Session 4:

Asset Allocation

Asset Management (ieb Programme)

Dr Dirk Nitzsche (E-mail : [email protected])

Content
• Different philosophies : Active vs passive investments
• Broad asset allocation : Equity vs Bonds (but also i.e. commodities,
real estate or crypto)
• Asset Allocation
• Asset Allocation Decisions : Strategic Asset Allocation (SAA) and Tactical Asset
Allocation (TAA)
• Alternative Asset Allocation Approaches
• International investments

• Performance attribution
Passive vs Active Portfolio
Management Strategies
Investment Policies : Passive
• Origins from 1970 : John Bogle (Vanguard) and Wells Fargo ‘s index portfolio
• Assume that markets are efficient
• Based on results of portfolio theory and CAPM
• CAPM : ‘concept of the market portfolio’
• Manage portfolios that are surrogates for the market portfolio or those tailored
for particular (not average) clients - index funds

• The aim: to achieve average performance through returns which are equal to the
market as a whole
• success judged by how small is the difference between fund’s return and index return -
‘tracking error’
• Important to choose the right benchmark portfolio.
Investment Policies : Active
• Assumes :
• do not believe in market efficiency and have different forecasts than consensus (i.e.
can do better)
• there are mispriced securities or groups of securities
• Believe certain segments of markets are doing well/not so well

• Active portfolio: differences between proportions in the actual and

benchmark portfolio
• ‘bets’ are placed on certain securities

• The aim: to outperform the benchmark index

• success judged by how large is the difference between fund return and index return
General Approaches to Active Strategies
• Asset allocation (AA)
• Allocating the funds within one asset class or between asset classes
• Strategic AA: based on long-term forecasts and used for determining longer term
position in an asset class
• Tactical AA: based on short-term forecasts and used for determining switching between
or within asset classes
• Security (sector) selection or stock screening
• Based on various active quant techniques such as:
• Momentum investing, earnings surprise, style investing, use of relative valuation
techniques, optimisation etc.
• Market Timing
• Determining when to switch from one asset (class) to another
• Can be done at individual security level and market level
Passive vs Active Investment Management
• Turnover and transaction costs
• Passive fund small (low management fees <0.5%)
• Active management must generate at least 1.25% of gross additional return to
break even with passive
• Greater diversification in passive management
• Frequent revising of portfolios by active managers in search for the
‘winners’
• The aim of a passive fund is to achieve returns close to the market
returns, while active is trying to outperform a benchmark
Do Active Portfolio Managers Beat Passive
Portfolio Managers?
Percentage of active general equity funds that were beaten
by Vanguard (S&P) Index Fund after expenses

100%

90%
71%
80% 63%
70% 52%
60%

50%

40%

30%

20%

10%

0%
1 Year 5 Years 10 Years

Time period ending 31 December 2001

Source: B. Malkiel (2003)

Asset Allocation
What is Asset Allocation (AA)?
• Asset Allocation traditionally involves allocation of funds between the
following asset classes: equities, bonds, property, cash

• Within each of these asset classes, separate allocation decisions need to be

made: value vs. growth stocks; domestic vs. international stocks; government
vs. corporate bonds etc.

• Practitioners dilemma: traditional vs. alternative asset classes (commodities,

private equity, FX, hedge funds)
Asset Allocation in Practice
• In 1980s and 1990s institutional investors allocated most funds to
equity
• Barclays Capital: £100 invested in 1899 in UK stock market (with income
reinvested) would be worth around £25,022 in real terms (about 100 years
later); while the same investment in gilts and cash will be worth £323 and
£286 respectively.

