CHARTERED INSTITUTE FOR SECURITIES & INVESTMENT

WINTER 2015CHIEF EXAMINER’S REPORT-

PORTFOLIO CONTRUCTION THEORY

IntroductionThe task of this exam is to assess knowledge and understanding of portfolio

construction within wealth management against the unit syllabus. Occasionally the exam may draw on a small number of low mark questions from the Financial Markets syllabus or the level assumed. This will be to a very minor extent. The exam does not test the Applied Wealth Management syllabus.

On successful completion of this exam candidates will have demonstrated strong conceptual and applied knowledge and understanding of the principal analytical tools of portfolio construction, familiarity and comfort with the application of quantitative and qualitative problems in portfolio construction, and an ability to rigorously analyse problems in portfolio construction. Up-to-date knowledge and understanding of significant financial events and developments may be examined. Following the Freedom and Choice reforms, PCT naturally needs to be more involved in examining the sustainable management of wealth over a long period of time, especially where it concerns income in retirement.

Exam compositionQuestions on taxation will tend to comprise 10% to 30% of the exam, either

stand-alone or integrated within another question. This exam sitting had slightly under 20% of the total mark allocated to questions on taxation. Questions will continue on tax issues relevant to major asset classes, securities, funds and strategies. The focus is taxation of the portfolio/fund/strategy rather than taxation of the individual. There may occasionally be a question concerning CGT or IHT. Where there are a low number of marks is likely to be allocated and this is more likely to appear as a multiple choice question (MCQ). Questions on tax in the exam focused on net-returns on inflation linked bonds, after-tax valuation within the capital asset pricing model, the taxation of funds, and taxation of Reporting funds and Non- Reporting funds. Numerical questions will tend to comprise 30% to 50% of the exam. Questions that examine charts and tables will tend to comprise 5% to 20% of the exam. Interpretative questions will tend to comprise 20% to 50% of the exam. The last three of these have long applied.

Advice for exam successBe neat. Help the examiner to be able to read the paper. Being untidy with

poor handwriting can only lose you marks as the examiner is so busy making out each word that the meaning of the answer can become lost. Underline or highlight key points if you wish. If the examiner cannot find or read your answers marks cannot be given. A poorly ordered script may lead to lower marks if the examiner becomes distracted looking for the answer. Do not split your answer to a question by entering parts of the answer in different parts of the answer book.

Be precise, succinct and efficient in your word use. At Chartered level the examiner expects to see descriptive, explanatory, discursive, analytical and critical skills in use. Demonstrate excellent critical and appraisal skills on interpretive questions.

If the question involves a calculation, ensure the final answer is clear. Ensure the workings can be followed so that marks for correct procedure can be given. It can sometimes help to set out the formula you intend to use

The ability to tackle interpretive questions well is important to passing the exam and a major reason for high scores. Interpretive questions often elicit a range of answers and candidates can and do score high marks with very different answers. Set out reasoning, assumptions, choices made, and justify decisions taken within the answer. The policy and process are at least as important as the delivery solution. Answers that dive straight into a solution tend not to score high answers. An answer that nothing should change, if strongly reasoned and justified, can score high marks.

Competence with both numerical and narrative questions are needed in the exam. The exam board often looks for demonstration of good numeracy and preponderance of marks ie, no zero marks, when setting grade boundaries. Preponderance exists when there is a run of good marks - numerical and narrative, theoretical and applied, across the various sections.

Candidates are expected to think and reason beyond standard workbook narratives if they are to be successful in the exam. Candidates should remain mindful that the exam’s remit is to test the syllabus. The workbook is an important but ultimately incomplete interpretation of the syllabus. Do not expect exam questions that look for answers straight from the workbook and do presume high predictability of exam questions based on the past. Expect to use three quarters to a whole of a workbook.

Performance on the SectionsSection A comprised 20 MCQs worth 20 marks. 9% of candidates obtained

less than 50%. 9% obtained 50-59%, 20% obtained 60-69%, 33% obtained 70%-79%, 23% obtained 80%-89%, and 6% obtained 90% or more.

Section B comprised short to medium answer questions worth 40 marks. 33% of candidates obtained below 50%. 15% obtained 50-59%, 17% obtained 60-69%,

16% obtained 70%-79%, 13% obtained 80-89%, 16% obtained 70%-79%, and 6% obtained 90% or more.

