Capital Market Expectations, Market Valuation, and Asset Allocation

Asset Allocation Asset/Liability management p. discuss the strengths and limitations of the following approaches to asset allocation: mean-variance, resampled efficient frontier, Black-Litterman, Monte Carlo simulation, ALM, and experience based;

"A simple asset allocation approach that blends surplus optimization with Monte Carlo simulation follows these steps: ■ Determine the surplus efficient frontier and select a limited set of efficient portfolios, ranging from the MSV portfolio to higher-surplus-risk portfolios, to examine further. ■ Conduct a Monte Carlo simulation for each proposed asset allocation and eval- uate which allocations, if any, satisfy the investor's return and risk objectives. ■ Choose the most appropriate allocation that satisfies those objectives. Below we elaborate on the steps."

Asset Allocation r. formulate and justify a strategic asset allocation, given an investment policy statement and capital market expectations;

"Boxes on the left, labeled C1, C2, and C3, are concerned primarily with the capital markets. Those on the right are investor specific (I1, I2, and I3). Those in the middle (M1, M2, and M3) bring together aspects of the capital markets and the investor's circumstances to determine the investor's asset mix and its performance. The asset allocation review process begins at the top of the diagram and proceeds downward. Then the outcomes (M3) provide feedback to both the capital-market- and investor-related steps at the next asset allocation review."

"Equity Market Valuation" Formula: "10-year Moving Average Price/Earnings" g. judge whether an equity market is under-, fairly, or over-valued

"Campbell and Shiller's P/10-year MA(E) The numerator of P/10-year MA(E) is the real S&P 500 and the denominator is the moving average of the preceding 10 years of real reported earnings. "Real" denotes that the stock index and earnings are adjusted for infla- tion using the Consumer Price Index (CPI). The purpose of the 10-year moving average of real reported earnings is to control for business cycle effects on earnings

"Capital Market Expectations in Portfolio Management" Statistical tools: DCF Models c.demonstrate the application of formal tools for setting capital market expectations, including statistical tools, discounted cash flow models, the risk premium approach, and financial equilibrium models;

"Discounted cash flow models (DCF models) express the idea that an asset's value is the present value of its (expected) cash flows. Formally, the value of an asset using a DCF approach is as follows" "For simplicity, we represent the discount rate in Equation 4 as the same for all time periods—a flat term structure of discount rates." "DCF models are a basic tool for establishing the intrinsic value of an asset based on fundamentals (e.g., its projected cash flows) and its fair required rate of return. DCF models have the advantage of being forward-looking. They do not address short-run factors such as current supply-and-demand conditions, so practitioners view them as more appropriate for setting long-term rather than short-term expectations. That said, asset prices that are disconnected from fundamentals may reflect conditions of speculative excess that can reverse abruptly.31"

"Capital Market Expectations in Portfolio Management" Inventory Cycle e.discuss the inventory and business cycles, the impact of consumer and business spending, and monetary and fiscal policy on the business cycle;

"Economists have found evidence of a short-term inventory cycle, lasting 2-4 years. The inventory cycle is a cycle measured in terms of fluctuations in inventories. The inventory cycle is caused by companies trying to keep inventories at desired levels as the expected level of sales changes. ■In the up phase of the inventory cycle, businesses are confident about future sales and are increasing production. The increase in production generates more overtime pay and employment, which tends to boost the economy and bring further sales. ■At some point, there is a disappointment in sales or a change in expectations of future sales, so that businesses start to view inventories as too high. Then, business cuts back production to try to reduce inventories and hires more slowly (or institutes layoffs). The result is a slowdown in growth. ■It usually takes a year or two for business to correct inventory levels after an inflection point. ■A good indicator of the inventory position is the inventory/sales ratio. When the inventory/sales ratio has moved down, the economy is likely to be strong in the next few quarters as businesses try to rebuild inventory. Conversely, when the ratio has moved sharply up, a period of economic weakness can be expected.

"Equity Market Valuation" Gordon Growth Model and forward earnings yield d. critique the use of discounted dividend models and macroeconomic forecasts to estimate the intrinsic value of an equity market;

"Equation 5 presents the Gordon growth model where V0 is intrinsic value, D1 is the dividend per share to be received one-year from today, r is the required return, and the constant annual dividend growth rate is g:" "Assuming markets correctly set price, P0, equal to intrinsic value, then P0 = V0. The expected dividend, D1, can be determined as the payout ratio, p, times expected earnings, E1. Sustainable growth, g, can be estimated as return on equity, ROE, times the earnings retention rate, (1 − p). Substituting D1 = p E1 and g = ROE (1 − p) into Equation 5 and noting that P0 = V0 we are able to derive Equation 6. Equation 6 provides a Gordon growth model estimate for the forward earnings yield, E1/P0:" "Assuming markets correctly set price, P0, equal to intrinsic value, then P0 = V0. The expected dividend, D1, can be determined as the payout ratio, p, times expected earnings, E1. Sustainable growth, g, can be estimated as return on equity, ROE, times the earnings retention rate, (1 − p)" "Thus, implicit in the Fed model equilibrium are the assumptions that the required return, r, and the accounting rate of return on equity, ROE, for risky equity securities are equal to the Treasury bond yield, yT."

"Capital Market Expectations in Portfolio Management" Statistical tools: Equity Models c.demonstrate the application of formal tools for setting capital market expectations, including statistical tools, discounted cash flow models, the risk premium approach, and financial equilibrium models;

"Grinold and Kroner (2002) provided a restatement of the Gordon growth model that takes explicit account of repurchases" "The term ΔS is negative in the case of net positive share repurchases, so −ΔS is a positive repurchase yield in such cases." "Equation 6 consists of three components: an expected income return, an expected nominal earnings growth return, and an expected repricing return (from expected P/E ratio expansion or contraction). ■Expected income return: D/P − ΔS. ■Expected nominal earnings growth return: i + g. ■Expected repricing return: ΔPE. The expected nominal earnings growth return and the expected repricing return constitute the expected capital gains. The Grinold-Kroner model can be used not only in expectations setting, but also as a tool to analyze the sources of historical returns."

Asset Allocation Formula: Human Capital r. formulate and justify a strategic asset allocation, given an investment policy statement and capital market expectations;

"Human capital, the present value of expected future labor income, is not readily tradable. In addition to human capital, an individual has financial capital, which consists of more readily tradable assets such as stocks, bonds, and real estate." ■Strategic asset allocation for individual investors should consider both their financial capital and their human capital (the present value of their expected future labor income). ■Human capital as a share of total capital tends to decline as an individual approaches retirement. Consequently, if an investor's human capital is risk free or low risk and uncorrelated with his financial capital, his optimal allocation to stocks tends to decline as he approaches retirement, all else equal. ■To the extent the investor's human capital is positively correlated with stocks, the investor's allocation to stocks will be less than otherwise. Individual investors have a focus on after-tax returns. ■A young investor with relatively safe human capital assets and/or greater flexi- bility of labor supply has an appropriate strategic asset allocation with a higher weight on risky assets such as stocks than an older investor. The allocation to"

"Equity Market Valuation" Top-down analysis e. contrast top-down and bottom-up approaches to forecasting the earnings per share of an equity market index; using a relative equity valuation model."

"In top-down forecasting, analysts use macroeconomic forecasts to develop market forecasts and then make industry and security forecasts consistent with the market forecasts. In bottom-up forecasting, individual company forecasts are aggregated to industry forecasts, which in turn are aggregated to produce a market forecast."

"Capital Market Expectations in Portfolio Management" "l. identify and interpret macroeconomic, interest rate, and exchange rate linkages between economies;

"Macroeconomic Linkages" ■Countries' economies are directly affected by changes in the foreign demand for their exports. ■Cross-border direct business investment. "Interest Rate/Exchange Rate Linkages" ■short-term interest rates are affected by developments in other countries because one central bank pursues a formal or informal exchange rate link with another currency, called pegging The countries that follow this strategy find two benefits. ■First, domestic business has some reassurance that exchange rates are not going to fluctuate wildly. ■Second, by pegging the exchange rate, a "pegged" country often hopes to control inflation." ■If a country is following such an exchange rate policy, then the level of interest rates will depend on overall market confidence in the peg. A high degree of confidence in the exchange rate peg means the interest rate differential can converge to near zero." "The key factor linking bond yields (especially real bond yields) is world supply and demand for capital or the perceptions of supply and demand."

