Portfolio Formation and Asset Allocation

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					Portfolio Formation and Asset
           Allocation
           04/10/07
Portfolio Formation and Asset
Allocation
• Understand the individual investor life cycle

• Develop objectives and constraints
  • Our focus will be on developing return and risk
    objectives
  • The objectives and constraints allow us to assign
    initial asset allocations


• Introduction to asset allocation
  • Description of asset classes (note: Chapter 3
    provides a more detailed description of securities)
  • Importance of asset allocation                   2
Portfolio Formation and Asset
Allocation

  • Passive equity management strategies

  • Security market indices
    • Understand styles, index calculations
    • Concept of benchmark




                                              3
Individual Investor Life Cycle
• Accumulation phase
  • early to middle years of working career
  • Longer time horizon affords individuals in this phase to take
    more risk.

• Consolidation phase
  • past midpoint of careers
  • Earnings greater than expenses
  • Still long time horizon but capital preservation becomes more
    important

• Spending/Gifting phase
  • begins after retirement
  • Capital preservation and inflation protection are very
    important
                                                               4
Individual Investor Life Cycle

Net Worth                                             Spending Phase/ Gifting
  Accumulation Phase        Consolidation Phase       Phase

  Long-term:                Long-term:                Long-term:
          Retirement                                          Estate Planning
                                    Retirement
         Children’s                                   Short-term:
                            Short-term:
         college
                                    Vacations                 Lifestyle Needs
                                                              Gifts
  Short-term:                       Children’s
          House                     college
          Car



          25           35         45             55       65           75
    Exhibit 2.1                                           Age          5
Investment Policy Statement

• The investment policy statement (IPS)
  is a road map that:
  • specifies investment goals and acceptable
    risk levels

  • should be reviewed periodically

  • guides all investment decisions

                                            6
The Need For An IPS
• Helps investors understand their own
  needs, objectives, and investment
  constraints

• Sets standards (benchmark portfolios)
  for evaluating portfolio performance

• Reduces the possibility of inappropriate
  behavior on the part of the portfolio
  manager                                    7
Investment Objectives
 • The primary objectives that need to be
   addressed in constructing an IPS are the
   client‟s risk and return objectives.

 • These objectives can be stated in
   qualitative and quantitative terms.
   • For example, a qualitative return objective may
     be to „provide adequate retirement income‟. A
     qualitative risk objective or assessment maybe
     to find that the client can tolerate a moderate
     level of risk.

                                                  8
Investment Objectives

• For asset allocation purposes, a quantitative
  specification of return and risk objectives are
  more useful.




                                               9
Investment Objectives

• Return objectives
 • Capital preservation – maintenance of
   the purchasing power of their
   investment

 • Capital appreciation - growth of the
   portfolio in real terms to meet future
   need


                                            10
Investment Objectives

• Return objectives
 • Current income - focus is in generating
   income rather than capital gains


 • Total return – focus is on increasing
   portfolio value through capital gains and
   reinvestment of current income.



                                               11
Investment Objectives

• Return objectives
 • A simple additive formulation of the absolute return objective is a
   good starting point.



 • However, the effect of compounding and of expenses should be
   incorporated in stating a IPS return objective:

               Return  (1  SR)(1  IR)(1  exp) - 1

 where SR = spending rate, IR = expected inflation rate and exp =
   investment expense


                                                                   12
Investment Objectives

• Return objectives
 • Multi-period considerations:
   • If a client‟s return objective is stated as an arithmetic mean
     annual return objective but is based on the compound rate of
     return on the portfolio, the objective should be adjusted
     upward to reflect the fact that arithmetic returns required to
     achieve a goal are higher than returns stated as a compound
     rate. The adjustment should be based on the following
     approximation:


               CGR  E ( AR)  0.5 *            2


   Where CGR = required compound growth rate, AR is the
    arithmetic mean return and σ is the portfolio standard
    deviation.                                                   13
Investment Objectives

• Risk Objectives
  • An IPS can state a client‟s level of risk qualitatively
    based on the client‟s risk tolerance

  • This risk tolerance is based on his ability and
    willingness to take on risk and is a function of:
     • Psychological makeup
     • Current wealth
     • Age

  • A client‟s risk tolerance is typically assessed using
    a questionnaire.

