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ASSET MANAGEMENT PART I:

STRATEGIC ASSET ALLOCATION


Martijn Boons - Nova SBE

TODAY


Strategic asset allocation: How to allocate wealth


optimally across broad asset classes?
AMI - Strategic Asset Allocation

What is an asset class?


 Intuition from answer to How much to invest in
risky versus riskless asset? easily generalizes


Asset allocation for short investment horizons


Risky: aggregate stock market portfolio, e.g., S&P500
 Riskless: short-term Treasury bill


Asset allocation for long investment horizons




Advantages of being a long-term investor


Horizon
 Buy and hold versus rebalancing
 When returns are not versus are predictable


RECALL FROM INVESTMENTS


Investors should control the risk (= variance) of their portfolio not
by re-allocating among risky assets, but through the split between
risky and risk-free

Optimal portfolio of risky assets: market portfolio


 Held by the aggregate market, and in CAPM equilibrium
optimal for all investors
 If not exactly optimal, at least well-diversified and attractive

Although theory suggests market portfolio contains all risky


assets, aggregate stock market index usually used as proxy
 Uncertain market return equals capital gain + dividend:
 =

 
 


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with ( ) =  and ( ) =  

Combine with short-term Treasury bills according to risk aversion


 (Nominally) Risk-free one-period return is known at time 
 
and equals  =  ,
,

THE SINGLE-PERIOD PROBLEM




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Investor chooses fraction  of wealth invested in risky


asset to maximize mean-variance utility over portfolio
return



max (, ) (, ), with , =  +(1-)





(, ) = +(1 ) and (, ) =  

Assumptions
 Wealth is 1$, to abstract from wealth effects
 Ascertains investor has constant relative risk
aversion (CRRA): dollar investment in risky asset
increases in wealth, but the share of wealth
invested in risky asset remains constant
 No practical constraints: positivity or no short-sales
(x 0), no leverage (0 x 1)

SOLUTION


Unconstrained solution from FOC


 =

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 ! "
 #$

 increasing in   , and decreasing in % and  


Example:  = 8%,  = 2%,  = 20%, and %=3
1 6%

 =
= 0.50
3 (20%)
 Traditional portfolio advice: put 50% of wealth in
stocks
Note, Sharpe ratio of optimal portfolio is independent of %:
  (  )
.=
=




The excess return per unit of risk offered by the market


portfolio

THE CAPITAL ALLOCATION LINE



/01
=8%

2%+0.5*
6%=5%
%=3
 =2%
Slope=0.3

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% = 1.5

1. CAL plots expected


return versus standard
deviation of optimal
portfolios
2. Indifference curves
determine which portfolio
choice is optimal for
each % (with utility
increasing in northwest
direction)


0.5*20%=
10%

= 20%

Question: for which % is 100% in the risky asset optimal?


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THE DYNAMIC PORTFOLIO CHOICE


PROBLEM
Horizon of one period is unreasonable for most investors
 Pension funds (horizon of liabilities 20 years)
 Saving for a house, college, new campus etc.

2.

Investor may want to change portfolio weights every period


over this horizon
 What is a period? Year (individuals), quarter (institutions),
, second (high-frequency traders)?
 Why change?
1.
Time-varying investment opportunities (e.g.,
predictable returns and volatilities as the investor
passes through economic recessions / expansions),
2.
when approaching the horizon,
3.
or when risk aversion varies over time.

Main insight from dynamic portfolio choice: optimal


weight depends on horizon or time 3, or both

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1.

SETUP OF THE DYNAMIC PROBLEM (I)




Wealth dynamics: 7 = 7 1 + , 




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Consider the portfolio choice at time  for an investor


with horizon at time 4 >  + 1
Wealth varies from  to  + 1 due to portfolio return, which
is a function of the portfolio choice

Suppose T=5

The sequence of weights over time, { }, is called a dynamic


trading strategy. Dynamic because weights can change
over time.

SETUP OF THE DYNAMIC PROBLEM (II)




Maximize expected utility of wealth at horizon T by


choosing a dynamic trading strategy: max (;(7< ))
{9 }

Note, although chosen at , weights = are not


implemented immediately. The strategy optimally
responds to changes in asset returns, utility etc.