Asset Allocation t. formulate and justify tactical asset allocation (TAA) adjustments to strategic asset class weights, given a TAA strategy and expectational data."

"Tactical asset allocation (TAA)107 involves deliberately underweighting or overweight- ing asset classes relative to their target weights in the policy portfolio in an attempt to add value. TAA is active management at the asset-class level. TAA is based on the following principals: 1 Market prices tell explicitly what returns are available. Cash yields reveal the immediate nominal return accorded short-term investors. The yield to maturity of T-bills is the nominal reward for holding them to maturity. Thus, at least for this and similar pure discount instruments, investors have objective knowledge of prospective returns. 2 Relative expected returns reflect relative risk perceptions. When investors perceive more risk, they demand payment for assuming it. If relative expected returns reflect relative risk perceptions and those perceptions do not have a be fruitful 3 Markets are rational and mean reverting. If the TAA manager can identify departures from equilibrium in the relative pricing of asset classes, the manager may try to exploit them with knowledge that departures from equilibrium compress a proverbial spring that drives the system back towards balance." The tactical asset allocator should be aware that deviations from fair value based on historical analysis could persist if the economic environment has changed. Factors such as: ■changes in assets' underlying risk attributes; ■changes in central bank policy; ■changes in expected inflation; and ■position in the business cycle"

Asset Allocation Asset/Liability management p. discuss the strengths and limitations of the following approaches to asset allocation: mean-variance, resampled efficient frontier, Black-Litterman, Monte Carlo simulation, ALM, and experience based;

"That efficient frontier is more precisely the "asset-only" efficient frontier, because it fails to consider liabilities. Net worth (the difference between the market value of assets and liabilities), also called surplus, summarizes the interaction of assets and liabilities in a single variable. The ALM perspective focuses on the surplus efficient frontier. Mean-variance surplus optimization extends traditional MVO to incorporate the investor's liabilities" Exhibit 30 shows a surplus efficient frontier. The x-axis represents the standard deviation and the y-axis gives expected values. The leftmost point on the surplus efficient frontier is the minimum surplus variance (MSV) portfolio, the efficient portfolio with the least risk from an ALM perspective. The MSV portfolio might correspond to a cash flow matching strategy or an immunization strategy. The rightmost point on the surplus efficient frontier represents the highest-expected-surplus portfolio. Exhibit 30 plots the investor's liability as a point with positive standard deviation but negative expected value (because the investor owes the liability and so effectively has a short position)."

"Equity Market Valuation" Fed Model d. critique the use of discounted dividend models and macroeconomic forecasts to estimate the intrinsic value of an equity market;

"The Fed model is a theory of equity valuation that hypothesizes that the yield on long-term U.S. Treasury securities (usually defined as the 10-year T-note yield) should be equal to the S&P 500 earnings yield (usually defined as forward operating earnings divided by the index level) in equilibrium. Differences in these yields identify an overpriced or underpriced equity market. The model predicts: ■ U.S. stocks are undervalued if the forward earnings yield on the S&P 500 is greater than the yield on U.S. Treasury bonds. ■ U.S. stocks are overvalued if the forward earnings yield on the S&P 500 is less than the yield on U.S. Treasury bonds." "The key criticism of the Fed model is that it ignores the equity risk premium. (Informally, the equity risk premium is the compensation demanded by investors for the greater risk of investing in equities compared to investing in default-risk-free debt.)" "The earnings yield can also be a poor measure of the true value of equities if significant growth opportunities exist. Some authors have also argued that the Fed model comparison is flawed because the earnings yield is real while the Treasury yield is nominal."

"Capital Market Expectations in Portfolio Management" Statistical tools: Equity Models c.demonstrate the application of formal tools for setting capital market expectations, including statistical tools, discounted cash flow models, the risk premium approach, and financial equilibrium models;

"The Gordon growth model assumes that there is a long-term trend in dividends and corporate earnings, which is a reasonable approximation for many developed country economies.32 The expression for the Gordon growth model solved for E(Re), the expected rate of return on equity, is" "According to the Gordon growth model, share price should appreciate at a rate equal to the dividend growth rate. Therefore, in Equation 5, the expected rate of return is composed of two parts: the dividend yield (D1/P0) and the capital gains (or appreciation) yield (g)."

"Capital Market Expectations in Portfolio Management" h. demonstrate the use of the Taylor rule to predict central bank behavior;

"The Taylor Rule ■Assesses the central bank's stance predicts changes This rule links a central bank's target short-term interest rate to the rate of growth of the economy and inflation. ■"The Taylor rule gives the optimal short-term interest rate as the neutral rate plus an amount that is positively related to the excess of the forecasts of GDP and inflation growth rates above their trend or target values." ■if the forecast GDP growth rate and/or the forecast inflation rate are above the trend or target level, short-term interest rates need to be raised by half the difference between the forecast and the trend or target. Conversely, GDP growth and/or inflation rates below trend or target would motivate the Fed to lower the fed funds rate. The intuition in this last case is that when GDP forecast growth is below trend, lowering the interest rate will stimulate output by lowering corporations' cost of capital. When forecast inflation is below target, lowering the interest rate will help the inflation rate return to target through its stimulative effect on the money supply."

"Capital Market Expectations in Portfolio Management" Statistical tools: Equity risk Premium Model c.demonstrate the application of formal tools for setting capital market expectations, including statistical tools, discounted cash flow models, the risk premium approach, and financial equilibrium models;

"The equity risk premium is the compensation required by investors for the additional risk of equity compared with debt (debt has a prior claim on the cash flows of the company). "long-term" has usually been interpreted as 10 or 20 years. equity risk premium in practice is specifically defined as the expected excess return over and above a long-term government bond yield."

"Equity Market Valuation" Formula: H-Model d. critique the use of discounted dividend models and macroeconomic forecasts to estimate the intrinsic value of an equity market;

"The growth rate of corporate earnings and dividend cash flow, adjusted for inflation, should bear a close relationship with real GDP growth over the long term." "The H-model provides a convenient means for modeling initially high ("supernormal") dividend growth rates that gradually transition to a lower, long-run growth at a constant mature-stage growth rate. The H-model involves an approximation to the value estimate that would result from period-by-period discounting of cash flows in the phase prior to the mature or terminal phase when a constant growth rate is assumed. It incorporates a growth rate in dividends that is expected to prevail in the initial period gS, a period of years, N, where the dividend growth rate declines in a linear fashion, and a long-term dividend growth rate gL that is expected to prevail to perpetuity beginning at the end of period N. With an initial annualized dividend rate at time zero of D0 and a discount rate to perpetuity of r, the H-model estimate of value, V0"

"Equity Market Valuation" Formula: Tobin's Q Ratio g. judge whether an equity market is under-, fairly, or over-valued

"Tobin's q ratio" ■Tobin's q is calculated as the market value of a company (i.e., the market value of its debt and equity) divided by the replacement cost of its assets. According to economic theory, Tobin's q is approximately equal to 1 in equilibrium. ■If it is greater than 1 for a company, the marketplace values the company's assets at more than their replacement costs, so additional capital investment should be profitable for the company's suppliers of financing. ■a Tobin's q below 1 indicates that further capital investment is unprofitable" By contrast, Strong economic arguments exist that both Tobin's q and equity q should be mean-reverting series, assuming that Tobin's q will revert to the comparison value, a Tobin's q below, at, or above the comparison value is interpreted as the market being under-, fairly, or overvalued. The calculation of Tobin's q often poses difficulties. It is much more difficult to obtain an accurate estimate of replacement costs of the company's assets (the denominator of Tobin's q). Liquid markets for many assets (e.g., many kinds of industrial equipment) do not exist. Moreover, such items as human capital, trade secrets, copyrights and patents, and brand equity are intangible assets that are often difficult to value."

"Capital Market Expectations in Portfolio Management" Statistical tools: Multifactor model, covariance c.demonstrate the application of formal tools for setting capital market expectations, including statistical tools, discounted cash flow models, the risk premium approach, and financial equilibrium models;

"We compute the markets' variances and covariance using Equations 3a and 3b, respectively:" "This structure has been found useful for modeling asset returns and covariances among asset returns. Multifactor models are useful for estimating covariances for the following reasons: ■ By relating the returns on all assets to a common set of return drivers, a multi- factor model simplifies the task of estimating covariances: estimates of covari- ances between asset returns can be derived using the assets' factor sensitivities. ■ When the factors are well chosen, a multifactor model approach may filter out noise (i.e., random variation in the data specific to the sample period). ■ Such models make it relatively easy to verify the consistency of the covariance matrix, because if the smaller factor covariance matrix is consistent, so are any covariances computed on the basis of it."

