Reading 3.5

Question 1

What is the core-satellite approach to asset allocation?

Answer 1

It combines passive investing with active management aimed at outperforming a benchmark. The strategy can be effective for investors wanting to diversify using lower-cost investments without foregoing the potential for outperformance by specific, actively managed strategies.

The strategy involves constructing two sub-portfolios, referred to as core and
satellite portfolios

Question 2

Describe the 2 subportfolios of the core-satellite approach

Answer 2

1) Core portfolio - investors’ strategic asset allocation and consists of passive, often low-cost investments that track an asset class’s overall performance and require limited monitoring.

2) Satellite portfolio - adds alpha via tactical asset allocation and consists of actively managed, higher-cost investments that require extensive analysis.

The approach varies across investors depending on their expertise. For instance, some investors may view venture capital as a satellite asset, while others may use it as part of a core portfolio.

Question 3

How is the concept of layered portfolios (core satellity portfolio) based on behavioral finance?

Answer 3

a core-satellite framework enables investors to target areas in which they think they can better control risks or want to assume more risk.

Question 4

Advantages of the core-satelite approach?

Answer 4

1. Diversification without foregoing potential for high returns from actively-managed strategies
2. Flexibility to tailor the portfolio to meet specific investment objectives
3. Ability to target specific risks (either to control them or to increase exposure)
4. Ability to focus more effort on the satellite portfolio (which generates excess return) and less on the benchmarked, lower-return core portfolio

Question 5

Describe what is the bottom-up approach to portfolio construction (or ____) and the process of doing so

Answer 5

screening technique

The approach involves examining all investment opportunities and selecting the apparent best.

Process:
1) screening: identifying suitable investments or those considered to the best.
2) performing intensive analysis and due diligence to rank opportunities by their attractiveness and identify likely top performers.

Question 6

Describe what is the top-down approach to portfolio construction and the process of doing so

Answer 6

Examines macroeconomic conditions in targeted markets and determining the strategic asset allocation: the combination of industry sectors and geographies most likely expected to meet the program objectives.

Question 7

Pros & Cons of the bottom-up approach to asset allocation

Answer 7

Pros:
- Simplicity and Ease: easy to understand and implement. It focuses on individual asset analysis and ranking based on alpha
- Robustness: Since it relies on ranking, it’s less sensitive to specific data manipulation or estimation errors.
- Performance Focus: By concentrating on high-alpha opportunities, it has the potential to enhance expected portfolio performance.

Cons:
- Concentration Risk: The focus on best performers can lead to an unbalanced portfolio heavily concentrated in a few assets. This increases overall portfolio risk.
- Macroeconomic Blindness: Focusing on individual assets might cause the approach to miss broader economic trends that could impact the entire portfolio.

Question 8

Pros & Cons of the top-down approach to asset allocation

Answer 8

Pros:
- Big-Picture View: considers macroeconomic conditions and market trends, ensuring the portfolio aligns with the overall investment goals and risk tolerance.
- Strategic Allocation: focuses on strategic asset allocation – the mix of asset classes (e.g., stocks, bonds, real estate) best suited for the investment objectives. This promotes diversification and reduces risk from any single asset class.
- Risk Management: By considering factors like political, economic, and currency risks, the approach helps manage overall portfolio risk exposure.

Cons:
- Limited Flexibility: Strict adherence to pre-determined asset allocation can be difficult in practice. Finding enough suitable investments within each category might be challenging.
- Active Management: requires active management to seek out investments that fit the predetermined allocations. This can be time-consuming and resource-intensive.
- Market Dependence: success hinges on accurately predicting macroeconomic conditions and market trends, which can be inherently uncertain.

Question 9

Describe what is the mixed approach to portfolio construction and the process of doing so

Answer 9

1. Top-Down for Wish List: The investor defines their target asset allocation based on investment strategies (e.g., growth stocks, venture capital) instead of just asset classes (stocks, bonds). This “wish list” allocation reflects their overall investment goals and risk tolerance.
2. Bottom-Up for Manager Selection: Using a bottom-up approach, the investor then identifies high-quality investment opportunities (e.g., specific funds or managers) within each desired strategy. This ensures focus on individual asset quality, not just meeting pre-determined quotas.

