Topic Two:
Asset Allocation: Decisions & Strategies
Keith Brown
The Asset Allocation Decision
A basic decision that every investor must make is how to distribute his or her
investable funds amongst the various asset classes available in the marketplace:
ƒ
ƒ
ƒ
ƒ
ƒ
ƒ
Stocks (e.g., Domestic, Global, Large Cap, Small Cap, Value, Growth)
Fixed-Income (e.g., Government, Investment Grade, High Yield)
Cash Equivalents (e.g., T-bills, Bank Deposits, Commercial Paper)
Alternative Assets (e.g., Private Equity, Hedge Funds)
Real Estate (e.g., Residential, Commercial)
Collectibles (e.g., Art, Antiques)
The Strategic (or Benchmark) allocation is the proportion of wealth the investor
decides to place in each of these asset classes. It is sometimes also referred to as the
investor’s long-term normal allocation because it is presumed to be the “baseline”
allocation that will remain in place until the investor’s life circumstances change
appreciably (e.g., retirement)
2-1
Asset Allocation for Chile AFPs –
July 2009
2-2
Examples of Strategic
Asset Allocations
2-3
Examples of Strategic
Asset Allocations (cont.)
2-4
Examples of Strategic
Asset Allocations (cont.)
University Endowments (Average):
2-5
Examples of Strategic
Asset Allocations (cont.)
University Endowments (Large (Q4) vs. Small (Q1) AUM):
2-6
Examples of Strategic
Asset Allocations (cont.)
University of Texas General Endowment Fund (GEF):
2-9
2-7
Examples of Strategic
Asset Allocations (cont.)
University of Texas General Endowment Fund (GEF):
2-8
Examples of Strategic Asset
Allocations (cont.)
Public Retirement Fund (Teacher Retirement System of Texas):
2-9
TRS: The Need for an “All Weather”
Portfolio (1948 – 2009)
Favorable GDP & CPI
Stagnant GDP, Low CPI
66% of observations
13% of observations
Global Equity: +15.9%
Stable Value: +7.5%
Real Return: +9.4%
Global Equity: -15.4%
Stable Value: +19.2%
Real Return: -6.2%
Frequency
9
8
7
6
5
4
3
9%
7%
3Q08
1
4Q08
2
5%
2Q09
0
1Q09
3%
1%
-1%
-3% & less
US CPI
YOY Chg
US GDP
YOY Chg
Low GDP, High CPI
21% of observations
Global Equity: 0.3%
Stable Value: +6.8%
Real Return: +10.4%
2 - 10
Examples of Strategic Asset
Allocations (cont.)
Public Retirement Fund (Texas Teacher Retirement System):
Note: Returns and Asset Class Performance are highly regime dependent (1947-2009)
GROWTH
H IG H
HIGH
IN F L A T IO N
36
Stock
Credit
Treasury
Commodity
High Yield
REITS
50
Stock
Credit
Treasury
Commodity
High Yield
REITS
LOW
28
Return Volatility Sharpe
Stock
6.1% 17.56% 0.3
Credit
6.5% 12.39% 0.5
Treasury
9.1%
6.41% 1.4
Commodity
20.1% 30.79% 0.7
High Yield
1.1%
9.52% 0.1
REITS
12.3%
3.49% 3.5
30
Return Volatility Sharpe
Stock
4.4% 19.86% 0.2
Credit
15.3%
7.57% 2.0
Treasury
13.1%
4.45% 2.9
Commodity -12.5% 23.76% -0.5
High Yield
7.1% 13.70% 0.5
REITS
5.4%
5.11% 1.0
LOW
LOW
In fla tio n
H IG H
Growth
HIGH
Return Volatility Sharpe
11.8% 15.26%
0.8
3.2%
6.43%
0.5
4.2%
3.76%
1.1
25.1% 17.80%
1.4
7.7%
5.34%
1.4
11.3%
2.50%
4.5
Return Volatility Sharpe
15.4% 14.98%
1.0
8.4%
6.39%
1.3
6.6%
4.31%
1.5
10.1% 16.60%
0.6
9.9%
6.05%
1.6
9.9%
3.16%
3.1
HG-HI
Stock
Credit
Treasury
Commodity
High Yield
REITS
HG-LI
Stock
Credit
Treasury
Commodity
High Yield
REITS
LOW
Weights
18.9%
0.0%
0.0%
54.9%
0.0%
26.2%
Weights
61.6%
0.0%
0.0%
16.4%
0.0%
22.0%
LG-HI
Weights
Stock
0.0%
Credit
0.0%
Treasury
0.0%
Commodity
27.6%
High Yield
0.0%
REITS
72.4%
LG-LI
Weights
Stock
0.0%
Credit
100.0%
Treasury
0.0%
Commodity
0.0%
High Yield
0.0%
REITS
0.0%
2 - 11
Examples of Strategic Asset
Allocations (cont.)