Section C comprised three case study questions of 20 marks each. Each candidate is to answer any 2 of the 3 questions. 7% of candidates obtained below 50%. 23% obtained 50-59%, 44% obtained 60-69%, 22% obtained 70-79%, and 4% obtained 80% or more. In Section C, Q12 on portfolio performance measurement was most popular, with 97% of candidates selecting it. Q11 on stranded assets and investing in a world of climate change was least popular, with 25% of candidates attempting it. 78% of candidates attempted Q13 on asset allocation. In Section C, Question 13 was the least well answered, and Question 12 best answered.

Specific Issues and Answers to Each Question

Section ASection A of the paper assesses candidates’ broad knowledge of the syllabus.

Marks in Section A often predict how well a candidate will score across other sections. This being the case, an effective spread of knowledge is important for a good overall exam mark.

Question 1There were 20 MCQs worth one mark each. The mean median and modal

mark was 14 out of 20. The standard deviation of marks was 3 marks. The maximum mark was 19 and the minimum 7. The 20 parts to question 1 are as follows:

The correct answer to each multiple choice question was (a) B, (b) C, (c) B, (d) C, (e)D, (f) B, (g) D, (h) A, (i) B, (j) D, (k) C, (l) C, (m) B, (n) A, (o) B, (p) B, (q) A, (r) C,(s) C, and (t) D. Candidates often incorrectly answered (h), (n), (o), (j), (p).

Section BSection B of the paper tested candidates’ knowledge and ability to appraise

specific parts of the syllabus via questions that require short to medium length answers. The mean, median, and modal mark was 24, 25 and 24 out of 40 respectively. The standard deviation was 7 marks. The maximum mark was 38 and the minimum 5. Many candidates remain underprepared on the numerical questions. Answers to the 9 questions in section B are as follows:

Question 2This 2 mark question asked candidates to explain whether foreign or domestic

inflation is likely to matter most to an investor. The mean, median and modal marks were 1.5, 2 and 2 respectively. The maximum mark was 2 and the minimum 0.

Candidates arguing that the UK inflation mattered more tended to presume that a portfolio of UK assets was being managed but there was nothing in the question to indicate that was the case. The portfolio might just as well have been one of emerging market investments. Some marks were given for a well-argued answer

regardless of the conclusion but the best answer was that the inflation rate that matters is the investor’s domestic inflation rate. The selection of an overseas inflation rate is the more arbitrary because it is not the inflation rate that the client is most likely to be trying to protect his/her purchasing power against. If nominal returns are deflated by the inflation rate in each country invested in, it is not clear what the real return presented to the client indicates.

Overall, it’s better to show overseas nominal returns because the foreign inflation rate is not relevant to the domestic investor. If the exchange rate is moving in step with differences in overseas/domestic inflation then converting local market returns to the client’s domestic currency will already take account of inflation – it is in the exchange rate.

Question 3This 2 mark question asked candidates to calculate the real, inflation adjusted

portfolio return. The mean, median and modal marks were 1, 1 and 2 respectively. The maximum mark was 2 and the minimum 0.

US$ real return = ((15600000*1.55)/(13840000*1.65) / (1+0.02)-1= 3.8%

One incorrect route taken by some candidates was to adjust by UK inflation.

Another incorrect route taken was to deduct US inflation and not divide.

Question 4This 3 mark question assessed candidates’ understanding of compounding and

annualised numbers, an area that is regularly tested. Overall the question had a mean, median and modal mark of 1.5, 1.5 and 1.5 respectively. The maximum mark was 3 and the minimum 0.

Last year’s US$ real return = ((15600000*1.55)/(13840000*1.65) / (1+0.02)-1= 3.8% This year’s US$ real return = ((15200000*1.7)/(15600000*1.55) / (1+0.15)-1= 5.3%

Compound real 2 year return in US$ is ((1+3.8%) x (1+5.3%))-1 = 9.3% Annualised total return is ((1+9.3%)^0.5)-1= 4.54%

Question 5This 9 mark question asked candidates to calculate the return and tax paid on

an investment in an index linked bond. The mean, median and modal mark was 4, 3.5 and 3 respectively. The maximum mark was 9 and the minimum 0. The correct answers are:

a. Explain how the client will be taxed on the investment.

