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Capital Market Expectations

Part 1: Framework and Macro Considerations

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FinTree Fruit 1 : Introduction & Framework

Capital market expectations (CME) represent the investor’s expectations regarding the risk and return
prospects of broad asset classes.

Framework for Delveloping Capital Market Expectations

• Specify the set of expectations needed, including the time horizon(s) to which they apply.

• Research the historical record.

• Specify the method(s) and/or model(s) to be used and their information requirements.

• Determine the best sources for information needs.

• Interpret the current investment environment using the selected data and methods and judgment.

• Provide the set of expectations needed, documenting conclusions.

• Monitor actual outcomes and compare them with expectations, providing feedback to improve the
expectations-setting process.

Characteristics of a Good Forecast

• Unbiased, objective, and well researched

• Efficient, in the sense of minimizing the size of forecast errors; and

• Internally consistent, both cross-sectionally and intertemporally

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FinTree Fruit 2 : Challenges in Forecasting

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Limitations of Economic Data

• The time lag with which economic data are collected, processed, and disseminated can impede their use.

• One or more official revisions are substantial, which may give rise to significantly different inferences.

• Definitions and calculation methods change too.

• Changes in construction method of data.

Data Measurement Errors and Biases

• Transcription errors - These are errors in gathering and recording data.

• Survivorship bias - Reflects only entities that survived to the end of the period.

• Appraisal (smoothed) data - volatilities are biased downward and correlations are understated.

The Limitations of Historical Estimates

• Changes in Regime - Changes in technological, political, legal, and regulatory environments, can all
alter risk–return relationships and and give rise to the statistical problem of nonstationarity.

• Frequency of Data - Although higher-frequency data improve the precision of sample variances,
covariances, and correlations, they do not improve the precision of the sample mean.

• Non-Normally Distributed Data - Historical asset returns, in particular, routinely exhibit skewness
and “fat tails,” which cause them to fail formal tests of normality.

Ex Post Risk Can Be a Biased Measure of Ex Ante Risk

Looking backward, we are likely to underestimate ex-ante risk and overestimate ex-ante anticipated
returns. High ex-post returns that reflect fears of adverse events that did not materialize provide a poor
estimate of ex-ante expected returns

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Biases in Analysts’ Methods

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• Data-mining bias arises from repeatedly searching a dataset until a statistically significant pattern
emerges.

• Time-period bias relates to results that are period specific.

The Failure to Account for Conditioning Information

Unconditional forecasts, which dilute the information by averaging over environments, can lead to
misperception of prospective risk and return.

Interpretation of Correlations

A significant correlation b/w variable A & B implies at least four possible explanations:

• A predicts B

• B predicts A

• C predicts A & B

• The relation between A & B is spurious

Psychological Biases

Exogenous Shocks to Growth

Anchoring Confirmation Prudence

Bias Bias Bias

Status Quo Overconfidence Availability

Bias Bias Bias

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• Anchoring bias is the tendency to give disproportionate weight to the first information received or
first number envisioned, which is then adjusted. Analysts can try to avoid anchoring bias by

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consciously attempting to avoid premature conclusions.

• Status quo bias reflects the tendency for forecasts to perpetuate recent observations - that is, to avoid
making changes and preserve the status quo, and/ or to accept a default option. This bias may reflect
greater pain from errors of commission (making a change) than from errors of omission (doing
nothing). Status quo bias can be mitigated by disciplined effort to avoid “anchoring” on the status
quo.

• Confirmation bias is the tendency to seek and overweight evidence or information that confirms one’s
existing or preferred beliefs and to discount evidence that contradicts those beliefs. This bias can be
mitigated by examining all evidence with equal rigor and/or debating with a knowledgeable person
capable of arguing against one’s own views.

• Overconfidence bias is unwarranted confidence in one’s own intuitive reasoning, judgment,

knowedge, and/or ability. This bias may lead an analyst to overestimate the accuracy of forecasts
and/or fail to consider a sufficiently broad range of possible outcomes or scenarios. Analysts may not
only fail to fully account for uncertainty about which they are aware (“known unknowns”) but they
also are very likely to ignore the possibility of uncertainties about which they are not even aware
(“unknown unknowns”).

• Prudence bias reflects the tendency to temper forecasts so that they do not appear extreme or the
tendency to be overly cautious in forecasting. In decision-making contexts, one may be to cautious
when making decisions that could damage one’s career or reputation. This bias can be mitigated by
conscious effort to identify plausible scenarios that would give rise to more extreme outcomes and to
give greater weight to such scenarios in the forecast.

• Availability bias is the tendency to be overly influenced by events that have left a strong impression
and/or for which it is easy to recall an example. Recent events may likewise be overemphasized. The
effect of this bias can be mitigated by attempting to base conclusions on objective evidence and ana-
lytical procedures.

Interpretation of Correlations

The analyst usually encounters at least three kinds of uncertainty in conducting an analysis:

• Model uncertainty pertains to whether a selected model is structurally and/or conceptually correct.

• Parameter uncertainty arises because a quantitative model’s parameters are invariably estimated
with error.

• Input uncertainty concerns whether the inputs are correct.

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FinTree Fruit 3 : Economic & Market Analysis

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Analysis of Economic Growth

Two major components of economic output are:

• Trend Growth - Relevant for setting long-term return expectations for asset classes.

• Cyclical Variation - Measures short-term movements in an economy.

Exogenous Shocks to Growth

New products Natural Financial

Policy Geopolitics Natural
and resources Crisis
Changes Disasters
technologies

FinTree Fruit 4 : Applying Growth Analysis to Capital Market Expectations

The expected trend rate of economic growth is a key consideration in a variety of contexts:

1. It is an important input to discounted cash flow models of expected return.

2. A country with a higher trend rate of growth may offer equity investors a particularly good return.

3. A higher trend rate of growth in the economy allows actual growth to be faster before accelerating
inflation becomes a significant concern.

4. The average level of real government bond yields is linked to the trend growth rate.

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Decomposition of GDP Growth and Its Use in Forecasting

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Growth from Labor Input Growth from Labor Productivity

Labor Force Labor Force Capital Total Factor

Size Participation Productivity

Anchoring Asset Returns to Trend Growth

Trend growth rate provides a baseline value for estimating:

• Bond yield over long horizons

• Long-run equity appreciation, which is a measured as:

e k
Vt = GDP x St x PE t

Nominal Share of PE Ratio

GDP Profits in
the economy
Earnings
GDP

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FinTree Fruit 5 : Approaches to Economic Forecasting

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Econometric Modeling

Econometrics is the application of statistical methods to model relationships among economic variables.

• Structural models specify functional relationships among variables based on economic theory.

• Reduced-form models have a looser connection and are simply more-compact representations of
underlying structural models.

Strengths Weakness

• Robust Models • Complex & time consuming

• Forecasts close to reality. • Inputs not easy to forecast

• Can be modified • Model may be misspecified

• Imposes discipline to analysis • May give false sense of precision

• Quantitatively measure effects of • Rarely forecast turning points

exogenous changes

Economic Indicators

Economic indicators are economic statistics published by official agencies and/or private organizations.

• Lagging economic indicators and coincident indicators reflect recent past and current economic
activity, respectively.

• A leading economic indicator (LEI) moves ahead of the business cycle by a fairly consistent time
interval, and provides information about upcoming changes in economic activity.

Strengths Weakness

• Intuitive • History subject to frequent revision

• Simple in construction • Current data not reliable as input

for historical analysis
• Focuses primarily on indetifying
turning points • Overfitted in-sample

• May be available from 3rd parties • Can provide false signals

• Easy to Track • May provide little more than binary

guidance
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Checklist Approach

Checklist assessments require continually monitoring the widest possible range of data.

Strengths Weakness

• Limited complexity • Subjective

• Flexible to : • Time-Consuming

- incorporate structural changes • Manual process limits depth of

- add/drop items analysis
- draw information from various
sources • May allow inconsistent &/or biased
views, theories, assumptions.
• Breadth

FinTree Fruit 6 : Business Cycle Analysis

The business cycle arises due to uncertainties in the economy, expectational errors and incompetence to
adjust rapidly to unexpected events hence, they are difficult to forecast.

Sources of uncertainties may be exogenous or endogenous to the system.

The business cycle can be monitored using the following variables:

• GDP growth
• Industrial production
• Employment/Unemployment
• Purchasing manager indexes
• Orders for Durable goods
• Output gap
• Leading indicator indexes

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Phases of Business Cycle

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• Initial recovery - This period is usually a short phase of a few months beginning at the trough of the
cycle in which the economy picks up. Negative output gap is large, decelerating inflation, interest
rates continue to decrease, stock market may perform. Attractive stocks - cyclical & riskier asset.

• Early expansion - The economy is gaining some momentum. Unemployment starts to fall but the
output gap remains negative, consumers borrow and spend, profits typically rise rapidly. Short rates
are moving up and stocks trend upwards.

• Late expansion - The output gap has closed, and the economy is increasingly in danger of overheat-
ing. A boom mentality prevails. Unemployment is low, profits are strong, both wages and inflation are
rising. Interest rates and stock markets are typically rising. Cyclical assets may underperform while
inflation hedges such as commodities outperform.

• Slowdown - The economy is slowing and approaching the eventual peak. Economy and business
confidence starts to fall, inflation continues to rise, interest rate are rising likely to peak. Credit
spreads widen and stock market may fall.

• Contraction - Recessions typically last 12 to 18 months. Business production and consumer spending
drops sharply, tightening credit, unemployement rises quickly. Interest rates drop as central bank
eases monetary policy and stock market declines in earlier stages but starts to rise in later stages.

Initial Recovery Early Expansion Late Expansion Slowdown Contraction

Short-term and bond yield Short-term rates move up Short-term interest rates Short-term rates peak Short-term rates drop
low rise
Yield curve flattens Bond yields top out Bond yields decline
Bond yields may still decline Long-term rates rise slowly
Stocks trend upward Yield curve may invert Yield curve steepens
Stock markets may rise Pressure on credit market-
briskly builds up Credit spreads widen Credit spreads stay elevated

Cyclical assets - small Stocks rise, but more Stocks may fall Stocks reach bottom, may
stocks,high yield, EM volatile start to rise at the end of the
equities and bonds - attract Utility and quality stocks contraction phase
investors. Cyclical assets underper- outperform
form

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Market Expectations & the Business Cycle

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Its quite difficult to correctly predict the next phase of business cycle because:

• The phases vary substantially in length and amplitude.

• It is difficult to distinguish between cyclical forces and secular forces playing on the economy and the
markets.

• The connection between real economy and capital market return is quite uncertain.

FinTree Fruit 7 : Inflation & Deflation : Trends and Relation to Business Cycle

Deflation tends to:

• Decrease the value of debt-financed investments.

• Undermine central bank’s ability to affect monetary policy to control the economy.

Inflation is procyclical and tends to:

• Increase during late stages of a business cycle

• Decrease during recessions and the early stages of recovery.

Similar to inflation, inflation expectations are also procyclical:

• Very long-term inflation expectations are unaffected by periodic fluctuations.

• Short-term inflation expectations turn up with actual inflation.

• Intermediate-term inflation expectations interweave with different phase of cycles.

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Effects of Inflation in Asset Classes:

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Cash Bonds Stocks Real Estate

• Is attractive (unat- • When inflation • If inflation is within • Rental income with

tractive) in rising ( ) nominal bond expected range - expected inflation &
(declining) rate price holding Neutral effect on asset values remian
environment. bonds incur stocks stable.
capital losses
• Is attractive inves- (gains) • Unexpected rise in • Unexpected in
ment in deflation- inflation -ve effect inflation - demand
ary environment. on stock. for real estate , result-
ing in faster in rental
• Cash is essentially a income and asset
zero duration, values.
inflation protected
asset that earns a • Unexpected in
floating real estate. inflation (or deflation)
puts pressure on
expected rental
income and asset
prices.

FinTree Fruit 8 : Analysis of Monetary and Fiscal Policy

Monetary policy is often used as a mechanism for intervention in the business cycle. This use is inherent
in the mandates of most central banks to maintain price stability and/or growth consistent with the
economy’s potential ( using policy rates and liquidity provision at it’s disposal).

The common theme is that central banks virtually always aim to moderate the cyclical behavior of
growth and inflation, in both directions. Thus, monetary policy aims to be countercyclical.

Fiscal policy can also be used to counteract cyclical fluctuations in the economy:

• Progressive tax regimes imply that the effective tax rate on the private sector is pro-cyclical—rising
as the economy expands and falling as the economy contracts.

• Means-based transfer payments helps to mitigate fluctuations in disposable income for the most
vulnerable households.

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Taylor’s Rule

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• Taylor Rule relates a central bank’s target short-term interest rate to the rate of growth of the econo-
my and inflation.