AMI - Strategic Asset Allocation

Turnover constraints play a role in practice due to


transaction costs

Examples of dynamic weights:


Lower investment in risky asset as 4 approaches (Bequest
motive)
 Invest less in risky asset in high volatility recessions or
more when prices are low after crash. State dependency
from


Time-varying return (distribution)


2.
Time-varying risk aversion, i.e., may vary with wealth
Abstract from (2) today!
1.

DYNAMIC PROGRAMMING (I)


The solution to this problem is easily found working backwards

Final wealth is the product of current wealth and uncertain oneperiod returns: 7> = 1 + , (1 + ,> )


Assuming again current wealth 7 = 1

Given uncertain wealth at t+4, choose portfolio weights that


maximize expected utility at t+5(=T):
max (;(7> )) = max (;(1 + ,> (A )))
9@

9@

Solution to this single-period problem, assuming mean-variance


utility:
1 A ,A

A
=

%
A
 Conditional moments, as state of economy at t+4 unknown
 Indirect utility: the maximum utility obtained at t+4,

A = (;(1 + ,> A


)

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DYNAMIC PROGRAMMING (II)




Now, solve the two-period problem: Given wealth at  + 3, choose


B and A to maximize expected utility at t+5 (=T):

The optimal strategy conditional on any outcome at  + 3 is

already known: A


.

Thus, re-write this problem as a one-period problem:


max (;(1 + ,A (B ))A )
9C

The first part is identical to what a single-period investor


would do at  + 3.
 The A -term captures the advantage of being a long-term
investor. The utility derived from this A -term depends on
uncertain wealth and investment opportunities at  + 4


Working back to , we are solving such a one-period problem at


each point in time..

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max (;(7> ))

9C, 9@

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GRAPHICAL REPRESENTATION

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Note how different this approach is


from buy and hold, which solves
one five-period problem!

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LESSONS
Dynamic portfolio choice over long horizons is
first and foremost about solving one-period
portfolio choice problems!
 This view destroys two widely held
misconceptions:


2.

Long-term investors are fundamentally different


from short-term investors
Buy-and-hold is optimal

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1.

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1. LONG-TERM INVESTING IS NOT SO


DIFFERENT FROM SHORT-TERM INVESTING
Dynamic programming shows that long-run investors do
everything that short-run investors do!

However, long-run investors can do more, because they have the


advantage of a long horizon.
 The horizon effect enters through the indirect utility (VFG ) in
each one-period problem
 For instance, suppose at t you know that stock market returns
will be high from t+1 to t+2. How might this affect the optimal
portfolio choice xF ?
 Some will invest more risky, because future return can
compensate if returns are low from t to t+1
 Some will invest less risky, to ensure that they have
sufficient money to invest when it is most attractive at t+1
 Exact solution depends, among other things, on
Covt(, , , ) with mean-variance utility, and smoothing
preferences with other utility functions

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2. A LONG-RUN INVESTOR SHOULD NOT


BUY AND HOLD!


Buy and hold solves a single, long-horizon problem




Thus, dynamic portfolios can do everything buy and


hold portfolios do, but also much more!


In practice, optimal long-horizon investing is not to buy


and hold; long-horizon investing is a continual process of
buying and selling.

Suppose you calculate the optimal weight in stocks for


the next ten years is 50%.
You need to rebalance each period!
 If not, over a sufficiently long period of time, you will have
100% in risky assets. That is not what you wanted, right?

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Special case of dynamic investing where the investors


optimal choice is to do nothing

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REBALANCE WHEN RETURNS ARE NOT


PREDICTABLE!


Suppose returns are not predictable (i.i.d.) and the risk-free


rate is fixed

Returns are in fact hard to predict!

In this case, the dynamic strategy is a series of identical


one-period strategies


Intuition: we can take A out of the maximization


max (;(1 + ,A (B )))A
9C

 ! "
#$

Long-run weight (t) = Short-run weight (t) = 

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THE CASE FOR REBALANCING




Investors rebalance infrequently and incompletely


 Partial explanations include: inertia, natural tendency
to invest more in assets that do well than in assets
doing poorly, transaction costs (rebalancing bands)

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For the two asset case (stock market and risk-free asset),
rebalancing is countercyclical:
 Buy (sell) stocks after low (high) returns
Portfolio rebalancing ensures wealth remains to be
allocated optimally (in line with risk preferences) over
time, and is also advantageous if returns are
 mean-reverting / predictable: prices drop when
expected future returns increase (more on
predictability later)
 Example: Great depression

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COUNTERCYCLICAL REBALANCING IN THE


GREAT DEPRESSION

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With rebalancing: sell some stocks before they are hit hard in 1930,
and buy some stocks before they rebound in 1932
Reduces variance
and increases returns
Similar evidence obtains in recent financial crisis!

