure?

A) Asset class systematic risk.

B) One that lies on the efficient frontier.

C) Long-term systematic risk exposure.

D) Investors desired systematic risk exposure.

---

Answer and Explanation

Strategic asset allocation reflects the investors desired systematic risk exposure.

tycoon

What does Strategic Asset Allocation allow managers to do with respect to systematic risk?

A) Reduce.

B) Monitor and control.

C) Eliminate.

D) Identify and minimize.

---

Answer and Explanation

Strategic asset allocation reflects the investors desired systematic risk exposure and allows the manager to monitor and control risk not to reduce, eliminate or minimize it.

tycoon

Strategic asset allocation is based upon:

A) short-term capital market expectations and the investment policy statement.

B) long-term capital market expectations and the investment policy statement.

C) long-term capital market expectations and risk/return preferences of the investor.

D) short-term capital market expectations and risk/return preferences of the investor.

---

Answer and Explanation

Strategic asset allocation is based on long-term capital market expectations (which forms the basis for the generation of the efficient frontier) and the investment policy statement (IPS) of the investor. The IPS includes not only the risk/return objectives of the investor but also the investors constraints.

tycoon

According to the modern portfolio theory, which risk is rewarded?

A) Efficient risk.

B) Systematic risk.

C) Total risk.

D) Standard deviation.

---

Answer and Explanation

According to modern portfolio theory, only systematic risk is rewarded. Total risk (may be measured by standard deviation) is comprised on systematic and unsystematic risk.

tycoon

The first step in the portfolio construction process is called:

A) tactical asset allocation.

B) efficient frontier optimization.

C) capital market expectation.

D) strategic asset allocation.

---

Answer and Explanation

Strategic asset allocation is the first step in the portfolio construction process. 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.

tycoon

Assignment of asset class weights for a portfolio based on long-term capital market expectations is called:

A) tactical asset allocation.

B) strategic asset allocation.

C) portfolio optimization.

D) risk minimization.

---

Answer and Explanation

Strategic asset allocation is the assignment of weights to different asset classes based on long-term capital market expectations. Tactical asset allocation is based on short-term capital market expectations.

tycoon

In a market that can be characterized by up-down or down-up movements, rather than a sustained up or down trend, which of the following statements is least accurate with regard to the benefits of rebalancing the asset mix of a portfolio?

A) Under a buy and hold strategy, asset allocation changes occur solely in response to changes in relative market values.

B) Disciplined rebalancing strategies are superior to a buy and hold strategy.

C) Momentum-based rebalancing strategies outperform disciplined rebalancing strategies.

D) Market-timing strategies usually underperform disciplined rebalancing strategies.

---

Answer and Explanation

Disciplined rebalancing (e.g., maintaining a 60% stock / 40% bond mix) is superior to a momentum-based rebalancing strategy when the market is not following a sustained trend.

tycoon

Which of the following statements regarding the strategic asset allocation process is least accurate?

A) Strategic asset allocation, similar to tactical asset allocation, employs a short-run capital market projection.

B) The strategic asset allocation review is typically performed once per year.

C) Strategic asset allocation is similar to a "constant mix" strategy.

D) The strategic asset allocation must be rebalanced periodically for changes in the valuation of the various asset classes in the portfolio.

---

Answer and Explanation

Strategic asset allocation employs a long-term capital market projection.