• Taylor Rule Equation :

Target
= R neutral + Exp. Inflation + 0.5 x (Expected GDP Growth - Trend GDP Growth)
Nominal Rate
+ 0.5 x (Expected Inflation - Target Inflation)

FinTree Fruit 9 : What Happens When Interest Rate are Zero or Negative

Individuals’ preference to hold currency (when facing negative interest rates) would lower bank’s
reserves and deposits causing credit contraction.

The contraction of credit would further put upward pressure on interest rates leading to slowdown in
economic growth which would in turn require additional stimulative policies.

QE (quantitative easing) : Central banks purchase high-quality government securities at a large scale.
This action boost bank’s excess reserves and lower sovereign bond yields.

Implications of Negative Interest Rates for CME

When interest rates are negative, in forming capital market expectations for:

• Longer time horizons:‘long-term equilibruium short-term rate’ is used as a baseline rate in models.

• Short-term horizons: expected path of interest rates should be considered.

Key considerrations when forming CMEs in a negative interest rate enviornment:

• Negative Rate = Save Less = Less Credit = Downward Pressure on Growth

• As a result of quantitative easing - banks balance sheet and reserves will grow.

• Quantitative easing’s effectiveness is debatable.

• Historical Data is less likely to be reliable.

• Effects of other monetary policy measures appear simultaneously.

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FinTree Fruit 10 : Monetary and Fiscal Policy Mix and the Shape of the Yield Curve

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The mix of fiscal and monetary policies affect the:

• Level of interest rates

• Shape of the yield curve

• Relative supply of government bonds of various maturities

FISCAL POLICY MONETARY POLICY NOMINAL RATES

Loose Loose
Real Rates Expected Inflation

Tight Tight
Real Rates Expected Inflation

Loose Tight Mix

Real Rates Expected Inflation

Tight Loose Mix

Real Rates Expected Inflation

The Yield Curve and the Business Cycle

• Yield curve flatterns during the expansion phase, at the peak it is completely flat or even inverted
and then steepens at the bottom of the cycle.

• The curvature of the yield curve is primarily determined by the expected future path of the
short-term rates.

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Monetary Policy & Money Market Rates Bond Yields & the

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Automatic Stabilizers Yield Curve

Initial Recovery • Stimulative stance • Low/bottoming • Long rates bottoming

• Moving towards tight- • Expected to rise over • Shortest rates start to
ening progressively shorter rise
horizons • Curve is steep

Early Expansion • Dropping stimulus • Rise and speed up • Yield rises

• Statble at longer matur-
ities
• Yield curve’s 1st half
steepening, last half
flattening

Late Expansion • Becoming restrictive • Above average & rising • Yields rise at slow pace
• Expectations may be • Curve flattening from
moderated by eventual longest maturities
peak / decline inward

Slowdown • Tight • Approaching peak • Yields peak, then may

• Tax revenue may decline sharply
increase • Curve flat to inverted

Contraction • Increasingly more • Declining • Yields declining

stimulative • Curve steepening.
• Steepest at the tip of
initial recovery phase

FinTree Fruit 11 : International Interactions

A country’s international interaction depend on the country’s :

• Relative Size

• Degree of Specialization

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Macroeconomic Linkages

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Current and capital accounts levels signify the macroeconomic linkages between two countries.

Current Account represents:

• Net exports of goods and services

• Net investment income flows

• Unilateral transfers

Capital Account (financial account) represents:

• Net investment flows for foreign direct investments (FDI) -buying/selling of productive assets across
borders.

• Portfolio Investment flows (PI) involving transactions in financial assets.

Four Primary tools used to balance the current and capital accounts are:

• Changes in income (GDP)

• Relative prices

• Interest rates

• Asset price

Interest rate/ ExchangeRate Linkages

The Link between interest rates and exchange rates is crucial for investors. A country can achieve at
maximum only two of the following:

• Free movement of capital

• Fixed Exchange rate

• Independent Monetary policy

Two Countries share a yield curve when:

• There is perfect capital mobility

• Exchange rates are credibly fixed

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Capital Market Expectations

Part 2 : Forecasting Asset Class Returns

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FinTree Fruit 1 : Introduction

This reading primarily evaluates ‘capital market expectation (CME) setting for specific asset classes -
fixed income, equities, real estate, and currencies.

FinTree Fruit 2 : Overview of Tools & Approaches

Approaches to Forecasting :

Surveys Judgement Formal Tools

Asking a group of Qualitative information

experts for their derived from various
opinions. sources and filtered
through the
lens of experience.

Statistical Methods Discounted Cash Flow Risk Premium Model

Three major types of statistical

methods include:
The expected return is calculated
as the sum of risk-free rate plus
Sample statistics: such as sample
one or more risk premiums (for
means, variances, and correlations,
which investors demand
to describe the distribution of
compensation).
future returns. However, sample
statistics aresubject to sampling
Three main methods for modeling
error.
Basic method for establishing the risk premiums include:
intrinsic value of an asset on the
Shrinkage estimation: weighted
basis of present value of it’s • Equilibrium model e.g. CAPM
average of two estimates of the
expected cash flow at its fair
same parameter one based on
required rate of return. • Factor Model (beta)
historical sample data and the
other based on some other source
• Building Blocks
or information.

Time-series estimation: involves

Risk Premium approaches can be
forecasting a variable on the basis
used for both fixed income and
of lagged values of the variable
equity
being forecast and often lagged
values of other selected variables.
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FinTree Fruit 3 : Forecasting Fixed Income Returns

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Forecasting Fixed-Income Returns

Discounted Cash Risk Premium Equilibrium Model

Flow Approach

Applying DCF to Fixed Income

• Discounted cash flow Is useful for fixed income securities valuation.

• For other asset classes (e.g., equities) there is so much uncertainty with respect to the cash flows. For
these asset classes, discounted cash flow is essentially a conceptual framework rather than a precise
valuation model.

Yield to Maturity (YTM)

Yield to Maturity (YTM) is the most common valuation method for bonds. Realized return diverge from
initial YTM, due to:

• Pontential capital gains or losses on the sale of the bond prior to maturity.

• Reinvestment of coupon payments

Both causes mentioned above work in opposite direction.

In interest rates, induce capital losses but reinvestment income.

In interest rates, induce capital gains but reinvestment income.

When investment horizon is:

• Shorter than the bond duration capital gain/loss impact will tend to dominate.

• Longer than the bond duration reinvestment impact will tend to dominate.

• Equal to duration of the bond or portfolio realized return will approximately be equal to the initial
YTM

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The Building Block Approach to Fixed-Income Returns

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The expected bond return includes the following four components

The Short-term The Term The Credit The Liquidity

Default-free Rate Premium Premium Premium

The Short-term Default-free Rate

• Is the rate of the highest-quality liquid security with the maturity equal to the investment horizon.

• Is closely linked to the cyclical factors of monetary policy.

• Observed rate provides a reasonable base to estimate the expected return on a risky asset.

• Under extreme conditions, the observed rate require some adjustment.

• When maturity of the risky asset is fairly longer than the benchmark, an adjustment is needed. The
adjustment can be made using either of the following two approaches.

Approach 1: Use yield on a longer zero-coupon bond with duration equal to the forecast horizon
(Includes term instrument premium)

Approach 2 : Estimate the short-term rate by rolling the short-term instrument over the forecast hori-
zon (Future contract short term instrument)

• Analysts may formulate their own projections using data and models.

The Term Premium

In general, Term premiums:

• Are positive

• Increase with maturity

• Are somewhat proportional to duration and vary overtime.

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Ilmanen (2012) argued that there are four main drivers of the term premium for nominal bonds:

Level-dependent inflation uncertainty : Higher (lower) levels of inflation tend to coincide with greater
(less) inflation uncertainty. Hence, nominal yields rise with inflation because of changes in both expected
inflation and the inflation risk component of the term premium.

High inflation level

(+) Higher term premium
High uncertainty

Ability to hedge recession risk : In theory, assets earn a low (or negative) risk premium if they tend to
perform well when the economy is weak.

Higher Ability to Lower Term

Hedge Premium

When growth and inflation are primarily driven by aggregate demand, nominal bond returns tend to be
negatively correlated with growth and a relatively low term premium is warranted.

High inflation level (+) High growth

Demand Led Inflation Supply Led Inflation

Nominal -ve Nominal +ve

Bond Return Growth Bond Return Growth
correlation correlation

Lower Term Premiums Higher Term Premiums

Supply and demand : The relative outstanding supply of short-maturity and long-maturity default-free
bonds influences the slope of the yield curve.

Cyclical effects : The slope of the yield curve varies substantially over the business cycle: It is steep around
the trough of the cycle and flat or even inverted around the peak.

Trough Peak
Slope of Yield
Curve
Steep Flat/Inverted

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The default-free spot rate curve demonstrates:

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Expected path of
Short term Rates
Required Term
premium of each
maturity

However, we cannot directly deduce the term premium from the spot curve by subtracting the short-term
rates from the spot rates at each maturity.

The Credit Premium

The credit premium is the additional expected return demanded for bearing the risk of default losses,
importantly, in addition to compensation for the expected level of losses.

Bond’s credit quality is an important determinant of credit spreads and credit premiums.

• ‘Downgrade bias’ (deterioration in credit quality) may induce a larger spread change than ‘Upgrade
bias’ (improvement in credit quality).

• Default losses (likelihood of actual losses) are a major concern for below-investment grade bonds.

• Defaults increases in recession

• Default rate and severity of losses are correlated.

Relation of Credit Premiums and Maturity

Historical evidence shows that credit premiums tend to be high at short end of the yield curve compared
to long end.

One possible reason of this is due to ‘event risk’. Another reason is that maybe it is due to illiquidity.
(Short-term bonds are mainly long-term bonds near maturity (e.g. 20-year bond due in 2 years) and trade
less frequently)

Many protfolio managers use credit ‘barbell strategy’ to gain advantage of current rates by taking credit
exposures at short maturities and interest rate exposure by purchasing long maturities government bonds.

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High
Credit
Spreads

Low
Credit Short Longer
Spreads Maturity Maturity

Short Longer
Maturity Maturity

The Liquidity Premium

The liqudity of bonds in general depends on the willingness of dealers to hold bonds in inventory.

The higher the inventory risk, the lower the likelihood of finding a buyer quickly.

In General, liquidity tends to be better for bonds that are

• Priced near par/reflective of current market levels,

• Relatively new,

• From a relatively large issue,

• From a wellknown/frequent issuer,

• Standard/Simple in structure, and

• High Quality.

As a baseline estimate of liqudity premium, analysts can use a yield spread between “highest-quality
fixed rate option-free bond and “similar bond from the next highest quality large issuer.” Typically
government bond & government agency bonds.

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FinTree Fruit 4 : Risks In Emerging Market Bonds

• Investing in emerging market debt involves all the same risks as investing in developed country debt,

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such as interest rate movements, currency movements, and potential defaults.

• Some additional risks highly significant for emerging/frontier markets, divided in two categories are:

Economic Risk / Political Risk /

Ability to Pay Willingness to Pay

• Fiscal deficit to When ratio is persistently An emerging Country’s willingness

GDP ratio: >4%, it is regarded as risky to is highly influenced by the
indicating substantial credit country’s political and legal risks
risk. such as peak property rights,
corruption, political instability etc.

• Debt to GDP ratio >70-80% is regarded as

extremely dangerous.

• Annual growth rate Presistent annual growth rate

<4% is not favorable because it
indicates that the country is
slowly catching up with the
industrial countries and per
capita income is growing very
slowly or even falling.

• Current account Ratio persistently>4% is

deficit to GPD ratio regarded as risky as it indicates
lack of competitiveness.

• Foreign debt to >50% indicates risky level

GDP ratio

• Foreign debt to >200% indicates risky level

Current account <100% indicates safe level.
receipts ratio

• Foreign reserves to >200% indicates safe level

short-term debt <100% indicates risky level.
ratio

• Access to external- At the time of crisis whether

support mechanism the country has connections for
support from IMF, World Bank
or other international agencies.

Note : Emerging/ frontier markets are heterogenous in nature therefore risks considerably vary across
countries
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FinTree Fruit 5 : Forecasting Equity Returns

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Historical Statistics Approach to Equity Returns

• Historical sample averages do not provide precise estimates.

• Shrinkage estimators can often provide more reliable estimates by combining the sample mean with
a second estimate of the mean return.

Historical Statistics Approach to Equity Returns

• Gordon growth model is relatively stable and a preferable method over historical stock returns.

• Grinold-Kroner Model is a restatement of the Gordon growth model and it explicitly takes into
account the imapact of number of shares in the market and changes in market valuations. It is
expressed as follows:

growth rate of earnings per share

Buyback -ve
Issue +ve

E(Re) = Expected rate of return on equity

D/P = Expected divident yield
= Expected % change in number of shares outstanding

Sources of Expected rate of return on equity :

• Expected cash flow (income) return =

}
• Expected nominal earning growth return = %E
Combined represents
• Expected repricing return = (P/E tends to increase when ‘expected capital gains return’
investors expect stocks to be less risky in future)

Nominal GDP growth

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Risk Premium Approaches to Equity Returns

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Equity risk premium can be measured as the amount by which expected return on equity exceeds the
expected return on either risk-free rate or default-free bond.

