Reading 4

Question 1

MVO

Answer 1

Most common approach to asset allocation. Assumes investors are risk averse, so they prefer more turn for same level of risk.

Given an opportunity set of investable assets, their expected returns and variances, as well as pairwise correlations between them, MVO identifies the portfolio allocations that maximizes the turn for every level of risk

Question 2

Utility Maximization

Answer 2

Um = E(Rm) - (0.005 x Lambda x variance of m)

• if in % terms eg 8% is 8.0, then use 0.005
  if in decimal like 0.08, use 0.5

Question 3

What is lambda

Answer 3

Captures each individual investor’s preference for trading off risk and return.

It is unique to each individual and is based on the investor’s willingness and capacity to take on risk

risk-neutral: Lamba = 0
typically between 1 and 10
risk average: level of 4

Question 4

What is MVO budget constraint / unity constraint

Answer 4

asset weights must add up to 100%

Question 5

MVO non-negativity constraint

Answer 5

all weights in the portfolio should be positive and between 0% and 100%; no short positions

Question 6

What is the MVO Process

Answer 6

Inputs: expected returns, variances, covariances (Correlations), risk aversion factor, constraints

MVO: maximize utility, subject to constraints

Outputs: asset allocations (portfolio weights), portfolio expected return, portfolio variance

Question 7

Criticisms of MVO

Answer 7

1. GIGO: garbage in, garbage out
2. concentrated asset class allocations
3. skewness and kurtosis
4. risk diversification
5. ignores liabilities
6. single period framework

Question 8

What is reverse optimization?

Answer 8

Instead of starting with expected returns (and other inputs) and deriving optimal portfolio weights, start with what we assume to be “optimal” portfolio weights from the global market portfolio and derive the expected returns consistent with those weights.

Then we use these return estimates (Called implied returns) to do a traditional MVO and derive optimal portfolio weights for our particular investor.

Question 9

What does reverse optimization process look like?

Answer 9

1. Inputs: assumed optimal asset allocations, variances, covariances (correlations), risk aversion factor, constraints
2. Reverse MVO: maximize utility, subject to constraints
3. Outputs: implied returns
4. Inputs: implied returns, variances, covariances (correlations), risk aversion factor, constraints
5. MVO: maximize utility, subject to constraints
6. Outputs: revised asset allocations, portfolio expected return, portfolio variance

Question 10

What is the benefit of starting with a market portfolio in reverse MVO?

Answer 10

derived returns already reflect a highly diversified portfolio and you avoid the tendency of MVO to come up with highly concentrated asset allocations

Question 11

Black-Litterman Model

Answer 11

Extension of reverse optimization in which the implied returns (actually implied excess returns) from a reverse optimization are subsequently adjusted to reflect the investor’s unique views of future returns

eg. derives an expected return for EM equities as 6.5%, but you think its too low, you could adjust the expected return by 75 bps to 7.25% and rerun MVO using adjusted return estimates

Question 12

What is the Black-Litterman Model Process?

Answer 12

Inputs: assumed optimal asset allocations, variances, covariances (correlations), risk aversion factor, constraints

Reverse MVO: maximize utility, subject to constraints

Outputs: implied returns

Black Litterman

Inputs: reverse implied returns, variances, covariances (correlations), risk aversion factor, constraints

MVO: maximize utility, subject to constraints

Outputs: revised asset allocations, portfolio expected return, portfolio variance

Question 13

How does inclusion of human capital and real estate property impact individual investor’s portfolio?

Answer 13

increases capacity to bear risk

Question 14

Why are less liquid asset classes difficult to include in MVO?

Answer 14

1. there are few indexes available that accurately track these illiquid investments, making it harder to find data to use for estimating return, risk and correlations
2. Even where indexes exist to provide return data, they are generally not investable as a passive alternative to active management of these asset classes.
3. the risk-return characteristics of a specific real estate, private equity, or infrastructure investment are different from those of its asset class. Eg any one infra fund is not fully diversified, and therefore, its risk and return characteristics reflect both systematic and nonsystematic risk

Question 15

How do you address illiquidity in MVO?

Answer 15

1. Exclude illiquid asset classes when running an MVO, but use them to meet separately set target asset allocations.
2. Include the illiquid asset classes in MVO and model the inputs of the specific (not asset class) investments you plan to use (ie the risk estimate will be based on both nonsystematic and systematic)
3. include illiquid asset classes in MVO using highly diversified asset class inputs, recognizing that the actual investments made may have different characteristics.

Question 16

Marginal Contribution to Portfolio Risk

Answer 16

Change in total portfolio risk for a small change in the asset allocation to a specific asset class

Question 17

Marginal Contribution to Total Risk: Formula

Answer 17

MCTR = (beta of asset class wrt portfolio) x (total portfolio risk measured by sd)

Question 18

Absolute contribution to total risk

Answer 18

ACTR - weight x MCTR

Question 19

% of risk contribution by position

Answer 19

ACTR / total portfolio risk

Question 20

How do you know you have reached optimal allocation to each asset class?

Answer 20

When ratio of excess return to MCTR is equal for all asset classes and is equal to Sharpe of the total portfolio

Question 21

Plan Surplus

Answer 21

Market Value of investment portfolio assets - PV of pension liabilities

Question 22

Funding ratio

Answer 22

market value of assets / PV of liabilities

A pension plan is fully funded if funding ratio = 1 (ie surplus = 0)

Question 23

Quasi Legal Liabilities

Answer 23

Not legal obligations, but are cash outflows expected to occur in the future and are essential to the mission of the institution

Question 24

What are the 3 approached to liability-relative asset allocation?