Question 10

What is the Evolution of mixed Approach?

Answer 10

1) New investment programs often prioritize finding the best available funds quickly to avoid “cash drag” (unused capital).

2) As the portfolio grows and diversifies, a more top-down approach can be implemented to identify and manage potential portfolio concentrations.

Question 11

What is Risk budgeting

Answer 11

refers to a general framework of portfolio construction and maintenance based on selecting levels of risk and allocating the portfolio’s aggregate risk to various categories of risk.

Question 12

How does risk budgeting work (4 characteristics)?

Answer 12

• limits the range of possible allocations via constraints
• does not apply optimization to identify a unique portfolio
• only part of an asset allocation process
• needs to be combined with other techniques to identify a unique, optimal portfolio

Question 13

Risk budgeting typically has two goals:

Answer 13

1. To organize and quantify the process of allocating portfolio risk exposures.
2. To identify portfolio allocations that bear risks as efficiently as possible relative to the asset allocator’s other goals.

Question 14

What is a risk bucket

Answer 14

it indicates the amount of a risk that is acceptable

Question 15

How does risk budgeting work using the RISK BUCKETS

Answer 15

1) Determine the combination of buckets
2) Fill each bucket with assets that meet the bucket risk type

Question 16

9 Types of risk buckets

Answer 16

1) equity risk bucket
2) interest rate risk bucket
3) illiquidity risk bucket
4) credit risk bucket
5) total risk (i.e., volatility)
6) systematic risk,
7) multiple beta risks (e.g., factor risks),
8) value-at-risk,
9) active risks

Question 17

What is an OBJECTIVE FUNCTION

Answer 17

An objective function defines what you’re looking for in a portfolio. It could be maximizing return, minimizing risk, or achieving a balance between the two.

Question 18

3 most widespread portfolio optimization approaches used TOGETHER with RISK BUDGETING

Explain each one

Answer 18

1) Mean-variance optimization - uses historical data to maximize expected return for a given level of risk (volatility)

2) equal marginal risk contribution - each asset class contributes equally to the overall additional risk of the portfolio

3) maximizing diversification - spreading your investments across uncorrelated assets to minimize risk

Question 19

Explain what does passing mean:

Risk budgeting is typically combined with a portfolio optimization approach that maximizes the objective function.

Answer 19

once the risk budget is understood, a portfolio optimization technique is used to create a portfolio that creates the most return within the risk limits of the buckets

Question 20

return variance of a portfolio may be expressed as (formula)

Answer 20

Question 21

variance of a 2 asset portfolio (formula)

Answer 21

Question 22

The marginal contribution (MC) of asset i to the total risk of a portfolio P may be expressed as (formula)

Answer 22

Question 23

Contribution of an asset to the total risk of the portfolio is positively related to three factors:

Answer 23

1. The correlation of the asset’s returns with the total portfolio return
2. The asset’s volatility
3. The weight of the asset in the portfolio

Question 24

The MCs (marginal contribution) of a portfolio’s assets can be added together to get total portfolio risk. Thus, the total risk of an N-asset portfolio may be expressed as:

Answer 24

Question 25

Risk parity (RP) approach to asset allocation constructs portfolios that ____ the risk contribution of each asset class. The approach aims for diversification by ___, essentially diversifying across _____(i.e., so that each asset class [except cash] contributes the ____ to the portfolio's total risk)

Answer 25

equally weight risk equally-weighted risks same amount of risk

Question 26

Under the RP approach, in a stock-bond allocation, the relatively low-risk bonds are initially ____ relative to stocks until the risk from the bond allocation ____ the risk from the stocks

Answer 26

over-weighted equals

Question 27

How can Low-risk RP portfolios may be leveraged

Answer 27

margin or financial derivatives

Question 28

When leveraged low-risk portfolios should be preferred to unleveraged high risk portfolios?