An Equilibrium Approach

One version of ICAPM is Singer-Terhaar model that takes into account the market [Link]
Singer–Terhaar model is actually a combination of two underlying CAPM models:

• The first assumes that all global markets and asset classes are fully integrated.

• The second underlying CAPM assumes complete segmentation of markets.

Risk Premium = Beta * (RM - RFR)

r
Risk Premium = s m * (R M - RFR)
m m

Risk Premium = r s (RM - RFR)

m

Risk Premium = r x s x world sharpe ratio

Integrated Segmented

G S
RP = r s (R M - RFR) RP = 1 s (R M - RFR)
m m

}
} we can simply set r equal to 1
since each asset is perfectly
correlated with itself.

G S
Weighted average of the two component estimates: x RP + (1 - ) RP

represents degree of integration of the given asset

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FinTree Fruit 6 : Forecasting Real Estate Returns

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Historical Real Estate Returns

The heterogeneity, indivisibility, immobility, and illiquidity of real estate pose a severe problem for
historical analysis.

Real estate owners have to rely on appraisals for property valuation.

Use of appraised values:

• Smoothed the return

• Understate the correlations with other assets.
• Overstate the benefits of adding real estate to a traditional portfolios

Time-series model is a standard method used for ‘un-smoothing’ the appraisalbased valuations.

Real Estate Cycles

Real estate is subject to cycles that both drive and are driven by the business cycle.

Real estate is a major factor of production in the economy.

Supply and demand imbalance derive boom-bust cycle in real estate.

BOOM BUST

As the perception of demand Optimistic projections

property values Overbuilding property values

lease rates, occupancy lease rates, occupancy

investment in property it takes several months or years to

absorb excess supply

boost economic activity

perceived profits induce building

new capacity

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Capitalization Rates

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Cap rate for real estate is equaivalent to earning yield for equities.

Cap rate may vary depending on the type, location and quality of the property.

Current years NOI

Cap Rate =
Property Value

During stable periods, the long-run NOI growth rate should be close to GDP growth. If an investor has a
finite time period, the formula changes by subtracting from expected return the change in the cap rate.

For long run E(Rre) = Cap rate + NOI growth rate

For finite horizon E(Rre) = Cap rate + NOI growth rate -

NOI growth rate can be subdivided into real component plus inflation.

Risk Premium Perspective on Real Estate Expected return

From Risk Premium Standpoint, real estate indicates some bond-like and some equity-like charateristics.

Bond-like risks:

• Credit premium
• Term premium

Equity-like risks:

• Significant equity risk premium (fluctuations in property values, uncertainties regarding rent growth,
lease term, vacancies)

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Real Estate in Equilibrium

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Real estate can be incorporated into an equilibrium framework, there are, however, a few important
considerations:

• First, the impact of smoothing must have been removed from the risk/return data and metrics used.

• Second, it is important to recognize the implicit assumption of fully liquid assets in equilibrium
models.

• Third, real estate is still location specific and may, therefore, be more closely related to local, as
opposed to global, economic/market factors than are financial claims.

Public versus Private Real Estate

REITs are more liquid than direct real estate.

REITs act like:

• Equities in the short run

• Real estate in the long run

Two basic forms of real estate investments are:

• Direct investment
• Indirect investment

Long-Term Housing Returns

• Savills World Research (2016) estimated that residential real estate accounts for 75% of the total
value of developed properties globally.

• The database cover 145 years (1870-2015) found that residential real estate was the best perform-
ing asset class over the entire sample period, with a higher real return and much lower volatility
than equities.

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FinTree Fruit 7 : Forecasting Exchange Rates

FinTree
Following are the three primary ways in which trade in goods an services influence the exchange rate:

Current Account &

Trade Flows Purchasing Power Parity
Exchange Rate

• Net trade flows are essentially: • According to PPP, differences • When restrictions are placed
Imports - Exports in inflation between two coun- on capital flows, exchange rate
tries should be reflected in the sensitivity tends to increase
• Smaller net trades flows do not changes in the exchange rate relative to the current account
significantly affect current between them i.e. (trade) balance.
currency exchange rate,
provided they can be financed. • Current account balances will
= have the largest influence on
• If trade-related flows through Difference in expected inflation. exchange rates when they are
the foreign exchange market persistent and sustained.
become large relative to financ-
ing/investment flows, it is likely • When PPP holds, real exchange • Howerver, it is not the size of
that a crisis is emerging. rate is constant. the current account balance
that matters as much as the
• Some reasons for deviations length of the imbalance.
from PPP are trade barriers,
impact of capital flows.

• PPP works well over medium

and long term.

FOCUS ON CAPITAL FLOWS

Implications of Capital Mobility

Investment in each currency is considered as a separate portfolio. When capital flows freely, expected %
change in exchange rate is equal to the excess risk-adjusted expected return on domestic portfolio over
the foreign portfolio.

This notion is expressed as:

E(% D/F
D F D F D F D F D F
)

Overshooting mechanism suggests that the adjustment of investment opportunity between domestic and
foreign market take place in three phases.

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1st Phase : In short-run exchange rate overshoots.

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2nd Phase : In the medium-term, adjustment in asset prices take place gradually.

3rd Phase : In the long run, economy reaches new long-run equilibrium in all markets by adjusting
various risk premiums and diffusing initial overreaction.

Uncovered Interest Rate Parity

Uncovered interest rate parity (UIP) asserts that the expected percentage change in the exchange rate
should be equal to the nominal interest rate differential and not the premium differentials.

Contrary to UIP, the empirical evidence consistently shows that carry trades - borrowing in low-rate
currencies and lending in high-rate currencies earn meaningful profits on average.

Hot Money : Vigorous flows of capital in response to interest rate differentials are often referred to as
hot moneyflows.

Hot money flows are problematic:

Encourage firms to
Nearly inevitable
They limit the central fund longer-term
overshooting of the
bank’s ability to run needs with short-term
exchange rate is likely
an effective monetary money, setting the
to disrupt non-finan-
policy. stage for a crisis when
cial businesses.
the financing dries up.

Portfolio Balance, Portfolio Composition, and Sustainability Issues

Strong economic growth in a country tends to correspond to an increasing share of that country’s currency
in the global market portfolio.

Thus, investors will have to be induced to increase their strategic allocations to assets in that country /
currency.

All else the same, this would tend to weaken that currency, partially offsetting the increase in the curren-
cy’s share of the global portfolio and upward pressure on risk premiums in that market. However, there
are several mitigating factors:

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• With growth comes wealth accumulation: As growth occurs, domestic investors will likely absorb
more local assets due to their preference for domestic investments.

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• Productivity-driven growth: Strong productivity gains will attract both foreign and domestic funding
through financial flows and foreign direct investment.

• Small initial weight in global portfolios: Countries with high growth rates often have small economies
and limited foreign access to local markets, suggesting a greater ability to increase local-currency
asset shares in global portfolios without destabilizing their currencies.

Large, persistent current account deficits funded in local currency can exert downward pressure on
exchange rates over time, but several factors can mitigate this:

• Source of the Deficit: Deficits from strong investment spending are easier to finance if seen as profit-
able, while those due to low savings or poor fiscal discipline are more concerning.

• Reserve Currency Status: Certain currencies, like the US dollar, have special status due to their
prevalence in official reserves, safe-haven perception, and use in pricing major commodities and
international trade. A small deficit in a reserve-currency country can be beneficial for global liquidity,
though this status is not permanent.

Current account imbalance reflects transfer of capital from deficit country to surplus country. Typically
transfer of wealth decreases (increases) the demand of assets for the deficit (surplus) country.

FinTree Fruit 8 : Forecasting Volatility

Estimating a Constant VCV Matrix with Sample Statistics

The simplest and most heavily used method for estimating constant variances and covariances is to use
the corresponding sample statistic variance or covariance computed from historical return data.

There are two main problems with this method, both related to sample size:

• If the number of assets exceeds the number of historical observations, then some portfolios will
erroneously appear to be riskless.

• Given typical sample sizes, this method is subject to substantial sampling error.

A useful rule of thumb that addresses both of these issues is that the number of observations should be
at least 10 times the number of assets in order for the sample VCV matrix to be deemed reliable.

This method does not address the issue of imposing cross-sectional consistency.

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VCV Matrices from Multi-Factor Models

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• Factor models are used to handle large number of observations.

• The key to making this work is that the covariances are fully determined by exposures to a small
number of common factors.

The return on the ith asset is computed as:

The variance on the ith asset is computed as:

The covariance between the ith and jth assets is:

• Benefit : A well-specified factor model contain significantly less estimation error and have superior
cross-sectional consistency.

• Problem : Factor based VCV matrix will be most likely mis-specified: resulting in biased and incosn-
sistent VCV matrix (i.e. more precision but less accuracy)

Shrinkage Estimation of VCV Matrices

• Each element (variance or covariance) of the final shrinkage estimate of the VCV matrix is simply a
weighted average of the corresponding elements of the sample VCV matrix and the target VCV
matrix.

• Same weights are applied to all elements of a particular category (i.e. sample and target).

• Incorporating target VCV to sample VCV improves the efficiency of sample VCV matrix estimates
i.e. smaller mean-squared error (MSE).

• MSE is equal to estimator’s variance plus square of its bias.

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Estimating Volatility from Smoothed Returns

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• The smoothing dampens the volatility of the observed data and distorts correlations with other
assets. Thus, the raw data tend to understate the risk and overstate the diversification benefits of
these asset classes.

The main idea is that observed returns are a weighted average of current and past true, unobserv-
able returns. One widely used model shows that the current observed return, Rt , is given by:

observed data. Equivalently, the standard deviation is 3 times larger.

• To address this issue, the analyst assumes a relationship between the unobservable return and one or
more observable variables. For private real estate, a suitable choice might be a REIT index, while for
private equity, an index of comparable publicly traded equities could be utilized.

Time-Varying Volatility: ARCH Models

• It is well known, however, that financial asset returns tend to exhibit volatility clustering, evidenced
by periods of high and low volatility. A class of models known collectively as autoregressive condition-
al heteroskedasticity (ARCH) models has been developed to address these time-varying volatilities.

• One simple from of these models is specified below:

Persistance
Factor Variance Beta Shock

•
, then
variance would be deterministic.

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• The remembers

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•

FinTree Fruit 9 : Adjusting a Global Portfolio

Macro-Based Recommendations

A sample checklist of the following six questions provide a valuable starting point for a systematic
approach. Though analysts should be careful about what has already been reflected in asset prices.

• Have there been significant changes in the drivers of trend growth, globally or in particular coun-
tries?

• Are any of the market becoming more/less globally integrated?

• Where does each country stand within its business cycle? Are they synchronized?

• Are monetary and fiscal policies consistent with long-term stability and the phases of the business
cycle?

• Are current account balances trending and sustainable?

• Are any currencies under pressure to adjust or tending? The relation of the currency with country’s
economy, capital flows and competitiveness

Quantifying the Views

A concise, sample stepwise illustration of the process is provided below.

Step 1: Use appropriate techniques to estimate the VCV matrix for all asset classes.

Step 2: Use Singer-Terhaar model and estimated VCV matrix to determine equilibrium expected
asset returns.

Step 3: Use Grinold-Kroner model to estimate equity market returns based on various assessments.

Step 4: Use building block approach to estimate expected returns on bonds.

Step 5: Establish directional views on currencies relative to portfolio’s base currency.

Step 6: Incorporate a currency component into expected returns for equities and bonds.

Step 7: Use Black-Litterman framework to combine equilibrium expected returns from Step 2 with
the expected returns determined in Steps 3-6.

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Overview of Asset Allocation

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FinTree Fruit 1 : Introduction

Asset Allocation: Importance in Investment Management

• In the asset allocation sequence, this reading helps us understand the “big picture”

• The investment process begins with understanding the asset owner’s entire circumstance, objectives,
including any constraints and preferences form the basis for asset allocation and gives a structure within
which other decisions—such as the decision to invest passively or actively take place.

• Asset allocation is widely considered to be the most important decision in the investment process. The
strategic asset allocation decision completely determines return levels.

• The asset owner’s best interest rests on a foundation of good investment governance, which includes the
assignment of decision-making responsibilities to qualified individuals and oversight of processes.

• Portfolio management process must reconcile investor objectives with the possibilities offered by the
investment opportunity.

FinTree Fruit 2 : Investment Governance Background

Effective investment governance ensures that assets are invested to achieve the asset owner’s investment
objectives within the asset owner’s risk tolerance and constraints, and in compliance with all applicable
laws and regulations.

Governance Structures

• Governance and management are two separate but related functions. Both are directed toward achiev-
ing the same end.

• Governance focuses on clarifying the mission, creating a plan, and reviewing progress toward achieving
long- and short term objectives.

