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  • 1. CFA L3 – Asset Allocation CFA Level 3 - Asset Allocation Dynamic Strategies for Asset Allocation Sharpe 1. Buy-and-Hold Strategy  Investment Strategy:  The buy-and-hold strategy maintains an exposure to equities that is linearly related to the value of equities in general. The strategy involves buying, then holding, an initial mix (equities/bills). No mater what happens to relative values, no rebalancing required; hence this is sometimes termed the “do nothing” strategy.  Payoff Profile  The payoff diagram for a buy-and-hold strategy is a straight line, so the value of the portfolio rises (falls) as equities rise (fall), with a slope equal to the equity proportion in the initial mix.  The value of the portfolio will never fall below the specified floor, and the portfolio has unlimited upside potential.  Increasing equity prices favor a buy and hold strategy; the greater the equity proportion in the initial mix, the better (worse) the strategy will perform when equities outperform (underperform) bills.  Appropriateness / Risk Tolerance - The strategy is particular appropriate for an investor whose risk tolerance above the specified floor varies with wealth, but drops to zero at or below that floor.  Costs - After the initial portfolio transaction, transaction costs are not an issue. The strategy is tax efficient for taxable investors. 2. Constant-Mix Strategy  Investment Strategy:  The constant-mix strategy maintains an exposure to equities that is constant percentage of total wealth. Periodic rebalancing to return to the desired mix requires the purchase (sale) of equities as they decline (rise) in value.  Payoff Profile  This strategy, which generates a concave payoff diagram, offers relatively little downside protection and performs relatively poorly in up markets.  The strategy performs best in a relatively flat (but oscillating or volatile) market and capitalizes on market reversals. The constant mix strategy performs particularly well in a time period when equity values oscillate greatly, but end close to their beginning levels; greater volatility around the beginning values accentuates the positive performance.  Appropriateness / Risk Tolerance - The constant-mix strategy is particularly appropriate for an investor whose risk tolerance varies proportionately with wealth; such as investor will hold equities at all levels of wealth. This strategy requires some rule to determine when rebalancing takes place; typical approaches avoid transaction costs until either the value of a portion of the, or of the entire, portfolio has changed by a given percentage.  Costs - At this point, transaction costs are incurred to rebalance. Taxes can be material for taxable investors. 3. Constant Proportion Strategy  Investment Strategy:  The constant proportion strategy maintains an exposure to equities that is constant multiple of a “cushion” specified by the investor. The investor sets a floor below which she/he does not wish assets to fall, and the value of that floor is invested in some non-fluctuating asset (i.e., Treasury bills, money market funds). Under normal market conditions the value of the portfolio will not fall below this specified floor. The investor then selects a multiplier to be used. The initial commitment to equities equals the multiplier times the “cushion” (the difference between the value of the total assets to be invested and the value of the floor) [$ in equities = multiplier x (assets – floor)].  As equity values rise (fall), the constant-proportion strategy requires the investor to purchase (sell) additional equities. Thus following this strategy (via the formula indicated above) keeps equities at a constant multiple of the cushion (assets-floor) and generates a convex payoff diagram.  Payoff Profile - The constant-proportion strategy tends to give good downside protection and performs best in directional, especially up, markets; the strategy does poorly in flat but 1
  • 2. CFA L3 – Asset Allocation oscillating markets and is especially hurt by sharp market reversals.  Appropriateness / Risk Tolerance - The strategy is particularly appropriate for an investor who has zero tolerance for risk below the stated floor but whose risk tolerance increases quickly as equity values move above the stated floor. This strategy requires some rule to determine when rebalancing takes place; typical approaches avoid transaction costs until either the value of a portion of the, or of the entire, portfolio has changed by a given percentage.  Costs - At this point, transaction costs are incurred to rebalance. Taxes can be material for taxable investors.  Other Characteristics (guideline ans for 2002 exam):  The constant-proportion strategy is consistent with higher risk tolerance, because the strategy calls for purchasing more equities as equities increase in value; higher risk tolerance is reflected in the resulting increased allocation to equities over time.  