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THE DIVERSIFICATION RETURN (SEE ERB


AND HARVEY, 2006)


Portfolio diversification decreases portfolio variance


without reducing portfolio arithmetic return

This benefit is obtained in a single period, but dies out if


you do not rebalance (weight in risky asset  100%)

However, what is less well understood is that


diversification does increase portfolio geometric
return
This diversification return exists for a long-term investor
and is collected by rebalancing (also known as rebalancing
return or variance reduction)
 Which two consecutive returns do you prefer: (90%,-50%) or
(10%,-10%)?
 Excel example


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OPPORTUNISTIC STRATEGIES WHEN


RETURNS ARE PREDICTABLE (I)
If returns are predictable (not i.i.d.): additional benefits
from long-term horizon
 Long-term weight (t) =
1. Long-run myopic weight +
2. (Short-run weight (t) Long-run myopic weight) +
3. Opportunistic weight (t)
 Strategic asset allocation is the sum of these three
components!
1. Long-run fixed weight determined by long-run
average return and volatility
1  I
% 
This is the constant rebalancing weight in the i.i.d. case!


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OPPORTUNISTIC STRATEGIES WHEN


RETURNS ARE PREDICTABLE (II)
2.

 ! ",
 #$

I "
!
,
 #$

where  ( ) =  ,  ( ) = 

If market Sharpe ratio is temporarily high: both


short-and long-term investors can benefit.
3. Captures how long-term investor can take
advantage of time-varying, predictable returns in
ways short-run investors cannot.
 The knowledge that market Sharpe ratio is going
to be high in the future: only the long-term
investor can benefit.


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Tactical asset allocation: the response of both


short- and long-run investors to changing means
and volatilities

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CHARACTERIZING THE OPPORTUNISTIC


WEIGHT


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Difficult, but two broad determinants


1.
Investor-specific: risk tolerance (like in one-period
portfolio) and horizon
2.
Asset-specific: how do returns vary over time?
 Interaction between horizon and time-variation is
crucial:
 An asset with low returns (high volatility) today, but
high returns (low volatility) in the (long-run) future is
not attractive for short-term investors, but long-term
investors might want to invest in them.
We can obtain more insight into the opportunistic weight
(or intertemporal hedge demand, as it was coined in
Merton (1973)), thinking about optimal buy-and-hold
portfolios as in Campbell and Viceira (CV, 1999, 2002,
2005)

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THE CV-APPROACH
CV set out to find the optimal portfolio choice for buy-andhold investors with investment horizon K

If returns are predictable, long-term portfolio choice is


(among other things) determined by the conditional
expectation and conditional variance of the risky assets
returns over the investors horizon K


(L)

(L)

More formally, (L)


(  ( ),  ( )), where  ( ) is
the average expected per period return over horizon K
L
( ( ) defined analogously)

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Empirically, forecasts of returns and variances follow from


a regression of stock and t-bill returns on a set of predictors
(e.g., the dividend yield)
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OPTIMAL BUY-AND-HOLD PORTFOLIOS (I)


To get the necessary intuition, let us think about a
case where , is time-varying, but the market risk
M
premium 
=  , is constant

Optimal investment in risky asset for investors with a


K-period horizon are of the following approximate
form:
L
M L
M L
/OP
(
,

1  ( )
1
 
, )

(L)
+ ( 1)
M L
%  ( M L )
%
 (
)

M L
L
/OP ( , , ) is



where
the average per period
covariance of risky assets return with risk-free return
over horizon K
1.
Myopic demand of a K-period investor (as before)

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OPTIMAL BUY-AND-HOLD PORTFOLIOS (II)

Suppose the covariance is positive: on average, excess


market returns are high whenever expected future returns
L
on both market and t-bills are high (, )


Risk averse investor (%>1) will under-weight market portfolio


(relative to myopic demand), because it pays off exactly when
he does not need the money, i.e., when the future is bright
Risk loving investor (%<1) will over-weight (relative to myopic
demand), because he will be able to invest more in exactly
those states where expected future returns are high

Thus, long-run portfolio deviates from myopic


portfolio. Short-run investors do not hedge
M L
L
intertemporally: /OP ( , , )=0 for K=1!

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Intertemporal hedge demand defined over


M L
L
/OP ( , , )

2.