• Management efforts are geared to outcomes - execution of the plan to achieve the agreed-on goals and
objectives.

• Typical Governance Structure has 3 Levels:

- Governing investment committee
- Investment staff
- Third-party resources

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• The investment committee may be a committee of the board of directors, or the board of directors may
have delegated its oversight responsibilities to an internal investment committee made up of staff.

• Investment staff may be large, with full in-house asset management capabilities, or small - responsible
for overseeing external investment managers and consultants.

• The term “third-party resources” is used to describe a range of professional resources—investment

managers, investment consultants, custodians, and actuaries.

• Effective governance models perform the following tasks:

- Articulate the long- and short-term objectives

- Allocate decision rights and responsibilities

- Specify IPS related methods

- Specify SAA related methods

- Establish a reporting framework

- Periodically undertake a governance audit

Articulating Investment Objectives

• Articulating long- and short-term objectives for an investor first requires an understanding of purpose
that is, what the investor is trying to achieve.

• Objective statement to be properly understood requires additional context, including the obligations the
assets are expected to fund, the nature of cash flows into and out of the fund, and the asset owner’s
willingness and ability to withstand interim changes in portfolio value.

• The ultimate goal is to find the best risk/return trade-off consistent with the asset owner’s resource
constraints and risk tolerance.

• Asset owners have their own unique return requirements and risk sensitivities. Managing an investment
program without a clear understanding of long- and short-term objectives is similar to navigating with-
out a map.

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Articulating Investment Objectives

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Investment Activity Investment Committee Investment Staff Third-Party Resource

Mission Craft and approve N/A N/A

Investment policy state- Approve Draft Consultants provide input

ment

Asset allocation policy Approve with input from Draft with input from Consultants provide input
staff and consultants consultants

Investment manager and Delegate to investment Research, evaluation, Consultants provide input
other service provider staff; approval authority and selection of invest-
selection. retained for certain ment managers and
service providers. service providers.

Portfolio construction Delegate to outside Execution if assets are Execution by independent

(individual asset selec- managers, or to staff if managed in-house investment manager
tion) sufficient internal
resources.

Monitoring asset prices Delegate to staff within Assure that the sum of Consultants and custodi-
& portfolio rebalancing confines of the invest- all sub-portfolios equals an provide input
ment policy statement. the desired overall
portfolio positioning;
approve and execute
rebalancing.

Risk management Approve principles and Create risk management Investment manager
conduct oversight. infrastructure and manages portfolio within
design reporting. established risk guide-
lines; consultants may
provide input and sup-
port

Investment manager Oversight Ongoing assessment of Consultants and custodi-

monitoring managers an provide input

Performance evaluation Oversight Evaluate manager’s Consultants and custodi-

and reporting continued suitability for an provide input
assigned role; analyze
sources of portfolio
return.

Governance audit Commission and assess Responds and corrects Investment Committee
contracts with an inde-
pendent third party for
the audit.

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Investment Policy Statement

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• The investment policy statement (IPS) is the foundation of an effective investment program.

• A well-crafted IPS can serve as a blueprint for ongoing fund management and assures stakeholders that
program assets are managed with the appropriate care and diligence.

Asset Allocation and Rebalancing Policy

• The investment committee, typically retains approval of the strategic asset allocation decision.

• In an institutional setting, rebalancing policy might be the responsibility of the investment committee,
organizational staff, or the external consultant.

Reporting Framework

An effective framework enables the overseers to evaluate quickly and clearly how well the investment
program is progressing toward the agreed-on goals and objectives.

Benchmarking is necessary for performance measurement, attribution, and evaluation. Two separate levels
of benchmarks -

• Measures the success of the investment managers relative to the purpose for which they were hired.
• Measure the gap between the policy portfolio and the portfolio as actually implemented.

Management reporting - necessary to understand which parts of the portfolio are performing ahead
of or behind the plan and why, as well as whether assets are being managed in accordance with investment
guidelines.

Governance reporting - addresses strengths and weaknesses in program execution. Good governance struc-
tures minimizes the need for an extraordinary committee meeting.

The Governance Audit

• The governance audit should be performed by an independent third party.

• The governance auditor examines the fund’s governing documents, assess firm’s execution capacity and
portfolio’s performances.

• Good governance seeks to avoid decision-reversal risk—the risk of reversing a chosen course of action at
exactly the wrong time, the point of maximum loss.

• Good investment governance prevents key person risk—over-reliance on any one staff member.

• Good governance works to assure accountability.

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FinTree Fruit 3 : The Economic Balance Sheet & Asset Allocation

FinTree
An economic balance sheet includes conventional assets and liabilities (“financial assets” and “financial
liabilities” ) as well as additional assets and liabilities—known as extended portfolio assets and liabilities.

Investor Type Extended Assets Extended Liabilities

Individuals Human capital, PV of future consumption

PV of pension income, and
PV of expected inheritances.

Institutions Underground mineral PV of prospective payouts

resources, PV of future intel-
lectual properties royalties

FinTree Fruit 4 : Approaches to Asset Allocation

We can identify three broad approaches to asset allocation:

Asset-only approaches to asset allocation focus solely on the asset side of the investor’s balance sheet.
Mean–variance optimization (MVO) is the most familiar and deeply studied asset-only approach.

Liability-relative approaches to asset allocation are intended to fund liabilities such as surplus- optimi-
zation, liability-hedging portfolio construction etc.

Goals-based approaches to asset allocation, , are used primarily for individuals and families, aligned to
specified goals ranging from supporting lifestyle needs to aspirational.

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Allocation Approach Relation to Economic B/S Typical Objective Typical Uses & Asset Owner

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Asset only Does not explicitly model Maximize Sharpe ratio Liabilities or goals not
liabilities or goals for acceptable level of defined and/or simplicity is
volatility important

• Some foundations,
endowments
• Sovereign wealth funds
• Individual investors

Liability relative Models legal and Fund liabilities and Penalty for not meeting
Quasi-liabilities invest excess assets for liabilities high
growth
• Banks
• Defined benefit pensions
• Insurers

Goals based Models goals Achieve goals with Individual investors

specified required proba-
bilities of success.

Relevant Risk Concepts

Asset-only approaches focus on asset class risk and effective combinations of asset classes. Downside
risk can be represented in various ways, including semi-variance, peak-to-trough maximum drawdown,
and measures that focus on the extreme (tail) segment of the downside, such as value at risk (VAR).

Liability-relative approaches focus on the risk of having insufficient assets to pay obligations when due,
which is a kind of shortfall risk.

Goals-based approaches are concerned with the risk of failing to achieve goals. The risk limits can be
quantified as the maximum acceptable probability of not achieving a goal.

FinTree Fruit 5 : Modeling Asset Class Risk

Greer (1997) specifies three “super classes” of assets:

• Capital Assets: An ongoing source of value (e.g., interest or dividends); valued by net present value.

• Consumable/Transformable Assets: Assets like commodities that can be consumed or transformed in

production but do not provide ongoing value.

• Store of Value Assets: Neither income-generating nor consumable; examples include currencies and
art, with value realized through sale or exchange.

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The following are five criteria that will help in effectively specifying asset classes for the purpose of asset
allocation:

Assets within an asset class should be relatively homogeneous

• Assets within an asset class should have similar attributes.

• In the example just given, defining equities to include both real estate and common stock would result
in a non-homogeneous asset class.

Asset classes should be mutually exclusive

• Overlapping asset classes will reduce the effectiveness of strategic asset allocation in controlling risk
and in developing asset class return expectations.

• For example, if one asset class for a US investor is domestic common equities, then world equities
ex-US is more appropriate as another asset class rather than global equities, which include US equities.

Asset classes should be diversifying

• For risk control purposes, an included asset class should not have extremely high expected correlations
with other asset classes or with a linear combination of other asset classes.

• In general, a pairwise correlation above 0.95 is undesirable.

The asset classes as a group should make up a preponderance of world investable wealth

• Selecting an asset allocation from a group of asset classes satisfying this criterion should tend to
increase expected return for a given level of risk.

• However, such factors as regulatory restrictions on investments.

Asset classes selected for investment should have the capacity to absorb a meaningful proportion of an
investor’s portfolio.

• If liquidity and expected transaction costs for an investment of a size meaningful for an investor are
unfavorable, an asset class may not be practically suitable for investment.

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Modern four types of asset classes in practise:

• Global Public Equity

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• Global Private Equity
• Global Fixed Income
• Real Assets

FinTree Fruit 6 : Strategic Asset Allocation

• Strategic asset allocation or “policy portfolio”: It is an asset allocation that is expected to be effective
in achieving an asset owner’s investment objectives, given his or her investment constraints and risk
tolerance, as documented in the investment policy statement.

• The optimal asset allocation is the one that is expected to provide the highest utility to the investor at
the investor’s investment time horizon.

• Selection of a strategic asset allocation generally involves the following steps:

- Determine and quantify the investor’s objectives

- Determine the investor’s risk tolerance and how risk should be expressed and measured.

- Determine the investment horizon

- Determine other constraints and the requirements they impose on asset allocation choices

- Determine the approach to asset allocation

- Specify asset classes, and develop a set of capital market expectations

- Develop a range of potential asset allocation choices for consideration

- Test the robustness of the potential choices

- Iterate back to Step 7 until an appropriate and agreed-on asset allocation is constructed

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FinTree Fruit 7 : Strategic Asset Allocation: Assets Only

• The focus here is mean–variance optimization.

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• If a portfolio is efficient, it has the highest Sharpe ratio among portfolios with the same volatility of
return.

Global Market Portfolio : This portfolio, which sums all investable assets (global stocks, bonds, real estate,
and so forth) held by investors, reflects the balancing of supply and demand across world markets.

In financial theory, it is the portfolio that minimizes diversifiable risk, which in principle is uncompensated.

At a minimum, the global market portfolio serves as a starting point for discussion and ensures that the
investor articulates a clear justification for moving away from global capitalization market weights.

The global market portfolio is expressed in two phases:

- Allocates assets in proportion to the global portfolio of stocks, bonds, and real assets.

- Disaggregates each of these broad asset classes into regional, country, and security weights using
capitalization weights.

Common tilts (biases) include overweighting the home-country market, value, size, and emerging markets.

Investing in a global market portfolio faces several implementation hurdles:

- Estimating the size of each asset class on a global basis is an imprecise exercise given the uneven
availability of information on non-publicly traded assets.

- The practicality of investing proportionately in residential real estate, much of which is held in
individual homeowners’ hands, has been questioned.

- Private commercial real estate and global private equity assets are not easily carved into pieces
of a size that is accessible to most investors.

Remedies to the above hurdles:

- Proxies for the global market portfolio are often based only on traded assets, such as portfolios
of exchange-traded funds (ETFs).

- Some investors have implemented alternative weighting schemes, such as GDP weight or equal
weight.

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FinTree Fruit 8 : Strategic Asset Allocation: Liability Relative

FinTree
• Uses economic and fundamental factors to link liabilities and assets.

• Fixed income assets play key role for this approach.

• Liability Glide Path : A technique typically, where allocation gradually shifts from return -seeking
assets to liability hedging assets.

• Risk factors (duration, inflation, credit risk) based modelling can improve performance of liability
hedging assets.

FinTree Fruit 9 : Strategic Asset Allocation: Goal Based

• The approach’s characteristic use of sub-portfolios is grounded in the behavioral finance insight that
investors tend to ignore money’s fungibility and assign specific dollars to specific uses a phenomenon
known as “mental accounting”.

• Goals can be classified into various dimensions. Two of those classification systems are as follows:

Classification 1 (Brunel) :

- Personal goals - to meet current lifestyle requirements and unanticipated financial needs.

- Dynastic goals - to meet descendants’ needs.

- Philanthropic goals

Classification 2 (Chhabra) :

- Personal risk bucket - to provide protection from a dramatic decrease in lifestyle (i.e., safe-haven
investments)

- Market risk bucket - to ensure the current lifestyle can be maintained (allocations for average
risk-adjusted market returns)

- Aspirational risk bucket - to increase wealth substantially (greater than average risk is accepted)

There are some drawbacks to the goals-based approach to asset allocation:

• Sub-portfolios add complexity.

• Goals may be ambiguous or may change over time.

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FinTree Fruit 10 : Implementation Choices

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Passive/Active Management of Asset Class Weights

• Strategic asset allocation incorporates an investor’s long-term, equilibrium market expectations.

• Tactical asset allocation involves short-term tilts away from the strategic asset mix that reflect
short-term views - for example: to exploit perceived deviations from equilibrium.

• A strategy incorporating deviations from the strategic asset allocation that are motivated by longer-term
valuation signals or economic views is sometimes distinguished as “dynamic asset allocation” (DAA).

• A program of tactical asset allocation must be evaluated through a cost–benefit lens.

Passive/Active Management of Allocations to Asset Classes

• With a passive management approach, portfolio composition does not react to changes in the inves-
tor’s capital market expectations or to information on or insights into individual investments.