The constant-proportion strategy will do well in an advancing equities market; by buying equities as their values rise, each marginal purchase has a high payoff.  The constant-proportion strategy would do poorly in a higher volatility environment for equities, because the strategy would sell on weakness but buy on strength, only to experience reversals; conversely, the strategy does much better in the face of lower volatility.  The constant-proportion strategy provides good downside protection, because the strategy sells on weakness and reduces exposure to equities as a given floor is approached. 4. Option Based Portfolio Insurance  Investment Strategy:  The strategy requires the specification of an investment horizon.  The floor value is set at the end of the future time horizon. ]  The current floor is the PV of the end of horizon floor, discount at the risk-free rate. An amount equivalent to the floor is invested in treasury bills (T-bills).  The cushion is the difference between the portfolio value and the current floor and is invested in call options.  Investment rules are designed to give the same payoff as a portfolio invested in T-bills and call options.  OBPI is Similar to CPPI in the following ways:  Both are CONVEX strategies. Recall that a convex strategy sells stocks when they are falling and buys stocks when they are rising.  OBPI assumes investor risk tolerance is directly related to wealth levels. The floor value denotes the level of zero risk tolerance.  However, OBPI differs from CPPI in that:  The floor value is invested in T-bills and rises at the risk-free rate over the life of the strategy.  The cushion is invested in Call options. The result is that at the horizon date, you are either fully invested in the stock market (your calls were in-the-money) or you are fully invested in T- bills (your options were out-of-the-money and expired worthless). FLASHCARD CONCEPTS 1. Buy & Hold Strategy: Do nothing. The Floor Value is the original amount that was placed in T-bills and there is no re-balancing required. 2. Constant Mix: Here, the floor value of the portfolio is set to zero and the portfolio is rebalanced to maintain a constant stock-to-total-asset proportion.  You sell stocks as the market rises and buy stocks as the market falls. This is a CONCAVE strategy.  Buy & Hold always beats a constant mix strategy when no market reversals occur; however, constant mix outperforms in flat, oscillating markets.  Risk Tolerance is proportionate to wealth levels. 3. Constant Proportion Portfolio Insurance (CPPI): The floor value of the portfolio is a positive value. As the portfolio value rises above the floor value, you invest more in stocks.  Here, you buy stock as the market rises and sell stock as the market falls. This is a CONVEX Strategy.  CPPI performs well in bull markets, but performs poorly in flat, oscillating markets  Risk tolerance falls as the portfolio approaches the floor value 4. Options-based Portfolio Insurance (OBPI): Similar to CPPI in that both are CONVEX. However, OBPI differs in that it:  The floor value is Invested in T-bills and rises at the risk-free rate over the life of the strategy.  The cushion is invested in Call options. The result is that at the horizon date, you are either fully 2
  • 3. CFA L3 – Asset Allocation invested in the stock market (your calls were in-the-money) or you are fully invested in T-bills (your options were out-of-the-money and expired worthless). PROBLEM SET: 1. Suppose that initially, you have $100 in stock and $35 in T-bills so that total assets are $135. Suppose also that the stock market index at the time (t0) was 124 and at t1 it rose to 135. At t2, the stock market had fallen back to 130. Assuming at t0, you are at your optimal Stock to Total Asset (S/TA) ratio. CALCULATE the following: i. Optimal S/TA - 100/135 = .7407 or 74.1% ii. Stock Holdings at t1 under Buy & Hold - % increase in market = (135-124)/124 = .0887or 8.87% hence, s = 100x1.0887 = $108.87 iii. Optimal Stock Holdings (under Constant Mix) - % decrease in market = (130 - 135)/135 = -.037 or -3.7% hence, s = 108.87x(1-.037) = $104.84 iv. Amount of Stock to buy or sell at t1 (under a Constant Mix) - s = $108.87 so solve the following for x: (108.87 + x) / 143.87 = .741 →x = -2.26 v. Amount of Stock to buy or sell at t2 (under a Constant Mix) - s = 108.87 - 2.26 = 106.61 at end of t1 The drop in the market was -3.7 so s = (106.61)(1-.037) = 102.66 & TA = 143.87 - (106.61 - 102.66) = 139.92 so solve for x: (102.66 + x)/139.92 = .741 →x = 1.02 2. Identify the relative investor risk tolerance characteristics of each of the following 4 investment strategies  Buy & Hold - The investor’s tolerance for risk is zero if the value of the investor’s asset falls below the floor value.  