Public Retirement Fund (Texas Teacher Retirement System):
Current Policy
Global Equity
US Large Cap
US Small Cap
EAFE Unhedged
Emerging Markets
Private Equity
Total Global Equity
Stable Value
Cash
US Aggregate
US Treasurys ‐‐ Intermediate
US Treasurys ‐‐ Long
US Investment Grade Credit
US High Yield
WGBI ex US Unhedged
Bank Loans
Emerging Market Debt
Hedge Funds
Total Stable Value
Real Return
Real Assets
REITS
Direct Real Estate
Value Added Real Estate
US TIPS
Global Inflation Linked Bonds
Gold
Commodities
Total Real Return
Total Fund
20%
Pre 2007 Policy
36%
Suggested Policy ‐ 8% Target
4%
5%
11%
9%
15%
12%
8%
10%
1%
9%
10%
4%
16%
60%
64%
46%
1%
1%
1%
0%
28%
0%
0%
0%
0%
15%
0%
0%
0%
0%
0%
0%
2%
2%
0%
0%
0%
0%
0%
0%
0%
32%
4%
2%
20%
33%
5%
0%
0%
0%
0%
9%
5%
3%
1%
5%
0%
5%
0%
0%
0%
5%
0%
0%
0%
0%
0%
0%
3%
20%
3%
18%
100%
100%
99%
2 - 12
0%
0%
35%
0%
The Importance of the Asset Allocation
Decision
In an influential article published in Financial Analysts Journal in
July/August 1986, Gary Brinson, Randolph Hood, and Gilbert
Beebower examined the issue of how important the initial strategic
allocation decision was to an investor
They looked at quarterly return data for 91 pension funds over a
ten-year period and decomposed the average returns as follows:
ƒ Actual Overall Return (IV)
ƒ Return due to Strategic Allocation (I)
ƒ Return due to Strategic Allocation and Market Timing (II)
ƒ Return due to Strategic Allocation and Security Selection (III)
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The Importance of the Asset Allocation
Decision (cont.)
Graphically:
In terms of return performance,
they found that:
2 - 14
The Importance of the Asset Allocation
Decision (cont.)
In terms of return variation:
Ibbotson and Kaplan support this conclusion, but argue that the
importance of the strategic allocation decision does depend on
how you look at return variation (i.e., 40%, 90%, or 100%).
2 - 15
Components of University Endowment
Returns
Notice that over time,
university endowment
returns (R) exceed their
benchmark (RB) by 165
basis points.
Of this 165 basis points of
outperformance, 148 is due
to security selection (RS)
and 17 is due to market
timing (RT)
2 - 16
Components of University Endowment
Returns (cont.)
To see how much of the overall
endowment return is explained
by the various components,
consider several versions of the
following regression: R = a + bRk
+ e, where k = B, T, or S
When this regression is run for a
single fund over several years,
the vast majority (74.2%) of the
variation in total returns is
explained by the strategic asset
allocation decision. This is
comparable to the Brinson et al
result for pension funds
However, when the evaluating
the cross-sectional performance
of a group of funds during a
single year, the security
selection decision is almost five
time more important that the
asset allocation decision (72.8%
vs. 15.3%).
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Asset Allocation and Building an
Investment Portfolio
I. Global Market Analysis
- Asset Class Allocation
- Country Allocation Within Asset Classes
II. Industry/Sector Analysis
- Sector Analysis Within Asset Classes
III. Security Analysis
- Security Analysis Within Asset Classes
and Sectors
2 - 18
Asset Allocation Strategies
Strategic Asset Allocation: The investor’s “baseline” asset
allocation, taking into account his or her return requirements,
risk tolerance, and investment constraints.