• A portfolio manager for an active management strategy will respond to changing capital market
expectations or to investment insights resulting in changes to portfolio composition.

• Some strategies use both passive and active elements (Blend).

Factors that influence asset owners’ decisions to invest on the passive/active spectrum :

- Available investments: The existence of an investable and representative index for indexing purpose.

- Scalability of active strategies being considered: The potential value of an active strategy may
decrease beyond a certain asset level, and small investors may face participation limits.

- The feasibility of investing passively while incorporating client-specific constraints: Client-specific

constraints, such as ESG criteria, may not align with existing index products.

- Beliefs concerning market informational efficiency: A strong belief in market efficiency would lead
investors away from active management for the considered asset classes.

- The trade-off of expected incremental benefits relative to incremental costs and risks of active
choices: Active management costs, including management fees, trading costs, and turnover-induced
taxes, must be weighed against the lower costs of index alternatives, which vary by asset class.

- Tax status: Taxable investors generally face higher hurdles for profitable active management than
tax-exempt investors, often holding active investments in tax-advantaged accounts.

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Risk Budgeting Perspectives in Asset Allocation and Implementation

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• Risk budgeting addresses the questions of which types of risks to take and how much of each to take.

• Risk budgets (budgets for risk taking) can be stated in absolute or in relative terms and in money or
percent terms.

• Active risk budgeting addresses the question of how much benchmark-relative risk an investor is willing
to take in seeking to outperform a benchmark.

• Two levels of active risk budgeting, can be distinguished as follows:

- At the level of the overall asset allocation, active risk can be defined relative to the strategic asset
allocation benchmark.

- At the level of individual asset classes, active risk can be defined relative to the asset class bench-
mark.

FinTree Fruit 11 : Rebalancing: Strategic Considerations

Rebalancing

• It is the discipline of adjusting portfolio weights to more closely align with the strategic asset allocation.

• An investor’s rebalancing policy is generally documented in the IPS.

• Benefits of portfolio rebalancing:

- Ordinary price changes cause the assets with a high forecast return to grow faster than the
portfolio as a whole. Because high-return assets are typically also higher risk, in the absence of
rebalancing, overall portfolio risk rises.

- The mix of risks within the portfolio becomes more concentrated as well. Systematic rebalanc-
ing maintains the original strategic risk exposures.

• Rebalancing is countercyclical, it is fundamentally a contrarian investment approach. Behavioral

finance tells us that such contrarianism will be uncomfortable; no one likes to sell the most recently
best-performing part of the portfolio to buy the worst.

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A Framework for Rebalancing

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• The simplest approach to rebalancing is calendar rebalancing, which involves rebalancing a portfolio to
target weights on a periodic basis—for example, monthly, quarterly, semiannually, or annually.

• Percent-range rebalancing involves setting rebalancing thresholds or trigger points, stated as a percent-
age of the portfolio’s value, around target values. Example: target allocation to an asset class is 50%,
trigger points at 45% and 55% of portfolio value define a 10 percentage point rebalancing range.

Strategic Considerations in Rebalancing

Strategic considerations generally include the following, all else being equal:

- Higher transaction costs for an asset class imply wider rebalancing ranges.

- More risk-averse investors will have tighter rebalancing ranges.

- Less correlated assets also have tighter rebalancing ranges.

- Beliefs in momentum favor wider rebalancing ranges, whereas mean reversion encourages tighter
ranges.

- Illiquid investments complicate rebalancing.

- Derivatives create the possibility of synthetic rebalancing.

- Taxes, which are a cost, discourage rebalancing and encourage asymmetric and wider rebalancing
ranges.

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Principles of Asset Allocation

FinTree Fruit 1 : INTRODUCTION

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• Asset allocation determines long-term exposures to asset classes, aligning client goals, constraints, and
risk tolerance.

• Two-Step Process –
I. Step 1: Asset allocation – Sets long-term exposures to asset classes.
II. Step 2: Implementation – Selects specific investments to achieve target allocations.

• Asset allocation and implementation are often conducted separately due to complexity and different
review frequencies (strategic allocation less frequent, implementation more frequent).

FinTree Fruit 2 : ASSET-ONLY ASSET ALLOCATIONS AND MEAN–VARIANCE OPTIMIZATION

Mean–Variance Optimization (MVO) :

• Developed by Markowitz (1952, 1959)

• MVO is the most widely used method for setting asset allocation policy.
• Combines assets with less-than-perfect correlation to reduce portfolio risk.
• Focuses on overall portfolio risk, not just individual asset risks.
• Risk-Budgeting Tool – Helps investors allocate their "risk budget" efficiently.

MVO requires 3 sets of inputs:

Returns Pair-wise correlations Risks

for assets in the
opportunity set

Objective function :

the return for asset mix m

the expected variance

Um = E(Rm) - 0.005 λ σ2m of return for asset mix m

the investor’s risk

aversion coefficient
the investor’s utility
for asset mix (allocation) m

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• Um can be interpreted as the certainty-equivalent return which is the risk-free return an investor
considers equally valuable as the utility of a risky portfolio.

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MVO – Risk Aversion and Optimization :

Optimization Objective – Selects the asset mix that maximizes the certainty equivalent (return adjusted
for risk).

Risk Aversion (λ):

Low λ (0-3): Small penalties for risk → Aggressive [Link] λ (4): Represents typical risk aversion.
Moderate λ (4): Represents typical risk aversion.
High λ (7-10): Large penalties for risk → Conservative mix.
λ = 0: Risk-neutral (indifferent to volatility).

Without constraints, MVO provides a closed-form solution for optimal asset weights based on inputs.

MVO – Budget Constraint/ Unity Constraint :

Fully Invested Portfolio – Asset allocation weights must sum to 100% (unity), ensuring no leverage or
uninvested cash.

Ensures practical, real-world portfolios by reflecting a fully allocated investment approach.

Efficient Asset Mixes and the Efficient Frontier :

• Efficient Mixes – Asset combinations that:

I. Maximize return per unit of risk or
II. Minimize risk for a given return.

Maximum Expected Return Portfolio ,

100% allocation to the asset with the
highest expected return
(not necessarily the riskiest).

Global Minimum
Variance Portfolio
– lowest risk.

Efficient Frontier

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• Efficient Frontier Slope Dynamics –

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I. Steepest at Global Minimum Variance Portfolio (leftmost point).
II. Flattens towards Maximum Return Portfolio (rightmost point).

• Corner Portfolios –

"Kinks" in the slope indicate portfolios where assets enter or exit the efficient mix.

Risk Aversion and Estimation :

- Precise estimation of an investor's risk aversion coefficient (λ) is difficult.

- Best Practices for Estimation –

• Assess both risk preference and risk capacity.
• Use validated questionnaires to approximate risk preference.

- Combine risk preference with risk capacity to determine overall risk tolerance.

Time Horizon :
• MVO operates on a single-period basis.
• Strategic asset allocation is typically revisited annually or every 3 years.
• Investors rerun analysis and adjust allocations based on updated capital market assumptions.
• Ensures the portfolio aligns with evolving market conditions and investor goals.

Cash Allocation in Asset Allocation :

Cash is included to trace efficient frontier with other assets.

Risk-Free Approach –
Separate cash as risk-free; optimize only risky assets.

Efficient frontier = risk-free rate + tangent portfolio (highest Sharpe ratio).

Resulting Frontier –
Linear combination of risk-free asset and tangency portfolio forms new efficient frontier

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Cash and Two-Fund Separation

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Tobin’s Two-Fund Separation –
• Investors hold risk-free asset + tangency portfolio.
• Can borrow at risk-free rate to leverage or split for lower risk.

Practical Approach –
• Over longer horizons, cash returns are uncertain.
• Include cash in optimization to reflect liquidity needs.

Advisory Practice –
• Adjust cash for short-term needs (e.g., 6 months of expenses).
• Balances liquidity with strategic asset allocation.

Human Capital & Asset Allocation:

• Human capital in stable careers resembles inflation-linked bonds (steady, grows with inflation).
• Commission-based or seasonal careers introduce uncertain, volatile cash flows.

Risk Capacity –

• Large human capital can increase risk capacity in asset allocation.

• Important to account for human capital when evaluating total wealth.

FinTree Fruit 3 : MONTE CARLO SIMULATION

• Monte Carlo simulation helps address complex issues like rebalancing and taxes, which are difficult
to analyze analytically.

• It incorporates tax impacts and transaction costs in multi-period investment scenarios.

• Different rebalancing strategies result in varying outcomes, making simulation a practical solution.

Terminal wealth as a criterion:

• The value of wealth at the end of the investment horizon can help evaluate asset allocations.

• With cash flows, terminal wealth becomes path dependent, as the sequence of returns
interacts with cash flows.

• When terminal wealth is path dependent, Monte Carlo simulation can model this interaction effectively.

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FinTree Fruit 4 : CRITICISMS OF MEAN-VARIANCE OPTIMIZATION

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Concentrated allocations in a
High Sensitivity to Inputs
small set of asset classes.

Ignores factors beyond

Common Criticisms Risk Concentration
mean and variance

Mismatch between asset Disregards trading costs, rebalancing, and

allocations & liabilities. taxes in a multi-period setting.

• Sensitivity to input errors is common to all optimization models using forward-looking forecasts &
cannot be fully resolved in any optimization framework.

FinTree Fruit 5 : ADDRESSING THE CRITICISMS OF MEAN-VARIANCE OPTIMIZATION

Methods to overcome some of the criticisms of MVO include :

Improved Inputs:
Enhance return estimates to reduce sensitivity.

Optimization Constraints:
Stabilize asset allocations with constraints.

Statistical Frontier:
Treat efficient frontier as a statistical tool.

Focus on Returns:
Prioritize accurate expected return estimates.

Reverse Optimization :

• Solves for expected returns using optimal portfolio weights, covariances, and risk aversion.

• Market-cap weights are often used as starting points, reflecting collective market consensus.

• Can use alternative starting weights like policy portfolios or peer allocations.

• Reverse MVO links to CAPM by using beta to infer expected returns based on market portfolio.

• Reverse-optimized returns are referred to as implied or imputed returns.

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Black-Litterman Model :

• Combines reverse optimized returns with investor’s views to adjust expected returns for

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optimization.

• Reflects both market consensus and individual forecasts.

• Improves asset allocation consistency with systematic risk.

• Accounts for correlations of the assets with each other.

Black-Litterman Model Enhances mean-variance optimization by allowing integration of unique views

while maintaining a diversified and realistic asset allocation.

FinTree Fruit 6 : ADDRESSINGCONSRAINTS BEYOND BUDGET CONSTRAINTS, RESAMPLED MVO

& OTHER NON-NORMAL OPTIMIZATION PROCESSES

Additional constraints are applied to:

• Incorporate real-world constraints and reduce input sensitivity/portfolio concentration.

• Improve robustness and practicality of MVO.

Common Constraints in Optimization

Set Allocation Assign fixed percentages to specific assets (e.g., 30% to real estate).
Allocation Range Define a range for asset allocation (e.g., 5%-20% for emerging markets)

Liquidity Limits Set upper limits on illiquid assets (e.g., private equity).
Relative Allocation Control asset relationships (e.g., emerging market equities < developed equities).

Liability-Relative Constrain allocations to match liability characteristics.

Optimization

Practical considerations:

• Good constraints should reflect actual investment circumstances.

• Constraints used solely to control optimization output should be applied cautiously.

• Too many constraints shift from optimization to specifying an asset allocation.

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Resampled Mean–Variance Optimization :

• Combines Markowitz’s mean-variance optimization with Monte Carlo simulation.

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• Aims to create more-diversified allocations by addressing errors in forward-looking inputs.

• Process: Monte Carlo simulation generates multiple capital market assumptions to create
simulated optimization frontiers.

• Asset allocations from these frontiers are averaged to form the resampled frontier.

• Adds robustness to the optimization by incorporating the uncertainty in input assumptions.

Criticisms of Resampled Mean–Variance Optimization :

Concave “Bumps”:
Some frontiers exhibit unexpected decreases in expected return as risk increases.

Over-Diversification:
Riskier allocations may become excessively diversified.

Input Errors:
Estimation errors in the original inputs are inherited by the optimized allocations.

Lack of Theoretical Foundation:

The approach lacks strong theoretical grounding.

Other Non-Normal Optimization Approaches :

• Variance is an incomplete risk measure for non-normal distributions.

• Beyond Mean and Variance, Preferences may also consider skewness and kurtosis, as real asset returns
show more extreme values than normal distributions suggest.

• Advanced Utility Functions:

Optimizers use non-normal distributions and Conditional VaR to model asymmetric risk preferences.

• Investor Behavior:
Prospect theory suggests investors value losses more than equivalent gains, driving the need for models
that account for this asymmetry.

• Empirical Evidence suggests that historical returns often deviate from normal distributions,
necessitating adjustments in optimization models.

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FinTree Fruit 7 : ALLOCATING TO LESS LIQUID ASSET CLASSES

• Illiquid assets may provide higher expected returns as compensation for illiquidity and offer

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diversification benefits.