Constant Mix - Investor’s risk tolerance remains constant regardless of the wealth level. They will hold stocks at all levels of wealth.  Constant Proportion Portfolio Insurance (CPPI) - Investor risk tolerance is similar to that of the buy & hold. Investor risk tolerance drops to zero when total assets drop below the floor value.  Option-based Portfolio Insurance (OBPI) - Similar to CPPI & Buy & Hold in that the floor value denotes the level of zero risk tolerance. 3. Compare & Contrast Constant Proportion Portfolio Insurance (CPPI) with Options-based Portfolio Insurance (OBPI).  Comparisons: Both CPPI & OBPI are CONVEX portfolio strategies that essentially sell stock as the stock market falls. Both methodologies rely on a predetermined floor value that denotes the investors zero risk tolerance level.  Contrasts: Under CPPI, the ‘cushion’ is invested directly into stocks whereas under OBPI, the cushion is invested in call options on the underlying market. Also, under OBPI, the floor value is determined as of the chosen horizon date. At the horizon, the portfolio will be either entirely stock or T-bills. 4. You expect the stock market to be relatively volatile over the next year. You also expect that the annual holding period return will be roughly zero. Recommend and Justify a Portfolio investment strategy given your forecast. Of the 4 strategies outlined in this reading, the constant mix strategy will perform the best. Although the constant 3
  • 4. CFA L3 – Asset Allocation mix strategy will under-perform in a steady bull or bear market, constant mix strategies outperform in an oscillating environment because you are always buying more shares whenever the market falls. Hence, each up movement will have a slightly higher level of capital gains 4
  • 5. CFA L3 – Asset Allocation Asset Allocation Maginn & Tuttle FLASHCARD CONCEPTS  The asset allocation decision is the most important determinant of portfolio performance. 95% of the variance of mutual fund returns can be attributed to asset allocation.  Investment management can be broken down into a 3-stage process (a) Asset Allocation (b) Manager Selection (c) Security Selection  You should remember the formulas for expected asset & portfolio returns. These are the most probable calculations on the Level III Test  Make sure you remember all Level I & II material on efficient frontiers and MPT. Calculations usually aren’t required, but a solid description is. The correlation between assets and asset classes is the key to MPT  Investor preferences are quantified through indifference curves. You always want to invest on the highest possible indifference curve (max. utility).  Tactical Asset Allocation - Take advantage of perceived inefficiencies in relative securities prices. This is a contrarian investment strategy. Tactical allocation typically takes a short run view. Risk tolerance is assumed to be a constant.  Strategic Asset Allocation - longer-term, policy level decision. The strategic asset mix is that allocation that would prevail under ‘normal’ market conditions. Strategic allocation can also be though of as a constant mix strategy.  Individual v. Society or Average Risk Tolerance -  If your individual risk tolerance moves in tandem with changes in the average risk tolerance of all investors, then a buy-and-hold strategy is best  If your risk tolerance is more sensitive than average to changes in wealth, then Portfolio Insurance (CPPI) is optimal  If your risk tolerance is constant relative to the average, then tactical allocation should be used PROBLEM SET: 1. List 3 features of investor indifference curves  An investor is indifferent between any 2 portfolios that lie on the same indifference curve  Investors want to be on the highest possible indifference curve  Indifference curves do not intersect  Less risk averse individuals have flatter indifference curves  The y-intercept is called the certainty equivalent rate of return 2. Discuss the similarities and differences between strategic & tactical asset allocation strategies  Strategic Asset Allocation is a constant mix strategy whereas tactical asset allocation changes its exposure to certain market sectors depending upon changing capital market expectations.  Long-run capital market expectations are used in strategic management whereas short-term projections are used in tactical management. Tactical management attempts to take advantage of perceived market inefficiencies.  Investor risk tolerance remains constant, independent of investor wealth for both methods.  Both Tactical & Strategic strategies can be though of as ‘contrarian’ in nature. The Tactical strategy is contrarian because as prices rise, expected returns fall ant the strategic approach is contrarian because as prices rise, the portfolio weight associated with an asset class needs to be reduced. Thus, both approaches sell in rising markets and buy in falling markets. 3. For Each of the Four main asset allocation strategies, Comment on their relative level of performance in a market environment that is characterized by rapidly changing market conditions  Integrated Asset Allocation - Like all asset allocation techniques, IAA involves a feedback loop where 5