Answer 28

If low-risk RP portfolios have higher Sharpe ratios (i.e., expected excess return to risk ratios)

Question 29

THREE STEPS TO IMPLEMENTING THE RP APPROACH

Answer 29

1. Identifying a definition for the total risk of the portfolio (similar to risk budgeting), typically measured by standard deviation (volatility) 2. Determining the marginal risk contribution of each asset class to the portfolio's total risk. 3. Determining the portfolio weights for all available assets.

Question 30

Sharpe Ratio formula

Answer 30

Question 31

What does the leverage aversion theory state?

Answer 31

that many investors cannot or are unwilling to lever up low-volatility portfolios to produce attractive returns.

Question 32

What is the result of the aversion theory state?

Answer 32

Low demand for low-volatility stocks and, thus, these stocks are undervalued (which means they have higher expected returns).

Question 33

When does the Risk Parity Approach outperform?

Answer 33

When the less risky assets (bonds) outperfrom risky assets (stocks)

Question 34

What is the volatility anomaly? Has the anomaly waned?

Answer 34

This anomaly maintains that portfolios of low-volatility stocks have historically outperformed the market. Anomaly has waned since its discovery.

Question 35

What is the betting against beta anomaly?

Answer 35

portfolios of low beta stocks have historically outperformed the market on a risk-adjusted basis

Question 36

CRITICISMS OF THREE POPULAR RATIONALES FOR RISK PARITY

Answer 36

1. Past attractive performance of RP portfolios will persist - NOT TRUE 2. Being able to lever a RP portfolio means that high Sharpe ratios are always preferred. - INTRODUCES FUNDING LIQUIDITY RISK, MAY NEED TO SELL PREMATURELY 3. RP guides portfolios to the optimal allocation to alternative assets - NO DATA THAT LOW RISK ALTERNATIVES ARE GOOD FOR PR PORTFOLIO

Question 37

What is the funding liquidity risk?

Answer 37

a risk associated with leverage that does not exist in unlevered portfolios

Question 38

For who is the RP approach and not apporpriate?

Answer 38

1) INSTITUTIONAL AND HIGH-NET-WORTH INVESTORS: w/o constraints in asset allocation policies, and can use leverage 2) ACTIVE MANAGERS: can implement to maximize risk-adjusted return since it does not use expected returns

Question 39

4 quantitative asset allocation strategies:

Answer 39

1) equally-weighted 2) inverse-volatility weighted 3) minimum volatility strategies 4) market-weighted strategy

Question 40

How does the market-weighted asset allocation strategy work?

Answer 40

It allocates to each asset in proportion to its total market capitalization (cap) relative to the market's market cap = like SPY

Question 41

In alternative investing, applying market-weighted asset allocation is problematic for 3 REASONS:

Answer 41

1. ILIQUID & INDIVISIBLE: The illiquidity and granularity (indivisibility) of real assets (e.g., real estate and natural resources) makes precise market weighting impossible. 2. ESTIMATION OF SIZE IS HARD: Estimating the size and value of privately-traded asset sectors is difficult. 3. DOUBLE COUNTING: Calculating the total value of publicly-traded asset sectors is complicated by publicly-traded investment pools (e.g., ETFs, structured products, and financial derivatives). These pools, which are conduits of underlying exposures, complicate the issue due to potential multiple (e.g., double) counting of asset values.

Question 42

How does the EQUALLY-WEIGHTED STRATEGY work?

Answer 42

constructs a portfolio with equal allocations to each asset or sector

Question 43

Another name for the EQUALLY-WEIGHTED STRATEGY

Answer 43

1/N DIVERSIFICATION STRATEGY or naive asset allocation strategy

Question 44

What are the 3 key justifications for implementing Equally Weighted Strategy?

Answer 44

1. MINIMIZES PORTFOLIO RISK: when the opportunity set of investments is made up of assets with equal volatilities (and equal alphas), and asset pairs with equal correlations. 2. may be SUITABLE WHEN FORECASTING ASSET VOLATILITIES AND/ OR CORRELATIONS IS DIFFICULT 3. When long-term mean reversion of asset returns is likely based on the hypothesis that VERY LARGE ASSETS HAVE SMALLER LONG-TERM GROWTH OPPORTUNITIESthan very small assets.

