Asset Allocation

1

• Asset Allocation management techniques
• Claudio Porzio

2
Overview of the Investment Process

• Specify objectives
• Identify constraints
• Formulate an investment policy
• Monitor performance
• Reevaluate and modify portfolio as determined
  from monitoring

3
Client needs and characteristics
The risk tolerance

• All investors would like to realize the highest
  possible return but not all are able to sustain
  the same level of risk they have a different
  risk tolerance / aversion and can considered
  risk averse risk neutral risk lover.
• Risk can be defined as
• partial loss of invested capital (downside risk)
• high volatility of invested capital (standard
  deviation).

4
Client needs and characteristics

• Risk preferences
• Risk and return
• Measures of risk
• Risk profile (personality)
• conservative risk (growth direction),
  conservative risk (income direction), medium
  risk, aggressive risk (ML)
• Cash needs (what is time horizon?)
• Determinants of time horizon
• age, level and stability of income,
  liquidity needs
• Time horizon and asset choice
• Tax status
• After tax return
• Tax planning over time
• Taxes and asset choice

5
Client needs and characteristics

• The investor risk aversion can be analysed
  studying
• its financial characteristics
• Financial savings potential
• Net worth
• Investment specific objectives
• Time horizon
• its personal characteristics
• Past investment experiences
• Financial knowledge

6
Client needs and characteristics

• Financial savings potential
• Expected income
• Projected expenses
• Net worth
• Stock and flows
• Level and stability (change over time)
• Investment specific objectives
• Maximize the capital value (aggressive investor)
• Preserve the capital value (defensive investor)
• Accumulate the capital for future expenses

7
Client needs and characteristics

• Past investment experiences
• October 1987
• September 1992
• August 1998
• September 2001
• Financial knowledge
• Actual professional status
• Level of instruction

8
the investment process

• Identifying investment objectives and their
  priority
• Defining the time horizon (how long time money
  can be invested ?)
• Identifying the maximum loss that can be accepted
  during the defined time horizon

Investment Objectives Time Horizon Risk Profile
ASSET ALLOCATION for collective
products Individual portfolios
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Objectives
SHORT (1 y)
VERY LONG (30 y)
MEDIUM (5 y)
LONG (10 y)

• Retirements needs
• Buying a car
• Inheritance
• Buying a new house
• ..

TIME
OBJECTIVES
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Specifying Objectives

• Balance risk and return
• Life Cycle is critical to the process of
  determining the risk/return trade-off
• Younger investors - willing to bear more risk
  for higher returns
• Older investors - willing to accept lower
  returns for lower risk

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Specifying Objectives

• Personal Trusts
• Determined by the individual for whom the funds
  are being managed
• Mutual Funds
• Varies with type of fund
• Detailed in the prospectus
• Pension Funds
• Depends on average time to retirement of
  individuals

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Specifying Objectives

• Life Companies
• Investments are hedged against potential claims
  of policy holders
• Non-Life Companies
• Invest premiums not paid back to policyholders
  for loss
• Hedge against potential claims

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Time

• Financial Planning
• Relationship between risk and time horizon

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Risk

• Risk tolerance
• does not depend from market trends
• shows how much is possible to loose on short time

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Investor constraints

• Speed and ease with which as asset can be
  converted into cash
• The planned liquidation date
• Specific regulations that may apply to the
  investor
• Special considerations related to tax position of
  the investor
• Special considerations related to the underlying
  investors
• Diversification requirements related to employment

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Investment Policy

• Individual - depends on life cycle
• Younger Higher equity
  Lower safe assets
• Older Lower equity
• Higher safe assets
• Institutional - depends on objectives
• Example - an all stock mutual fund would want
  nearly 100 in stock
• Sector or Region allocations

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Product Diversification
III Group
I Group
II Group
IV Group
V Group
Return
Risk
Product range
It is necessary to have a full range of products
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Service Production Placement Areas
Product Diversification
Service Placement Area
Portfolio D
Portfolio C
RETURN
Portfolio B
Service Production Area
Portfolio A
VOLATILITY - TIME
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Product Diversification
UNIT TRUST CLOSED END FUNDS R.E.CLOSED END FUNDS
PENSION FUNDS INDEX LINKED POLICIES UNIT LINKED
POLICIES
INDIVIDUAL PORTFOLIO MANAGEMENT
SCHEMES securities / mutual funds own products /
other A.M.
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Product Diversification
Third party distribution Focus on affluent and
HNW
Separate accounts including guaranteed wraps
Retirement products and unit-linked insurance
policies
The higher growth segments
Alternative products
Other innovative vehicles using mutual funds as
underlying instruments
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The asset allocation process

