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    1. The traditional investment organization funnels ....doc 1. The traditional investment organization funnels ....doc Document Transcript

    • 1. The traditional investment organization funnels information through various levels to arrive at a portfolio composition decision. In brief, various economic and financial market data are received by the firm's security analysts. This information is used to assess the relative attractiveness of groups of securities. These security rankings are transmitted to an investment committee which creates an approved list of stocks eligible for purchase by the firm's portfolio managers. The portfolio managers weigh information from their own sources as well as from the firm's security analysts to select the most attractive securities from the approved list. The portfolio managers combine these securities into portfolios subject to various constraints such as maximum security weights, maximum economic sector weights, portfolio risk characteristics, client preferences, and so on. The decision-making process in the traditional investment organization could be made more "quantitative" by employing such techniques as dividend discount models to identify expected security returns. Further, various optimization techniques could be used in the portfolio construction process to ensure that the firm's portfolios most efficiently incorporate the security analysts' risk and return forecasts. 2. The traditional approach to investment management follows a very deliberate and time-consuming process of analyzing information relevant to security selection. For example, there is the collection and analysis of company financial data by the investment organization's security analysts, the analysts' use of "second-hand" information obtained from "street" analysts (that is, analysts working for brokerage firms), the reporting of the analysts' conclusions to the organization's investment committee, the consideration of this information by the committee, and the committee's ultimate decision whether to buy or sell the securities. These procedures, as well as other factors, can hinder the rapid processing of the large volume of information required to effectively and quickly identify mispriced securities in a highly efficient market. 3. Unique student answer. Ideally, students should discuss such factors as the likely range of outcomes for various asset mixes and how they feel about experiencing the extremes of those ranges, particularly on the downside. 4. Most investors have only a vague understanding of their own Chapter 23 Page 1
    • risk-return preferences. It is extremely difficult to translate these subjective and ill-defined feelings into quantitative terms that can be used in the investment process. Even if the appropriate questions are asked regarding investors' risk-return preferences, they often will give seemingly inconsistent answers to similar questions that are presented in different contexts. The problem of determining institutional investors' risk- return preferences is compounded by the fact that a number of parties are usually involved (with a pension fund, for example, those parties include current retirees, current workers, and plan trustees). Weighing the preferences of these parties, even if those preferences are reasonably well- specified, is quite difficult. 5. As the proportion of the portfolio invested in common stocks rises, so will the portfolio's expected return and standard deviation. The three primary factors that determine the shape of a stock-Treasury bill portfolio's distribution of potential returns are the expected returns on stocks andTreasury bills, the standard deviations of stocks and Treasury bills(by definition, zero for Treasury bills on a forward-looking basis), and the covariance between stocks and cash (by definition, zero). 6. The slope of an investor's indifference curve represents the amount of additional return that the investor requires in exchange for accepting an incremental increase in risk, if the investor's level of satisfaction (that is, utility) is to remain constant. The "typical" risk-averse investor has indifference curves that slope upward to the right (with expected return on the vertical axis and risk on the horizontal axis) and are convex. For such an investor, the amount of additional expected return required for the same incremental increase in risk rises as the total risk borne by the investor increases. 7. As indicated by Equation (23.2), for a selected combination of a risky portfolio and the riskfree asset, an investor's risk tolerance can be estimated as: τ= [ ] 2 (r C − r f ) σ S 2 (r S − r f ) 2 Chapter 23 Page 2
    • In this problem: r C = .70 × 12% + .30 × 5% = 9.9% Thus: τ = 2 × [(9.9 - 5.0) × (18)²]/(12 - 5)² = 64.8 8. We know that the 60/40 stock/bond asset allocation represents Zinn's optimal combination of risk and return. Zinn's risk tolerance can be approximated by computing utility at two stock/bond allocations very close to this optimal point. As a first approximation, Zinn's utility can be assumed to be unchanged at these two allocations. Setting the utility of these two allocations equal to one another allows us to solve for Zinn's risk tolerance. With the 59/41 stock/bond mix: r p = (.59 × 18%) + (.41 × 10%) = 14.7% σ 2 = (.59)² × (22)²+(.41)² × (5)²+(2 × .59 × .41 × .5 × 22 × 5) p = 199.3 Thus Zinn's utility is given by: U = r p - σ 2 /τ p = 14.7 - 199.3/τ With a 61/39 stock/bond mix: r p = (.61 × 18%) + (.39 × 10%) = 14.9% Chapter 23 Page 3