Question 45

EQUALLY WEIGHTED ASSET ALLOCATION approach inherently constructs a well-diversified portfolio, which likely has relatively high allocations to less risky assets. This is because...

Answer 45

equity is typically the largest and riskiest asset class. Therefore, equally weighting the assets tends to underweight equities relative to a well-diversified portfolio.

Question 46

How does the INVERSE VOLATILITY-WEIGHTED PORTFOLIO STRATEGIES work?

Answer 46

constructs a low-volatility portfolio by establishing the weight of each asset or asset class as proportional to the inverse of its volatility

Question 47

The portfolio weight for each asset or asset class in a INVERSE VOLATILITY-WEIGHTED PORTFOLIO may be expressed as (formula)

Answer 47

Question 48

The difference between the inverse volatility-weighted and RP approaches is that ...

Answer 48

the inverse volatility-weighted approach makes allocations BASED ONLY on each asset's stand-alone RISK (i.e., volatility), whereas the RP approach takes into account each asset's DIVERSIFICATION benefit.

Question 49

How does the MINIMUM VOLATILITY PORTFOLIO ALLOCATION STRATEGIES work?

Answer 49

uses an optimization technique (e.g., mean-variance optimization) to identify weights that MINIMIZE A PORTFOLIO'S RETURN VOLATILITY (or variance) as stated in a Markowitz framework

Question 50

The strategies do not account for

Answer 50

None of the strategies account for expected returns.

Question 51

The RP, equally-weighted, inverse-volatility weighted, and minimum volatility strategies generate the same allocations in 3 certain circumstances.

Answer 51

1) When all investments are equally risky and perfectly correlated, all four strategies pick the same holdings (showing their risk-reducing nature). 2) Equal weighting and volatility weighting ignore connections between investments (correlations) when making allocation decisions. 3) Risk parity and inverse volatility become similar when investments have different risks but perfectly correlated returns.

Question 52

There are two issues with factor investing:

Answer 52

1. Factor-based portfolios are NOT ENTIRELY PASSIVELY MANAGED since weights of factors can become very high or low, investors NEED TO REGULARLY REBALANCE THEIR PORTFOLIOS 2. Direct investments that aim to maintain specific factor exposures MAY NOT BE VIABLE FOR INSTITUTIONAL INVESTORS WHO CANNOT TAKE SHORT POSITIONS(since most factor strategies take long and short positions)

Question 53

4 examples of how investment pools (e.g., hedge funds) generate returns by actively managing FACTORS

Answer 53

1) merger arbitrage strategy exploits a factor related to the risk of a merger being completed 2) The convertible arbitrage strategy exploits a form of the implied volatility factor 3) Many equity long/ short and market-neutral strategies have significant exposures to equity market factors 4) Many global macro strategies use the carry trade factor

Question 54

There are 4 important practical issues related to risk-factor-based asset allocation:

Answer 54

1. GLOBAL ADOPTION UNLIKELY (some allocation strategies are not sustainable, all investors cannot short => capacity is limited, and as more capital is allocated to factor investing, strategies become expensive and the risk premium will decline or disappear. 2. MAY REQUIRE EXTREME POSITIONS (e.g., going short all growth stocks), and many institutional investors are not permitted to make such allocations. 3. DOESN'T ALWAYS OUTPERFORM TRADITIONAL ASSET CLASS ALLOCATION (investing in stocks, bonds, etc.). Even if it does outperform sometimes, you need to consider the costs involved (transaction fees, management fees) and the fact that some factors might not be as profitable anymore because more investors are chasing them (reducing the potential reward). 4. CAN'T ISOLATE ALTERNATIVE INVESTMENTS' FACTORS- alternative investments can be great for getting certain factors, it can be tricky to control exactly which factors you're getting because they often come bundled together.

Question 55

How does the NEW INVESTMENT MODEL works?

Answer 55

It allocates investments with flexibility, and pursues alpha and beta separately. - Beta is handled through cost-conscious products that mirror market performance (ex: ETFs) - Alpha is pursued through targeted alternative investments (RE, HF, PE) in potentially less efficient markets where there's room for skilled investors to outperform.