"Capital Market Expectations in Portfolio Management" "a. discuss the role of,and a framework for, capital market expectations in the portfolio management process;

"capital market expectations (CME): the investor's macro expectations concerning the risk and return prospects of asset classes and are essintial inputs on deciding strategic asset allocation The process of capital market expectations setting involves the fol- lowing steps: 1 Specify the final set of expectations that are needed, including the time hori- zon to which they apply. 2 Research the historical record. 3 Specify the method(s) and/or model(s) that will be used and the information needs for developing expectations. 4 Determine the best sources for information needs. 5 Interpret the current investment environment using the selected data and methods, applying experience and judgment. 6 Formulate the set of expectations that are needed, documenting conclusions. 7 Monitor actual outcomes and compare to expectations, providing feedback to improve the expectations-setting process."

"Equity Market Valuation" Formula: Equity q Ratio g. judge whether an equity market is under-, fairly, or over-valued

"the ratio of a company's equity market capitalization divided by net worth measured at replacement cost. Their measure differs from the price-to-book value ratio because net worth is based on replacement cost rather than the historic or book value of equity. The principles of that application parallel those given for Tobin's q."

"Equity Market Valuation" Bottom-up analysis e. contrast top-down and bottom-up approaches to forecasting the earnings per share of an equity market index; using a relative equity valuation model."

"■ Bottom-up forecasts tend to be more optimistic than top-down forecasts. Top-down models can be slow in detecting cyclical turns if the current statis- tical relationships between economic variables deviate significantly from their historic norms."

"Capital Market Expectations in Portfolio Management" p. evaluate how economic and competitive factors affect investment markets, sectors, and specific securities;

"■ In managing cash and equivalents, central bank actions are closely watched. ■ For investors buying and selling nominal default-free bonds for the short term, developments in the business cycle and changes in short-term interest rates must be closely watched. News of stronger economic growth usually makes bond yields rise. For long-term investors, inflation expectations are of great importance. For holders of corporate bonds and other defaultable debt, the spread over Treasuries in relation to the business cycle is an important factor. ■ Investing in emerging market debt involves special considerations, such as country risk analysis. Emerging market governments borrow in a foreign cur- rency and so cannot simply inflate their way out of a problem in servicing the debt; this limitation increases the risk of default. ■ Inflation-indexed bonds are not exposed to the risk of unexpected inflation. Generally, yields on such instruments rise with real economic growth and the level of short-term interest rates. ■ Investors in common shares should analyze economic factors, first, in the way that they affect company earnings and, second, in the way that they affect interest rates, bond yields, and liquidity. The trend growth in the aggregate economy largely determines the trend growth in aggregate corporate earnings." " Among the systematic factors affecting real estate returns are growth in con- sumption, real interest rates, the term structure of interest rates, and unexpected inflation.

Asset Allocation b. compare strategic and tactical asset allocation;

"■ Tactical asset allocation involves making short-term adjustments to asset-class weights based on short-term predictions of relative performance among asset classes. "■ Strategic asset allocation is the allocation of funds among different asset classes so as to satisfy an investor's long-term objectives and constraints (Typically 5+ years).

"Capital Market Expectations in Portfolio Management" o. demonstrate the use of economic information in forecasting asset class returns;

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"Capital Market Expectations in Portfolio Management" r.recommend and justify changes in the component weights of a global investment portfolio based on trends and expected changes in macroeconomic factors."

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Asset Allocation j. evaluate the theoretical and practical effects of including additional asset classes in an asset allocation;

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"Capital Market Expectations in Portfolio Management" f.discuss the impact that the phases of the business cycle have on short-term/long-term capital market returns;

1 Initial Recovery Government bond yields may continue to come down through this phase in anticipation of a further decline in inflation but are likely to be bottoming. Stock markets may rise strongly at this point because fears of a longer recession (or even a depression) dissipate. Cyclical assets—and riskier assets, such as small stocks, higher-yield corporate bonds, and emerging market equities and bonds—attract investors and perform well. 2 Early Upswing Capital market effects: A key question is how long it will take before infla-tion starts to become a problem. Short rates are moving up at this time as the central bank starts to withdraw the stimulus put in place during the recession. Longer bond yields are likely to be stable or rising slightly. Stocks are still trend- ing up. This phase usually lasts at least a year and often several years if growth is not too strong and the output gap closes slowly. 3 Late Upswing Capital market effects: Typically, interest rates are rising as the monetary authorities become restrictive. Any heavy borrowing puts pressure on the credit markets. Central banks may aim for a "soft landing," meaning a period of slower growth to cool the economy but not a major downturn. Bond markets anxiously watch this behavior, and bond yields will usually be rising as a result of changed expectations. Stock markets will often rise but may be nervous too, depending on the strength of the boom. Nervous investors mean that equities are volatile. 4 Slowdown Capital market effects: Short-term interest rates are high and rising at first but then may peak. Bonds top out at the first sign of a slowing economy and then rally sharply (yields fall). The yield curve often inverts. The stock market may fall, with interest-sensitive stocks such as utilities and financial services per- forming best. 5 Recession Capital market effects: Short-term interest rates drop during this phase, as do bond yields. The stock market usually starts to rise in the later stages of the recession, well before the recovery emerges."

Asset Allocation Defined benefit plan considerations s. compare the considerations that affect asset allocation for individual investors versus institutional investors and critique a proposed asset allocation in light of those considerations;

1 Regulatory constraints. Regulations rely on the prudent person concept rather than limitations on asset-class holdings in their oversight of pension investing and may place percentage limits for the aggregate holdings of certain illiquid or alternative investments 2 Liquidity constraints. A fund may have sufficiently high liquidity requirements that it must limit its percentage of illiquid assets (e.g., private debt, private equity, or real estate). "From an ALM perspective, the following are desirable characteristics for an asset allocation: ■ The risk of funding shortfalls is acceptable. ■ The anticipated volatility of the pension surplus is acceptable. Low pension surplus volatility is generally associated with asset allocations whose duration approximately matches the duration of pension liabilities, because pension lia- bilities behave similarly to bonds as concerns interest rate sensitivity. ■ The anticipated volatility of the contributions is acceptable. From an asset- only perspective, a reasonable starting point is the efficient asset allocation with the lowest standard deviation of return that meets the specified return objective of the pension fund In either an ALM or AO approach, if pension liabilities are fixed in nominal terms, inflation is not a concern. Otherwise, the advisor needs to consider how much inflation protection the asset allocation is expected to afford

Asset Allocation i. select and justify an appropriate set of asset classes for an investor;

A mean-variance investor will evaluate an asset allocation (mix) m using Equation 1: In Equation 1, E(Rm) and σm are expressed as percentages rather than as decimals.16 We can interpret the investor's expected utility for asset mix m, Um, as the asset mix's risk-adjusted expected return for the particular investor. The quantity 0.005R ␣2 Am is a risk penalty that is subtracted from the allocation's expected return to adjust it for risk. The risk penalty's size depends on the investor's risk aversion, RA, and on the standard deviation of the asset mix, σm. The more risk averse the investor, the greater the penalty subtracted from expected return." To apply a quantitative approach to asset allocation, however, we must quantify an investor's attitude to risk. The most precise way to do so is to measure the investor's numerical risk aversion, RA. Numerical risk aversion can be measured in an interview or questionnaire in which the investor expresses preferences among sets of choices involving risky and certain returns. Risk aversion is the inverse of risk tolerance: A lower value of risk aversion means a higher tolerance for risk."

Asset Allocation o. explain the major steps involved in establishing an appropriate asset allocation;

After the preliminaries of specifying and listing IPS-permissible asset classes, asset allocation involves a series of steps on the capital markets side and the investor side. On the capital markets side, the steps are to 1) observe capital market conditions; 2) formulate a prediction procedure; and 3) obtain expected returns, risks, and correlations from the prediction procedure based on capital market conditions. On the investor side, the steps are to 1) observe the investor's assets, liabilities, net worth, and risk attitudes; 2) formulate the investor's risk tolerance function; and 3) obtain the investor's risk tolerance. The optimization approach (optimizer) is specified and the investor's asset mix is determined using the optimizer, using the investor's capital market expecta- tions and risk tolerance as inputs. Finally returns are observed, which provides feedback for the next asset allocation review."