    • σ 2 = (.61)² × (22)²+(.39)² × (5)²+(2 × .61 × .39 × .5 × 22 × 5) p = 210.1 Thus Zinn's utility is given by: U = r p - σ 2 /τ p = 14.9 - 210.1/τ Setting the two utility calculations equal to each other gives: 14.7 - 199.3/τ = 14.9 - 210.1/τ Solving for τ yields a value of 54.0. 9. An overpriced stock generally should be held in a smaller amount than one would choose were it correctly priced. If the stock were considerably overpriced, the optimal position might involve a zero (or even negative) weighting. However, if it were only slightly overpriced, the optimal position might well be positive, particularly if the investor faced practical constraints such as limits on the number of securities in a portfolio and transaction costs. The investor must take into account both the security's covariances with other securities in the portfolio as well as the security's expected return in determining an optimal position for that security in the portfolio. Risk considerations may cause an investor to hold a positive position in an overpriced security. 10. This is a very complex question faced by many investors. It raises additional questions concerning how risk should be defined over long periods of time. For example, one could argue that stocks, while having a relatively high standard deviation of returns compared to bonds on a year-to-year basis, have considerably reduced relative volatility when examined over ten-year holding periods. Further, one could argue that over long periods of time the chances of stocks underperforming bonds are almost zero. For an investor with a long time horizon, and the desire to achieve a high level of consumption, stocks might be viewed as less risky than bonds. Nevertheless, an investor with a proclaimed distant investment horizon might desire to place bonds in his or her portfolio Chapter 23 Page 4
    • because his or her effective time horizon is actually much shorter. That is, the investor may not be able to "stomach" the high variability of an all-stock portfolio in the short- run. Or the investor may be protecting against an unlikely, but still possible, catastrophic financial event (for example, a severe and prolonged economic slump) which could cause the value of stocks to drop sharply relative to bonds. 11. Using equation (23.2) in the text, an investor's risk tolerance is given by: τ = 2[( r C - rf) σ S2 ]/( r S - rf)² In Birdie's case: τ = 2{[(.40 × 18 + .60 × 7) - 7] × 441}/(18 - 7)² = 32.1 The risk tolerance figure of 32.1 implies that Birdie is willing to accept up to 32.1 units of variance (5.7% in standard deviation terms) for each additional percentage point of expected return. 12. Using equation (23.2) in the text to calculate Dee's risk tolerance: τ = 2{[(.60 × 15 + .40 × 6) - 6] × 400}/(15 - 6)² = 53.3 The certainty equivalent return is given by: u = r p - (1/τ) σ p 2 In Dee's case: u = (.60 × 15 + .40 × 6) - [(1 / 53.3) × (.60 × 20)²] = 8.7% 13. The certainty equivalent return for a risky portfolio is the riskfree return that the investor feels is just as attractive as the expected (but uncertain) return of the risky portfolio. The certainty equivalent return represents the vertical Chapter 23 Page 5
    • intercept of the indifference curve on which the risky portfolio lies. Thus identifying the feasible risky portfolio with the highest certainty equivalent return is the same as identifying the feasible risky portfolio that puts the investor on his or her highest possible indifference curve. 14. Much of the growth in passively-managed investments can be attributed to increased investor awareness regarding the highly efficient nature of the U.S. stock market. Investors have come to understand that very few professional investors can be expected to consistently beat the market on a risk- adjusted basis. Because of the negative impact of active management fees and transaction costs on active manager performance, many investors have come to view passive management as a cost-effective means of investing in financial assets. 15. This statement is false. It is based on the mistaken notion that the average active manager will generate results similar to that of the market. If that were the case, then passively investing in the market would result in returns similar to that of the average manager - something one could conceivably call "mediocrity." However, due to the costs of active management, primarily management fees and transaction costs, the average active manager must by definition produce results below those of the market. Thus passive management implies settling for above-average performance. 16. If one views the entire stock market as the appropriate investment target, then an investor like Gavvey could segment an actively managed portfolio into bets for and against each stock contained in the stock market. Assuming that the stock market contains about 8,000 securities and that Gavvey's portfolio holds 50 securities, Gavvey has decided not to own 7,950 securities (thus these securities have been effectively short sold relative to the target) and has chosen to own long positions in 50 securities. (Presumably Gavvey owns these securities in proportions greater than the proportions that each security represents of the stock market's value.) 17. The one-stage approach to security selection processes information regarding expected returns, standard deviations, and covariances among all available securities simultaneously in order to arrive at an optimal portfolio. The two-stage approach, on the other hand, first processes information concerning expected returns, standard deviations, and Chapter 23 Page 6
