Presentation for Kaplan Professional Master of Applied Finance - Extract Only

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Topic 3: Asset Allocation
Presenter : Jeremy Oorloff
FIN226 Investment Management

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• Concept of active and tactical asset allocation
• Testing models ability to meet investment objectives
• Strategic Asset Allocation
• Aspects of portfolio construction
• The issues reviewed in this topic are:
Topic’s Objectives:

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- Cash (domestic and international)
- Fixed interest (domestic and international)
- Property (domestic and international) and will include real
property and real estate investment trusts (REITs)
- Shares or Equities (both domestic and international)
- Indexed bonds
- Alternative assets
• Typical asset classes are
Asset classes
Asset allocation in portfolio construction

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• SAA is a risk control measure established as part of the
investment strategy to achieve an investors long-term
investment objectives
• Key objective of the strategic or neutral asset allocation
is to provide the investor with a return commensurate
with a known risk-return profile
• Benchmark asset allocation for each class may include
tolerance ranges around the benchmark which define
acceptable levels of risk
• SAA is reviewed infrequently unless there is a major
change in circumstances such as a radical shift in
expected long-term returns e.g. GFC Mark 1
Strategic asset allocation (SAA)

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• Introducing alternative asset classes can also enhance
overall returns from a portfolio
• A common example of this is to invest the overseas
shares portfolio in investments in emerging country
share markets (called ‘emerging markets’) e.g. China
or India
• A critical benefit of investing in emerging markets is that
their returns have not been strongly correlated with the
returns in the developed markets
Role of alternative asset classes

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- The cash sector expected return is directly related to the
inflation outlook and the expectations for monetary policy.
- The domestic fixed income sector expected return will reflect a
broader range of factors, primarily the inflation outlook and
expectations for real rates. Real rates may widen or narrow to
accommodate changing levels of uncertainty on, for instance,
the current account or budgetary positions.
• Expected returns per asset class can be defined:
Expected returns and valuation signal

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- For a given level of confidence in the valuation signal, a bigger
mis-valuation (i.e. a bigger return differential between two asset
classes) will generally suggest a bigger shift away from the
neutral
• Extent of mis-valuation identified
- The decision to overweight or underweight an asset class
depends on the confidence the asset allocator has in the
forecasts
• Level of confidence in valuation signals
Interpreting the opportunities

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- the use of active and/or passive managers,
- the mix of balanced managers (i.e. managers who cover
multiple asset classes and the weightings between them) and
specialist managers (managers who cover only a single asset
class),
- internal management versus external management,
- and arrangements for the management of any overseas
component
• Decisions which are typically made in this step include:
Implementing asset allocation

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- involves actions to bring the actual asset allocation into line with
the SAA so that the asset allocation does not drift over time
away from the desired strategic position
• Rebalancing
- it could be implemented with a configuration of specialist
managers supported by a rebalancing policy and value is added
principally by the specialist managers in selecting individual
securities
• Passive approach
Passive v active management

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- Brokerage, futures exchange and clearing fees on an SPI
contract amount to less than 0.01% of the value of the contract.
This compares to the transaction costs on physical shares of
generally more than 0.50% of value (excluding ‘market impact’)
• One approach to minimising costs is to utilise
derivatives
• Futures contracts on 3 and 10-year government bonds
and the S&P/ASX 200 index are the most commonly
used
• A purchase of Share Price Index (SPI) futures contracts
provides the fund with an exposure to movements in the
S&P/ASX 200 index at a fraction of the cost of buying a
portfolio of securities
Use of derivatives

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• Monitoring should be undertaken on a regular basis
(preferably quarterly) to ensure that problems are
detected and acted upon as early as possible
• The investment objectives and investment strategy
should be reviewed on say either annually or every
three years to ensure that they remain suited to the
fund’s circumstances
• Any study should consider the taxation status of the
fund, any government regulations which inhibit
investment alternatives, the availability of investment
products in which to invest, assumptions with respect to
the state of various markets, and so on
Monitoring strategic asset allocation

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Topic 3: Asset Allocation
Presenter : Jeremy Oorloff
FIN226 Investment Management