• Illiquid assets carry Idiosyncratic risk and are harder to diversify, making performance
representation difficult.

Index Limitations:

• Fewer indexes exist to represent aggregate performance for illiquid assets.

• Existing indexes often underestimate the true volatility of illiquid assets.

Challenges:

• Lack of accurate indexes complicates assumptions.

• Passive vehicles for illiquid asset classes are scarce.

Listed Alternative Indexes:

• Securities in alternative indexes often overlap with other asset classes.

• Overlap increases correlations between asset classes.
• Optimization Concern: Higher correlations amplify input sensitivity, negatively affecting optimization.

FinTree Fruit 8 : RISK BUDGETING

• Risk Budgeting allocates portfolio risk across components.

• Risk Allocation – Determine total risk and distribute it within the portfolio.

• Efficiency – Allocates risk in the most efficient manner.

• Optimization is achieved through the process of achieving the best risk allocation.

• Objective – Maximize return per unit of risk.

Marginal Contribution to Risk

• Measures how much a specific position adds to overall portfolio risk.

• Estimates portfolio risk change from altering position size.

• Identifies which holdings contribute most to risk.

• Facilitates efficient risk allocation to enhance returns.

Application:

• Used for managing total, active, or residual risk.

• Aids in constructing optimal risk budgets by aligning risk with return objectives.
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Formula:

MCTRi = βi × σp

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where:
βi = Beta of asset class ‘i’ with respect to the portfolio
σp = Portfolio Std. Deviation

Absolute Contribution to Risk (ACTR):

• ACTR quantifies how much an asset class contributes to total portfolio volatility.

• Used to evaluate whether asset classes contribute appropriately to portfolio risk relative to their weights.

Formula:

ACTRi = wi × MCTRi

where:
wi = weight of asset class ‘i’ in the portfolio
MCTRi = Marginal Contribution to total risk of asset class ‘i’

Optimal Asset Allocation:

An asset allocation is optimal when:

(Excess Return) = Sharpe Ratio of Tangency Portfolio
MCTR
This ensures risk is allocated efficiently, maximizing return per unit of risk.

Outcome:
The portfolio achieves the highest Sharpe ratio possible, representing the most efficient balance of
risk and return.

FinTree Fruit 9 : FACTOR BASED ASSET ALLOCATION

• Allocation based on investment factors rather than traditional asset classes.

• Aims to diversify portfolio risk across underlying return drivers rather than broad asset classes.

Factor Types:

• Derived from market premiums and anomalies (e.g., size, value, momentum).

Construction:

• Factors are typically zero-dollar (self-financing) portfolios.

• Example: Size Factor = Long small-cap stocks, short large-cap stocks.

Market Neutrality:

• Short positions offset long positions, reducing market exposure.

• Factors exhibit low correlations with the market and each other.

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Asset Classes vs. Risk Factors Optimization

• Practitioners have debated whether optimizing based on asset classes or risk factors is better.

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• Key Finding by Idzorek and Kowara (2013) is that neither approach is inherently superior.

• When the same range of potential exposures is available, both approaches offer similar
risk-return possibilities.

• The decision between asset classes and risk factors depends more on specific investment objectives
rather than a clear superiority of one method.

FinTree Fruit 10 : DEVELOPING LIABILITY RELATIVE ASSEET ALLOCATION & CHARACTERIZING THE
LIABILITIES

• Focuses on ensuring an institution's capital is sufficient to meet future cash flow liabilities,
which is critical for regulated entities like banks and pension plans.

• Risk measures such as the probability of meeting future cash flow requirements help institutions
assess their ability to cover liabilities.

Characterizing the Liabilities:

Fixed Liabilities Amount and timing are predetermined (e.g., corporate bonds).

Contingent Liabilities Depend on uncertain future events (e.g., defined benefit pension plans,
insurance policies).
Quasi-Liabilities Future cash obligations essential to the institution's mission but not
legally binding.

Characteristics of Liabilities Affecting Asset Allocation

Fixed vs. contingent cash flows affect payment certainty.

Legal liabilities are binding; quasi-liabilities are not.

Duration and convexity impact interest rate sensitivity.

Liability size relative to the institution affects risk.

Inflation, economics, and rates influence liability flows.

Longevity risk affects timing of liabilities.

Regulations govern liability calculations.

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Surplus & Funding Ratio

• Surplus = Market value of assets − Present value of liabilities.

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• Funding ratio = Market value of assets / Present value of liabilities

Funding Status Fully Funded Overfunded Underfunded

Funding Ratio 1 >1 <1

Surplus 0 >0 <0

• The funding ratio and surplus depend on the discount rate assumption.

• Discount rates are set by regulations and market conventions.

• Economic theory suggests discount rates should reflect the risk-free rate for liabilities.

• Difficulty arises in hedging liabilities due to uncertainty in economic growth and longevity.

FinTree Fruit 11 : APPROACHES TO LIABILITY RELATIVE ASSET ALLOCTION: SURPLUS OPTIMIZATION

Three Major Approaches to Liability-Relative Asset Allocation:

1. Surplus Optimization: Extends MVO to surplus volatility as risk measure.

2. Hedging/Return-Seeking Portfolios: Separates assets into hedging and return-seeking portfolios.

3. Integrated Asset-Liability Approach: Optimizes both assets and liabilities together.

Surplus Optimization:

• Adapts asset-only MVO by focusing on surplus return instead of asset return.

• The objective is to maximize expected surplus return, considering a penalty for surplus
return volatility.

Objective Function:
ULR
m
= E(Rs,m) - 0.005 λ σ2(Rs,m)
where:
ULR
m
= Surplus objective function for asset mix m.
E(Rs,m) = Expected surplus return.

Surplus optimization assumes the relationship between assets and liabilities is approximated by a
correlation, exploiting hedges between them.

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Surplus Optimization Steps

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[Link] asset categories and set planning horizon (usually 1 year).

[Link] expected returns, volatilities, and liability returns.

[Link] constraints on the investment mix.

[Link] correlation matrix and volatilities for assets and liabilities.

[Link] surplus efficient frontier and compare with asset-only frontier.

[Link] recommended portfolio mix.

Example: Surplus Efficient Frontier

XYZ Pension Fund has an aggressive mix:
60% Equities, 30% Bonds, 10% Cash
Expected Surplus: $5 million
Surplus Volatility: 12%

Goal:
Reduce surplus volatility while maintaining the expected surplus.

Exhibit: Surplus Efficient Frontier

Total Surplus ($, billion)

.
Current mix

Surplus Risk (Std. Dev.)

Optimization:
• Surplus efficient frontier suggests a more conservative mix: 60% Bonds, 40% Equities.
• New Expected Surplus: $5 million
• New Surplus Volatility: 6% (reduced by 50%)
Decision:
• Moving to the optimized mix reduces volatility without changing expected surplus.
• Optimized Mix: 60% Bonds, 40% Equities for better risk management.
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Outcome:
• Optimal Mix: Balances surplus return and volatility.

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• Hedging: Reduces surplus risk with liability-matching assets.
• Tailored Allocation: Aligns with risk tolerance and funding goals.

FinTree Fruit 12 : APPROACHES TO LIABILITY RELATIVE ASSET ALLOCATION

Hedging/Return-Seeking Portfolio Approach:

Two Portfolio Approach

Hedging Portfolio Return-Seeking Portfolio

Focuses on matching liabilities using Allocates surplus for growth

[Link] flow matching
[Link] matching Managed independently using methods
[Link] like mean–variance optimization,
with higher risk for potential returns.
Ensuring capital sufficiency for
future obligations.

Forming the Hedging Portfolio

1. Asset-Liability Consistency:

Hedge with assets that reflect the same risk factors as liabilities
(e.g., inflation-linked bonds for inflation-dependent liabilities)
2. Discount Rates Impact:

High discount rates = higher funding ratios, lower contributions.

low discount rates = lower funding ratios, higher contributions.
3. Uncertain Liabilities:

Full hedging is challenging due to non-marketable factors like economic growth.

The law of large numbers can reduce liability uncertainty.
Limitations of the Two-Portfolio Approach
Funding Ratio Below 1:

• If the funding ratio is less than 1, a fully hedging portfolio isn't possible without extra contributions.
• Strategies like glide paths can help improve the funding ratio.
No True Hedging Portfolio:

• In some cases, no perfect hedging assets are available (e.g., for weather-related risks).
• Partial hedges can be used, but they may not fully eliminate risk.
Basis Risk:
• Imperfect hedges may not fully match liability risk.
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Integrated Asset-Liability Approach

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• Involves managing both assets and liabilities together to optimize financial performance and risk
management.
• Aligns asset allocation with liability management, ensuring institutions can meet future obligations
efficiently.
Objective:
• Optimize asset allocation to meet liabilities and maximize returns.
Asset–Liability Management (ALM):
• Commonly used by banks and financial institutions.
• Manages the balance between assets and liabilities.
• ALM helps ensure that banks can meet liquidity needs and regulatory requirements by aligning
asset duration with liability profiles.
Dynamic Financial Analysis (DFA):
• Used by insurance companies.
• integrates asset and liability management, forecasting future liabilities (e.g., insurance claims).
• Ensures that asset strategies support the company’s ability to meet these liabilities.
Implementation:
• Uses multi-period models to align assets with liabilities based on risk factors and economic conditions.
• Key Benefit:
Ensures financial stability by integrating asset and liability management for better risk control.

Characteristics of the Three Liability-Relative Asset Allocation Approaches

Surplus Optimization Hedging/Return-Seeking Integrated Asset-Liability

Characeristic Portfolios Portfolios

Simplicity Simplicity Simplicity Increased Complexity

Correlation Linear or Non-Linear Linear or Non-Linear Linear or Non-Linear

All levels of Risk Conservative Level

Risk Level of Risk All levels of Risk

Funded Ratio Positive Funded Ratio

Any Funded Ratio for Basic Approach Any Funded Ratio

Time Horizon Single Period Single Period Multiple Periods

FinTree Fruit 13 : FACTOR MODELING IN LIABILITY RELATIVE APPROACHES

• Addresses uncertainties in liability cash flows driven by economic conditions and inflation.
• Aligns asset returns with liability drivers (e.g., inflation, salary growth).
• Can be implemented by any of the three liability-relative asset allocation methods.

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FinTree Fruit 14 : EXAMINING THE ROBUSTNESS OF ASSET ALLOCATION ALTERNATIVES

Objective:

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Evaluate asset allocation performance by simulating events or analyzing historical scenarios to
understand risks and outcomes.
Sensitivity Analysis:
• Test the impact of specific changes.
• Analyze how changes affect asset values and liabilities
Historical Event Study:
• Use past events to assess potential impacts on assets and liabilities.
• Simulate how conditions from those events would affect the current portfolio.
Simulation & Scenario Modeling:
• Model future uncertainty using multiple scenarios for asset returns and liability values.
• Generate probabilistic outcomes based on these scenarios over a planning horizon.
Consistency in Assumptions:
• Align asset return assumptions with corresponding liability impacts
(e.g., interest rates should affect both consistently).
Regulatory Stress Testing:
• Stress tests ensure compliance with regulatory requirements, examining how portfolios hold up
under extreme conditions.

FinTree Fruit 15 : DEVELOPING GOALS BASED ASSET ALLOCATION

• Segments an investor's portfolio into sub-portfolios aligned with individual goals, each with a
specific time horizon and required probability of success.
• Emphasizes funding personal or institutional objectives over maximizing aggregate portfolio returns.

Challenges of Goals Based Asset Allocation

Multiple Goals: Limited Resources: Conflicting Goals:

Each goal has a unique Not all goals can be funded Internal contradictions may
time horizon and urgency. with available assets. arise between goals.

• Goals-Based Approach increases the likelihood of meeting individual goals.

Process:
• Iterative adjustments to ensure consistency across sub-portfolios.
• Alignment with overall investor objectives while maintaining goal specificity.

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Institutional and Individual Ways of Defining Goals

Institutions Individuals

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Goals Single Multiple
Time Horizon Single Multiple
Risk Measure Volatility (Return or Surplus) Probability of missing goal
Return Determination Mathematical Expectations Minimum Expectations
Risk Determination Top-down/Bottom-up Bottom-up
Tax Status Single, Often Tax-exempt Mostly Taxable

Minimum Expectations in Goals Based Investing:

• Minimum return required over a time horizon with a set probability of success, ensuring critical
goals are met.
• Guides sub-portfolio design to prioritize essential goals, balancing return potential with acceptable
downside risk.

Example – Goals-Based Asset Allocation Analysis

Scenario

An investor seeks to achieve a financial goal within six years. The expected return of the portfolio is
8% per year with a volatility of 12%. The investor wants the goal to be met with at least 95% confidence.
Portfolio Projection

Over the six-year horizon, the portfolio is projected to return 48% in total, with a volatility of 29.4%.
The compounded annual return at a 95% confidence level is estimated at only 2%, which is much lower
than the expected 8% return.
Implications

Given the 95% confidence level, the portfolio’s returns are expected to fall short of the target rate (8%).
As a result, a lower discount rate must be used to calculate the required capital to meet the goal.
This adjustment ensures that the investor reserves more capital to achieve the desired outcome within
the six-year timeframe.