• Asset mix has changed since 2008: bonds represent greater

proportion of the holdings and more alternatives are present
• Reasons: high equity market returns from 1990s may not be repeated in the
near future; when markets are in downturn, investors turn to less risky
investments and alternatives in more recent years
CFA Guidelines on Investment Process
• Define objectives: desired investment outcomes (return and risk objectives)
• Define constraints: regulatory, legal
• Formulate investment policy statement to include:
• Client description, investment horizon, statement of investment goals and
objectives/constraints, schedule for review of performance, asset allocation considerations
that are accounted for when developing strategic asset allocation and rebalancing guidelines
among others
• Investment policy is the basis for strategic asset allocation
• Monitor and rebalance portfolio (if and when needed)
• Portfolio manager given a mandate: set of instructions detailing his task and how the
performance will be evaluated, including the specification of the manager’s benchmark.
• Fact: there is no correct way to formulate an investment process
Summary and Some Ideas
• Strategic Asset Allocation : Passive
• Fixed weights : For example - 40% Equity, 40% Bonds, 20% Cash
• Age based weights : 100 or 120-rule  100 or 120 – age to invest in stocks
• Other weighting possible : Consider risk tolerance

• Tactical Asset Allocation : ‘More Active’

• Example : if 40% Equity, 25% large cap and 15% small cap
• Looking at each asset class separately
• Short term asset allocation
• Stock picking
• Quantitative investment models
Age Based Rules
Age Risk Tolerance (Stocks/Bonds)
120- Rule (High Risk) 100-Rule (Low Risk)
20 100/0 80/20
30 90/10 70/30
40 80/20 60/40
50 70/30 50/50
60 60/40 40/60
70 50/50 30/70
80 40/60 20/80
90 30/70 10/90
Strategic Asset Allocation (SAA)
Approaches
Different Building Blocks for Strategic Asset
Allocation
Different Strategic Asset Allocation (SAA)
Approaches
• First step : to design the SAA policy - this is the allocation to asset classes that in
the long-term would meet client's needs

• Main approaches to SAA:

• Fixed allocation (say 60% equities/40% bonds)
• 1/N, equal weights strategy
• Market capitalisation-based
• Following the median manager allocation, especially among pension managers.
• Mean-Variance Optimisation (MVO): choosing asset weights so as to provide max
risk adjusted return (Sharpe ratio)
• Liability driven investment (LDI): asset/liability issues.
• Black–Litterman approach: more sophisticated approach to MVO
Strategic Asset Allocation – 1/N Equal Weights
• Viewed as naïve and too simple
• Advantage: not relying on historical data
• Simply allocate the same weight to each asset class

• Less popular, but is it underestimated?

The evidence shows that it has low level of complexity and that it achieves
higher Sharpe ratios than for instance MVO
Strategic Asset Allocation – Market Cap Based
• Value weighted portfolio
• Using assets in proportion according to their market cap, as in the
world market portfolio (in the CAPM)
• (same concept used in construction of stock market indices)

• This represents the base portfolio in Black-Litterman approach

Strategic Asset Allocation – Fixed Allocation
• Fixed allocation in traditional asset classes, popular being 60%
Equities and 40% Bonds
• Benefit: Easy for you to understand the risk and return level of your
investments.
• Cons:
• Risk tolerance for most people changes: in bull markets investors become more aggressive,
and vice versa.
• You may end up with a portfolio that is too conservative when you are young and too
aggressive when you are old.
• Many investors end up with a portfolio too conservative to have any chance at all of having
the retirement they want because they base their investments only on their risk tolerance,
without knowing what return they need to achieve their life goals.
Strategic Asset Allocation – Following the
Median Manager
• Choose SAA to reflect allocation of a median portfolio manager
• Popular when performance measured with peer-group benchmark
like in some pension funds
• Aim is NOT to underperform the median manager
• Managers protected from being fired for taking higher-than-average risks
• Drawback: Herding bias
Strategic Asset Allocation – MVO Approach
• ‘Best’ long-term asset mix to achieve investor’s objectives (5 years)
• Objective of SAA: identify return requirement of the fund and
combine asset classes in such a way that the expected return is
achieved with the lowest volatility; i.e. identify efficient frontier for
any given group of asset classes
• Based on long-term view of asset performance and on investor’s risk
profile / investment horizon; so need to know:
1. Long-term expected returns of asset classes
2. Volatility of those asset classes
3. Correlations between those asset classes
SAA – MVO : Determining Long-Term Volatility
and Correlations and Expected Return
• Estimates of required parameters are based on
historical values– BUT both volatility and correlations
as well as expected returns are time varying