Asset Allocation Experience based approach p. discuss the strengths and limitations of the following approaches to asset allocation: mean-variance, resampled efficient frontier, Black-Litterman, Monte Carlo simulation, ALM, and experience based;

Although these approaches appear to be ad hoc, their thrust often is consistent with financial theory when examined carefully. Furthermore, they may inexpensively suggest asset allocations that have worked well for clients in the broad experience of many investment advisors 1 A 60/40 stock/bond asset allocation is appropriate or at least a starting point for an average investor's asset allocation. 2 The allocation to bonds should increase with increasing risk aversion. 3 Investors with longer time horizons should increase their allocation to stocks. 4 A rule of thumb for the percentage allocation to equities is 100 minus the age of the investor.

Asset Allocation n. explain expected effects on share prices, expected returns, and return volatility as a segmented market becomes integrated with global markets;

As a market becomes integrated: ■ Equity prices: stock prices usually increase as investors buy equities that were previously unavailable. Equity prices also increase because the covariance with world markets will be lower than the stand-alone variance of the emerging equity, increasing its value in a portfolio. ■ Expected return: As prices rise in a newly integrated market, the expected return for the market should decline as asset pricing will now depend on the covariance. ■ Return volatility: With integration, return variability may decline over the long run as the economy matures. There should be less deviation from fundamental value as information flow increases and less political risk as the government pursues market-oriented reforms. ■ Diversification benefits: Despite the lower volatility that results, greater integration could reduce diversification benefits because emerging markets may become more correlated with the rest of the world. ■ Market microstructure and market efficiency: Improved. A favorable market microstructure is one where transactions costs are low, the depth of trading volume is high, and transactions are executed quickly. A better market microstructure improves informational efficiency reflected in prices. ■ Cost of capital and economic growth: With increased equity prices, decreased risk, and increased liquidity, the cost of capital for emerging companies should decline. As more, cheaper capital is invested, economic growth should increase.

"Capital Market Expectations in Portfolio Management" m. discuss the risks faced by investors in emerging-market securities and the country risk analysis techniques used to evaluate emerging market economies;

Emerging market risks include: ■They have inadequate domestic savings and therefore rely heavily on foreign capital. Managing the foreign debt often creates periodic crises and losses to investors. ■more volatile political and social environment ■The potential for growth is often blocked by governments protecting vested interests, requiring structural reform ■Economies concentrated in a few areas such as particular commodities or in a narrow range of manufactured goods. Others rely heavily on oil imports and are thus vulnerable to fluctuation in oil prices or are dependent on continuing capital inflows. Analysis technique: 1 How sound is fiscal and monetary policy? 2 What are the economic growth prospects for the economy? 3 Is the currency competitive, and are the external accounts under control? 4 Is external debt under control? 5 Is liquidity plentiful? 6 Is the political situation supportive of the required policies?

"Equity Market Valuation" Formula: Yardeni model g. judge whether an equity market is under-, fairly, or over-valued

Equation 9 presents the Yardeni model stated as the justified (forward) earnings yield on equities." ■The Yardeni model addresses some of the criticisms of the Fed model. As inputs, Yardeni used the Moody's A-rated corporate bond yield, yB, the consen- sus five-year earnings growth forecast for the S&P 500 from Thomson Financial, LTEG, and the coefficient d, which represents a weighting factor measuring the importance the market assigns to the earnings projections. Yardeni found that the historical values for d averaged about 0.10. ■A justified forward earnings yield that is below, equal to, or greater than the forward earnings yield value implied by current equity market index values (using consensus forward earnings estimates, for example) would indicate that equities are undervalued, fairly valued, or overvalued in the marketplace. ■A valuation judgment can also be made by using Equation 9 solved for P0, which gives the Yardeni model expression for the fair value of the equity market: E1/(yB − d × LTEG). The judgment would be that the equity market is undervalued, fairly valued, or overvalued if the fair value estimate is above, equal to, or below the current equity market level""E1 is an estimate of next year's earnings, r is the required return, and g is the earnings growth rate. Equation 8 shows that, given the assumptions of the model, the earnings yield, E1/P0, is equal to the required return, r, minus the growth rate, g" ■Limitations of the Yardeni model include that the risk premium captured by the model is largely a default risk premium and not the future equity risk premium, which is unobservable. Also, the consensus five-year earnings growth forecast for the S&P 500 from Thomson Financial may not be sustainable, and evidence suggests that the weighting factor varies significantly over time."

Asset Allocation Asset allocation considering human capital Mortality risk Longevity risk r. formulate and justify a strategic asset allocation, given an investment policy statement and capital market expectations;

Example of asset allocation weights considering human capital "Mortality risk is the risk of loss of human capital if an investor dies prematurely." "Longevity risk is the risk that the investor will outlive his or her assets in retirement."

"Equity Market Valuation" c. demonstrate the use of the Cobb-Douglas production function in obtaining a discounted dividend model estimate of the intrinsic value of an equity market;

Exercise... This approach can be useful to financial analysts because it gives insights into the long- term potential economic growth in individual countries, in larger regions, and for the world as a whole. The Cobb-Douglas estimate of the growth of total production can help to estimate corporate profit growth and develop corporate cash flow projections for stock market composites. Use to forecast long-term expected growth, then apply to H-Model to estimate intrinsic value of equity

"Capital Market Expectations in Portfolio Management" k. explain how exogenous shocks may affect economic growth trends;"

Exogenous shocks are events from outside the economic system that affect its course. These could be short-lived political events, changes in government policy, or natural disasters, for example. ■Over time, trends in an economy are likely to stay relatively constant. As such, they should already be discounted in market expectations and prices. ■Exogenous shocks may have short-lived effects or drive changes in trends. They are typically not built into prices or at most are only partially anticipated. Shocks cannot be forecast in general. But there are two types of economic shock that periodically affect the world economy and often involve a degree of contagion, as problems in one country spread to another. ■Oil shocks are important because a sharp rise in the price of oil reduces consumer purchasing power and also threatens higher inflation. ■Financial shocks threaten bank lending and therefore economic growth.

"Capital Market Expectations in Portfolio Management" Statistical tools: Financial equilibrium models Traditional ICAPM formula c.demonstrate the application of formal tools for setting capital market expectations, including statistical tools, discounted cash flow models, the risk premium approach, and financial equilibrium models;

Financial equilibrium models describe relationships between expected return and risk in which supply and demand are in balance. In that sense, equilibrium prices or equilibrium returns are fair if the equilibrium model is correct "Assuming that the risk premium on any currency equals zero—as it would be if purchasing power parity relationships hold—the ICAPM gives the expected return on any asset as the sum of: ■the (domestic) risk-free rate, and ■a risk premium based on the asset's sensitivity to the world market portfolio and expected return on the world market portfolio in excess of the risk-free rate." The Traditional ICAPM assumes: ■Perfect markets (markets without any frictional costs, where all assets trade in liquid markets)" ■Completely integrated markets: there are no impediments or barriers to capital mobility across markets. (ie. legal barriers, investor preferences, or market segmentation) ■Liquid markets

"Capital Market Expectations in Portfolio Management" Business Cycle e.discuss the inventory and business cycles, the impact of consumer and business spending, and monetary and fiscal policy on the business cycle;

In addition to the inventory cycle, often lasting 9-11 years, the business cycle represents fluctuations in GDP in relation to long-term trend growth. Consumer spending is typically the most important factor affecting GDP (it often accounts for 60-70 percent of GDP). Retail sales and consumer consump- tion are closely watched for indications of consumer spending. 1 Initial Recovery: ■upswing in the inventory cycle, which is sometimes the main cause of the recovery. The output gap is still large. 2 Early Upswing: ■Output gap closesbusinesses build inventories and step up investment in the face of strong sales and increased capacity use. ■output gap closes slowly, reducing the problem of inflation 3 Late Upswing ■At this stage of the cycle, the output gap has closed and the economy is in danger of overheating. Confidence is high; unemployment is low. 4 Slowdown ■The slowdown is exacerbated by the inventory correction as companies try to reduce their inventory levels. 5 Recession A recession ■There is often a large inventory pullback and sometimes a large decline in business investment.