At basic rate of tax which is 20%.

b. What is the compound nominal total return on the bond as a £ amount gross of tax over the 5 year holding period?

£118,392

c. What is the total tax payable by the client as a £ amount over the 5 year holding period?

£13,270

d. What is the tax payable by the client as a percent of the total return? 11%

The table below sets out the workings.

e. What is the tax payable by the client as a percent of the total return?The actual tax rate is constant so long as tax payer stays in current basic rate band, but the deduction for tax is more modest the lower the coupon (bond yield). The tax burden will fall as the interest rate falls because coupons now make-up a smaller proportion of total return. The capital gain part of total return is tax-free.The higher the yield the more coupons, or income, make-up a larger proportion of total return and the greater the tax paid per unit of total return. This means the relationship between the level of coupon payments (yield) and effective tax paid – the effective tax rate, is positive.

UK Government Inflation linked bond questioncolumn 1 column 2 column 3 column 4 column 5 column 6

RPI RPI indexRPI adjusted capital growth on

£500,000 principal Coupon rate %

RPI adjusted coupon

100.0Year 1 bond purchased at start of year at Par‐ 2% 102.0 510000 2.5% 12750Year 2 2% 104.0 520200 2.5% 13005Year 3 2% 106.1 530604 2.5% 13265Year 4 2% 108.2 541216 2.5% 13530Year 5 bond matures and principal paid‐ 2% 110.4 552040 2.5% 13801

Net RPI adjusted principal paid at maturity (552,040 500,000)‐ 52,040Total RPI adjusted coupons paid by maturity (sum of all the coupons) 66,352Total return UK£ is the sum of coupons and principal (52,040 + 66,352) 118,392Total tax payable UK£ = 20% of coupons (66,352 x 20%) 13,270Tax paid / total return (13,270 / 118,392) 11%

step 1: form inflation index by compounding annual RPI (column 3). Interest and principal (original capital) are separate. Interest paid out each yr. Principal paid at maturitystep 2: calculate RPI adjusted principal paid on maturity. Multiply principal by total change in inflation over the period. =(end inflation index / start inflation index) * original principal step 3: calculate RPI adjusted annual coupons. Multiply coupon rate (%) by total change in inflation up to this date. =(current year inflation index / start inflation index) * coupon rate % step 4: sum the annual RPI adjusted coupons paid (they're paid out as cash not re invested). ‐ Calculate tax paid by multiplying total RPI coupons paid by 20%step 5: calculate total UK£ return = RPI adjusted principal paid on maturity £500,000 first invested (step 2) + annual RPI adjusted coupons paid out ‐step 6: divide UK£ tax paid by UK£ total return. The answer is the effective tax rate paid by client .

Question 6This 7 mark question asked candidates to suggest the most appropriate asset

allocation taking into account a person’s risk tolerance. The mean, median and modal mark was 4, 4 and 5 respectively. The maximum mark was 6.5 and the minimum 0.

We need to match each client to the most appropriate portfolio. This is achieved by incorporating the numerical risk tolerance score within the overall calculation. This can be calculated as:

Expected return – risk of portfolio. Where risk of the portfolio to the client is standard deviation / risk tolerance factor. This gives an investment suitability, measured by client utility per portfolio.

Portfolio Stock BondExpected Return on Portfolio

Risk (Standard Deviation) of

Portfolio

Risk Tolerance

Ms A

Risk Tolerance

Mr B2 8

1 5.00% 95.00% 5.00% 4.00% 3.0% 4.5%2 25.00% 75.00% 6.00% 7.00% 2.5% 5.1%3 70.00% 30.00% 7.50% 10.00% 2.5% 6.3%4 90.00% 10.00% 8.20% 18.00% -0.8% 6.0%

Correct answer is Ms A = portfolio 1, and Mr B = portfolio 3.

Why is there a difference in these two outcomes?

