Strategic Asset allocation

1. Strategic Asset allocation MFIN5600 institutional wealth management

2. overview • Define objectives and constraints • Form capital market expectations (CPPIB – Economic and Financial Market Forecasts group) • Use as inputs to strategic asset allocation • Outcome: a set of portfolio weights assigned to different asset classes, i.e. the “Reference” or “Policy” Portfolio

3. Reference/policy portfolio Harvard Management company • “The Policy Portfolio is a theoretical portfolio allocated among asset classes in a mix that is judged to be most appropriate for Harvard University, from both the perspective of potential return and risk over the long term” • “(it will be) reviewed … for continued fit with the University’s risk profile and our projection of long-term market returns, volatility, and correlations” • “The Policy Portfolio (is) a guide …. to the actual allocation in the investment portfolio and also serves as a measuring stick against which we judge the success of our active investment management activities”

4. Revisions to strategic asset allocation • How often should client revisit the allocaton? • Harvard Endowment Fund • Appears to be 8-10 years • But it is actually more often – 2012 policy portfolio slightly different from 2013’s (more real assets and fixed income in 2013’s) • Internal studies may be more frequent than actual outcomes (observed changes) • More dramatic changes for funds that were slow to move away from the 60/40 model

5. Strategic asset allocation: history • Markowitz: mean-variance analysis • Minimize variance/standard deviation given a level of expected return • Do clients care about upside volatility? • Markowitz (1959) realizes that it is downside risk that matters to investors: semi-variance (SV) below mean or below target return • SV is a special case of the lower partial moment (2nd moment)

6. history • But due to a lack of computer power at the time, Markowitz proceeded with  for his analysis • If return distribution is symmetric (i.e., normal), then the optimal allocation outcomes are the same • What if returns are not normally distributed? • Group project 1 • Use alternative measures of risk in the optimization and compare* • Can also include discussion of non-financial risks that should be monitored * In Morningstar Direct: Home  Training  Live session/videos/User Guides  Determine optimal allocation strategies

7. Asset allocation and portfolio performance • Suppose portfolio returns can be attributed to the following three elements: • Strategic asset allocation • Market timing (tactical asset allocation) • Security selection (e.g., stock picking) • How important is the strategic asset allocation decision, out of the three?

8. Importance of strategic asset allocation Empirical findings • Time-series studies (same fund over time) • Asset allocation explains 90%+ of the variations in portfolio returns on average • Brinson, Hood and Beebower (1986), Brinson, Singer and Beebower (1991), and Blake, Lehmann, and Timmermann (1999) • Interpretation: funds with similar asset allocation have similar returns over time

9. Importance of strategic asset allocation • Cross-sectional studies (different balanced mutual funds within the same period) • Strategic asset allocation explains ~ 40% of the variations in portfolio returns • Ibbotson and Kaplan (2000) • Financial Crisis of 2008: Canadian pension plans had returns ranging from -25% to +6% (average: -18%) • What made the difference was the use of alternative strategies (recall comparison of Harvard’s portfolio to a 60/40 portfolio) • Overall, asset allocation is the most important factor in determining portfolio returns; the other factors (tactical and security selection) are secondary.

10. Risk objectives in asset allocation • General description can be qualitative: Below average or above average risk tolerance • But in conducting strategic asset allocation, need to quantify risk attitude • For individual investor: numerical risk aversion score, measured through interview, questionnaire (see TD Mutual Funds example) • Recall the utility function: • Translate/map risk aversion score from questionnaire to an A for client, and compare the utility derived from different investments, given their and

11. Risk objectives in asset allocation • Example: if A = 4 • Another way to quantify risk tolerance: specify an acceptable level of volatility (e.g.,  = 10%, thereby eliminating portfolio P above) • Downside risk: If investor is averse to loss (use a different risk metric) • Or if there is a target, then can consider shortfall risk, i.e., risk that return will fall below a certain percentage

12. Additional measures of risk in asset allocation • Roy’s safety-first criterion (1952) • A simple shortfall risk measure for ranking portfolios where is the portfolio return, is the threshold level of return, and is the s.d.of • Sortino Ratio • Similar to Roy’s, but uses downside risk instead in the denominator: where DDP is downside deviation (standard deviation calculated using only returns below the target, RL)

13. Return objectives • Quantitative return objectives are easier to define: specify return needed to achieve goals • Long-term investors care about compounded growth rate • Use geometric mean returns, rather than arithmetic mean returns • Example: • 10% return in first year, 8% in second year • If arithmetic: mean = ? • If geometric: mean = • One approximation of the relationship if distribution is normal:

14. Specification of asset classes • What constitutes an asset class? • Assets within a class should be relatively homogeneous • Have similar attributes/features • Asset classes should be mutually exclusive • Global equities and U.S. equities • Asset classes should be diversifying • Correlation? • Asset classes as a group should comprise the majority of world investable wealth

15. Global equities • Global versus international • Examples of global indices: MSCI All-Country World, FTSE Global Equity • Examples of international (developed market) indices: MSCI EAFE, FTSE Developed, MSCI World • When investing in foreign assets, investors should consider the following special issues: • Currency risk affects both return and volatility, and investors must decide whether to hedge • Increased correlations across countries in times of stress • Emerging markets are less liquid, less transparent and more likely to exhibit non-normal return distributions (but if markets are efficient, investors will receive compensation for bearing these risks)

16. Inflation-sensitive assets • Assets that provide a good hedge against inflation • Gold, on average, maintains its value over time. If bought a dollar's worth of gold 200 years ago, after adjusting for inflation, it would be worth $1.07 in the fall of 2010 • CPPIB: In addition to real return bonds, also Infrastructure, real estate • OTPP: Also includes commodities • “We invest in commodities, which typically mirror short-term changes in inflation, as a hedge against the cost of paying inflation-protected pensions.”