"Capital Market Expectations in Portfolio Management" b. discuss challenges in developing capital market forecasts;

Limitations of economic data: ■The analyst needs to understand the definition, construction, timeliness, and accuracy of any data used, including any biases. ■The time lag with which economic data are collected, processed, and disseminated can be an impediment to their use. ■Official revisions from the source, to the initial values ■Definitions and calculation methods change. Among the challenges in setting capital market expectations are: ■the limitations of economic data (including lack of timeliness as well as changing definitions and calculations); ■data measurement errors and biases (including transcription errors, survivorship bias, and appraisal [smoothed] data); ■the limitations of his- torical estimates (including nonstationarity) ■ex post risk as a biased risk mea- sure (historical prices may reflect expectations of a low-probability catastrophe that did not occur); ■biases in analysts' methods (including data-mining bias and time-period bias); ■the failure to account for conditioning information; ■the mis- interpretation of correlations; and ■psychological traps (including the anchoring trap, the status quo trap, the confirming evidence trap, the overconfidence trap, the prudence trap, and the recallability trap); ■and model uncertainty."

Asset Allocation g. evaluate return and risk objectives in relation to strategic asset allocation;

Qualitative return objectives describe the investor's fundamental goals, such as to achieve returns that will: ■provide an adequate retirement income (for an individual currently in the workforce); ■maintain a fund's real purchasing power after distributions (for many endow- ments and foundations); ■adequately fund liabilities (for investors such as pension plans and insurance companies); or ■exceed the rate of inflation in the long term (from the prospectus of an inflation-protected bond fund)." ■ The specification of a numerical return objective should account for the costs of earning investment returns and inflation as well as their compound effects through time. A multiplicative return objective takes compounding into account and is the most precise; an additive objective does not and thus will underestimate the return needed, despite providing a quick approximation.

Asset Allocation l. describe risk, cost, and opportunities associated with nondomestic equities and bonds;"

Risks of International Assets ■ Currency risk: exchange rate fluctuations affect both the magnitude and volatility of return. Appreciating foreign currencies will increase the investor's return in home currency terms, whereas depreciating currencies will detract from that return. Low correlations between foreign equity prices and FX, as well as diversification benefit of holding multiple currencies reduce currency risk of foreign investment ■ Political risk: results when a country does not have responsible fiscal and monetary policies necessary for economic growth and/or when the country does not possess the appropriate legal and regulatory structure necessary for the growth of financial markets. Costs of International Assets ■ Lower liquidity: Higher trading costs and market impact costs ■ Withholding taxes on income by foreign governments ■ low free-float. Free-float refers to the proportion of stock that is publicly traded, which will be low when the government, other companies, founding families, and/or management have large equity holdings. ■ Other investment costs can be higher abroad if the financial market infrastructure is not well-developed. Registration, settlement, clearing, custodial costs and higher management fees Opportunities in International Assets ■ First, foreign markets may offer better valuations than domestic markets. ■ Second, although global markets tend to crash together in the short term, over the long term a global equity portfolio provides better protection against adverse events than a local portfolio, especially when equally weighted. ■ Third, world bond markets' correlations are usually low, often lower than that between equity markets. Diversifying with nondomestic bonds offers opportunities for a better risk-return tradeoff, especially for lower risk portfolios. ■ Fourth, although particular markets may have outperformed in the past and certain economies may be poised for future growth, the past often does not forecast the future and the valuations of strong economies will reflect their prospects. No one market is always going to be the best investment and it is very difficult to predict which markets will outperform."

"Capital Market Expectations in Portfolio Management" Statistical tools: Financial equilibrium models Singer-Terhaar approach to ICAPM formula c.demonstrate the application of formal tools for setting capital market expectations, including statistical tools, discounted cash flow models, the risk premium approach, and financial equilibrium models;

Singer-Terhaar approach accounts for imperfections in global market, including illiquidity of cash flows, market segmentation / market integration To arrive at an expected return estimate using the Singer-Terhaar approach: ■Estimate the perfectly integrated and the completely segmented risk premiums for the asset class using the ICAPM. For simplicity, weare assuming that the Sharpe ratios of the Global Investment Market (GIM) and the local market portfolio (used in Equation 11) are the same. ■Add the applicable illiquidity premium, if any, to the estimates from the prior step. ■Estimate the degree to which the asset market is perfectly integrated (from 1-0). ■Take a weighted average of the perfectly integrated and the completely segmented risk premiums using the estimate of market integration from the prior step (equation 10 is perfectly integrated, equation 11 is perfectly segmented)

Asset Allocation c. discuss the importance of asset allocation for portfolio performance;

Time-series empirical study: Brinson, Hood, and Beebower (1986) interpreted the importance of asset allocation as the fraction of the variation in returns over time attributable to asset allocation, based on regression analysis. This approach takes the perspective of a single portfolio over time and concluded that asset allocation explained an average 93.6 percent of the variation of returns over time. The range was 75.5 percent to 98.6 percent Cross-sectional variation study: cross- sectional variation of returns—that is, the proportion of the variation among funds' performance explained by funds' different asset allocations. Ibbotson and Kaplan (2000) found that asset allocation explained about 40 percent of the cross-sectional variation in mutual fund returns. The remaining 60 percent was explained by factors such as asset-class timing, style within asset classes, security selection, and fees. Note:The degree of diversity among asset allocations must affect the cross-sectional importance of asset allocation that we will find after the fact. The cross-sectional percentage of variation explained, 40 percent, was much lower than the median time-series result, 87.6 percent, for the mutual funds. Forty percent, however, is sufficiently large to suggest that those investors in practice significantly differentiate themselves from peers through asset allocation. In other results, Ibbotson et al. concluded as did earlier researchers that after expenses, the sample pension funds and balanced funds were not adding value through timing and security selection."

Asset Allocation e. explain the advantage of dynamic over static asset allocation and discuss the trade-offs of complexity and cost;

■ Both are types of asset liability matching strategies. ■ A dynamic approach recognizes that an investor's asset allocation and actual asset returns and liabilities in a given period affect the optimal decision that will be available next period. The asset allocation is further linked to the optimal investment decisions available at all future time periods. ■ In contrast, a static approach does not consider links between optimal decisions at different time periods, somewhat analogous to a driver who tries to make the best decision as she arrives at each new street without looking further ahead."

Asset Allocation p. discuss the strengths and limitations of the following approaches to asset allocation: mean-variance, resampled efficient frontier, Black-Litterman, Monte Carlo simulation, ALM, and experience based;

■ In a mean-variance approach to asset allocation, a non-negativity constraint on asset-class weights is specified. A small number of portfolios called corner portfolios completely describe the resulting efficient frontier. We can find the weights of any portfolio on the minimum-variance frontier (and efficient fron- tier) using the two corner portfolios that bracket it in terms of expected return. This result allows us to easily identify the composition of any efficient portfolio." ■ Simulation and mean-variance analysis are used to develop the resampled efficient frontier. Because the procedure takes account of estimation error, the resampled efficient portfolios on the frontier may be more diversified and stable over time than conventional mean-variance efficient portfolios. The resampled efficient frontier is used as if it were a conventional efficient frontier to select the portfolio that best satisfies the investor's needs." "■ The Black-Litterman approach with a constraint against short sales reverse- engineers the expected returns implicit in a diversified market portfolio; it com- bines those expected returns with the investor's own views (if any) in a system- atic way that takes into account the investor's confidence in his or her views." ■Monte Carlo simulation is used to evaluate a proposed asset allocation's mul- tiperiod performance. Important real-life complications such as cash inflows and outflows, taxes, and transaction costs can be modeled in a Monte Carlo simulation." ■The ALM approach to strategic asset allocation focuses on optimizing with respect to net worth or surplus (the value of assets minus the present value of liabilities). In its mean-variance implementation, ALM involves selecting a portfolio from the surplus efficient frontier; Monte Carlo simulation is helpful in evaluating the range of outcomes of a surplus efficient portfolio in funding liabilities over the investor's time horizon. ■Experience-based approaches include the ideas that a 60/40 stock/bond alloca- tion is appropriate for the average investor; that the allocation to bonds should increase with the investor's risk aversion; that the allocation to stocks should increase with the investor's time horizon; and that younger investors should allocate more to stocks than older investors.

