05.Asset Allocation

8/8/2019 05.Asset Allocation

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Asset allocation One step

Security selection

Rarely (if ever) done as it is too costly

Securities Security

Selection

Overall

Portfolio


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Asset allocation Two steps

Security selection and Asset allocation

Asset allocation usually precedes stockselection

Securities Security

Selection

Asset-class

Portfolio

Stock

Portfolio

BondPortfolio

Asset

Allocation

Overall

Portfolio


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Asset allocation

Involves defining asset classes

Typical institutional asset classes Domestic equities

Foreign equities

Fixed income Real estate

Private equity

Policy portfolio defines the target allocation to

each of the asset classes


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Whats the big deal?

Both asset allocation and security selectioncontribute to the overall performance of theportfolio

However, studies have shown that asset

allocation has an overwhelmingly moreimportant effect than pure security selection


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Defining asset classes

Functional attributes play a dominant role indefining asset classes Debt versus equity

Private versus public Liquid versus illiquid

Domestic versus foreign


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Typical asset classes

Domestic stocks Largecap / Midcap /Smallcap

Value/growth

Industry

International stocks Developed / emerging

Domestic bonds Long term / intermediate

term / short term

Government / corporate High yield

Municipal

International bonds

Real Estate

Alternative investments Commodities / natural

resources

Currencies

Private equity / venturecapital

Hedge funds


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Criteria for determining asset classes

Relatively few in number Explain a substantial proportion of variance in returns Relative independence

Does the asset class help efficient diversification? What is its correlation with other asset classes?

Eg. intermediate term bonds vs. long term and short termbonds

Homogeneity If club dissimilar components, then impose the unnecessary

constraint that components be held in same relative proportion Eg. Foreign stocks is perhaps not an asset class

Capacity Should be sufficiently large to absorb a meaningful fraction of

portfolio

Have a low-cost index for each class


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Defining asset classes example

Fixed income frequently treated as hedgeagainst downturns

This strictly implies only high-quality, long-term, non-callable bonds, essentially

government bonds Junk bonds should not be mixed

Contain equity-like risks

TIPS should not be mixed with this What is the impact of unanticipated inflation?


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Strategic and tactical asset allocation

Strategic asset allocation Long-term forecasts of expected returns, variances,

and covariances

What to do for the long-term

Tactical asset allocation (TAA) How funds are to be divided at any particular point

of time given short-term forecasts

What to do under current market conditions


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Portfolio revision

Previous portfolio may become sub-optimal Change in attitude towards risk and return

Forecasts have changed

Weights have changed due to different performanceof asset classes

Benefits to be weighed against transactioncosts


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Alternative asset classes

Three main types Absolute return

Real estate

Private equity

Contribute to the portfolio constructionprocess by pushing back the efficient frontier

Facilitate structuring of truly diversifiedportfolios

Lack efficient pricing Opportunities for astute active managers


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Absolute return

Positions in marketable securities exhibitinglittle correlation with traditional stock andbond movements

Two types

Event driven: Depend on the timing of a specificcorporate finance transaction Returns dependent on events rather than on the overall

stock market

Value driven: Employ hedged portfolios

Absolute return depends on active management

05.Asset Allocation

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