Ms A is less risk tolerant. This means she prefers a lower risk portfolio, other things equal. Mr B is more risk tolerant. This means he prefers a higher risk portfolio, other things equal. In the formula the expected portfolio return to different asset mixes is reduced by risk of portfolio / risk tolerance factor. This formula acts as a risk penalty. The risk tolerance is the denominator so the smaller it is the greater is the risk penalty that reduces expected return. This will generally lead to a less risk tolerant investor being matched to an asset mix with lower risk and a more risk tolerant investor being matched to an asset mix with higher risk.

What other technique might one use? Answers included:

Qualitative survey Measure capacity for loss Client experience with investments Markowitz portfolio theory – find minimum variance portfolio or highest Sharpe

ratio portfolio and mix with proportions of risk-free asset Construct utility curve for each client Open discussion with client Rely on peer group designed portfolios such as from WMA Show client charts of drawdown and losses Use a different formula for expected utility that still uses a risk aversion score e.g.

ER – 0.5 x risk aversion score x standard deviation squared.

Question 7This 4 mark question on smart, or alternative, beta was answered well. The

mean, median and modal mark was 3, 3.5 and 4 respectively. The maximum mark was 4 and the minimum 0.

High scoring scripts mentioned many of the following:

Merits Opportunity to follow a long-run investment anomaly such as high dividend

stocks, low P/E, or momentum. Not procyclical so potentially lower risk in times of market downturns. Can have lower and more stable correlation to other assets, so may provide

more diversification. Many of the smart beta indices are by design underweight the largest stocks in

the market cap universe, therefore if biggest drop in the biggest stocks, alternative beta indices will outperform.

Drawbacks Higher fees and charges Higher and unknown annual turnover because the individual constituent

weights are determined endogeneously by an optimiser. Unclear when to rebalance the index. If they become popular and everyone follows the anomaly will presumably

disappear. There is evidence of reducing anomaly size e.g. day of the week effect, momentum.

There are some concerns that the anomaly exists only as a backtest – that the index was created by datamining rather than discovering a persistent structural effect.

Liquidity can be a concern - some smart beta indices are liquid, others not. Incentives - there’s no incentive to manage overall assets in any particular

strategy - compensation for managers is in the form of management fees and not performance fees. The index provider has few incentives to continue to research and improve the index.

Question 8This 6 mark tax related question was relatively well answered, with a

significant minority of candidates scoring full marks. The mean, median and modal mark was 4.5 out of 6. The maximum mark was 6 and the minimum 0. The correct answer is:

A)The reporting fund has all capital return taxed at marginal CGT rate. All CGT allowance has been used.4% x (1-0.28) = 2.88% net.

All income is taxed at dividend rate.

2% x (1-0.325) = 1.35% net.

2.88% + 1.35% = 4.2% to 4.3%

A very small number of candidates stated that their working assumption was that as the fund was not sold there is no CGT to pay. The large majority presumed the spirit of the question was to calculate the net return for each of the two types of fund like- for-like, and deducted the CGT.

B)For non-reporting fund – tax all as income. All income and gain is charged at highest income tax rate. Higher rate income tax 40%. All the return is taxed at marginal income tax rate. All CGT allowance has been used.

6.5% x (1-0.40) = 3.9% net.

Question 9This 3 mark question asked about the convertible bond premium. Answers were of a very high standard, with a mean, median and modal mark of 3 out of 4. The maximum mark was 3 and the minimum 0.

The convertible bond enables the holder to exploit the upside potential of equity whilst retaining the safety of a bond. Investors can be expected to pay a premium for instruments that offer equity growth potential but remove equity downside risk. A convertible bond essentially has an attached call option on the equity. The option has time value that one would expect investors to value in normal circumstances. The premium will be a function of:

How long time there is to run on the option – more time equals more potential growth in the share price.

The expected performance in the underlying stock. Credit characteristics - the company’s forecast credit default and downgrade

probability relative to its credit rating on issuance.

Question 10This 4 mark question asked about after tax valuation using the capital asset pricing model. Answers were of a much better standard than the last time a similar question was asked. The mean, median and modal mark was 3 out of 4. The maximum mark was 4 and the minimum 0.

Very important to answering correctly is that neither stock was sold. They remain in the portfolio. Capital gains tax is not relevant. Also important is the investor, who is a higher rate tax payer. Both of the equities, A and B, pay dividends. The valuation of both is asked on an after-tax basis.