Asset Allocation a. explain the function of strategic asset allocation in portfolio management and discuss its role in relation to specifying and controlling the investor's exposures to systematic risk;

■ In strategic asset allocation, an investor's return objectives, risk toler-ance, and investment constraints are integrated with longrun capital market expec-tations to establish exposures to IPS-permissible asset classes. ■ The strategic asset allocation specifies the investor's desired exposures to systematic risk. ■ Asset allocation appears to explain a large fraction in the variation of returns over time for a given portfolio. The proportion of the cross-sectional variation of portfolios' returns explained by portfolios' different asset allocations appears to be smaller but still very substantial.

Asset Allocation f. explain how loss aversion, mental accounting, and fear of regret may influence asset allocation policy;

■ Loss aversion: individuals are risk-seekers when faced with the prospect of a substantial loss. ■ if a client is loss averse, one approach may be to incorporate an appropriate shortfall risk constraint or objective in the asset allocation decision. Managing assets with such a constraint or objective should reduce the chance that the client finds himself facing the prospect of a substantial loss. An ALM approach may be appropriate for such clients as well. ■Mental Accounting: investors will place total wealth into separate accounts and buckets. Each bucket is associated with a different level of risk tolerance depending on a purpose the investor associates with it ■The standard finance approach to asset allocation involves determining an optimal asset allocation for the total portfolio, typically reflecting an overall, blended measure of a client's risk tolerance. ■adopting a multi-strategy or goal-based asset allocation procedure" ■developing a set of asset allocations for stand-alone portfolios ignores the correlations between assets across portfolios; the resulting overall asset allocation may fail to use risk efficiently.

Asset Allocation Downside risk & Shortfall risk Roy's Safety-first formula g. evaluate return and risk objectives in relation to strategic asset allocation;

■ Quantifying shortfall risk, the risk that a portfolio's value will fall below some minimum acceptable level during a stated time horizon. ■Roy's safety-first criterion: the optimal portfolio minimizes the probability over a stated time horizon that portfolio return, RP, will fall below some threshold level RL that the investor insists on meeting or exceeding Equation 2 gives the distance from the expected return to the shortfall level in the numerator. The denominator converts the result into units of the portfolio's standard deviation of return. There are two steps in choosing among risky portfolios using Roy's criterion (assuming normality): 1 Calculate each portfolio's SFRatio. 2 Choose the portfolio with the highest SFRatio. If there is an asset offering a risk-free return for the time horizon being considered, and if RL is less than or equal to that risk-free rate, then it is safety-first optimal to be fully invested in the risk-free asset.

"Capital Market Expectations in Portfolio Management" Statistical tools: Risk premium approach / build up model c.demonstrate the application of formal tools for setting capital market expectations, including statistical tools, discounted cash flow models, the risk premium approach, and financial equilibrium models;

■ Risk premium approach (also known as build-up approach) expresses the expected return on a risky asset as the sum of the risk-free rate of interest and one or more risk premiums that compensate investors for the risky asset's exposure to sources of priced risk (risk for which investors demand compensation). ■ The real risk-free interest rate is the single-period interest rate for a completely risk-free security if no inflation were expected. In economic theory, the real risk-free rate reflects the time preferences of individuals for current versus future real consumption. ■ The inflation premium compensates investors for expected inflation and reflects the average inflation rate expected over the maturity of the debt plus a premium (or discount) for the probability attached to higher inflation than expected (or greater disinflation). The sum of the real risk-free interest rate and the inflation premium is the nominal risk-free interest rate, often represented by a governmental Treasury bill YTM. ■ The default risk premium compensates investors for the possibility that the borrower will fail to make a promised payment at the contracted time and in the contracted amount. ■ The illiquidity premium compensates investors for the risk of loss relative to an investment's fair value if the investment needs to be converted to cash quickly. ■ The maturity premium compensates investors for the increased sensitivity, in general, of the market value of debt to a change in market interest rates as maturity is extended, holding all else equal. The difference between the interest rate on longer-maturity, liquid Treasury debt and that on short-term Treasury debt reflects a positive maturity premium for the longer-term debt (and possibly different inflation premiums as well). ■ A tax premium may also be applicable to certain classes of bonds in some tax jurisdictions"

Asset Allocation h. evaluate whether an asset class or set of asset classes has been appropriately specified;

■ The asset classes chosen for strategic asset allocation should satisfy the following five criteria: ■ Assets within an asset class should be relatively homogeneous. Assets within an asset class should have similar attributes. ■ Asset classes should be mutually exclusive. Overlapping asset classes will reduce the effectiveness of strategic asset allocation in controlling risk and also introduce problems in developing asset-class return expectations. For example, if one asset class for a U.S. investor is domestic common equities, then world equities ex-U.S. is more appropriate as an asset class than world equities includ- ing U.S. 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 the other asset classes. Otherwise the included asset class will be effectively redundant in a portfolio because it will duplicate risk exposures already present. 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. From the perspective of portfolio theory, 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. Furthermore, including more markets expands the opportunities for applying active investment strategies, assuming the decision to invest actively has been made. ■ The asset class should have the capacity to absorb a significant fraction of the investor's portfolio without seriously affecting the portfolio's liquidity or creating market impact

"Equity Market Valuation" b. evaluate the relative importance of growth in total factor productivity, in capital stock, and in labor input given relevant historical data;

■ The existence of TFP growth, ΔA/A, means that total output can grow at a faster rate than would be predicted simply from growth in accumulated capital stock and the labor force. TFP is typically linked to innovation and technical progress. However, changes in work organization, government regulation, and the literacy and skills of the workforce, as well as many other factors, also affect TFP.

Asset Allocation "m. explain the importance of conditional return correlations in evaluating the diversification benefits of nondomestic investments;

■ global correlations tend to increase in times of increased volatility. Correlations appear to depend on, i.e., are conditional on, global volatility." ■ the estimated correlation between any two markets will be biased upward during periods of rising volatility. ■ Traditional mean‒variance portfolio formation assumes that the correlation statistic is constant through time, when in fact it generally is not. An alternative to the usual mean‒variance analysis with unconditional correlations would be to use conditional correlations in the analysis, for example, optimizing based on expected correlations during normal market periods and stressful market periods

Asset Allocation k. demonstrate the application of mean-variance analysis to decide whether to include an additional asset class in an existing portfolio;

■ the Sharpe ratio of the asset class, ■ the Sharpe ratio of the existing portfolio, and ■ the correlation between the asset class's return and portfolio p's return, Corr(Rnew,Rp). Adding the asset class (denoted new) to the portfolio is optimal if the following condition is met: ■ For the investor to gain by adding the asset class, that asset class's Sharpe ratio must exceed the product of the existing portfolio's Sharpe ratio and the correlation of the asset class's return with the current portfolio's return. ■ an asset class should be added if its risk premium per unit of risk is greater than the risk premium per unit of risk for the existing portfolio, adjusted for the new asset's correlation with the existing portfolio. ■ Note that a comparison based on the new asset's Sharpe ratio and the existing portfolio's Sharpe ratio without correlation adjustment is incorrect." ■ A correlation less than 1 implies risk reduction benefits, which must be taken into account. All else equal, a lower correlation makes it more likely that the new asset class should be added to the existing portfolio. It is also true that lower standalone risk (σnew), holding all else constant, increases the chance that the new asset class should be included in the portfolio.

"Capital Market Expectations in Portfolio Management" i.evaluate 1) the shape of the yield curve as an economic predictor 2) the relationship between the yield curve and fiscal and monetary policy;

■"Money Supply Trends: If money growth is particularly strong in relation to nominal GDP, chances are that growth will accelerate in the near future and that inflation may eventually accelerate." ■"Fiscal policy: means manipulating the budget deficit to influence the economy. Governments increase spending or cut taxes to stimulate the economy and cut spending or raise taxes to slow the economy. ■First, an analyst should focus on the changes in the government budgetary deficit, not its level. ■Second, it is only changes in the deficit due to deliberate changes in government fiscal policy that matter. During recessions, the deficit tends to rise because tax revenues fall and government spending on unemployment benefits increases. In contrast, when the economy grows strongly, the budget deficit naturally falls." Yield curve implications: ■If fiscal and monetary policies are both tight, then the situation is unambiguous and the economy is certain to slow. ■if both monetary policy and fiscal policy are expansionary, then the economy can be expected to grow. However, monetary and fiscal policies are sometimes at odds with one another. These situations create opportunities for investors as well as risks.