Correlations have risen over time due to globalisation

(many companies operating in foreign markets) - is there
any benefit in international diversification and global asset
allocation then? YES!
Strategic Asset Allocation – MVO: Choosing
the Strategic Portfolio
Asset allocator produces mean-
variance frontier which can B

Expected return: established

via 'building block approach'
enable them to select a E
A
Efficient frontier

strategic investment portfolio – D

the one with maximum risk

adjusted return (Sharpe ratio):
Individual asset
classes

C F

Standard deviation, risk: established using

historic estimates of volatilities and correlations
Strategic Asset Allocation – MVO : What are
the Problems?
• Michaud (1989) “ The Markowitz Optimisation Enigma: Is ‘Optimized’ Optimal?”,
Financial Analysts Journal, Jan/Feb 1989:
• Assumes normal distribution and requires long history of data
• Meaningless optimal portfolio (only a few assets in very high weightings)
• Based on risk and return which are both subject to estimation error
• Liquidity of assets is often ignored – introducing liquidity as a constraint results in
less return maximisation and less risk reduction, moving efficient frontier to the
lower right corner on the mean/standard deviation graph
• Existence of ‘optimally equivalent’ portfolios: portfolios that have statistically
identical risk return profile but very different composition
• Small changes in inputs in MVO result in large changes to optimal portfolio
• Despite these problems, optimisation is used in solving asset allocation problems
and index tracking
Strategic Asset Allocation – MVO : What are
the Problems?
• ‘Garbage in = Garbage out’
• If one asset class has much higher Sharpe ratio than others, optimiser will
suggest (often unreasonably) high weight to that asset class
• Sensitivity of optimisers (particularly to return) expectations:
• Asset class A has return of 5.01% and B return of 5%, both having standard
deviation of 3.5%. Common sense would lead you to allocate equal weights to
these asset classes but standard MVO optimiser will allocate 100% weight to
A!
• Constrain weights in MVO to avoid barbell solutions
Strategic Asset Allocation – Black and
Litterman (BL)
• Version of Global optimisation combining CAPM, investor expectations and
traditional MVO analysis is given by BL model from Goldman Sachs.
• BL process starts with determining equilibrium rates of returns: using weights of asset class in
the global market portfolio, level of risk and level of volatility
• BL process then allows asset allocator to add tactical (short-term) views about asset classes
in both absolute and relative terms.
• The equilibrium and tactical views are integrated to produce efficient frontier. Allocator can
adjust inputs and tactical views until the ‘satisfactory’ allocation is reached.
• Note: the model requires very subjective input from the asset allocator (more than in MVO)
• Black F. and Litterman, R. (1992) “Global Portfolio Optimisation”, Financial
Analysts Journal, September/October 1992.
Strategic Asset Allocation – Liability Driven
Investing (LDI) Approach
• Popular with pension funds
• Objective of LDI: return on the assets should at least match the payout on
liabilities
• Objective until mid 1990s – beat the peer-group benchmark
• Example of LDI objective: match the change in liabilities plus outperformance of x% p.a.-
focuses on the liabilities first and then addresses the desired level of outperformance over
the liabilities, subject to various risk constraints

• LDI objective should be viewed as a refinement of existing investment objectives