Equity ARequired return for Stock A = 0.5% + 1.2 x (5.5% – 0.5%) = 6.5%. For stock A John has a further 25% to pay on the dividend received.

The pre-tax expected return for Stock A is 8.5%

The expected return on an after-tax basis for Stock A comprises 5.5% capital gain + dividend return. The after-tax dividend return is 3% x 0.75 (i.e. 1-0.25) = 2.25%.

Or this can be calculated from the gross dividend (10% more than the net received) of 3% x (100/90) x (1-0.325) = 2.25%. This method reduces the gross dividend by the full amount of dividend tax at 32.5%.

Either of the two ways to calculate the after tax return is fine. The after-tax expected return for Stock A is 5.5% + 2.25% = 7.75%. Stock A is undervalued. This is above the SML.

Equity BStock B also pays dividends. Required return for Stock B = 0.5% + 0.7 x (5.5% – 0.5%) = 4%. For stock B John has a further 25% to pay on the dividend received.

The pre-tax expected return for Stock B is 6%

The expected return on an after-tax basis for Stock B comprises 2% capital gain + dividend return. The after-tax dividend return is 4% x 0.75 (i.e. 1-0.25) = 3%.

Or this can be calculated from the gross dividend (10% more than the net received) of 4% x (100/90) x (1-0.325) = 3%. This method reduces the gross dividend by the full amount of dividend tax at 32.5%.

Either of the two ways to calculate the after tax return is fine. The after-tax expected return for Stock B is 2% + 3% = 5%. Stock B is also undervalued. This is above the SML.

Section CThe aim of Section C is to test depth of knowledge through three long answer

case study questions, as well as to test candidates applied skills.

Question 11The question was least popular, with only one-quarter of candidates selecting it. The mean, median and modal mark was 13, 13, and 15 out of 20. The maximum mark was 16.5 and the minimum 6. The question of investment and climate change is very much in investment and general media.

AStranded assets can occur when input costs required to exploit an asset to produce rise significantly, or when the price or value of the output or product fall significantly.

Climate change and carbon exposure has the potential to be a major challenge (and opportunity) for this investor with a long term horizon. At the very least the investor would need to be kept abreast of the risks posed by exposure to carbon and climate change and developing approaches to managing those risks.

Scientific consensus expects significant effects of climate change caused by man- made emissions of greenhouse gases throughout the globe which will almost certainly impact investment portfolios. Much of this impact is likely to be felt over the longer term - though the latest report from the IPCC notes that the:

Observed impacts of climate change have already affected agriculture, human health, ecosystems on land and in the oceans, water supplies, and some people’s livelihoods.

The investor will need to manage this portfolio risk proportionately and over the appropriate timescales.

The time horizon is relevant because markets discount and securities are valued based on their net present value. There is an empirical question concerning how far ahead markets do actually discount – the so called short termism debate. Presuming the market does discount appropriately new climate change information will move security prices.

Even if the market is not appropriately discounting sufficiently far ahead, regulation, legislation and voluntary initiatives might change in the short term which can alter prices. For example taxes and subsidies might alter in the short term to encourage new markets and deter more CO2 emitting markets.

There is evidence that forecast prices and valuations are building in scenarios for asset stranding. The share prices of several global coal companies are now essentially worthless, for example Peabody Coal. Candidates had quite different views as to whether fossil assets would strand. Of course uncertainty alone about the path of climate change and the materiality of news arrival about this create security price volatility.

BLand mines and cluster munitions – very minimal, if any, impact on an already highly diversified portfolio. There are very few companies, and they are idiosyncratic. Exposure to the defence industry is still obtainable so full sector weight – if desired, can be maintained without a high level of stock specific risk.

Companies with oil, gas, and coal reserves – if the oil, gas, and coal exploration and upstream sector is avoided there is likely to be some reduced level of diversification. The fund would not be as well diversified as could be and full sector weight is not going to be achievable. This might be desirable from a future perspective but potentially this could also translate into financial detriment in the short to medium

term should there be a market environment in which holding that sector was important from a risk and return perspective. Oil and gas companies are also very reliable dividend payers – many investors depend on this, especially in the charity market.

CHow may climate change risk be managed, mitigated, hedged or offloaded?