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OPPORTUNISTIC HEDGING DEMANDS IN


PRACTICE


In this way, current returns will be a hedge against


future stock returns
 Example: the global minimum variance portfolio

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Although elegant and intuitive, the optimal size of


hedging demands is debated heavily
CV estimate is large: risk-averse, long-run investor
over-weights stocks dramatically. Why?
 Mean-reversion captured by the fact that dividend
yield predicts stock returns with a positive sign insample
 When future expected stock returns increase,
current prices decrease and dividend yield
L
M L
increases (/OP ( , , )<<0)


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CV: STOCKS ARE LESS RISKY IN THE LONG


RUN

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ON MEAN REVERSAL AND PREDICTABILITY


IN STOCK RETURNS
Evidence in CV consistent with in-sample stock return
predictability by a range of variables:
 Cash-flow based (dividend yield, earnings yield); Business
cycle indicators (term spread); Technical (momentum)

Recent research questions extent and exploitability of this


predictability out-of-sample, i.e., for an investor that is making
his investment decisions in real-time
 Goyal and Welch (2008): coefficients unstable in sub-samples;
in-sample R2 small; out-of-sample R2 tiny

State-of-the-Art recommendation by Ang

the evidence for predictability is weak, so I recommend that both


the tactical and opportunistic portfolio weights be small in practice.
Opportunistic hedging demands become much smaller once investors
have to learn about return predictability or when they take into
account estimation error.

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EXTENSION: LIABILITY HEDGING


Few investors are without liabilities.

With liabilities the optimal long-run portfolio advice becomes:


First, meet the liabilities and then invest wealth, in excess of the
present value of liabilities, as before
 Long-run weight (t) = Liability hedge (t) + Short-run weight
(t) + Opportunistic weight (t)

Liability hedge: portfolio that best ensures investor meets


liabilities
 Invests in assets with large covariance with liabilities
 Intuition: if stock market return is high when liabilities
increase in value, it is attractive as a hedge. The more risk
averse the investor (%), the more weight he will place on
liability hedging.
Q

 ! ",
 #$




( 1)

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RST (" ,"U, )


V (" )

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EXAMPLES OF LIABILITY HEDGE


PORTFOLIOS
Cash flow matching: Match a portfolio of fixed, future outflows
with bonds of appropriate maturities

2.

Duration matching: Match duration of interest rate bearing


liabilities with a portfolio of Treasury bonds

3.

Assetliability matching: Match liability characteristics besides


just duration
 For most pension funds
 horizon exceeds longest available maturity of liquidly
traded Treasury bonds
 liabilities denominated in real, not nominal, terms, whereas
real, long-maturity bonds have only been traded in recent
years, but not in every country
 Additional risks that need to be matched: liquidity risk,
longevity risk, economic growth, and credit risk.

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1.

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THREE-WAY SEPARATION IS POPULAR




2.

3.

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1.

Practitioners frameworks usually consist of three


buckets
Protective portfolio, which covers personal risk.
The portfolio is designed to minimize downside risk
and is a form of safety first.
Market portfolio, which is a balance of risk and
return to attain market-level performance from a
broadly diversified portfolio and is exposed to
market risk.
Aspirational portfolio, which is designed to take
measured risk to achieve significant return
enhancement. Aspirational risk is a property of an
investors utility function and is a desire to grow
wealth opportunistically to reach the next desired
wealth target.

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CONCLUSIONS
Rebalancing is the foundation of any long-term
investment strategy!
 Under i.i.d. returns the optimal policy is to
rebalance to constant weights for both short- and
long-term investors.
 When returns are predictable, the optimal shortrun portfolio changes over time, and the long-run
investor has additional opportunistic strategies
 Liabilities need to be adequately matched before
the investment portfolio is constructed.


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LITERATURE
Books
 Ang, Asset Management, Ch. 2-4
 Campbell and Viceira, Strategic Asset Allocation, Ch. 2-3

Articles
 Erb and Harvey, 2006, The Tactical and Strategic Value of
Commodity Futures, Financial Analysts Journal.
 Merton, 1973, An Intertemporal Capital Asset Pricing Model,
Econometrica
 Campbell and Viceira, 2005, The term structure of the risk-return
trade-off, NBER Working Paper
 Campbell and Viceira, 2005, The term structure of the risk-return
trade-off, Financial Analysts Journal
 Goyal and Welch, 2008, A Comprehensive Look at The Empirical
Performance of Equity Premium Prediction, Review of Financial
Studies

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