The Goals-Based Asset Allocation Process

1. Creation of Portfolio Modules :
- Develop sub-portfolios (modules) tailored to individual client goals.
- Each module has its own risk/return profile and time horizon.

2. Matching Goals with Sub-Portfolios :

- Identify client goals and assign each goal to a specific sub-portfolio.
- Ensure that each sub-portfolio is appropriately sized to meet the goal’s objectives.

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Stylized Representation of the Goals-Based Asset Allocation Proccess

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Client Process (Regular Review/Rebalance) Module Process (Annual Review/Revision)
Module Construction & Revision
Describe all client goals Construct/
• Their cash flows Revise
• Their time horizons
• Client’s required probability
for achieving goal
Review Use

Yes

Can goal be matched Assess funding costs and assets needed

to portfolio?
Determine discount rate
Select Module • Module allocate capital
• Time Horizon to sub-portfolio
• Required Probability
of success
No

Custom Portfolio Structure sub-Portfolios

Optimizations

Review
Combine into overall portfolio

• Minimum expectations are adjusted for probability and time horizon, often leading to conservative
estimates.
• Under normal conditions, the actual performance may exceed these expectations, making funding
seem excessive in hindsight.

Optimal Sub-Portfolios
• It is possible to design an optimal sub-portfolio tailored to each individual goal.
Cost Consideration
• Fully customized sub-portfolios are expensive and typically reserved for complex cases.
• Most clients are served using standardized modules to balance efficiency and cost.

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Describing Client Goals

• Clients may not view all goals equally or define them clearly.

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Types of Goals

Cash Flow Based Goals Labeled Goals

Have defined cash flow needs and Vague goals with focus on features
time horizons. (e.g., low risk, capital preservation)
but without specific needs articulated.

• Determining goal urgency and minimum probability of success is often more complex than setting
time horizons.

Client Goal Classification and Probability of Success

Human-Centered Approach

• Maintain a conversational, non-technical tone to ease client engagement without needing

exact probabilities.
Goal Types
• Achieving Goals:
Needs – High urgency (90%-99% success probability).
Wants, Wishes, Dreams – Gradual decrease in urgency (dreams <60% probability).
• Avoiding Goals:
Nightmares, Fears, Worries, Concerns – Mirror structure for risks that client wants to avoid.
Classifying goals by urgency simplifies setting probability targets and portfolio allocation.

FinTree Fruit 16 : CONSTRUCTING SUB-PORTFOLIOS AND THE OVERALL PORTFOLIO

1. Defining Investor Needs:

• Start by identifying the financial needs/goals of the investor.
• Determine the capital required to meet each goal.
2. Sub-Portfolio Modules:
• Develop a range of sub-portfolio modules reflecting different levels of risk, return, and time horizons.
3. Matching Goals to Modules:
• Align each client goal with the most appropriate sub-portfolio.
• Key drivers:Time Horizon & Probability of Success
• Choose the sub-portfolio that maximizes return within the investor’s risk tolerance.
4. Optimization Focus:
• Ensure the highest return for each goal without compromising the required probability of success.

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The Overall Portfolio

1. Aggregating Sub-Portfolios:

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• The overall portfolio is derived by combining exposures from each sub-portfolio.
• Each module’s asset class/strategy is weighted based on the proportion of assets allocated to that module.
2. Asset Allocation Calculation:
• The final allocation is the weighted average of exposures from all modules.
• Expected return and volatility of the overall portfolio are calculated from this aggregation.
3. Liquidity Measure:
• Liquidity Formula:
Days to Liquidate
Liquidity = 1 -
Total Trading Days
• The fewer days required to liquidate, the higher the liquidity.

FinTree Fruit 17 : REVISITING THE MODULE PROCESS IN DETAIL

Tax Impact & Return/Volatility Adjustments:

• Each asset class/strategy is assigned unique return and volatility, factoring in taxes.

Optimization Process:

• Mean-variance optimization with goal-specific constraints (different from traditional efficient frontier).

Constraints in Module Design:

• Liquidity: Avoid illiquid assets in short-term portfolios.

• Non-Normal Distributions: Consider skew/kurtosis in alternative strategies.

• Drawdown Control: Limit downside risk to align with investor’s risk tolerance.

FinTree Fruit 18 : ISSUES RELATED TO GOALS BASED ALLOCATION

Goals-Based allocation must be reviewed regularly. The following two considerations dominate:

[Link] Horizon Stays Fixed:

• Fixed time horizons may not decrease as expected, especially for long-term goals like lifestyle needs,
where the horizon remains unchanged.

[Link] Requirement:

• Portfolios often outperform the required discount rate, leading to excessive allocations.
Rebalancing is necessary to align with the adjusted capital needs.

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Other Issues related to Goals Based Asset Allocation

Single Goal Simplicity:

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• Best suited for multiple goals. Single goals, like retirement, are better handled with traditional methods.

Complexity in Diverse Portfolios:

• Managing multiple goals with varying time horizons and urgencies is challenging for advisers, specially
with regulatory requirements for equal treatment across clients.

Goals Based Wealth Management Advisory Overview

Firm-wide Process for

Firm-wide Process Client Process
Specific Client Portfolio

Capital Market Specific Client Specific Client

Expectations Goals Allocation

+ + +
Definition of Assets Needed for Tactical View of
Client Goals Each Goal Opportunities

+ + +
Asset/Strategy Goals-Based Portfolio Tilting
Constraints Modules Model

= = =
Goals-Based Specific Client Specific Client
Modules Allocation Tilted Portfolio

FinTree Fruit 19 : HEURISTIC & OTHER APPROACHES TO ASSET ALLOCATION

The "120 Minus Your Age" Rule:

A simple rule for determining asset allocation based on age:

120 - Age = % allocated to stocks

This implies that as an individual ages, their portfolio gradually shifts from equities to fixed income.

Many target-date funds follow a similar age-based strategy, reflecting the reduction in human capital risk
as retirement approaches.

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The 60/40 Stock/Bond Heuristic

• Balanced portfolio with 60% in equities and 40% in fixed income as a default asset allocation.

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• This allocation aims to balance growth potential (equities) with stability and income (bonds).

• Reflects a moderate risk tolerance.

Some studies suggest that the global financial asset market portfolio is close to a 60/40 split.

The Endowment Model

• The Endowment Model emphasizes large allocations to non-traditional assets, including private equity.

• Focuses on active management and manager skill.

• Popularized by David Swensen at Yale University in the 1990s.

Risk Parity Asset Allocation

• Focuses on equalizing risk contributions from each asset in the portfolio, rather than maximizing
returns.

• This approach ensures optimal diversification by balancing risk across asset classes.

• The weight of each asset (wi) is determined based on its covariance with the portfolio and the overall
portfolio's variance.
1
wi × Cov(ri,rp) = σ2p
n
Where:
wi = Weight of Asset i
Cov(ri,rp) = Covariance between asset i and the portfolio
n = number of assets
σ2p = Portfolio Variance

Common Criticisms:

• Ignores expected returns, leading to potential lower returns.

• It can result in overweighting low-risk assets (e.g., bonds) and underweighting high-return
assets (e.g., equities).

This approach is best for investors focused on managing volatility and maintaining diversification.

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The 1/N Rule

• Divides wealth equally among all available assets.

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• At each rebalancing date, wealth is allocated as:

Weight of Asset i = 1/N

Best suited for investors who value simplicity and are not focused on optimizing risk-return trade-offs.

FinTree Fruit 20 : PORTFOLIO REBALANCING IN PRACTICE

Rebalancing aims to align the portfolio with its strategic asset allocation, minimizing utility loss from
divergence.

Benefits:

• Prevents expected utility loss by ensuring the portfolio stays aligned with the optimal allocation.

• Empirically shown to reduce risk and slightly enhance returns.

Interpretation of Empirical Findings:

1. Diversification Return:

• Rebalancing to a diversified portfolio generates a higher compound growth rate than individual asset
growth rates.

• Positive returns with low transaction costs create a "diversification return."

2. Short Volatility Return:

• Rebalancing a risky asset and risk-free asset portfolio mimics being "short volatility".
(via options strategies)

• Higher volatility increases the return from rebalancing, as portfolio adjustments benefit from
volatility premiums.

Rebalancing Methods:

• Rebalancing at fixed time intervals (e.g quarterly/annually).

Calander Rebalancing
• Low monitoring costs.

• Rebalances when an asset’s weight deviates beyond a set

Percentage-Range threshold (e.g., ±5%).
Rebalancing
• Better risk control.

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Factors Affecting the Optimal Corridor Width of an Asset Class

Factor Effect on Optimal Width Intuition

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Higher costs → wider High costs reduce the benefits of rebalancing,
Transaction Costs
corridor requiring larger tolerance.

Risk Tolerance Higher tolerance → wider Greater tolerance allows for larger deviations
corridor from the target.

Correlation with the Higher correlation → wider Synchronized assets reduce risk of large
rest of the Portfolio corridor divergence from target.

Volatility of the rest Higher volatility → narrower Increased volatility raises the risk of large
of the Portfolio corridor deviations.

Other Rebalancing Considerations:

Rebalancing to Target vs. Limits:

• Rebalancing to the upper or lower limits of allowed corridors reduces transaction costs but may
deviate from target proportions.

• This is particularly useful for illiquid assets.

Tactical Judgment:

• Decisions may be influenced by tactical considerations, balancing between strict target alignment
and flexibility.

Multi-Period Rebalancing:

• Optimal rebalancing over multiple periods and assets is complex and remains an unsolved problem
due to its interconnected nature.

Transaction Costs and Rebalancing:

• Fixed Transaction Costs: Favor rebalancing to target weights.

• Variable Transaction Costs: Favor rebalancing to the nearest corridor border, creating a
"no trade zone" within the corridor.

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Asset Allocation with Real-World Constraints

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FinTree Fruit 1 & 2: Introduction & Constrains in Asset Allocation & Asset Size

General asset allocation principles assume that all asset owners have equal ability to access the entirety
of the investment opportunity set, and that it is merely a matter of finding that combination of asset
classes that best meets the wants, needs, and obligations of the asset owner.

In practice, however, it is not so simple, An asset owner must consider a number of constraints when
choosing among asset allocation alternatives.

Asset Size

The size of an asset owner’s portfolio may limit the opportunity set by virtue of the scale needed to
invest or by the availability of investment vehicles.

Asset owners with larger portfolios:

• Generally consider a broader set of asset classes and strategies.

• They are more likely to have sufficient governance capacity sophistication and staff resources.

• They also have sufficient size to build a diversified portfolio of investment strategies, many of which
have substantial minimum investment requirements.

• On the other hand, their desired minimum investment may exhaust the capacity of active external
investment managers in certain asset classes and strategies.

Other Practical Considerations:

• Number of investment managers that might need to be hired to fulfill an investment allocation.

• Ability of the asset owner to identify and monitor the required number of managers.

• Investment managers tend to incur certain disadvantages from increasing scale: Growth in AUM
leads to larger trade sizes, incurring greater price impact, capital inflows may cause active invest-
ment managers to pursue ideas outside of their core investment theses.

• Asset owners, however, are found to have increasing returns to scale : The gains are derived from a
combination of cost savings related to internal management , a greater ability to negotiate fees with
external managers, and the ability to support larger allocations to private equity and real estate
investments.

• Owners of very large portfolios may face size constraints in allocating to active equity strategies,
choosing to invest passively in developed equity markets where their size inhibits alpha potential.

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FinTree Fruit 4: Time Horizon

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The changing composition of the asset owner’s assets and liabilities must also be considered.

Time Horizon

Changing Human Changing Character

Capital of Liabilities

As human capital with its predominately The term structure of liabilities changes
bond-like risk declines over time, the as they approach maturity.
asset allocation for financial capital
would reflect an increasing allocation to A pension benefit program is a simple
bonds. way to illustrate this point:

• When the employee base is young and

retirements are far into the future, the
liability can be hedged with long-term
bonds.

• As the employee base ages and

prospective retirements are not so far
into the future, the liability is more
comparable to intermediate- or even
short-term bonds.

• When retirements are imminent,

optimal asset allocation would also
have cash-like characteristics.

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FinTree Fruit 5: Regulatory and Other External Constrains

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Insurance Companies:

• Focused on matching assets to the projected, probabilistic cash flows of the risks they are underwriting.

• Fixed-income assets, are typically the largest component of an insurance company’s asset base.

• Need for capital to pay policyholder benefits and other factors that directly influence the company’s
financial strength ratings.

• Some of the key considerations are risk-based capital measures, yield, liquidity, the potential for forced
liquidation of assets to fund negative claims development, and credit ratings.