Managed – regularly monitor vital climate indicators, engage with companies and ask how they are adapting, engage with legislators and reporting bodies for improved climate change related investment data disclosure. Be ready to trade on news.

Mitigated – Procure funds that can demonstrate low carbon emissions and low fossil fuels reserves. This is based on the belief that such companies will over time be valued differently in the future to how they are now. For example low carbon equity indices. Increase the weighting in funds with holdings of physical assets. Make the situation into an investment opportunity by adding a fund offering investment in climate change solutions. Move towards more sustainability led funds and indices. Some energy sectors are probably now in a state of permanent managed decline, for example coal. Removing coal assets from portfolios may make immediate sense.

Hedged – find assets with a beta that’s different to a fund exposed to climate change. Some commodities may be natural hedge, where perhaps supply of a commodity falls or demand rises as climate change deepens. This might mean adding a fund that could receive investment allocation if capital market and climate change vital indicators suggest such allocation is warranted.

Offloaded – look to find a structured product or insurance product that tansfers the risk to a third party.

These techniques may be operationalised via strategic asset allocation (long-term) or tactical asset allocation (short to medium term). Some candidates discussed how the strategies above would fit within forms of asset allocation and risk management.

Question 12The question was by far the most popular as well as best answered in section

C. The mean, median and modal mark was 14 out of 20. The maximum mark was 19 and the minimum 4. High scoring scripts performed the following:

A: Treynor measure

Portfolio MarketReturn 0.07 0.08

Risk-free return 0.03 0.03Beta 0.8 1

Answer (0.07-0.03) / 0.8 = (0.08-0.03) / 1 =0.050 0.050

B: Sharpe ratio

Portfolio MarketReturn 0.075 0.07

Risk-free return 0.02 0.02Standard deviation

of returns 0.15 0.13Answer (0.075-0.02) / 0.15 = (0.07-0.02) / 0.13

0.37 = 0.38

C: Information ratio

Information ratio = (compound portfolio return - compound benchmark return) / tracking error (standard deviation of return difference).The compound portfolio return - compound benchmark return is also known as the active return.The question already provides the denominator. The standard deviation of the active return = 0.007 or 0.7%

Period Portfolio Return %

Compound Portfolio Return

Benchmark Return %

Compound Benchmark

Return

100.0 100.01 2.3 102.3 2.7 102.72 -3.6 98.6 -4.6 98.03 5.2 103.7 5.6 103.54 1.2 104.99 1.6 105.12

Compound Return = 4.99 %

Compound Return = 5.12 %

= (4.99% - 5.12%) / 0.007 = -0.18 to -0.19

D: the large majority of candidates demonstrated a very high level of knowledge on the advantages and disadvantages of each measure. A few of the key points many mentioned are as follows:

A common performance test is whether actively departing from a benchmark leads to improved risk adjusted performance. Treynor, Sharpe Ratio and Information Ratio measure this. They are different ways of measuring performance.

All measures are risk adjusted but the definition of risk varies. Treynor uses Beta. The measure looks at the return to systematic risk. This is suitable for a diversified investor but can be hard for clients to understand. The Treynor measure is based on

the Security Market Line. Treynor can be useful for measuring returns across different sectors and for any portfolio where a client holds a number of portfolios.

The Sharpe Ratio is the 'excess' return of an asset over the return of a risk free asset divided by the standard deviation of returns i.e. total risk, systematic and unsystematic. The Sharpe Ratio is more intuitive to understand and more applicable for clients who may not be fully diversified. The Sharpe Ratio is based on the Capital Market Line - appropriate for investors with one portfolio.

The Information Ratio is a measure of active return, the difference between the portfolio return and the return on the benchmark index, divided by the standard deviation of the active return, or tracking error. The information ratio measures a portfolio manager's ability to generate excess returns relative to a benchmark by looking at the active bets taken. Information ratio also attempts to identify consistency of fund manager performance. The ratio identifies if a manager has beaten the benchmark by a lot in a few months or a little every month (because this will be reflected in the standard deviation of the return difference). The higher the information ratio the more consistent a manager, which is a good. The Information Ratio can be used as an indicator of active or passive (index) management style. Like the Treynor measure this can be hard for clients to understand.