rather than a completely new approach
• Before LDI approach was introduced, the focus was purely on assets. Whereas in LDI
exposures to various asset classes, can be translated to an expectation of performance
relative to liabilities
LDI : Four Step Process
• Step 1- Creating Liability Matching Portfolio:
• Liability matching portfolio: lowest risk portfolio which is a combination of
assets having similar sensitivity to inflation, interest rates and other variables
as the liabilities
• Forecasts of cash-flows and their sensitivity to inflation, interest rates etc
• Typical liability matching portfolio would include:
• Index linked gilts, Corporate index linked bonds, Corporate bonds (to match liabilities
with shorter duration) and swaps (interest rate, inflation and credit default - to
synthetically match longer duration liabilities).
• Considered as the reference portfolio in the LDI strategy
LDI : Four Step Process
• Step 2 – Risk Budget and
Benchmark
Determine the overall risk constraints
of the portfolio, the aggregate target
outperformance and how much of
this will come from market exposure
(passive management) and how much
from active management. For
example a target of 0.5% or 1%
outperformance over liabilities which
is coming from market exposure
(beta) can be shown below:
LDI : Four Step Process
• Step 3 – Active manager
outperformance
A target of 2% outperformance over
liabilities might be adopted with 1% coming
from market exposure (beta) and 1% from
active management (alpha).
Active portfolio composition example: 55%
government and corporate bonds (liability
matching portfolio) and 45% other risky
assets (e.g. 25% active domestic and
international equity, 10% property, 5%
hedge funds and 5% commodities)
LDI : Four Step Process
• Step 4 - Implementation
• Be pragmatic, there is more than one way to apply
• Recall the structuring of fixed income portfolios to meet known liabilities …
classical immunisation, cashflow matching, etc.
• What if liabilities are uncertain (i.e. stochastic)? You can choose from a wide
range of assets, e.g. equities, hedge funds - these are also stochastic.
• Asset risk: asset allocation will produce different returns, volatilities,
correlations, etc: should it be static or dynamic asset mix?
• More than half of the UK pension funds have adopted LDI approach
Pension Funds : Change in Allocation to
Alternatives

Source: UBS Pension Fund Indicators 2018

Tactical Asset Allocation
Tactical Asset Allocation (TAA)
• TAA assumes systematically deviating from SAA in the short-run, in
response to changing market and economic conditions

• It is a contrarian approach that relies on the idea of long-term mean

reversion (return to equilibrium)
• Sell asset classes that have strengthened (i.e. in time of bubble)
• Buy asset classes that have weakened (i.e. in time of panic)
Tactical Asset Allocation
• Portfolio weights change frequently (every month, quarter, year)
• Combines intuition (market timing) with objective quantitative
models (forecasting models, mean-variance optimisation with
imposed restrictions on tactical deviations from benchmark weights)
• Main objective: alter positions in asset classes to obtain return above
the return expected from SAA positions
• Therefore, it is consistent with active portfolio management and
market inefficiency
Tactical Asset Allocation : Simple Example
• Assume that SAA decision is to invest 70% in UK equities and 30% in UK gilts.
• Asset allocator view: gilts are currently overvalued, equities are undervalued
• TAA decision: sell 5% of gilts and invest 5% more in equities
• If the view is correct, equities will rise in value, gilts will fall:
• So, new TAA decision will be to sell additional equity bought and buy back the gilts – going
back to the strategic position of 70/30 split between the two asset classes
• Value is added to the portfolio by: 1) increasing exposure to equities that rose in
value and 2) decreasing exposure to gilts that fell in value
Summary
Which form of Asset
Allocation (SAA or TAA) has TAA and
Security
greater contribution to the Selection

variance of total returns and 6.4%

determination of portfolio
performance?
SAA
93.6%

Brinson, Hood and Beebower (1986), many

other studies confirm these findings
Alternative Approaches to Asset
Allocation
Alternative Asset Allocation Approaches
• Momentum weight
• Risk parity
• Trending

• Smart beta funds and weighting schemes:

Using the same stocks as in a passive index but weighting them
using these (and other) alternative weighting schemes
Momentum Strategies
• Momentum investing on asset class level
• Momentum is traditionally applied to individual equities: invest in
stocks that performed best over recent history (up to 1 year), i.e.
winner stocks
• Brought to attention in 1990s
• Opposes efficient market theory
• Best known paper: Jagadeesh and Titman (1993), ‘Returns to buying
winners and selling losers: Implications for market efficiency’, Journal of
Finance
Naïve Risk Parity
• Allocating weights according to risk levels, so that the risk of each
asset class in a portfolio is equal
• Historical volatility is used as risk
• In a traditional 60/40 equity/bond allocation most of the portfolio risk
comes from equities
• Risk parity approach would reduce weight in equities and increase
weight in bonds to create portfolio with equal risk allocation between
these two asset classes
Naïve Risk Parity
• Calculating weights in risk parity:
Asset Class Vol 1/Vol Weight:
(1/Vol)/(Total 1/Vol)
Asset Class 1 20% 5 22.7%
Asset Class 2 15% 7 31.8%
Asset Class 3 10% 10 45.5%
Total 22 100%

• Drawback of approach: overweights low return asset classes

• Proponents say: leverage can improve returns.