• Asset Allocation Investment analysis process
  for building a new optimal portfolio by
• identifying the optimal mix among risky asset
  classes
• considering a defined holding period
• considering the customers risk return profile

• 4 elements to be considered
• Which asset classes
• Which proportion for each asset class
• How and when rebalancing the portfolio
• Which securities to be selected for each asset
  class

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The asset allocation process
Stock picking
Stock mkts return
Sector/ country selection
Economic Model
Asset allocation
Bond mkts return
Bond picking
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The asset allocation process
Bond return changes
Earnings growth
Economic growth
Asset allocation
Fair value stocks vs bonds
Market sentiment
Risk tolerance
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The asset allocation process
Expected Returns
Asset/liability structure
Asset allocation
Investment Horizon
Stock Std. Dev. Correlation
Risk Aversion
Legal Economic Restrictions
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The asset allocation process
Asset allocation
Benchmark
of Stock Mkt of Bond Mkt of cash
of single equities of single bonds
Model Portfolio
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The asset allocation process
20 EURO
30 Bonds
7.5 USA
2.5 GBP
35 EURO
55 Short term
Asset Allocation
10 USA
10 GBP
6 EUROPE
15 Stocks
5 USA
4 R.WORLD
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The asset allocation process
Portfolio management
3rd
Managing customers expectations
2nd
Analysing customers needs
1st
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1 Analysing customers needs
Skills required
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3 Portfolio management
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Portfolios building models

• For building the optimal portfolio it is possible
  to adopt 2 different models, each of one based on
  different investment approaches.
• top-down
• bottom-up

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The top-down model

• Advantages
• Strong theoretical framework
• Easy to understand and to communicate to customers

• Disadvantages
• Difficult choice of asset classes
• Portfolio diversification not fully achieved

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The top-down model

• For identifying asset classes it is necessary to
  determine which factors influence bonds and
  shares risk and return

SECURITIES
GROUPS
PORTAFOLIO
GR. 1
GR. 2
GR. 3
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The bottom-up model

• Disadvantages
• Empirical methodology without any theoretical
  framework
• Difficult to rationalise and to communicate to
  customers

• Advantage
• Cheap and easy in term of forecasting activities

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The integrated asset allocation
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The asset allocation process
Asset Allocation
Strategic Asset Allocation
Market timing
Stock selection
1
2
3
36
Strategic asset allocation

• Portfolio construction
• Strategic asset
  allocation
• Allocating financial resources among asset
  classes with weight in line with customers needs
• Investment objectives
• Risk tolerance
• Time horizon
• This means that does not exist an optimal
  portfolio but it must be coherent with investors

37
Strategic Asset allocation
38
Strategic Asset allocation

• It is the main component of the asset allocation
  process
• A study on the performance contribution of
  different elements (policy, stock selection,
  market timing), estimated that about 91,5 can be
  explained by strategic decisions.
• The strategic asset allocation tends to become
  more important when the holding period is
  increasing.
• An investment strategy based on strategic asset
  allocation and with a long holding period is able
  to reduce the overall risk in term of impact of
  short term market movements.
• By this way, it is possible to obtain higher
  returns.

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Strategic Asset allocation
investors Very prudential Risk aversion Maximum
investors Prudential Risk aversion High
Investors Aggressive Risk aversion Low
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Market timing Tactical Asset allocation

• Strategic asset allocation
• Construction of the portfolio to be hold for a
  long period with the objective of achieving
  determined investment goals
• Tactical asset allocation
• Short term changes among defined ranges of
  the portfolio structure with the objective of
  take advantage of forecasted market movements

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Market timing
Anticipating market trends Transforming
expected trends into portfolios changes and
rebalancing with the main objective of
positioning on the best expectations lines.
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Market timing

• Objective
• obtaining an outperformance compared to the
  benchmark increasing the portfolio reaction to
  expected markets trends
• Risk
• too high reduction of portfolios
  diversification
• Too high asimetry between risk tolerance and
  exposure to markets volatility

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Market timing
Opportunities given by the relative prices
movements are used without considering the risk
aversion level this is assumed constant at each
stage of rebalancing. Often, in such a context,
the asset manager tends to focus his interest on
a relative small number of securities for which
he has forecasts.