Question 13The question tested candidates’ knowledge of asset allocation. The mean, median and modal mark was 12 out of 20. The maximum mark was 17 and the minimum 6. High scoring scripts included the following:

A: main statistical criteria used to separate different asset classes.Within an asset class investments should be statistically similar – there should be high correlation.In different asset classes investments should be statistically dissimilar – there should be low correlation.

Extra on definition – but not expected to be part of the answer:An asset class groups together investments and securities with similar characteristics. No investment should be able to be classified in more than one asset class.Asset class should be easy to define and describe.

B: what is asset allocation and what is the evidence on its importance?Asset allocation is the process of how to distribute capital among different investments – what is the asset mix and in what proportions. A focus on assets is justified as investment theory says investors are only rewarded for non-diversifiable or systematic risk (beta). Systematic risk is investment risk that cannot be offloaded. We can remove diversifiable risk by mixing assets using broad, diversified holdings, funds, or indices.

EvidenceA selection of the evidence that should have been mentioned is:

Brinson, Hood and Beebower (1986) examine the investments of 91 large US pension plans for the period 1974-1983. They conclude: “…investment policy (asset allocation) explains on average 93.6% of the variation in total plan return.”

Analysis extended by Brinson, Singer and Beebower (1991) to cover 1977-87. Average % return variation explained by asset allocation differences is 91.5%.

Blake, Lehmann and Timmermann (1999) investigated more than 300 UK pension plans covering the period 1986-1994. Asset allocation in UK pension industry could explain 99.5% of the variation in plan total returns.

Ibbotson and Kaplan (2000) find that 90% of the variability in returns of a typical US fund across time is explained by the fund’s asset allocation.

Research says how much of the variability of returns is explained by asset allocation – not the level.

C: what are the different techniques one may use to arrive at an estimate for risk, expected return, and correlation.

To input a risk, return, and correlation for each asset class we can use the following types of data: If we believe historic returns and the sequence, or path, to be important we use

actual historic data. If we believe historic returns to be important but the sequence unimportant we use

bootstrap historic data. Use sampling techniques with similar mean and standard deviation as past. Use sampling techniques with adjusted mean and standard deviation. Use forward looking capital market assumptions. Mean and standard deviation

samples different to past. Use other investors’ asset allocation as a reference point and do what they do. Techniques 1, 2, 3, 4 and 5 are inputs into portfolio theory. Techniques 1, 2, 3, 4 and 5 take long-term asset returns and calculate volatility and correlations. Method 6 is a mimicking approach.

D: synopsis and appraisal of three of the following four asset allocation techniques.

Long-term, traditional, asset allocationOften used where long-term investment growth is desired. Appropriate where investor is happy to bear the risk through ups and downs. Reflects a belief that the investment objective will eventually be met. But long-term asset allocation is not automatically adaptive to changing conditions. We don’t really know when to rebalance. Do we choose the discipline of a rule? Or do we choose human interpretation of information and data? Designed to see through the short-term and deliver on a future objective. LTAA is usually efficiently set by a mean-variance optimisation process. It is inexpensive in terms of trading costs if rebalancing is only periodic. Suitable if you wish a more passive approach – means that you do not have to be an active investor constantly reconsidering portfolio allocation. Although the initial asset mix is objectively set the actual weights move about. It is then not delivering on the most efficient asset mix. By doing nothing maximum asset class weight will occur just prior to drop in an asset’s value and vice versa. Rebalancing

typically means investing less (more) in assets that have risen (fallen) in value, relatively speaking. The portfolio weights of a LTAA seem to have little basis for change at any point in time. If there is a liability, with a long-term asset allocation there is an element of luck whether or not we meet our liability. Perhaps better suited to an investor who has an aspirational goal that is likely to be met but who can afford for it not to be.