See: Asness, C., Frazzini, A., and Pedersen, L., (2011). "Leverage Aversion and Risk Parity", AQR
Capital Management, Working Paper
Trend Following
• Faber, M. (2007) “A quantitative approach to tactical asset allocation”,
Journal of Investing, 16, p.69-79. In the paper suggests that:
• Equal weight allocated to five risky asset classes (20%), namely: US stocks,
International stocks, Bonds, Commodities and property (REITs)
• Assess trend of each asset class individually
If a price of asset class is above its 10-month moving average – there is a positive trend and
vice versa
• If positive trend: invest 100% (full weight of 20%) in the risky asset class; if
negative trend invest 100% (full weight of 20%) in a risk-free asset.
• No short selling is allowed
Global Asset Allocation
Stock Market Capitalisation – June 2023
U.S.
Japan
UK
11% China
1%
2%
2%
2%
France
2%
2% Canada
Switzerland
3%
3%
4% 58%
Australia
4%

6%
Germany
India
Taiwan
South Korea
Others
Global Asset Allocation
• International portfolio diversification
• Additional profits opportunities for the same risk (i.e. improve risk
adjusted performance compared to local asset allocation)
• Prerequisite: Some independence in price behaviour across countries
(Average correlation between two country returns < 1)
• Domestic diversification argument extended to a larger cross section
of fairly independent assets
 0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9

0
1
01/04/1997
01/02/1998
01/12/1998
01/10/1999
01/08/2000
01/06/2001
01/04/2002
01/02/2003
01/12/2003
01/10/2004
01/08/2005
01/06/2006
01/04/2007
01/02/2008
01/12/2008
01/10/2009
01/08/2010
01/06/2011
01/04/2012
01/02/2013
01/12/2013
01/10/2014
Correlation : S&P500 / MSCI Europe (US Dollars)
Market (3 Year Rolling Window)

01/08/2015
01/06/2016
01/04/2017
01/02/2018
01/12/2018
01/10/2019
01/08/2020
01/06/2021
Correlation – S&P500 and European Stock

01/04/2022
01/02/2023
01/12/2023
 0.2
0.4
0.6
0.8

-0.2
0
1
01/04/1997
01/03/1998
01/02/1999
01/01/2000
01/12/2000
01/11/2001
01/10/2002
01/09/2003
01/08/2004
01/07/2005
01/06/2006
01/05/2007
Year Rolling Window)

01/04/2008
01/03/2009
01/02/2010
01/01/2011
01/12/2011
01/11/2012
Correlation : Nasdaq / China A-Shares

01/10/2013
01/09/2014
01/08/2015
01/07/2016
01/06/2017
01/05/2018
01/04/2019
01/03/2020
01/02/2021
01/01/2022
Correlation – Nasdaq and China A-Shares (3

01/12/2022
01/11/2023
 Solnik (1974) : Benefits of International
Diversification
Risk (%)
Non Diversifiable Risk

domestic

international

Number of Stocks
Source: B.Solnik, 1995, Financial Analyst Journal, “Why not diversify
internationally rather than domestically?”
Solnik (1974) : Non Diversifiable Risk
(Domestic vs International)
Exchange Rate - Eun and Resnick (1988) :
Proportion of USD Variance Returns
Country Ex. Rate Local Ret. 2 Cov
Canada 4.26 84.91 10.83
France 29.66 61.79 8.55
Germany 38.92 41.51 19.57
Japan 31.85 47.65 20.50
Switzerl. 55.17 30.01 14.81
UK 32.35 51.23 16.52