Tactical Asset Allocation: Adjustments to the investor’s strategic
allocation caused by perceived relative mis-valuations amongst
the available asset classes. Ordinarily, tactical strategies
overweight the undervalued asset class. Also known as market
timing strategies.
Insured Asset Allocation: Adjustments to the investor’s strategic
allocation caused by perceived changes in the investor’s risk
tolerance. Usually, the asset class that experiences the largest
relative decline is underweighted. Portfolio insurance is a wellknown application of this approach.
2 - 19
Sharpe’s Integrated Asset Allocation
Model
C1
Capital Market
Conditions
I1
Investor Assets, Liabilities
and Net Worth
C2
Prediction
Procedure
I2
Investor's Risk Tolerance
Function
I3
Investor's Risk Tolerance
C3
Expected Returns, Risk
and Correlations
M1
Optimizer
M2
Investor's Asset Mix
M3
Returns
2 - 20
Sharpe’s Integrated Asset Allocation
Model (cont.)
Notice that the feedback loops after the performance
assessment box (M3) make the portfolio management process
dynamic in nature.
The strategic asset allocation process can be viewed as going
through the model once and then removing boxes (C2) and (I2),
thus removing any temporary adjustments to the baseline
allocation.
Tactical asset allocation effectively removes box (I2), but allows
for allocation adjustments due to perceived changes in capital
market conditions (C2).
Insured asset allocation effectively removes box (C2), but allows
for allocation adjustments due to perceived changes in investor
risk tolerance conditions (I2).
2 - 21
Measuring Gains from Tactical Asset
Allocation
Example: Consider the following return and allocation characteristics
for a portfolio consisting of stocks and bonds only.
Allocation:
Strategic
Actual
Stock
60%
50
Bond
40%
50
Returns:
Benchmark
Actual
10%
9
7%
8
The returns to active management (i.e., tactical and security selection)
are:
Policy Performance:
Actual Performance:
(.6)(.10) + (.4)(.07)
(.5)(.09) + (.5)(.08)
Active Return =
2 - 22
= 8.80%
= 8.50%
- 30 bp
Measuring Gains from Tactical Asset
Allocation (cont.)
Also:
(Policy & Timing):
(.5)(.10) + (.5)(.07)
= 8.50%
(Policy & Selection): (.6)(.09) + (.4)(.08)
= 8.60%
so:
Timing Effect:
8.50 – 8.80
= -0.30%
Selection Effect: 8.60 – 8.80
= -0.20%
Other: 8.50 – 8.60 – 8.50 + 8.80
= +0.20%
Total Active
= -0.30%
2 - 23
Example of Tactical Asset Allocation:
Fidelity Investments
2 - 24
Example of Performance & Tactical Asset Allocation: Texas
Teacher Retirement System 2008
2 - 25
Texas TRS Attribution Analysis:
1/1/08 – 3/31/08
2 - 26
Example of Relative Performance:
UTIMCO - 2009
2 - 27
Example of Tactical Asset Allocation:
UTIMCO
2 - 28
Attribution Analysis Example: UTIMCO
Tactical Allocations
2 - 29
UTIMCO Cumulative Alpha:
9/1/02 – 1/31/06
2 - 30
The MBA Investment Fund Attribution
Analysis: 3/1/05 – 2/28/06
•
Over this period, both the Growth (+814 bp) and Value (+548) Portfolios outperformed their respective
benchmarks by a significant amount
Notice that this Attribution Analysis is calculated in a slightly different way; it isolates the Allocation Effect more
precisely by including a third term (i.e., Interaction Effect)
•
2 - 31
The MBA Investment Fund Attribution
Analysis: 3/1/06 – 2/28/07
•
Over this period, both the Growth (-219 bp) and Value (-442 bp) Portfolios underperformed their respective
benchmarks by a significant amount
2 - 32
The MBA Investment Fund Attribution
Analysis: 3/1/08 – 2/28/09
•
Over this period, the Growth (+219 bp) Portfolios outperformed its benchmark by a significant amount
2 - 33