• Forecasting skills (scenario analysis, conjunture
  etc.)

• Timing

• Managing all relationships among market variables
  (inflation/rates rates/stock returns
  Beta/returns etc.)

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Market timing

• Market timing and ?-based strategies

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Market timing and ?-based strategies
Market timing
MARKET
Strategies
Focus and Overweighting securities, sectors,
countries with (? gt1
Increasing ? of the portfolio
bullish
Focus and Undeweighting securities, sectors,
countries with (? lt 0)
Reducing the ? of the portfolio
bearish
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Market timing
Market Timing Duration-analysis
Using the Modified Duration it is possible to
follow a strategy based on the continuous
rebalancing of the portfolio duration
scenario
DURATION
Increasing rates
To be reduced
Decreasing rates
To be increased
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Tactical Asset allocationa mistake
Aggressive
Balanced
Prudential
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Security selection

• Analysing and selecting securities for deciding
  which ones are to be inserted in the portfolio
  the security selection is based on
• Technical Analysis, charts of market (price,
  volume, short sales) reveal future prices
• Fundamental Analysis, underlying economic
  factors determine value of security
• Private Information, trading ahead of the public.

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Security selection

• C.A.P.M. can be used in the stock selection
  process with reference to the so-called Security
  Market Line (SML)
• It is possible to identify best investment
  opportunities calculating differences between
  expected returns and equilibrium return according
  to the systematic risk

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Security selection

?
SML

PG
P.M.
Rf
?
PG Procter Gamble P.M Philip Morris
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Management tecniques

• Portfolios need maintenance and periodic
  revision
• Because the needs of the beneficiary will change
• Because the relative merits of the portfolio
  components will change
• To keep the portfolio in accordance with the
  investment policy statement and investment
  strategy

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Investment strategies

• Active Management Versus Passive Management
• Definition
• The managers choices
• Costs of revision
• Contributions to the portfolio

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Investment strategies

• Definition
• An active management policy is one in which the
  composition of the portfolio is dynamic
• The portfolio manager periodically changes
• The portfolio components or
• The components proportion within the portfolio
• A passive management strategy is one in which the
  portfolio is largely left alone

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Investment strategies

• Passive strategies
• Index funds
• holding securities, stocks and bonds, in a wide
  index (SP 500) in proportion to their market
  value
• assume markets are efficient i.e. you can not
  beat the market
• Markowitz Portfolio
• create an efficient portfolio by determining
  combinations of securities that maximize expected
  return for given risk.

55
Investment strategies

• Active strategies
• Assume market is not efficient (random walk) i.e.
  can predict the market.
• Take advantage of forecasted market movements, by
  shifting between cash and stocks and shifting
  between low and high-risk (beta) securities.
• Analyst has the skill to select undervalued
  securities. i.e. beat the market

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MANAGED PORTFOLIO
Benchmark
Active Mgmt
Security Selection among Market (bottom up)
Allocation among markets (Top-down)
Stocks
bonds
Asset Allocation
Market timing
Yield Curve
Country Allocation
Sector Allocation
Stock Picking
Spreads
Currency Allocation
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Investment strategies

• Active
• Higher costs trading, management, analysis
• Higher confidence from the investor
• Taking advantage from market inefficiencies

• Passive
• Lower costs
• Higher transparency
• Simple management
• Difficult to understand in bear markets

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The Managers Choices

• Leave the portfolio alone
• Rebalance the portfolio
• Asset allocation and rebalancing within the
  aggregate portfolio
• Change the portfolio components
• Indexing

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Active Strategies
Core Swing
Tactical Allocation pyramid
Constant Proportion Portfolio insurance
Constant Mix Strategy
Buy and Hold strategy
60
Buy-and-Hold Strategy

• A buy and hold strategy means that the portfolio
  manager hangs on to its original investments
• Academic research shows that portfolio managers
  often fail to outperform a simple buy and hold
  strategy on a risk-adjusted basis
• E.g., Barber and Odean show that investors who
  trade the most have the lowest gross and net
  returns