Var(R$) = Var(Rlocal) + Var(RS(local/$)) + 2Cov(RS(local/$), Rlocal)

Global Asset Allocation in Practice : Home
Bias
• Shares mostly held by domestic investors
• Why do investors shun foreign shares? Constraints and perceived
misconceptions:
• Lack of familiarity with foreign markets and cultures
• Regulations and political risk
• Lack of liquidity on foreign assets
• Currency risk
• Transaction costs
• Rising and time-varying correlations
• Home bias : Local UK fund managers tend to invest more in firms geographically
located near the home of the fund!
• See UK fund managers’ equity allocation chart by region on next slide
Global Asset Allocation : UK Equities Managed
by Regions
Benefits of Global Asset Allocation – Country
Effects?
• Low correlation between indices because economic shocks have
different effects across countries
– Local shocks
– Different responses of national markets to global shocks

Exchange rate
Benefits of Global Asset Allocation –
Sector/Industry Effects?
• Although there is a trend in increasing cross-country correlations, there are still
benefits of IPD when country indices with lower correlation are identified
• Low correlation between country indices because countries are specialised in specific
industries and these industries are imperfectly correlated – IPD benefits are in sector rather
than country effect diversification
• Example: An investment in the stock indices of Switzerland, Norway and
Indonesia represents a disproportionate bet on banking, energy and rubber
stocks respectively. The Swiss, Norwegian and Indonesian stock indices are
imperfectly correlated because the banking, energy and rubber industries do not
move exactly in tandem
• Implication for Global Asset Allocation
– Allocate portfolio weights to different industries
– Use industry analysts to select the most attractive stocks in each sector
Insured Asset Allocation
‘Insured’ Asset Allocation : Constant
Proportion Portfolio Insurance (CPPI)
• Dynamic asset allocation strategy that involves market timing
• Re-allocation of funds between equities and money market instrument (T-
bill for example)
• Feasible only if: reallocations are made frequently and if transaction costs
are low; also, there should be continuity in equity prices

• It can be illustrated through the formula:

E = m (V – F)
where E is value of equity, V is value of equity and bond portfolio, F is a
floor value of a portfolio, (V-F) is called a cushion and m is a multiplier
Constant Proportion Portfolio Insurance
(CPPI) - Example
Example :
Value of portfolio V = $100m
Floor F = $75m
Multiplier m=2
Level of market index 3,000
Then, Equity = 2 x ($100m – $75m) = $50m and Bonds = $50m