    • covariances among available securities within each asset class to arrive at desired portfolios for these asset classes. Funds are then allocated across these asset classes. The one-stage approach is superior to the two-stage approach in the sense that it uses all available information relevant to the construction of an optimal portfolio. In particular, it considers the covariances of securities across asset classes. The two-stage approach is sub-optimal in the sense that it ignores potentially valuable information. However, the two-stage approach is preferred by most investment managers because it is simpler and cheaper to implement. Investment managers frequently prefer to specialize in one particular asset class. They believe that they can bring superior skills to bear on the investment process in one asset class as opposed to spreading their knowledge across a number of asset classes. Once these managers have determined a desired portfolio within their specific asset class, a decision regarding the allocation of funds across asset classes is considered simpler to make. 18. Over time, the investment characteristics of stocks in a portfolio may change. For example, the betas of stocks may change over time. If the investor has a specific beta target for his or her portfolio, adjustments may be required to bring the portfolio back in line with that target. The primary reason for not making such revisions are transaction costs. The investor must weigh the expected benefits of a portfolio revision against the certain loss of value caused by engaging in security trading. 19. The simple reason that money managers tend to invest the portfolios of all their clients in a similar manner is that this is the easiest way to run their business. Spending time with clients to understand their individual investment objectives is a time-consuming and difficult process. To the extent that clients do not demand that their money managers pay close attention to their investment objectives, then the managers are unlikely to do so on their own initiative. If the clients are to receive individual attention, then they will have to be assertive in their dealings with their managers and perhaps seek out those managers who will provide such attention. Further, they will Chapter 23 Page 7
    • have to be prepared to clearly specify their investment objectives and thus require them to have a clear understanding of their preferences as regards the tradeoff between risk and expected return. Clients will also have to develop monitoring procedures to evaluate their managers’ investment activities relative to predefined goals and constraints. 20. Diversification of judgment refers to splitting funds among managers to avoid being seriously harmed by the investment decisions of one or two managers. The assumption is that not all of the managers will make similar errors in judgment simultaneously. Diversification of style refers to splitting funds among managers who pursue different security selection "styles." The investor attempts to avoid being excessively exposed to the possible poor performance of a particular investment style. The assumption is that not all investment styles will perform poorly simultaneously. 21. (From The CFA Candidate Study and Examination Program Review, 1991.) The main strength of Advisor One's approach is the fact that it is systematic and rigorous in attempting to determine long- term asset class returns and risk and in making an efficient risk-return trade-off. However, weaknesses are that this rigorous approach is applied too narrowly without recognizing that historic data may not represent the future and is time- period dependent, that statistical correlations and standard deviations are just one way to define and measure risk, and that current market conditions are ignored. The strength of Advisor Two's approach is the attempt to integrate current market data into the decision. A weakness is the lack of any checks or balances to ensure that the entirely subjective market forecast is consistent and reasonable. A significant weakness of both approaches is the omission of investor constraints in the process, and only a loose treatment of investor objectives. Advisor Two makes no mention of risk and Advisor One takes only the narrow view that standard deviation of asset returns represents risk. The recommended asset allocation process should draw from the strengths of each approach and correct their weaknesses. The process should address at least the following points: Chapter 23 Page 8
    • (1) A framework is needed within which to address the Donner College Endowment Fund's investment requirements and policies. Examples of such a framework include Sharpe's integrated asset allocation or Maginn & Tuttle's objectives and constraints for investment policy. The framework review should specify clearly what the Fund wishes to achieve. (2) Expectations for market returns and risks should be developed by some rigorous method, using all available information -- current and historic. Examples of rigorous approaches (among many others) include applications of Arbitrage Pricing Theory, discounted cash-flow valuation techniques, or multi-scenario techniques. The resultant market expectations should be placed in historic context and checked for past precedents, both by individual asset class and taken as a whole. Significant deviations from past norms should be thoroughly justified. (3) An asset allocation should be chosen to best meet the Fund's requirements and policies. Whether this asset allocation is done by quantitative modeling (such as an efficient frontier-type approach) or by other means, the resultant asset allocation should be re-checked versus the Fund's investment policy to confirm that all pertinent issues are addressed. For example, if the Fund has a spending budget which is affected by inflation, the asset allocation must be justifiable on that basis. (4) The asset allocation process must address future revision needs. Periodic review must identify any changes in the Fund's circumstances or investment policy and market expectations and make appropriate adjustment in the asset allocation. 