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Buy-and-Hold Strategy

• Defining investment expectations

Time
?
Performance
62
Buy-and-Hold Strategy

• Pay Off 50 Stock / 50 Bond

100
Portfolio Value
50
0
40
100
Stock market Index
63
Risk exposure 60 stock 40 Bond
Buy-and-Hold Strategy
The risk tolerance became equal to 0 when the
portfolio value is lt 40 of the initial value.
64
Buy-and-Hold Strategy

• The portfolio value is correlated to the stock
  market index

• The ratio between ? portfolio and ? stock market
  index is exactly equal to the initial weight of
  stocks on the portfolio

• The final portfolio value cannot be lower than
  the weight of free-risk assets

• The potential gain is unlimited

• The average return increases according to the
  stocks weight if the stock market index is
  higher than the risk free rate (and the opposite)

65
Buy-and-Hold Strategy
Advantages/Disadvantages

• Advantages
• Minimize operating costs
• No rebalancing and market timing activities

• Disadvantages
• Possible asymmetry between investors risk
  tolerance and portfolio market risk exposure

66
Rebalance the Portfolio

• Rebalancing a portfolio is the process of
  periodically adjusting it to maintain the
  original conditions
• Rebalancing within the Portfolio
• Constant mix strategy
• Constant proportion portfolio insurance
• Relative performance of constant mix and CPPI
  strategies

67
Constant Mix Strategy

• The constant mix strategy
• Is one to which the manager makes adjustments to
  maintain the relative weighting of the asset
  classes within the portfolio as their prices
  change
• The strategic asset allocation tends to remain
  unchanged
• Requires the purchase of securities that have
  performed poorly and the sale of securities that
  have performed the best

68
Constant-mix Strategy
Pay Off 60 Stock / 40 Bond
Stock weight
60
0
Portfolio Value
100
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Constant-mix Strategy

• A portfolio has a market value of 2 million. The
  investment policy statement requires a target
  asset allocation of 60 stock and 40 bonds.
• Date Portfolio Value Actual Allocation Stock Bonds
  
• 1 Jan 2,000,000 60/40 1,200,000 800,000
• 1 Apr 2,500,000 56/44 1,400,000 1,100,000
• What dollar amount of stock should the portfolio
  manager buy to rebalance this portfolio? What
  dollar amount of bonds should he sell?

70
Constant-mix Strategy
Solution a 60/40 asset allocation for a 2.5
million portfolio means the portfolio should
contain 1.5 million in stock and 1 million in
bonds. Thus, the manager should buy 100,000
worth of stock and sell 100,000 worth of bonds.
71
Constant-mix Strategy
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Constant-mix Strategy

• It is a dynamic strategy when the stock market
  index changes, weights change compared to the
  initial objectives so, it is necessary to buy
  /sell stocks and bonds for rebalancing the
  portfolio

• Generally, buying is required when the stock
  market has returns lower than the risk free rate
  on the contrary, selling is required when the
  stock market has returns higher than the risk
  free rate.

73
Constant-mix Strategy
Advantages/Disadvantages

• Advantages
• Constant equilibrium between between investors
  risk tolerance and portfolio market risk exposure

• Disadvantages
• Phigh transaction costs (depending on number of
  rebalancing so on market volatility)

Useful in relatively stable markets
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Constant-mix Strategy
With prolonged market trends, portofolios
managed using a C-M strategy realise
performances worst than those managed using a
BH strategy
The constant weight of stocks, reduces the
potential gains that can be obtained in case of
continuous bullish market and increases the
potential losses that can be obtained in case of
continuous bearish market
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Buy and Hold Constant Mix
100
C_Mix
Buy-and-Hold
Portfolio Value
0
Stock market Index
40
100
76
Buy and Hold Constant Mix
77

• Constant Proportion Portfolio Insurance
  Strategies (CPPI)

A constant proportion portfolio insurance (CPPI)
strategy requires the manager to invest a
percentage of the portfolio in stocks in
stocks Multiplier x (Portfolio value Floor
value)
Risky portfolio
Required investiment in stocks
Fixed minimun portfolio value
78