Answer 24

1. surplus optimization
2. 2 portfolio approach
3. Integrated asset-liability approach

Question 25

Surplus Optimization Approach

Answer 25

Extension of MVO in which we determine an efficient frontier based on the surplus with its volatility as our measure of risk, stated either in money or percentage terms

Question 26

Surplus Retuen

Answer 26

(change in asset value - change in liability value) / initial asset value

Question 27

objective function of surplus maximization

Answer 27

maximize Um - E(return on surplus) - (0.005 * lambda * variance of surplus)

Question 28

Two Portfolio Approach

Answer 28

Separate the asset portfolio into 2 sub-portfolios 1. hedging portfolio 2. return-seeking portfolio: using MVO to maximize utility and identify the optimal risk-return tradeoff

Question 29

What are the limitations of the 2 portfolio approach?

Answer 29

1. if the funding ratio is less than 1, it is difficult to create a hedging portfolio that completely hedges the liabilities 2. a hedging portfolio may not be available to hedge certain kinds of risk (eg earthquakes)

Question 30

Integrated Asset-Liability Approach

Answer 30

Banks, hedge funds with short positions and insurance companies make decisions about compositions of their liabilities jointly with their asset allocation decisions. There is a continuous feedback loop between the 2, which requires a multiperiod model. This is often referred to as an integrated asset-liability approach

Question 31

What is the risk parity approach?

Answer 31

Diversification is achieved by ensuring that each asset class contributes the same amount to the total portfolio risk

Question 32

How are asset correlations related to rebalancing frequency?

Answer 32

The higher the correlation of the asset class with the rest of the portfolio, the wider the corridor, because a portfolio tends to move with the asset class, and the allocations tend to stray more slowly from the target

Question 33

How does volatility impact rebalancing frequency?

Answer 33

The higher the volatility of the asset classes, the narrower the optimal corridor because higher volatility increases the likelihood that the actual allocation will diverge over time from the target allocation

Question 34

Benefit of MCS over MVO?

Answer 34

MCS is multi period

Question 35

What is the goal of risk budgeting?

Answer 35

Maximize return PER UNIT of risk. A risk budget identifies the total amount of risk and attributes risk to its constituent parts. an optimum risk budget allocates risk efficiently.

Question 36

Name 1 common criticism of MVO

Answer 36

Model outputs, the asset allocations, tend to be highly sensitive to changes in the model. Resulting asset allocations also tend to be highly concentrated in a subset of the available asset classes

Question 37

which factors do you use in factor based approaches?

Answer 37

The factors commonly used in the factor-based approach generally have low correlations with the market and with each other. This results from the fact that the factors typically represent what is referred to as zero dollar investment or self-financing investment, in which the underperforming attribute is sold short to finance an offsetting long position in the better-performing attribute. Constructing factors in this manner removes most market exposure from the factors because of the offsetting short and long positions, as a result, the factors generally have low correlations with the market and with one another. Also, the factors commonly used in the factor-based approach are typically similar to the fundamental or structural factors used in multifactor models.

Question 38

How is volatility related to rebalancing corridor?

Answer 38

The higher the volatility of the rest of the portfolio, excluding the asset class being considered, the more likely a large divergence from the strategic asset allocation becomes, which should point to a narrower optimal corridor, all else being equal

Question 39

Describe Black-Litterman Model

Answer 39

Starts with excess returns produced from reverse optimization, which commonly uses the observed market capitalization value of the assets or asset classes of the global opportunity set. It then alters the reverse-optimized expected returns that reflect an investor's own distinctive views yet still behaves well in an optimizer

Question 40

How do you identify if MVO was used?

Answer 40

concentrated asset classes

Question 41

List flaws of resampling

Answer 41

riskier asset allocations are over-diversified. However, the asset allocations do inherit the estimation errors in the original inputs

Question 42

The 60/40 stock/bond heuristic optimizes the growth benefits of equity and the risk reduction benefits of bonds. true or false?

Answer 42

False. It is not an optimization model. The 60/40 stock/bond heuristic allocates 60% of assets to equities, supplying long-term growth foundation and 40% to fixed income, supplying risk reduction benefits

Question 43

The Norway model is a variation of the endowment model that actively invests in publicly traded securities while giving consideration to environmental, social, and governance issues. True or false?

Answer 43

False The Norway model PASSIVELY invests in publicly traded securities subject to environmental, social, and governance concerns. In comparison, the endowment model asset allocation emphasizes active management of large allocations to non-traditional investments, seeking to earn illiquidity premiums.

Question 44

How do you achieve a hedging/return seeking portfolio?

Answer 44

first hedge the liabilities by allocating an amount equal to the PV of the fund's liabilities to the hedging portfolio. Hedging portfolio must include assets whose returns are driven by the same factors that drive returns of liabilities. The residual is surplus which would then be invested into a return-seeking portfolio.

Question 45

Some of the issues with MVO can be corrected by using reverse optimization to solve for risk parameters based on inputs for expected return and correlation. True or false?

Answer 45

False. Reverse optimization uses inputs for risk and correlation (or covariance) to solve for expected return

Question 46

Easily tracked indexes in asset classes similar to that of an illiquid asset often do not represent the non-idiosyncratic risk of the illiquid asset very accurately. True or false?

Answer 46

False An idiosyncratic shock will affect only a single institution or asset and will not ripple out into the rest of the system. Systemic risk focuses on the danger of the entire financial system collapsing, causing a major downturn in the real economy. easily tracked indexes for an asset class usually do not capture the idiosyncratic risk component of less liquid assets.

Question 47

No low-cost passive investment vehicles are available to allow one to closely track the aggregate performance of less liquid asset classes. True or false?

Answer 47

True Low-cost passive vehicles for tracking performance exist for publicly traded liquid assets but do not exist for illiquid assets.

Question 48

Marginal contribution to total risk

Answer 48

Beta relative to portfolio * SD of the portfolio