                                                        14
Investment Objectives

• Risk Objectives
  • A client‟s risk objective can be quantified in a
    number of ways:
     • Mean-variance utility
        • Based on the client‟s risk aversion, the asset mix with the
          highest expected utility for the client is optimal


            U m  E ( Rm )  0.005RA * m
                                                 2



        Where U is the utility for the client for asset mix m, E(R) is
         the expected return for asset mix m, and σ is the asset mix
         standard deviation.
                                                                   15
Investment Objectives

• Risk Objectives
  • A client‟s risk objective can be quantified in a
    number of ways:
     • Mean-variance utility
        • A guideline for the risk aversion parameter is as follows:

            1< Risk aversion < 2            high risk tolerance
            3< Risk aversion < 5            moderate risk tolerance
            6< Risk aversion < 8            low risk tolerance




                                                                   16
Investment Objectives

• Risk Objectives
  • A client‟s risk objective can be quantified in a
    number of ways:
     • Maximum acceptable standard deviation

     • Shortfall risk – the risk that a portfolio‟s value will fall
       below some minimum acceptable level during a stated
       time horizon.
        • We can use Roy’s safety first criterion to evaluate
          portfolios based on shortfall risk.



                                                                  17
Investment Objectives

• Risk Objectives
  • A client‟s risk objective can be quantified in a number of
    ways:
     • Shortfall risk –Roy’s safety first criterion:


                                    E ( R p )  RL
                        SFRatio 
                                         p

       where RL is the minimum acceptable return

         • The portfolio with the highest SFRatio is optimal


                                                                 18
Investment Constraints

• Liquidity needs
  • Vary between investors depending upon age,
    employment, tax status, etc.


• Time horizon
  • Influences liquidity needs and risk tolerance


• Tax concerns

                                                    19
Investment Constraints

• Legal and regulatory factors
  • Limitations or penalties on withdrawals

  • Fiduciary responsibilities - “prudent man” rule
     • Investments should be based on effect on portfolio
     • Certain types of risky investments must be avoided


  • Investment laws prohibit insider trading



                                                            20
Investment Constraints

• Unique needs and preferences
  • Personal preferences such as socially conscious
    investments could influence investment choice

  • Time constraints or lack of expertise for managing
    the portfolio may require professional management

  • Large investment in employer‟s stock may require
    consideration of diversification needs


                                                      21
Asset Allocation

• Asset allocation is the allocation of
  investable funds across asset classes
  that are IPS-permissible based on the
  objectives and constraints of the client.




                                         22
Asset Allocation: Selection of Asset
Classes

• Criteria to specify asset classes:
  • Assets within an asset class should be
    relatively homogenous
  • Asset classes should be mutually exclusive
  • Asset classes should be diversifying
    (correlations should be less than 0.95)
  • As a group, asset classes should make up
    a preponderance of world investable
    wealth
                                            23
Asset Allocation: Asset Classes
• Domestic equity – can be further broken
  down by style
• Domestic fixed income – can be broken
  down by government/corporate or by
  maturity
• Non-domestic equity – can be broken down
  by developed/emerging market
• Non-domestic fixed income
• Real estate
• Alternative investments
  • Private equity, natural resources, hedge funds   24
Asset Allocation: Including a New
Asset Class

• Based on mean-variance analysis, adding an
  asset class to a portfolio is optimal if:


       E ( Rnew )  RF     E ( R p )  RF   
                                           Corr ( Rnew, R p )
            new                p          
                                            




                                                                   25
The Importance of Asset
Allocation
• An investment strategy is based
  on four decisions
 • What asset classes to consider for
   investment
 • What normal or policy weights to assign
   to each eligible class
 • Determining the allowable allocation
   ranges based on policy weights
 • What specific securities to purchase for
   the portfolio                              26
The Importance of Asset
Allocation: Ibbotson and Kaplan
• Ibbotson and Kaplan (2000) reading
  examines mutual fund and pension fund
  total returns by separating these
  returns into policy returns and active
  returns.

• They use 10 years of monthly return
  data ending in March of 1998.
                                        27
The Importance of Asset
Allocation: Ibbotson and Kaplan
• They find that:
  • Over time, approximately 90% of a fund‟s
    return is explained by the fund‟s policy,
    i.e., the asset classes in which the fund is
    invested
  • Across mutual funds, about 40% of returns
    are explained by policy and 60% by timing,
    style, security selection and fees
  • On average, mutual funds return slightly
    less than the policy return but the best
    managers perform considerably better.
                                             28
Returns and Risk of Different
Asset Classes
• Historically, small company stocks have
  generated the highest returns. But the
  volatility of returns have been the highest
  too.

• Inflation and taxes have a major impact on
  returns

• Returns on Treasury Bills have barely kept
  pace with inflation

                                                29
Asset Allocation and
Cultural Differences
• Social, political, and tax environments
  influence the asset allocation decision
• Equity allocations of U.S. pension funds
  average 58%
• In the United Kingdom, equities make up
  78% of assets
• In Germany, equity allocation averages 8%
• In Japan, equities are 37% of assets

                                          30
Readings

• RB 2 (pages specified in syllabus),
• RM 1,
• RM 3 (sections 1, 2, 3.2 – 3.3, 4)
  • RM 3 is titled “Asset Allocation”




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