22. (From The CFA Candidate Study and Examination Program Review, 1989-90.) a. Whether one defines Asset Allocation as Ambachtsheer does ("...the means to achieve an appropriate package of risk, return and time.") or in some other terms, the challenge for the investment professional is the same: to integrate in some cost-effective way the return, risk and other relevant client factors involved with the assets available in the appropriate marketplaces. Sharpe identifies four Chapter 23 Page 9
    • categories of asset allocation approaches: Strategic (using consensus predictions passively in a long-term context); Dynamic (using "insurance" and hedging strategies to combine downside protection with upside potential); Tactical (using non-consensus predictions in an attempt to "beat the market"); and Dynamic Tactical (employing some kind of "insurance," together with non- consensus predictions intended to "beat the market"). The latter two types are, of course, approaches utilized by managers seeking to add value in an active management format either by superior selection, superior timing or both. Colinos Associates employs a Tactical approach; it seeks to add value by frequently updating the economic/market forecasts derived from its rigorous "scenario forecasting" procedure. The expected values this develops are combined with historical risk and covariance measures to produce an efficient frontier and a set of recommended allocations by which the assets of its varied clientele are deployed across the U.S. stock, bond and cash-equivalents markets. The process is repeated every six months, producing updated output for client discussion and implementation. Colinos' approach has several strengths: o It employs a recognized, disciplined methodology which is regularly repeated and updated. o It is a relatively simple, straightforward and easy-to- understand process. o It requires the firm's senior people to meet regularly for systematic discussion and decision, and has some consensus forecasting advantages. o It utilizes relevant economic and market variables known to affect returns/production. o It produces a fairly wide range of choice across the risk/return spectrum for the firm's client set, and permits allocations to be selected and varied according to client type and needs. o It forces interaction with clients to take place twice a year, providing recurring opportunity for discussion and Chapter 23 Page 10
    • education. o If its forecasts and expectations are correct, the firm can add value to client returns production. o The process produces allocation mixes that can be used as benchmarks for performance evaluation by clients and the firm. However, the method also has a number of weaknesses: o It is limited to only three U.S. asset classes; many clients would benefit from exposure to more, including real estate and international securities. o If the scenario forecasting exercise is done inexpertly by the firm's senior people and incorrect or misinterpreted output is produced, mix selection and results may well be adversely affected. o Unless the firm assists each client to determine where he/she/it should be on the continuum of available risk and return combinations included in the process output, they may make uninformed and/or sub-optimal mix selections. o The output does not appear to take into account the specific needs and constraints of the firm's clients. o For taxable clients, the process does not provide pre- tax or after-tax numbers, nor does it break total return down into its capital component and income component elements. o The historic risk and covariance numbers it employs may not apply in the future, yet are part of the expected values produced. o Adjustment of a three-year forecast on a twice-a-year basis may not fit the investment horizons of many clients, may result in excessive trading and high transaction costs, and may cause the long run superior performance of equities to be underweighted as an allocation factor. o The approach may not take into account the possible Chapter 23 Page 11
    • occurrence of outlying economic/market events; hence, the 90% probability level of achieving a pre-set minimum annual return requirement is not the protection it may appear to be and should be fully explained to clients who may otherwise think of it as some sort of "guarantee." Even without outliers, a 90% probability standard permits a great deal of uncertainty about achievement to remain. b. Any proposed alternative asset allocation approach should be more client-based, integrating current capital market conditions with the constraints and objectives of the wealthy client. Certainly, it would be more diversified and show a greater awareness of the tax status and time horizon of the client. For wealthy individuals, there are several weaknesses to the Colinos' approach to asset allocation which are key. First of all, it employs only three asset classes (cash, bonds and stocks), whereas most wealthy investors would require diversification which at least includes real estate assets and international