Strategic Asset Allocation Concepts

PORTFOLIO MANAGEMENT & RISK Strategic Asset Allocation Concepts Paris - ISC November 2007 Hermin Hologan, CFA

Paris – Institut Supérieur de Commerce

Risk Management – PORTFOLIO INVESTMENTS

Contents 1

Introduction – Learning Outcome Statements 2

Strategic Asset Allocation Concepts 3

Q&A 2

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1 Introduction – Learning Outcomes 3

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Learning Outcome Statements After completing this chapter, you will be able to do the

following :  Discuss the function of strategic Asset allocation in portfolio management 

Discuss the role of strategic asset allocation in relation to systematic risk exposures

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Differentiate between strategic asset allocation and tactical asset allocation

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Discuss desirable characteristics of asset classes

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Compare and contrast assetliability and asset-only 4 approaches to strategic asset

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Explain the advantages and disadvantages of implementing a dynamic versus a static approach to strategic asset allocation

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Explain cash flow matching and immunization with respect to strategic asset allocation

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2 Strategic Asset Allocation

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Discuss the function of strategic asset allocation in portfolio management Strategic asset allocation allocates proportions of the portfolio to different asset classes. ➘ It essentially combines capital market expectations (formally represented by the efficient frontier) and the investor’s risk, return and investment constraints. ➘ Strategic asset allocation is long term in nature, and hence the weights are called “targets” and the portfolio represented by the strategic asset allocation is called the “policy” portfolio. ➘ Short term deviation from the strategic asset allocation may be based on short-term capital market expectations andParis would be Supérieur the result of – Institut de Commerce 6 active management.

Discuss the role of strategic asset allocation in relation to systematic risk exposures Each asset class has its own and quantifiable systematic risk. ➘ Strategic asset allocation is a conscious effort to gain exposure to systematic risk via a specific weights to individual asset classes. ➘ Each asset class represents relatively similar investments (e.g. long term corporate bonds) with similar systematic risk factors. ➘ Exposure to specific asset classes in specific proportions enables portfolio managers to effectively monitor and control their systematic risk exposure. In other words, strategic asset allocation reflects the investor’s desired systematic Paris – Institut Supérieur risk de Commerce 7 exposure.

Differentiate between strategic asset allocation and tactical asset allocation

➘ Tactical asset allocation is the result of active management wherein managers deviate from the strategic asset allocation to take advantage of any perceived short-term opportunities in the market. ➘ Tactical asset allocation introduces additional risk, which has to be justified by additional return (or positive alpha)

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Discuss desirable characteristics of asset classes Asset classes are essentially baskets of securities or investments. These investments are relatively similar to each other and have similar risk factors. For example, the US equity asset class represents domestic equity exposure for an American investors. Each security in this asset class, while different, is similar to other securities in the asset class. Desired characteristics of an asset class include : ➘ Asset classes should be mutually exclusive (each asset class should belong to only one class) ➘ Asset classes should be exhaustive (each security should be represented by an asset class) ➘ Asset classes should have low correlation. This property ensures that each asset class has different risk exposures – Institut Supérieur de Commerce as compared to other assetParis classes. 9

Compare and contrast asset-liability and asset-only approaches to strategic asset allocation

The asset-liability strategic asset allocation is determined in conjunction with modeling the liabilities of the investors. For investors with specific liabilities (i.e. defined benefit pension plans or insurance companies), asset allocation is tailored to meet the liabilities and to maximize the surplus given an acceptable level of risk. This usually results in higher allocation toward fixed income assets. ➘ Strategic asset allocation involves specifically modeling liabilities and determining the asset allocation appropriate to fund the liabilities.

➘ Even for those investors who don’t have specific obligations (i.e. providing Paris – Institut Supérieur de Commerce 10 (contractual) liabilities, future post-retirement living expenses for an individual investor)

Compare and contrast asset-liability and asset-only approaches to strategic asset allocation (cont’d) In cases of asset-only strategic asset allocation, the focus in on earning the highest level of return for a given (acceptable) level of risk without any consideration for any liability Modeling. The liability (explicit or implied from future expected return cash outflows) is indirectly taken into consideration through the required rate of return. Because the asset-only approach does not specifically model liabilities, the risk of not funding liabilities is not accurately controlled.

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Explain the advantages and disadvantages of implementing a dynamic versus a static approach to strategic asset allocation ➘ Dynamic asset allocation takes a multi-period view of the investment horizon. In other words, it recognizes that asset (and liability) performance in one period affects the required rate of return and acceptable level of risk for subsequent periods. ➘ Static asset allocation ignores the linkages between optimal asset allocation across different time periods. For example, the manager using a static approach might estimate the necessary mean-variance inputs at a point in time and then construct the long term portfolio. The manager using dynamic allocation allows for changing parameters over time using such techniques as Monte Carlo simulation. This allows the manager to build in expected changes to inputs as well as model unanticipated changes 12 in macroeconomic factors. Paris – Institut Supérieur de Commerce

Explain the advantages and disadvantages of implementing a dynamic versus a static approach to strategic asset allocation (cont’d) ➘ Dynamic asset allocation is difficult and costly to implement. However, investors who have significant liabilities, especially those with uncertain timing and/or amount, find the cost acceptable. Usually, investors who undertake the asset-liability approach to strategic asset allocation prefer dynamic asset allocation to static asset allocation.

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Explain cash flow matching and immunization with the respect to strategic asset allocation ➘ Cash flow matching is the most basic form of the assetliability management approach to strategic asset allocation. Cash flow matching involves investing in assets (typically fixed-income securities) that produce the required cash flow needed to service the underlying liabilities. For example, a defined benefit pension plan may have detailed estimates of benefits to be paid to current and futures retirees over the next 25 years. Investments would then be made so as to generate the required cash flow for each of the next 25 years.

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Explain cash flow matching and immunization with the respect to strategic asset allocation (cont’d) ➘ Immunization (duration matching) takes this one stepfurther. It involves matching the weighted average duration of the assets with the weighted average duration of the liabilities. This practice is designed to immunize the surplus (asset – liabilities) against fluctuations in interest rates. If interest rates increase, the value of the asset and the value of the liabilities would both go down by (roughly) the same amount, leaving the surplus unchanged. Once again, this approach usually results in investment in mostly fixed-income assets.

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5 Q&A 16

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