• If index level falls to 2,900 or 3.3% it means that value of equity will fall by 3.3% to
$48.33m and the cushion will fall to $23.33m (C = 98.33m-75m)
• Appropriate stock position is now: $46.67m (= 2 x $23.33m), meaning that we should sell
$48.33m - $46.67m = $1.67m of equity and place it into bonds
• For summary of different scenarios refer to the next slide
Index I1/I0 E1 V C E B E/V
3000 100 25 50 50 0.5
2900 0.966667 48.33333 98.33333 23.33333 46.66667 51.66667 0.474576
2800 0.965517 45.05747 96.72414 21.72414 43.44828 53.27586 0.449198
2700 0.964286 41.89655 95.17241 20.17241 40.34483 54.82759 0.423913
2600 0.962963 38.85057 93.67816 18.67816 37.35632 56.32184 0.398773
2500 0.961538 35.91954 92.24138 17.24138 34.48276 57.75862 0.373832
2400 0.96 33.10345 90.86207 15.86207 31.72414 59.13793 0.349146
2300 0.958333 30.4023 89.54023 14.54023 29.08046 60.45977 0.324775
2200 0.956522 27.81609 88.27586 13.27586 26.55172 61.72414 0.300781
2100 0.954545 25.34483 87.06897 12.06897 24.13793 62.93103 0.277228
2000 0.952381 22.98851 85.91954 10.91954 21.83908 64.08046 0.254181
1900 0.95 20.74713 84.82759 9.827586 19.65517 65.17241 0.231707
1800 0.947368 18.62069 83.7931 8.793103 17.58621 66.2069 0.209877
1700 0.944444 16.6092 82.81609 7.816092 15.63218 67.18391 0.188758
1600 0.941176 14.71264 81.89655 6.896552 13.7931 68.10345 0.168421
1500 0.9375 12.93103 81.03448 6.034483 12.06897 68.96552 0.148936
1400 0.933333 11.26437 80.22989 5.229885 10.45977 69.77011 0.130372
1300 0.928571 9.712644 79.48276 4.482759 8.965517 70.51724 0.112798
1200 0.923077 8.275862 78.7931 3.793103 7.586207 71.2069 0.09628
1100 0.916667 6.954023 78.16092 3.16092 6.321839 71.83908 0.080882
1000 0.909091 5.747126 77.58621 2.586207 5.172414 72.41379 0.066667
900 0.9 4.655172 77.06897 2.068966 4.137931 72.93103 0.053691
800 0.888889 3.678161 76.6092 1.609195 3.218391 73.3908 0.042011
700 0.875 2.816092 76.2069 1.206897 2.413793 73.7931 0.031674
600 0.857143 2.068966 75.86207 0.862069 1.724138 74.13793 0.022727
500 0.833333 1.436782 75.57471 0.574713 1.149425 74.42529 0.015209
400 0.8 0.91954 75.34483 0.344828 0.689655 74.65517 0.009153
300 0.75 0.517241 75.17241 0.172414 0.344828 74.82759 0.004587
200 0.666667 0.229885 75.05747 0.057471 0.114943 74.94253 0.001531
100 0.5 0.057471 75 0 0 75 0
0 0 0 75 0 0 75 0
Constant Proportion Portfolio Insurance
Constant Proportion Portfolio Insurance
(CPPI) – Important Issues
• Value of the multiplier depends on the volatility of the underlying
equity market.
• Multiplier indicates that the index can drop by 1/m and the value of
the portfolio will not fall below floor even without rebalancing
• In our example index could have fallen by ½=50% before we would make
losses below floor value without any rebalancing
• Strategy works well in rising market but in a flat market, due to
reversals, substantial transaction costs are generated
• Cost of the strategy can be reduced by using futures contract for stock
market index and bonds rather than actual assets
‘Insured’ Asset Allocation – Concluding
Remarks
• Assumes that expected returns, risks and correlations remain the same
during the period of insurance
• Assumes that investors risk aversion is highly sensitive to the value of
assets: the higher that value, the lower risk aversion and more aggressive
asset mix is expected (and vice versa). If the asset value falls to the floor,
risk tolerance becomes zero, and optimal choice for investor is then least
risky one (T-bill).
• Unlike TAA, insured AA does take into account possible changes in
investor’s risk tolerance but it does not account for changes in expected
returns, variances and correlations (capital market prospects)
• Applying both TAA and insured AA is beneficial
Performance Attribution
Return Decomposition Analysis
• Attributes performance vs. benchmarks
• Can focus on asset allocation (top/down approach) or selection
(bottom up approach)
• Easy to calculate ( requires benchmark and portfolio returns and
weights)
• Easy to understand and explain
• Widely accepted in the industry
Active Management Effect
Active management effect is the total value added to a portfolio return. It is the difference
between the total portfolio return and total benchmark return. Total value added is obtained as the
sum of the following investment decisions or effects: asset allocation, security selection and
interaction between these two effects.

Total Value
Added
is the sum of:

Allocation Selection Interaction

Effect Effect Effect
Asset Allocation Effect
• Measures portfolio manager’s ability to effectively allocate the assets
to various market segments

• Positive allocation effect: portfolio is overweighted in a segment that

outperforms the benchmark and underweighted in a segment that
underperforms the benchmark

• Negative allocation effect: portfolio is overweighted in a segment that

underperforms the benchmark and underweighted in a segment that
outperforms the benchmark
Selection Effect
• The selection effect measures the investment manager’s ability to
select securities within a given asset class relative to a benchmark.
• The over or underperformance of the portfolio is weighted by the
benchmark weight, therefore, selection is not affected by the
manager’s allocation to the asset class.
• The weight of the asset class in the portfolio determines the size of
the effect—the larger the segment, the larger the effect is, positive or
negative.
Interaction Effect
• The interaction effect measures the combined impact of an
investment manager’s selection and allocation decisions within an
asset class.