Asset Allocation Black-Litterman Model and correction for estimation error p. discuss the strengths and limitations of the following approaches to asset allocation: mean-variance, resampled efficient frontier, Black-Litterman, Monte Carlo simulation, ALM, and experience based;

■A practical goal of the BL model is to create stable, mean-variance-efficient portolios which overcome the problem of expected return sensitivity and estimation error ■The equilibrium returns are the set of returns that makes the efficient frontier pass through the market weight portfolio. They are long-run returns provided by the capital markets that represent the information that is built into capital market prices and thus reflects the "average" investor's expectations. ■A major advantage of this approach is that its starting point is a diversified portfolio with market capitalization portfolio weights, which is optimal for an uninformed investor using the mean-variance approach." ■In the BL model, the investor assumes the market-capitalization weights are optimal

Asset Allocation Banks considerations s. compare the considerations that affect asset allocation for individual investors versus institutional investors and critique a proposed asset allocation in light of those considerations;

■Banks are financial intermediaries with a traditional focus on taking deposits and lending money. As such, they are taxable investors with predominantly short- and intermediate-term liabilities. ■a bank's securities portfolio is subject to a distinct set of regulations and is traditionally treated separately. ■A bank's securities portfolio plays an important role in 1) managing the balance sheet's overall interest rate risk, 2) managing liquidity (assuring adequate cash is available to meet liabilities), 3) producing income, and 4) managing credit risk. The first concern is the most important and dictates an ALM approach to asset allocation. Banks' portfolios of loans and leases are generally not very liquid and may carry substantial credit risk. Therefore, a bank's securities portfolio plays a balancing role in providing a ready source of liquidity and in offsetting loan-portfolio credit risk."

Asset Allocation Re-sampled efficient frontier and correction for estimation error p. discuss the strengths and limitations of the following approaches to asset allocation: mean-variance, resampled efficient frontier, Black-Litterman, Monte Carlo simulation, ALM, and experience based;

■Because forecasting returns, volatilities, and correlations is so difficult and subject to substantial estimation error, we have little confidence in the results of a single MVO. ■Using the sample values of asset classes' means, variances, and covariances as the assumed true population parameters, the simulation generates sets of simulated returns and, for each such set (simulation trial), MVO produces the portfolio weights of a specified number of mean-variance efficient portfolios (which may be called simulated efficient portfolios). Information in the simulated efficient portfolios resulting from the simulation trials is integrated into one frontier called the resampled efficient frontier. ■Numbering simulated efficient portfolios by return rank from lowest to highest, one approach to this problem of integration is to associate simulated efficient portfolios of equivalent return rank. Michaud defines a resampled efficient portfolio for a given return rank as the portfolio defined by the average weights on each asset class for simulated efficient portfolios with that return rank. Averaging weights in this fashion preserves the property that portfolio weights sum to 1. The set of resampled efficient portfolios represents the resampled efficient frontier. ■The portfolios resulting from the resampled efficient frontier approach tend to be more diversified and more stable through time than those on a conventional mean- variance efficient frontier developed from a single optimization. ■The resampled efficient frontier approach has been questioned on grounds such as the lack of a theoretical underpinning for the method and the relevance of historical return frequency data to current asset market values and equilibrium.

Asset Allocation s. compare the considerations that affect asset allocation for individual investors versus institutional investors and critique a proposed asset allocation in light of those considerations;

■Defined-benefit pension plans, life insurance companies, non-life insurance companies, and banks face high penalties for not meeting liabilities. ■Insurance companies and banks take an ALM approach to investing; ■DB pension plans frequently do also, or at least take ALM considerations into account. ■foundations and endowments tend to take an asset-only approach to investing. ■Of the investors listed, life and non-life insurance companies and banks are taxable and have a focus on after-tax returns."

"Capital Market Expectations in Portfolio Management" Measurements of economic activity variation ■Real GDP ■Output Gap ■Recession e.discuss the inventory and business cycles, the impact of consumer and business spending, and monetary and fiscal policy on the business cycle;

■In business cycle analysis, two cycles are generally recognized: a short-term inventory cycle, typically lasting 2-4 years, and a longer-term business cycle, usually lasting 9-11 years. ■They can be disrupted by major shocks, including wars and shifts in government policy. ■Both the duration and amplitude of each phase of the cycle, as well as the duration of the cycle as a whole, vary considerably and are hard to predict." "■ Real Gross domestic product (GDP): Real GDP is a calculation of the total value of final goods and services produced in the economy during a year. The main expenditure components are Consumption, Investment, Change in Inventories, Government Spending, and Exports less Imports. The total value of goods and services can change because the quantities of goods and services change and/ or because their prices change. To focus on increases in the quantity (output) of goods and services produced—which are directly associated with increases in the standard of living—rather than on price-driven increases in the value of output, economists focus on real GDP (reflecting an adjustment for changes in prices during the period). ■ Output gap: The output gap is the difference between the value of GDP estimated as if the economy were on its trend growth path (sometimes referred to as potential output) and the actual value of GDP. A positive output gap opens in times of recession or slow growth. When a positive output gap is open, inflation tends to decline. Once the gap closes, inflation tends to rise. When GDP is above its trend value, the economy is under inflationary pressure. However, because changing demographics and technology affect the economy's trend path, real-time estimates of the output gap can sometimes be quite inaccurate. ■ Recession: In general terms, a recession is a broad-based economic downturn. More formally, a recession occurs when there are two successive quarterly declines in GDP."

"Capital Market Expectations in Portfolio Management" g. explain the relationship of inflation to the business cycle and the implications of inflation for cash, bonds, equity, and real estate returns;

■Inflation is linked to the business cycle, tending to rise in the late stages of a business cycle and to decline during recessions and the early stages of recovery. However, the analyst also needs to note any long-term trends in inflation in formulating capital market expectations."

Asset Allocation Insurance company considerations s. compare the considerations that affect asset allocation for individual investors versus institutional investors and critique a proposed asset allocation in light of those considerations;

■Insurers are taxable enterprises, in contrast to defined-benefit pension plans, endowments, and most foundations. Therefore, insurers focus on after-tax return and risk. ■Like defined-benefit plans, however, insurers face contractual liabilities to insureds. ■An ALM approach to strategic asset allocation is generally chosen. ALM considerations include yield, duration, convexity, key rate sensitivity, value at risk, and the effects of asset risk on capital requirements given the spread of risk-based capital regulation. ■Public policy frequently views insurance portfolios as quasi trust funds, further stressing the importance of managing risk. ■Portfolio segmentation is a distinctive feature of life insurers' investment activities: In this approach, the insurer groups liabilities according to the product line of business or segment. Portfolio segmentation offers the following advantages: ■provides a focus for meeting return objectives by product line; ■provides a simple way to allocate investment income by line of business; ■provides more-accurate measurement of profitability by line of business. ■aids in managing interest rate risk and/or duration mismatch by product line; ■assists regulators and senior management in assessing the suitability of investments. ■Fixed-income investments constitute the majority holding of most life and non-life insurers.

Asset Allocation Monte Carlo Simulation and correction for estimation error p. discuss the strengths and limitations of the following approaches to asset allocation: mean-variance, resampled efficient frontier, Black-Litterman, Monte Carlo simulation, ALM, and experience based;

■Monte Carlo simulation involves the calculation and statistical description of the outcomes resulting in a particular strategic asset allocation under random scenarios for invest- ment returns, inflation, and other relevant variables. The method provides information about the range of possible investment results from a given asset allocation over the course of the investor's time horizon, as well as the likelihood that each result will occur. ■Using Monte Carlo simulation, an investment manager can effectively grapple with a range of practical issues that are difficult or impossible to formulate analytically. ■Can more easily incorporate the tax-rebalancing interaction in a Monte Carlo simulation.