securities. Secondly, Colinos develops portfolio recommendations which do not meet all the objectives and constraints of a wealthy client. Wealthy investors (as opposed to tax-exempt institutions) have to be concerned with taxes. As such, the bonds (and perhaps even the cash equivalent assets) in the portfolio should be municipals. In addition, long term capital gains are now taxed at ordinary rates and the wealthy investor will want to avoid taking them - particularly if the client is in later life when the assets can be passed to a remainderman/woman avoiding capital gains. Finally, it is obvious that the time horizon of the client is a major factor in the amount of risk the client takes. In general, younger clients with 20-30 year time horizons might be willing to sit with higher equity percentages than the Colinos model currently permits (60% maximum) because their time horizon is much longer than the Colinos 3-year horizon. As an alternative to Colinos' current approach, any number of asset allocation approaches could be utilized. Many methods have been described in the several ICFA publications in this subject area, including those attributed to Ambachtsheer; Bailard, Biehl & Kaiser; Brinson; Droms; Ellis, LaFleur and Sharpe. While each is Chapter 23 Page 12
    • different in its details, all have certain allocation steps in common and each requires the management firm to: o Determine and incorporate client return and risk objectives, considering such relevant constraining factors as time horizon, liquidity needs, tax situation, legal and regulatory matters, and any unique circumstances or preferences that might affect the allocation decision in a significant way. o Develop an appropriate set of market and asset-class expectations, including risk and covariance aspects as well as those relating to returns. o Specify an effective means for integration of the specific client factors with the market and asset-class expectations. o Routinely monitor outcomes against requirements and expectations, adjust the portfolio as necessary, and o Communicate at agreed-upon intervals concerning all aspects of the relationship with each member of the client set. The Scenario Forecasting approach employed by Colinos Associates is expandable to an international economic context employing the many classes of international assets now available for consideration in constructing broadly- diversified portfolios. Both the Brinson (World Wealth Portfolio) and Bailard, Biehl & Kaiser approaches take an international viewpoint for asset allocation. In most alternative approaches, the addition of asset classes supplementing the U.S. types used by Colinos Associates will not affect the approach's fundamentals, nor will extension of the time horizon or the incorporation of a currency hedge if such be required to properly reflect client goals and circumstances. However, all of the alternatives also require some set of market and asset- class return, risk and covariance expectations. This is as true for an Ellis (Investment Policy-type) approach as for the most active, value-adding approach. While, as in the Investment Policy case, such expectations may simply consist of historical experience carried forward into some long term future time frame, they can neither be omitted nor ignored. Determining the client-specific aspects of Chapter 23 Page 13
    • the problem is but one step in the allocation process; determining the market and asset-class expectational aspects is another. Integration of the former with the latter is the final step; until the client and the markets are brought together in some cost-effective and efficient manner of integration, no allocation of assets can occur. The method for so doing should be anchored in theory, explicit and explainable. Since asset allocation is a key decision, the firm must ensure that its method is understood and accepted by the clients on whose behalf it is employed. An example of the integration step is contained in the following brief description of one possible alternative to the Colinos Associates asset allocation approach: o Adopting an Investment Policy approach, the client's return requirements, including income needs, and risk tolerance are determined, with consideration given to each of the several constraints having an influence on the choices. In the risk tolerance assessment, the manager might have used the Downs, or Kaiser, or Barnewell methods in preference to the more general Life Cycle approach, or might have employed Monte Carlo simulation graphics. o In consultation with the investment manager, the client has opted to utilize historical return, risk and covariance data in a passive, long-term strategic context to generate required capital market/asset class expectations. This data is then developed into an efficient frontier of alternative asset mixes with the aid of an optimizer, including international securities, real estate and precious metals among the asset classes being utilized. o The optimal portfolio is selected, maximizing expected return at the risk level selected by the client to reflect required utility, and implementation occurs. o Subsequently, outcomes are monitored and reported periodically to the client, whose needs and circumstances are also monitored for changes of consequence. In this strategic approach, the portfolio is adjusted only when important changes in client factors require reconfiguration or when long-run capital Chapter 23 Page 14
    • market/asset class return/risk expectations change significantly from their original character. Chapter 23 Page 15
    • Chapter 23 Page 16