• For example, if an investment manager had superior selection and

overweighted that particular asset class, the interaction effect is positive.

• If an investment manager had superior selection, but underweighted that

segment, the interaction effect is negative. In this case, the investment
manager did not take advantage of the superior selection by allocating more
assets to that segment.
Calculating Performance Attribution
Security Selection

Actual Portfolio Passive (benchmark)

Actual Quadrant IV: Quadrant II:
Portfolio Policy and Active Asset
Actual Portfolio Return Allocation Return
Asset
Allocation ∑w a ,i R a ,i ∑w a ,i Rb ,i
Passive Quadrant III: Quadrant I:
(bench- Policy and Security Policy Return (Passive
mark) Selection Return Portfolio Benchmark)

∑w b ,i Ra ,i ∑w b ,i Rb ,i

where wa,i = actual portfolio weight for asset class i, wb,i = benchmark weight for asset class i;
Rb,i = passive benchmark return for asset class i and Ra,i = actual portfolio return for asset class i
Calculating Performance Attribution (Cont.)
Return contributed to Calculated as
Active Asset Allocation Quadrant II-I:
effect ∑ ( wa ,i Rb,i − wb.i Rb,i )
Security Selection effect Quadrant III-I:
∑ ( wb , i R a , i − wb , i R b , i )
Interaction effect Quadrant IV-II-III+I
∑ [(wa ,i − wb.i )( Ra ,i − Rb,i )]
Total value added Quadrant IV – I:
∑ ( w a , i R a , i − wb , i R b , i )
See Example – Word / pdf File
Example : Summing Up
(1) Asset Allocation (from table 2) = 0.3099%
(2) Security Selection (from table 3 and 5)
(a.) Equity Excess Return
• Sector Allocation = 1.29%
• Security Selection in sector = 0.18% (=1.47% - 1.29%)
1.47% x 0.6 (benchmark weight) = 0.882%
(b.) Bond Excess Return (from table 3)
0.44% x 0.3 (benchmark weight) = 0.132%
(3) Interaction (from table 4) = 0.0458%

Total excess return of active portfolio (1 + 2 + 3) = 1.37%

Summary
• Key debate : active vs passive portfolio management
• Asset allocation : Different definitions, different concepts, different
strategies
• Main concepts :
• Tactical asset allocation
• Strategic asset allocation

• Performance attribution : What decision to focus on?

References (Additional)
• Baca, S., Garbe B and R. Weiss, The rise of sector effects in major equity markets, Financial
Analysts Journal, Sep / Oct 2000, 34-40
• Bodie, Kane and Marcus, “Essentials of Investments”, pp 593-598 on Performance Attribution
• Black F. and Litterman, R. (1992) “Global Portfolio Optimisation”, Financial Analysts Journal,
September/October 1992
• Brinson, G., Hood R. and G. Beebower (1986), “ Determinants of Portfolio Performance”,
Financial Analysts Journal, July/August 1986.
• Brinson, G. Singer B and G. Beebower (1991), “ Determinants of Portfolio Performance II: An
Update”, Financial Analysts Journal, May/June 1991.
• Dahlquist, M. and C. R. Harvey (2001), “Global Tactical Asset Allocation”, The Journal of Global
Capital Markets, Spring 2001.
• Elton, E, Gruber, M, Brown, S and W. Goetzmann, Chapter 10 on International Diversification in
8th edition “Modern Portfolio Theory and Investment Analysis”, Wiley
• Hood, R. (2005), “Determinants of Portfolio Performance – 20 years later”, Financial Analysts
Journal, September/October 2005.
• Idzorek, T(2010), “Asset Allocation is King”, Morningstar Advisor, April/May 2010.
End of Lecture
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Asset Management