Tactical asset allocation
- Active strategy to deviate from our long-term allocation based on changing market circumstances.
- It is all about “Market Timing”
- Tilt weights towards assets you expect to do well.
Strategic asset allocation
- Long-term allocation to broad asset classes.
- Maximizes risk return trade-off given inherent risk return asset class characteristics.
- Periodical rebalancing towards long-term weights.
- Explains 90% of time-series variation of the performance in a single mutual fund
- Explains 40% of time-series variation of the 10 year performance in different mutual funds
Rule 1 - Do not neglect equities
Equities have an average premium of 5.5% over bonds
Rule 2 - Diversify idiosyncratic risk
- 30-50 stocks to eliminate firm-specific risk
- systematic risk cannot be diversified
Rule 2b - Diversify country risk
- Diversification benefit: volatility of global equity is lower than that per country
- Allocation of 40% foreign stock is appropriate
Problem: correlation is increasing between countries due to globalisation, so less benefit
Rule 2c - Diversify market development risk
- Emerging/Frontier markets: offers some diversification at moderate risk, however correlation is also expected to grow due to globalization
- Higher returns are just priced risk premiums related to political and liquidity risk
Rule 3 - Diversify into other asset classes
Combine (alternative) asset classes that are poorly correlated
The endowment model
highly-diversified, long-term portfolios that differ from a traditional stock/bond mix in that they include allocations to alternative asset categories as well as absolute return strategies.
Hedge funds conclusions
- Performance has a downward trend and is much lower than ETFs
- High losses in times of crisis
- High correlation with 60/40 portfolio.
- Underperformance the market. No evidence that a manager can beat the market regularly.
- The managements are not “active” in the sense we need. Passive is better.
Private equity evidence
- PE outperforms standard public equity benchmarks before costs.
- PE’s performance has gone down over the last decade and is equal to the S&P500.
- In their risk category, PE’s underperforms index of small value firms
- Despite decreasing returns, a lot of money has flown into PE funds lately.
Private debt what & conclusions
- Direct participation in debt of firms
- Not financed by banks, not issued or traded in an open market.
- Small but growing fast. Bank regulation with negative effects on real economy procyclicality increases demand for private debt.
- LPs primarily consider absolute return measures (IRR)
- Calculating risk adjusted returns is challenging
- Shortfall risk over a long time horizon is a good measure for risk
- Public Market Equivalent (PME) likely to substitute a 1 factor model (CAPM) and currently only method
to accurately reflect risk partially
Real estate advantages
Advantages:
- Private real estate: attractive risk return tradeoff (very good Sharpe Ratios)
- Offer high dividends (liquid income) – good for pension funds
and retired investors
Commodities
- Low correlation for livestock, agriculture and precious metals
- High correlation for oil and industrial metals
Bonds
- Negative correlations with equities – Perfect diversifiers.
- Portfolio 40/60 has better sharpe ratio than stocks
- Returns are very low, because of the low beta (CAPM)
- Bonds are especially good diversifiers when inflation is procyclical
Bonds - inflation is countercyclical
Negative inflation shock signals bad news about the future economy
- Equities drop in value because of lower than expected growth prospects
- Bonds drop because higher than expected inflation raises yields.
- Positive stock-bond correlation
- Examples: – oil shocks push up inflation and depressed the economy.
Bonds - inflation is procyclical
Positive inflation shock signals good news about the future economy.
- Equities surge because of better than expected growth prospects
- Bonds drop because higher than expected inflation raises yields
- Negative stock-bond correlation
- Example: higher inflation signals the economy picking up
Inflation-linked bonds
- Good hedge against inflation (long-term), however coupons (not principal) will decrease with deflation
- TIPS offer unusually high expected returns and low risk relative to nominal bonds
- Low volatility and low correlations with other assets (makes it a good diversifier)
- Investing too much in TIPS will make the portfolio unbalanced (due to its small market cap)
Private equity motives
- Investors seek Leverage: You want to take on additional risk, but you are limited by internal rules. You can implicitly take on leverage by investing in PE
- PE returns are artificially smooth and don’t move as public market returns, as they are not listed
- A portfolio that mixes public with private equity will “look” less risky, at least in the short run
- The manager of such mixed fund is less likely to be forced to sell at rock-bottom prices because of imposed
risk constraints or solvency rules
Real estate disadvantages
- Listed REITs: high volatility, high correlation with the market
- Low capital appreciation
Harvard Endowment
Main question is this case
Should HMC add inflation-linked bonds as an additional asset class?
Asset classes
Traditional & Alternatives
- Traditional: Cash, Bonds, Equities
- Alternatives: Private Equity, Private Debt, Real Estate, Commodities, Hedge Funds, Crypto
What is the role of the policy portfolio for HMC?
- Long-run (or ‘strategic’) asset allocation of the endowment over main asset classes
- Benchmark for performance measurement
How is policy portfolio determined?
- Specify objective (utility function)
- Specify asset classes
- Capital market assumption (ER, Vol, Correl)
- Optimization (w* or w/o constraints)
- Blacktesting (Simulation)
- Implementation
- Follow (performance management)
Importance of diversification
- Portfolios with large amounts of idiosyncratic risk are inefficient
- Stock index with beta 1 has volatility of 20% and an individual stock with same beta has vol = 38%
- Idiosyncratic risk is higher for small stocks