  • 6. CFA L3 – Asset Allocation current capital market conditions are fed back into the optimizer to recomputed the optimal asset allocation. If market conditions are changing rapidly, then transaction costs may outweigh the benefits of continual rebalancing.  Strategic Asset Allocation - In a constant mix strategy, the portfolio needs to be rebalanced periodically to maintain the constant proportions. The performance of a constant mix strategy depends on the behavior of the market and the decision rule regarding when the portfolio is to be rebalanced. For example, if the stock market rises rapidly and the fund is to be rebalanced annually, the fund’s asset allocation will be severely out of alignment (the stocks will be weighted too heavily in the portfolio). Note that there is a definite tradeoff cost between the number of rebalancing points and transactions costs.  Tactical Asset Allocation - Since tactical asset management is designed to take advantage of perceived inefficiencies in the asset markets, tactical allocation is better equipped to deal with rapidly changing market conditions. The performance of a tactical system in a rapidly changing market environment depends on the ability of the asset manager to correctly take advantage of perceived market inefficiencies.  Insured Asset Allocation - (portfolio insurance) depends on the ability to quickly move into and out of risky assets if the market conditions move in adverse directions. The October 1987 crash showed that portfolio insurance strategies are subject to failure when the market swings wildly in short periods of time. Strategy Assumption about Risk Tolerance Assumption about Capital Market Expectations Integrated Changes with Wealth Changing Strategic Constant Constant Tactical Constant Changing Insured Changes with Wealth Constant 6
  • 7. CFA L3 – Asset Allocation Monitoring & Rebalancing the Portfolio FLASHCARD CONCEPTS  Costs of NOT trading include (a) Holding an over-priced asset, (b) holding an inefficient portfolio and (c) holding a portfolio that does not meet client needs.  Costs of Trading are (a) commissions, (b) market impact, and (c) lost client confidence from excessive trading.  Perold & Sharpe’s constant mix asset allocation strategy is the same as the DISCIPLINED Rebalancing Strategy employed in this chapter. On average, a constant mix beats a drifting mix (i.e., a buy & hold comprised of both stocks & bonds).  Disciplined rebalancing also typically beats a momentum strategy. Recall from Perold that CPPI is a type of momentum strategy that buys as the market rises and sells as the market falls. Bottom line: a 60/40 constant mix strategy may be superior to other rebalancing strategies.  A Tactical Asset allocation strategy that employed futures contracts (in a simulation) outperformed the constant mix strategy. Using futures reduced transactions costs considerably.  Key Point: Transactions costs are not simply composed of brokerage fees and these costs must be considered when developing a portfolio rebalancing strategy. PROBLEM SET: 1. List three costs of portfolio rebalancing. Also list three costs of not rebalancing a portfolio  Costs of Portfolio Rebalancing:  Commissions  Potential Impact on Market Prices  Lost Client Confidence if he perceives excessive trading  Costs of Not Rebalancing:  Holding an over-priced asset  Holding an inefficient portfolio  Holding a portfolio that no longer fits the clients’ needs 2. List & Describe 4 factors that may force an individual to rebalance his portfolio  Change in Wealth: Theoretically, an increase in wealth brings an increased tolerance for risk. However, in practice, the result may be the opposite.  Changing Time Horizons: Usually, as the time horizon shortens, the investment mix becomes more conservative.  Changing Liquidity Requirements  Tax Circumstances  Laws & Regs.  Unique Circumstances & Preferences 3. Compare the simulated investment performance of a ‘disciplined rebalancing strategy’ with a tactical asset allocation strategy. Simulated results for TACTICAL rebalancing significantly outperformed a disciplined rebalancing strategy. 4. Compare the simulated investment performance of market timing rebalancing strategies (e.g., momentum) relative to a disciplined rebalancing strategy. Disciplined rebalancing also beat a Momentum based rebalancing strategy. The momentum based strategy shifted funds into stocks when the stock market was moving up relative to bonds and into bonds when bonds were going up relative to stocks Market-timing strategies tend to perform poorly relative to a disciplined rebalancing strategy. 7