CFA 3 Asset allocation

economic balance sheet

A balance sheet that provides an individual's total wealth portfolio, supplementing traditional balance sheet assets (i.e. current day assets) with human capital and pension wealth (i.e. future assets), and expanding liabilities to include consumption and bequest goals (again current and future liabilities). Also known as holistic balance sheet.

What's good about MCS?

MCS allows input variables (which are similar to the inputs used with the deterministic approach) to be given a probability distribution to allow for real world uncertainty.

utility maximization

U of m= expected returns of portfolio with asset allocation m - (investors risk aversion coefficient * variance of the portfolio with asset allocation m * 0.5), IMPORTANT if the expected return is 1%, just use 1 do not use 0.01 or else the ".5" in the subtracted part will not work.

info ratio

alpha / tracking error

appraisal ratio

alpha/standard deviation of the error variance of the error=(1-R2)*variance of the whole strategy

corner portfolio

an asset class either leaves the blend or joins the blend. there's a corner portfolio at each end of the efficient frontier

capital market line vs capital allocation line

capital market line: draw market portfolio (return on y, st dev on x). capital allocaiton line: draw made up portfolio based on the asset classes you've decided you want to invest in (return on y, st dev on x)

what is optimal asset class allocation

excess returns/marginal contribution to risk is equal for all asset classes AND equals the sharpe ratio

what does the IPS cover?

horizon to evaluate objectives and risk. tax. esg. legal regulatory or political considerations. any other constraints?

Mean Variance Optimization (MVO)

investing on the efficient frontier (lowest level of risk for any given level of return) mean is the return and variance is the risk MVO is software that does this calc. may be efficient but may not be diversified. also relies on normal distribution and asset classes often are skewed and not normal.

how do you get the tangent line for MVO?

it's the line that hits the efficient frontier and also goes through the risk free rate on the y axis it will also be the portfolio with the highest sharpe

What's wrong with deterministic probability?

its use of a single return assumption is not representative of actual market volatility

why choose passive or active

passive: efficient markets more likely passive. if you're taxable you want to avoid trading (more trading in active), lower fees active: alpha opportunities, you believe there's high skill. there's an inefficient market

illiquid asset classes

private equity, real estate, infrastructure, hedge funds

black litterman

reverse optimization approach where you can input expected return assumptions in place of what is derived. start with broad market portfolio (good starting point because you're starting well diversified and then tilting based on your expectations). observe the weights of asset classes (inputs) and then you get implied expected returns. then take the expected returns and use in an MVO. it's basically a backwards MVO.

marginal contribution to total risk

total portfolio risk * beta of the asset class you're measuring basically how much the total risk would go up if you add $ to this particular asset class. it's a sensitivity measure

absolute contribution to total risk

total portfolio risk * weight of the asset class in the portfolio * beta of asset to portfolio

what do you rebalance if asset class weight drifts outside of optimal corridor?

whole portfolio back to all target weights

what leads to wide/narrow rebalancing corridor?

wider: higher transaction costs, high correlations, higher risk tolerance narrow: higher volatility assets,

Roy's safety first critereon

(Return of portfolio - necessary return)/standard deviation of portfolio high safety first means low probability of shortfall