Constant proportion asset allocationA contemporary way to risk manage a portfolio with a liability. Useful when there’s a future lump sum – deposit for house, a retirement amount, to fund possible long-term care, an investor wishes to preserve and not lose. We do not wish to forgo capital gains by being in only safe assets however. CPPI is designed for this - to preserve an amount of capital and make a gain. CPPI is a method of portfolio insurance where the investor sets a floor on the £ value of his or her portfolio, then structures asset allocation around that decision. Done by dividing the portfolio into two sub- portfolios - a “risky sub-portfolio” of growth assets and a “safe sub-portfolio” of short-term Government bonds such as a Treasuries and other stable value assets. The capital of the portfolio is moved between the risky and safe sub-portfolios depending on the performance of the risky sub-portfolio. As portfolio value falls closer to the floor, more and more is placed in the safe sub-portfolio. We sell into falling market rather than buying into a falling market. CPPI invests more in assets that have risen in value and may rise again and less in assets that have dropped in value and may drop again. More and more upside potential is removed to protect the capital. The process stops a loss relative to the floor but it also takes away some upside potential. With CPPI there’s little exposure to the upside when the equity market (or growth assets) rise again. The capital in the ‘safe’ plus ‘risky’ portfolio after a maximum loss event = the floor or liability.

Asset liability modelA second contemporary way to risk manage a portfolio with a liability. For this asset allocation model we again need to create two sub-portfolios. The safe portfolio is the ‘hedge portfolio’ or ‘protection portfolio’. Whatever markets do this will hold sufficient assets (plus their expected growth) to meet all the liabilities taking into consideration the expected return on safe assets. We then leave this alone. Assets will be good match for the liability e.g. a future lump sum so perhaps inflation linked bonds plus others. A key difference with the ALM is we do not move capital between the 2 sub-portfolios. The second sub-portfolio is the ‘performance sub-portfolio’ with the remainder of the assets. Performance assets could be totally wiped out and the liability is still met. Now go for very risky sources of performance with this sub- portfolio. We can include leverage so long as this does not endanger the liability we wish to protect. Leverage will also depend on whether legally can do so. Leave the hedge portfolio to meet the liabilities. We leverage the ‘performance’ portfolio until a maximum loss event + repayment of borrowing = zero. All that remains is the assets in the ‘protection’ portfolio. The portfolio weights move in a very rational and ‘scientific’ way. We can specify whatever level of confidence we like about the maximum loss event. The more confident we want to be of covering it the more into the tail of the distribution we go, the higher the maximum expected loss and the less

we put into the CPPI risky sub-portfolio or the less leverage we use in the ALM ‘performance’ sub-portfolio.

Risk parity modelRisk budgeting is a general approach to volatility management. On what assets and in which proportions do I spend my risk tolerance? Risk budgeting is useful when there is no liability. Risk budgeting won’t stop a loss, but it should lessen the extent of drawdown, expected loss, and semivariance. Risk parity is a special case of risk budgeting where asset allocation concerns equal contributions of risk. Take the best risk diversified portfolio and use leverage.

Risk budgeting advocates claim that a typical portfolio of 60% equity 40% bonds is unbalanced in terms of risk. A 60% equity 40% bond portfolio historically has something like a 90/10 risk allocation. There is much more risk concentration than £ capital concentration. The financial crisis showed investors that this conventional long-term asset allocation is less diversified than we realise. Is there a better balance of risk than 60% equity 40% bond with good returns? The solution is a risk parity portfolio. Aim is for more stable portfolio from a risk concentration perspective.

Risk parity means the maximum risk diversified portfolio. With a portfolio of two main types of asset or sub-portfolio the risk parity portfolio is not the portfolio at the tangency of efficient frontier and capital market line. The maximum diversification portfolio, or risk parity portfolio, is usually rejected for it lies inside the capital market line. The risk parity portfolio almost always has more weight in lower-risk assets. This is because concentrating your risk may pay off, but it may not.

Once the maximum risk diversified portfolio has been found the lower return this will provide can be addressed. To achieve most return objectives there are two ways to get there using asset classes: sell low-risk assets and buy high-risk assets; or lever the best risk diversified portfolio. Risk parity is 2nd option.

Leverage counterbalances ‘lost’ return associated with holding low risk assets. Leverage (where it is permitted) is employed to move the risk parity portfolio up to the point it becomes risk equivalent to the Markowitz / Sharpe portfolio with greater expected return but greater risk concentration. The levered portfolio RP is risk equivalent to the Markowitz / Sharpe portfolio but with less risk concentration. There’s the same or similar expected return after paying for leverage. Not all investors are willing or able to apply the level of leverage suggested. If investor cannot easily ‘manufacture’ equity like return from combination of lower risk assets then it may be more efficient to hol