Asset Allocation

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Asset Allocation

• The Balancing Act

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Learning Objectives

• Understand different types of risk associated
  with investment decisions
• Distinguish between firm specific risk and market
  risk
• Understand the rationale behind developing an
  asset allocation strategy and its role as a tool
  to maximize returns / minimize risk
• Sub-Issue Benchmarking as a tool to analyze
  portfolio performance

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What is Asset Allocation?

• Spreading investments among different asset
  classes within a portfolio.
• Generate higher potential returns while at the
  same time effectively managing risk.
• A portfolio should include investments that tend
  to react differently to the economic climate.
• The highs and lows of a single investment should
  be offset by the performance of other investments
  in the portfolio

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Types of Asset Allocation Strategies

• By instrument
• Cash and Equivalents
• Fixed Income
• Equities
• By Sector
• Transportation, Metals Mining, Retail,
  Technology
• By Region
• US/Canadian/Foreign

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WICs Strategy

• Focused on firm-specific risk and security
  selection.
• There is nothing stipulated in its strategy
  regarding asset allocation policies (ie. market
  risk)
• Example In addition to considering whether to
  purchase Wall-Mart or K-Mart, WIC would also have
  to consider what portion of its assets to
  allocate to U.S. Equities, perhaps even
  considering weights by industry sector as well.

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Where is WIC Strong/Weak?

• STRONG
• Assessment of individual stocks and investment in
  a wide variety of industry sectors including
  REITS as part of the portfolio
• WEAK
• Portfolio construction including asset allocation
  and benchmarking

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Typical Steps Asset Allocation

• An asset allocation decision seemed to follow
  four logical steps
• Decide which asset classes to include and exclude
  from the portfolio
• Determine the normal policy or long-term weights
  for each of the asset classes allowed in the
  portfolio that remain unchanged over time
• Strategically alter the investment mix weights
  away from normal in an attempt to capture excess
  returns from fluctuations in asset class prices
  (ie. market timing)
• Select individual securities within an asset
  class to achieve superior returns relative to
  that asset class index

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How is WIC Different?

• Portfolio investment is small relative to other
  funds
• Implication It is difficult to assign a
  conservative portion of the portfolio to equities
  and get full representation of all industry
  sectors at one time
• The club can only vote on a weekly basis and may
  not be able to take advantage of short term
  disequilibrium in the markets
• In the summer, WIC does not trade at all (only
  stop-losses can be pre-determined and initiated
  if needed)
• WIC is subject to certain restrictions on
  investing from Foundation Westerns Policy
  Statement

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GO or NO GO?

• WHY
• An allocation policy seems consistent with
  educating the club on how to properly construct a
  portfolio that will maximize returns and minimize
  risk
• According the Brinson study, investment policy
  explains 91.5 of variability of total plan
  returns
• WHY NOT
• Emphasizing firm-specific risk may pique the
  interest of members more than asset allocation.
  They may find it sexier to discuss ratios and
  valuations rather than asset allocation.
• WIC is less concerned with risk and therefore
  does not need to attempt to diversify it away

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Determine Risk-Tolerance Level.

• WIC is MORE risk-averse
• WIC is not-for-profit, governed by Foundation
  Western, and as a result should not enter into
  risky ventures
• According to the Foundations Policy, WIC is
  constrained by certain stipulations
• Must protect the endowment so the club can always
  function as a going concern
• Given the clubs mandate of educating members, it
  is prudent to have a risk profile that is similar
  to a typical fund
• WIC is LESS risk-averse
• WICs investors have nothing to lose if returns
  are negative
• The original investment is only 90,000 and has a
  play money effect versus a typical fund with
  millions or billions of dollars

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Foundation WesternAsset Allocation Policy
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The Brinson Study

• Does not endorse the assumption of fixed asset
  allocation weights over time.
• Asset allocation policy should be determined by
  considering the long-term, the typical asset
  class return, and industry risk characteristics,
  while allowing for flexibility to take advantage
  of industry specific disequilibrium.
• Altering the investment mix in response to
  important asset price fluctuations is an integral
  aspect of the design of an actively managed
  portfolio.
• Ranges should be instituted for each asset class
  so that some industries can be weighted more
  heavily at different points at time.

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Benchmarking

• Benchmarks are used to determine relative
  performance of portfolios and securities
• The commonly used benchmarks for measuring stock
  returns are
• the SP 500 for stocks in general and big caps,
• the Wilshire 5000 and the Russell 3000 for the US
  markets in general,
• the Russell 2000 for small stocks,
• the TSX 300 for Canadian equities, and
• the Morgan Stanley EAFE for International
  Portfolios
• For bonds, the Scotia McLeod Canadian Bond
  Universe Index is often used
• The benchmark should combine indices in roughly
  the same proportion as the fund invests in
  different markets

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Foundation WesternBenchmarking Strategy
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WICs Asset Allocation Guidelines

• Cash 5-15
• Fixed Income15-25
• Equity 55-70
• Anything flexibility to own a substantial amount of
  equity.
• No differentiation between Canadian/US/Internation
  al Equity. It is not conducive considering how
  few securities WIC can hold given the minute
  100,000 investment.
• WIC will, however, segregate the fund into
  Canadian/US/International Equities to benchmark
  performance.
• The Analysts did not want to stipulate allocation
  rule based on market sectors.