• CPPI

A portfolio has a market value of 2 million. The
investment policy statement specifies a floor
value of 1.7 million and a multiplier of 2.
What is the dollar amount that should be
invested in stocks according to the CPPI
strategy? in stocks 2.0 x (2,000,000
1,700,000) 600,000 If the portfolio value is
2.2 million one quarter later, with 650,000 in
stock, what is the desired equity position under
the CPPI strategy? What is the ending asset mix
after rebalancing? in stocks 2.0 x
(2,200,000 1,700,000) 1,000,000 The
portfolio manager should move 350,000 into
stock. The resulting asset mix would be
1,000,000/2,200,000 45.5
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Stock 2(100-75)50Bond 100-50 50Stock mkt
Index -10 Stock500.945Portfolio
504595Stock 2(95-75)40
Stock to sell 5
CPPI
DATA Portfolio 100 M 2 Floor 75

• Stock mkt Index 10 Stock501.155Por
  tfolio5055105Stocki 2(105-75)60
  Stock to buy 5

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CPPI sell stocks as they fall, and buy stocks
as they rise
CPPI

• The portfolio value cannot be less the floor
  value even in a bearish market

• The protection offered by the floor, is no more
  valid in case of market going as in black monday

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The maximum instantaneous index reduction is
equal to 1/m (in the example 1/250)
CPPI

• In a bullish market, the CPPI strategy increases
  gains (the is an acceleration effect due to the
  stock weight)

• In a bearish market, the CPPI strategy reduces
  losses.

• In a volatile market, the CPPI strategy is
  unuseful. It sells stock before a bull trend and
  buys stock before a bear trend

82
CPPI

• M represents the weight of stock in the risky
  portfolio

• If mgt1 the CPPI becomes a Constant-Proportion
  Strategy

• If m1 the CPPI becomes a Buy_AND_Hold Strategy

• If mlt1 and Floor 0 the CPPI becomes a
  Constant-mix Strategy

83
Risk exposure floor 75 and m2
CPPI

• As in Buy and Hold, the risk tolerance

• 0 for portfolio value lt floor
• over the floor, it increases more rapidly

84
CPPI
Pay off floor 75 and m2
The CPPI does not dominate buy and hold it
dispends on the market trends
85
Relative Performance

• ? Linear strategies (do nothing) determine linear
  payoff

? Dynamic strategies (do something) following
the rule buys stocks as they fall and sell stock
as they rise determine concave payoff

• Low elasticity in bullish markets
• No protection floor
• Useful in volatile markets.

? Dynamic strategies (do something) following
the rule sell stocks as they fall ...
determine convex payoff

• High elasticity in bullish markets
• Good protection

86
Relative Performance
A CM strategy sells stock as it rises A CPPI
strategy buys stock as it rises In a rising
market, the CPPI strategy outperforms CM In a
declining market, the CPPI strategy outperforms
CM In a flat market, neither strategy has an
obvious advantage In a volatile market, the CM
strategy outperforms CPPI The relative
performance of the strategies depends on the
performance of the market during the evaluation
period In the long run, the market will probably
rise, which favors CPPI in the short run, the
market will be volatile, which favors CM
87
Relative Performance
88
Core-Swing Strategy
Objective
To realize the maximum portfolio
performance combining tactical and strategic
elements

• Semi-active Management Style obtained by dividing
  the managed portfolio into 2 blocks

Core Portfolio
Swing Portfolio
?
89
The core of the portfolio, replying composition
and return of the chosen benchmark, generally
managed with a CM strategy
Core-Swing Strategy
Core Portfolio
Controlling the overall portfolio risk
90
Core-Swing Strategy
Swing Portfolio
The remaining part of the portfolio, generally
managed in an active way with mispriced securities
Winning the market and obtaining an
extra-return over the benchmark
91
Core-Swing Strategy

• ? The investment manager can use his market
  timing ability with reference only to the
  so-called swing-component.
• Chance to reduce transaction costs compared to
  other strategies
• Chance to obtain an increasing return related to
  a correct market timing.
• Composition of Core portfolio passive management

92
Core-Swing Strategy

• The core and swing portfolio the optimal size

It depends from
? the investors risk aversion and tolerance
? characteristics of the market/sector of
reference
?efficiency degree of the selected benchmark
93
Core-Swing Strategy
Example Core 70 Swing 30
swing
94
? the swing portfolio is procyclical
Core-Swing Strategy
P

• Incoming and out coming of securities in the
  core portfolio (mainly due to rebalancing
  according to a Constant-mix strategy, utilise the
  swing portfolio

MARKET
T
SWING
SECURITIES
CORE