Pension Funds:

• Pension fund asset allocation decisions may be constrained by regulation and influenced by tax rules.

• Pension funds are also subject to a wide array of funding, accounting, reporting, and tax constraints
that may influence the asset allocation decision.

• Influenced by funding and financial statement considerations, such as the anticipated contributions, the
volatility of anticipated contributions, or the forecasted pension expense or income under a given asset
allocation scenario.

Endowments and Foundations:

• Tax incentives: Many countries provide tax benefits tied to certain minimum spending requirements.
These spending requirements may be relaxed if certain types of socially responsible investments are
made, which can, in turn, create a bias toward socially responsible investments.

• Credit considerations: Lenders often require that the borrower maintain certain minimum balance
sheet ratios.

Sovereign Wealth Funds:

• SWFs are government-owned pools of capital invested on behalf of the peoples of their states or coun-
tries, investing with a long-term orientation.

• They are not generally seeking to defease a set of liabilities or known obligations.

• The governing entities adopt regulations that constrain the opportunity set for asset allocation.

• SWFs are typically subject to broad public scrutiny and tend to adopt a lower-risk asset allocation in
order to avoid reputation risk.

• There may be cultural or religious factors that also constrain the asset allocation choices. Example:
ESG considerations are becoming increasingly important.

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FinTree Fruit 6: Asset Allocation for the Taxable Investor & After Tax Portfolio Optimization

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Some assets are less tax efficient than others because of the character of their returns the contribution of
interest, dividends, and realized or unrealized capital gains to the total return

• Interest income is usually taxed in the tax year it is received, and it often faces the highest tax rates.

• Jurisdictional rules can also affect how the returns of certain assets are taxed.

• Income from preferred shares may be taxed at more favorable dividend tax rates.

• Dividend income and capital gains are taxed typically (but not always) at lower tax rates than those
applied to interest income and earned income.

• Capital losses can be used to offset capital gains.

• Generally, interest income incurs the highest tax rate, with dividend income taxed at a lower rate in
some countries, and long-term capital gains receive the most favorable tax treatment in many jurisdic-
tions.

Entities and accounts can be subject to different tax rules. These rules provide opportunities for strategic
asset location—placing less tax-efficient assets in tax-advantaged accounts.

After-Tax Portfolio Optimization

Taxable assets may have existing unrealized capital gains or losses (i.e., the cost basis is below or above
market value), which come with embedded tax liabilities.

Approaches adjust the asset’s current market value:

• Subtracting the value of the embedded capital gains tax from the market value, as if the asset were sold
today.

• Assume the asset is sold in the future and discount the tax liability to its present value using the asset’s
after-tax return as the discount rate.

• Assume the asset is sold in the future and discount the tax liability to its present value using the asset’s
after-tax risk free rate.

After-tax risk-free rate is the more appropriate discount rate.

at pt
7KHH[SHFWHGDIWHUWD[VWDQGDUGGHYLDWLRQLVı ı íW

Taxes alter the distribution of returns by both reducing the expected mean return and muting the disper-
sion of returns.

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FinTree Fruit 7 : Taxes and Portfolio Rebalancing

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Reallocating assets to return the portfolio to its target strategic asset allocation is an integral part of sound
portfolio management.

Strategies to Reduce Tax Impact:

- Tax-loss harvesting is intentionally trading to realize a capital loss, which is then used to offset a current
or future realized capital gain in another part of the portfolio, thereby reducing the taxes owned by the
investor.

- Strategic asset location refers to placing (or locating) less tax-efficient assets in accounts with more
favorable tax treatment, such as retirement savings accounts.

- As a general rule, the portion of a taxable asset owner’s assets that are eligible for lower tax rates and
deferred capital gains tax treatment should first be allocated to the investor’s taxable accounts.

- One important exception to this general rule regarding asset location applies to assets held for
near-term liquidity needs.

FinTree Fruit 8 : Revising the Strategic Asset Allocation

• An asset owner’s strategic asset allocation is not a static decision.

• Many institutional asset owners typically re-visit the asset allocation policy at least once every 5 years
through a formal asset allocation study, and all asset owners should affirm annually that the asset
allocation remains appropriate given their needs and circumstances.

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The circumstances that might trigger a special review

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Change in Goals Change
Discounted
in Constraints
Cash Flow Change in Beliefs

• Changes in business conditions • Changes in the expected • Investment beliefs are a set of
affecting the organization payments from the fund. guiding principles that govern
supporting the fund and, the asset owner’s investment
therefore, expected changes in • A significant cash inflow or activities.
the cash flows. unanticipated expenditure.
• Changes in the economic envi-
• Changes in regulations ronment and capital market
• A change in the investor’s governing donations or expectations or a change in
personal circumstances that contributions to the fund. trustees or committee members
may alter her risk appetite or are two factors that guide
risk capacity. • Changes in time horizon investment activities.
resulting from the adoption
of a lump sum distribution
option at retirement.

• Changes in asset size as a

result of the merging of
pension plans.

FinTree Fruit 9 : Short-Term Shifts In Asset Allocation

• Strategic asset allocation (SAA), or policy asset allocation, represents long-term investment policy
targets for asset class weights.

• Tactical asset allocation (TAA) allows short-term deviations from SAA targets.

Objectives of TAA:

• Increasing return, or risk-adjusted return, by taking advantage of short-term economic and financial
market conditions that appear more favorable to certain asset classes.

• TAA is predicated on a belief that investment returns, in the short run, are predictable.

• TAA is not concerned with individual security selection.

• Generating alpha through TAA decisions is dependent on successful market or factor timing rather
than security selection.

• Tactical asset allocation shifts must still conform to the risk constraints outlined in the investment policy
statement, they do not expressly consider liabilities.

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Constrains to TAA:

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• The SAA policy portfolio is the benchmark against which TAA decisions are measured.

• The sizes of these bets are typically subject to certain risk constraints. The most common risk constraint
is a pre-established allowable range around each asset class’s policy target.

• Other risk constraints may include either a predicted tracking error budget versus the SAA or a range
of targeted risk.

Evaluation of TAA:

• A comparison of the Sharpe ratio realized under the TAA relative to the Sharpe ratio that would have
been realized under the SAA.

• Evaluating the information ratio or the t-statistic of the average excess return of the TAA portfolio
relative to the SAA portfolio.

• Plotting the realized return and risk of the TAA portfolio versus the realized return and risk of portfoli-
os along the SAA’s efficient frontier.

Drawbacks of TAA:

• Tactical investment decisions may incur additional costs higher trading costs and taxes.

• Increase the concentration of risk relative to the policy portfolio.

Discretionary TAA

• Predicated on the existence of manager skill in predicting and timing short-term market moves away
from the expected outcome for each asset class that is embedded in the SAA policy portfolio.

• Typically used in an attempt to mitigate or hedge risk in distressed markets while enhancing return in
positive return markets.

• P/E ratios, P/B ratios and the dividend yield are commonly used valuation measures that can be com-
pared to historical averages.

Macroeconomic Data Considered:

• Term spreads provide information about the business cycle, inflation, and potential future interest rates.

• Credit spreads gauge default risk, borrowing conditions, and liquidity.

• Current and expected GDP and earnings growth.

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Economic Sentiment Indicators:

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• TAA often assumes a close relationship between the economy and capital market returns.

• Consumer spending is a major driver of GDP in developed countries, consumer sentiment is a key
consideration.

• Consumer confidence surveys provide insight as to the level of optimism regarding the economy and
personal finances.

Market Sentiment:

• Margin borrowing: measures give an indication of the current level of bullishness. Higher prices tend to
inspire confidence and spur more buying; similarly, more buying on margin tends to spur higher prices.

• Short interest measures: rising short interest indicates increasing negative sentiment.

• The volatility index: measure of market expectations of near-term volatility.

Systematic TAA

Attempts to capture asset class level return anomalies that have been shown to have some predictability
and persistence.

Value Factor Momentum Factor

• Return of value stocks over the return of • Return of stocks with higher prior returns
growth stocks. over the return of stocks with lower prior
returns.
• Predictive measures for equities include
dividend yield, cash flow yield, and Shiller’s • Trend following is an investment strategy
earnings yield. will continue in the same trend that they
have most recently exhibited.
• Carry in currencies uses short-term interest
rate differentials to determine which curren- • Another trend signal is the moving-average
cies to overweight and and which to under- crossover. It signals upward trend when the
weight. moving average of the shorter time frame is
above the moving average of the longer time
• Carry in commodities compares positive frame.
and negative roll yields to determine which
commodities to own or short.

• For bonds, yields-to-maturity and term

premiums signal the relative attractiveness
of different fixed-income markets.
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FinTree Fruit 10 : Dealing With Behavioral Biases In Asset Allocation

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Loss Aversion:

• Loss-aversion bias is an emotional bias in which people tend to strongly prefer avoiding losses as
opposed to achieving gains.

• May interfere with an investor’s ability to maintain his chosen asset allocation through periods of
negative returns.

• In goals-based investing, loss-aversion bias can be mitigated by framing risk in terms of shortfall proba-
bility or by funding high-priority goals with low-risk assets.

• Shortfall probability is the probability that a portfolio will not achieve the return required to meet a
stated goal.

• Where there are well-defined, discrete goals, sub-portfolios can be established for each goal and the
asset allocation for that sub-portfolio would use shortfall probability as the definition of risk.

• Riskier assets can then be used to fund lower-priority and aspirational goals.

• In institutional investing, loss aversion can be seen in the herding behavior among plan sponsors.

Illusion of Control:

The illusion of control is a cognitive bias—the tendency to overestimate one’s ability to control events.

Investors Behaviour attributed to this bias:

• Alpha-seeking behaviors, such as attempted market timing in the form of extreme TAA shifts or all
in/all out market calls.

• Alpha-seeking behaviors based on a belief of superior resources (an edge over other investors in active
security selection and/or the selection of active investment managers.)

• Excessive trading, use of leverage, or short selling

• Reducing, eliminating, or even shorting asset classes that are a significant part of the global market
portfolio based on non-consensus return and risk forecasts.

• Retaining a large, concentrated legacy asset.

Hindsight bias - the tendency to perceive past investment outcomes as having been predictable, exacerbates
the illusion of control

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Mental Accounting:

• Mental accounting is an information-processing bias in which people treat one sum of money differently

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from another sum based solely on the mental account the money is assigned to.

• Investors may separate assets or liabilities into buckets based on subjective criteria.

• Goals-based investing incorporates mental accounting directly into the asset allocation solution.

• Concentrated stock positions also give rise to another common mental accounting issue that affects asset
allocation.

Representativeness Bias

• Representativeness, or recency, bias is the tendency to overweight the importance of the most recent
observations and information relative to a longer-dated or more comprehensive set of long-term obser-
vations and information.

• Return chasing is a common manifestation of recency bias, and it results in overweighting asset classes
with good recent performance.

• If asset prices follow a random walk, then shifting the asset allocation in response to recent returns, or
allowing recent returns to unduly influence the asset class assumptions used in the asset allocation
process, will likely lead to sub-optimal results.

• If, however, asset class returns exhibit trending behavior, the recent past may contain information
relevant to tactical shifts in asset allocation.

• And if asset class returns are mean-reverting, comparing current valuations to historical norms may
signal the potential for a reversal or for above-average future returns.

Framing Bias

• ,QIRUPDWLRQSURFHVVLQJELDVLQZKLFKDSHUVRQPD\DQVZHUDTXHV WLRQGLIIHUHQWO\EDVHGVROHO\RQWKH
way in which it is asked.

• The investor’s choice of an asset allocation may be influenced merely by the manner in which the
risk-to-return trade-off is presented.

• Standard deviation measures the dispersion or volatility around the mean (expected) return.

• VaR is the minimum loss that would be expected a certain percentage of the time over a certain period
of time given the assumed market conditions.

• Conditional value at risk (CVaR) is the probability-weighted average of losses when the VaR threshold
is breached.

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Availability Bias

• Information-processing bias in which people take a mental shortcut when estimating the probability of
an outcome based on how easily the outcome comes to mind.

• Easily recalled outcomes are often perceived as being more likely than those that are harder to recall or
understand.

• Familiarity bias stems from availability bias: People tend to favor the familiar over the new or different
because of the ease of recalling the familiar.

• In asset allocation, familiarity bias most commonly results in a home bias—a preference for securities
listed on the exchanges of one’s home country.

• Familiarity bias may also cause investors to fall into the trap of comparing their investment decisions
(and performance) to others’, without regard for the appropriateness of those decisions for their own
specific facts and circumstances.

Need for a Strong Governance Structure:

• Necessary first step to mitigating the effect that these behavioral biases may have on the long-term
success of the investment program.

• Bringing a diverse set of views to the deliberation process brings more tools to the table to solve any
problem and leads to better and more informed decision making.

• A clearly stated mission a common goal and a commitment from committee members and other stake-
holders to that mission are critically important in constraining the influence of these biases on invest-
ment decisions.

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