"Capital Market Expectations in Portfolio Management" q. discuss the relative advantages and limitations of the major approaches to forecasting exchange rates;

■Purchasing power parity (PPP) asserts that movements in an exchange rate should offset any difference in the inflation rates between two countries. ■PPP is useful in the long run—say, over periods of five years or longer. ■However, capital flows can cause exchange rates to depart from PPP levels for long periods of time. PPP is often not a useful guide to the direction of exchange rates in the short or even medium run (up to three years or so). There are also times when factors other than PPP dominate exchange rate movements (ie large current account deficit). ■The relative economic strength forecasting approach focuses on investment flows rather than trade flows and is useful in short-term. It suggests that a strong pace of economic growth in a country creates attractive investment opportunities, increasing the demand for the country's currency and causing it to appreciate. ■However, once the exchange rate reaches an excessive overvalued level, high yield is not enough to justify the likely exchange rate depreciation." ■The capital flows forecasting approach focuses on expected capital flows, particularly long-term flows such as equity investment and foreign direct investment (FDI). Inflows of FDI into a country increase the demand for the country's currency, all else being equal. ■Note that long-term capital flows may have the effect of reversing the usual relationship between short-term interest rates and the currency. ■The savings-investment imbalances forecasting approach explains currency movements in terms of the effects of domestic savings-investment imbalances on the exchange rate." ■The only way that investment can exceed savings in reality is for foreign savings to be used, since the accounts have to balance. But this solution requires a deficit on the current account of the balance of payments. If capital flows are attracted to the country, either due to high interest rates or due to attractive expected returns on investments, then the exchange rate will indeed rise as needed.

Asset Allocation q. discuss the structure of the minimum-variance frontier with a constraint against short sales;

■The Sign-Constrained MVF: Mean-Variance Optimization (MVO) including the constraints that the asset-class weights be non-negative and sum to 1. A negative weight would imply that the asset class is to be sold short (NA to strategic allocation). ■Each asset class in a minimum-variance portfolio is held in either positive weight or zero weight. But an asset class with a zero weight in one minimum-variance portfolio may appear with a positive weight in another minimum-variance portfolio at a different expected return level. This observation leads to the concept of corner portfolios. ■Adjacent corner portfolios define a segment of the minimum-variance frontier within which 1) portfolios hold identical assets and 2) the rate of change of asset weights in moving from one portfolio to another is constant. ■As the minimum-variance frontier passes through a corner portfolio, an asset weight either changes from zero to positive or from positive to zero. ■The GMV portfolio is included as a corner portfolio irrespective of its asset weights. ■Corner portfolios allow us to create other minimum-variance portfolios. In a sign-constrained optimization, the asset weights of any minimum-variance portfolio are a positive linear combination of the corresponding weights in the two adjacent corner portfolios that bracket it in terms of expected return (or standard deviation of return). ■Corner portfolios are generally relatively few in number. Knowing the composition of the corner portfolios allows us to compute the weights of any portfolio on the minimum-variance frontier.

Asset Allocation d. contrast the asset-only and asset/liability management (ALM) approaches to asset allocation and discuss the investor circumstances in which they are commonly used;

■The asset-only approach does not take explicit account of the investor's liabilities, if any. ■The asset/liability management approach involves explicitly modeling the investor's liabilities and adopting the asset allocation that is optimal in relation to funding liabilities. Risk minimizing strategies include: ■ A cash flow matching approach structures investments in bonds to match (offset) future liabilities or quasi-liabilities. When feasible, cash flow matching minimizes risk relative to funding liabilities. ■ An immunization approach structures investments in bonds to match (offset) the weighted-average duration of liabilities. Because duration is a first-order approximation of interest rate risk, immunization involves more risk than does cash flow matching with respect to funding liabilities. Matching convexity reduces risk further In general, the ALM approach tends to be favored when: ■the investor has below-average risk tolerance; ■the penalties for not meeting the liabilities are very high; ■the market value of liabilities are interest rate sensitive; ■risk taken in the investment portfolio limits the investor's ability to profitably take risk in other activities; ■legal and regulatory requirements and incentives favor holding fixed-income securities; and ■tax incentives favor holding fixed-income securities."

"Capital Market Expectations in Portfolio Management" j.identify and interpret the components of economic growth trends and demonstrate the application of economic growth trend analysis to the formulation of capital market expectations;

■The economic growth trend is the long-term growth path of GDP and reflects the average growth rate around which the economy cycles. ■Economic trends exist independently of the cycle but are related to it. ■Business cycles take the economy through an alternating sequence of slow and fast growth, often including recessions and economic booms." To summarize, with this approach, the trend growth in GDP is the sum of the following: ■growth from labor inputs, comprising ● growth in potential labor force size and ● growth in actual labor force participation, plus ■growth from labor productivity, comprising ● growth from capital inputs and ● TFP growth (i.e., growth from increase in the productivity in using capital inputs).

"Equity Market Valuation" "a. explain the terms of the Cobb-Douglas production function and demonstrate how the function can be used to model growth in real output under the assumption of constant returns to scale;

■The growth accounting equation allows one to decompose real GDP growth, ΔY/Y, into components that can be attributed to the observable factors: the growth of the capital stock, ΔK/K, the output elasticity of capital, α, the growth in the labor force, ΔL/L, the output elasticity of labor, 1 − α, and a residual factor—often called the Solow residual—that is the portion of growth left unaccounted for by increases in the standard factors of production, ΔA/A." ■The basic form of the Cobb-Douglas production function is set forth as Equation 1, where Y represents total real economic output, A is total factor productivity, K is capital stock, α is output elasticity of K, L is labor input, and β is the output elasticity of L. Total factor productivity (TFP) is a variable which accounts for that part of Y not directly accounted for by the levels of the production factors (K and L)." ■In Equation 3, the percentage growth in real output (or gross domestic product, GDP) is shown as ΔY/Y, and it is decomposed into its components: ΔA/A is growth in TFP; ΔK/K is the growth in the capital stock; ΔL/L is the growth in the labor input; α is the output elasticity of capital; and 1 − α is the output elasticity of labor where 0 < α < 1." "TFP growth means that aggregate output (i.e., GDP) can grow at a faster rate than would be predicted simply from growth in accumulated capital stock and the labor force. Interpreting TFP as a measure of the level of technology, growth in TFP is often described as a measure of "technical progress" and linked to innovation."

"Capital Market Expectations in Portfolio Management" d. explain the use of survey and panel methods and judgment in setting capital market expectations;

■The survey method of expectations setting involves asking a group of experts for their expectations and using the responses in capital market formulation. ■If the group queried and providing responses is fairly stable, the analyst in effect has a panel of experts and the approach can be called a panel method. ■These approaches are based on the straightforward idea that a direct way to uncover a person's expectations is to ask the person what they are."

"Capital Market Expectations in Portfolio Management" Statistical tools: Volatility clustering c.demonstrate the application of formal tools for setting capital market expectations, including statistical tools, discounted cash flow models, the risk premium approach, and financial equilibrium models;

■Volatility clustering is the tendency for large (small) swings in prices to be followed by large (small) swings of random direction. Volatility clustering captures the idea that some markets represent periods of notably high or low volatility." ■This model specifies that the volatility in period t, ␣t2, is a weighted average of the volatility in the previous period, σ2 , and the squared value of a random "noise" term, ␣t2 ." ■with 0 < β < 1. The coefficient β measures the rate of decay of the influence of the value of volatility in one period on future volatility, and the rate of decay is exponential. The higher β is, the more volatility in one period "remembers" what happened in the past and the more it clusters."

Asset Allocation Foundations and Endowments considerations s. compare the considerations that affect asset allocation for individual investors versus institutional investors and critique a proposed asset allocation in light of those considerations;

■We can consider foundations and endowments together, because they frequently share many characteristics as generally tax-exempt long-term investors with various spending commitments. ■Must generate a high long-term rate of return in order to provide a substantial spending flow as well as to compensate for inflation. ■In order to generate the high returns necessary to fund meaningful spending distributions, most endowments invest predominantly in equities or equity-like investments. Equities have been viewed as supplying the long-term growth bias, with bonds playing a role in diversification. ■Fiduciaries of endowments and foundations should focus on developing and adhering to appropriate long-term investment and asset allocation policies. Low- cost, easy-to-monitor, passive investment strategies are often their primary approach to implementing a strategic asset allocation.

"Capital Market Expectations in Portfolio Management" Statistical tools: Multifactor model, asset return c.demonstrate the application of formal tools for setting capital market expectations, including statistical tools, discounted cash flow models, the risk premium approach, and financial equilibrium models;

■multifactor model is a model that explains the returns to an asset in terms of the values of a set of return drivers or risk factors. ■By relating the returns on all assets to a common set of return drivers, a multi- factor model simplifies the task of estimating covariances: estimates of covari- ances between asset returns can be derived using the assets' factor sensitivities. ■εi = an error term with a zero mean that represents the portion of the return to asset i not explained by the factor model. The error term is assumed to be uncorrelated with each of the K factors and to be uncorrelated with the error terms in the equations for other assets."