CFA Study 13 May Night

At Elite dive center

Monte Carlo simulation can accommodate many future possible scenarios, such as portfolio rebalancing costs and non-normal distributions (i.e., distributions that require more than expected return and volatility as parameters).

For endowment target return, (return - target return) / volatility is the best ratio, compared to sharpe ratio (ratio 1) & ratio divide by beta

Ratio 1 (k – RF)/σ	Ratio 2 (k – kT)/σ	Ratio 3 (k – RF)/β

Brealer suggests bringing Black’s portfolio allocation ideas to the University Planning and Priorities Committee (UPPC). The UPPC is composed of six tenured faculty members and three final-year students. Three of the faculty members are from the arts area, and three are from the sciences area. Faculty appointments to the committee are for two-year, non-renewable terms. [-> Failed B, expertise for developing AA]

Brealer states that the UPPC desires to have the endowment invested in a socially responsible manner, which will require developing a new investment policy statement (IPS). The UPPC intends to draft the new IPS and present it to the board for approval. Upon receiving board approval, the UPPC will direct a financial advisory team and the investment managers to implement the asset allocation indicated in the IPS. Progress reports and governance audits will be provided to the board upon request [-> Governance audit should be periodic basis instead of upon request].

The board is agreeable to this plan and assigns Black to be part of the advisory team after the IPS is drafted and approved.

The process for creating and implementing the investment policy statement (IPS) by the University Planning and Priorities Committee (UPPC) most likely follows best governance practices in regard to:

A. transparency of decision rights for approving a proposed asset allocation.

B. expertise for developing the asset allocation.

C. governance audit reporting.

The board moves on to a discussion about the investment of the endowment with the recently raised funds. Ronald Black, an investment adviser to the board, suggests the following:

The asset allocation choice should have a heavy emphasis on fixed-income securities with cash distributions. This type of allocation will offset the future cash disbursements necessary to cover costs at the university in excess of tuition revenue.

The weightings within the portfolio should be able to deviate within 5% of the target portfolio weights to take advantage of short-term market opportunities for additional return.

Black’s suggestion to the board in regard to the asset weightings in the endowment portfolio is best described as allowing for an asset allocation that is:

1. A.dynamic.

2. B.tactical.

3. C.indexed.

B is correct. The ability to deviate from target portfolio weightings for short-term market opportunities is an example of tactical asset allocation, which is an active strategy. Dynamic asset allocation is a long-term active strategy, and indexing is a passive strategy.

A is incorrect. Dynamic asset allocation is a long-term active strategy, not a short-term strategy.

C is incorrect. The ability to deviate from target portfolio weightings for short-term market opportunities is an example of tactical asset allocation, which is an active strategy and not a passive strategy, such as indexing strategies.

Which asset allocation approach best describes the asset allocation choice suggested by Black to the board?

1. A.Mean–variance
2. B.Asset-segmentation
3. C.Liability-relative

Solution

C is correct. Investment in fixed-income securities specifically to generate cash distributions to offset the cash disbursements necessary for maintaining university costs in excess of tuition revenue is a liability-relative approach.

A is incorrect. A mean–variance approach is an asset-only approach that does not consider liabilities.

B is incorrect. An asset-segmentation approach is an asset-only approach that does not consider liabilities.

Overview of Asset Allocation Learning Outcome

1. Compare the investment objectives of asset-only, liability-relative, and goals-based asset allocation approaches

Based on an economic balance sheet, the answer to Wong’s question about the underfunding of the endowment (in $ millions) is closest to:

1. A. 105.6.

2. B. 55.6.

3. C. 196.6.

Solution

B is correct. Based on an economic balance sheet, the endowment will be underfunded by $55.6 million (see calculation below).

Endowment Assets
Financial assets
Immediately available funds	50.2
Immediately available funds, restricted to scholarships	53.2
Extended assets
PV of pledged future contributions to endowment, unrestricted	505.4
PV of pledged future contributions, restricted to scholarships	87.8
Clement’s donation for capital project	50.0
Total endowment assets	746.6
Endowment Liabilities
Financial liabilities
Current endowment obligations	89.5
Extended liabilities
PV of future endowment obligations	502.4
Brealer’s proposed capital project	210.3
Total endowment liabilities	802.2
Economic Net Worth (assets less liabilities)	–55.6

A is incorrect. It does not include the $50 million donation as part of the proposal (746.6 – 50.0 – 802.2).

C is incorrect. It does not include the $141 (= $53.2 + $87.8) million in restricted funds (746.6 – 53.2 – 87.8 – 802.2).

Overview of Asset Allocation Learning Outcome

1. Formulate an economic balance sheet for a client and interpret its implications for asset allocation

ASSET ALLOCATION WITH REAL-WORLD CONSTRAINTS

by Peter Mladina, Brian J. Murphy, CFA and Mark Ruloff, FSA, EA, CERA.

Peter Mladina is at Northern Trust and UCLA (USA). Brian J. Murphy, CFA, is at Willis Towers Watson (USA). Mark Ruloff, FSA, EA, CERA, is at Aon (USA).

LEARNING OUTCOMES

The candidate should be able to:

• discuss asset size, liquidity needs, time horizon, and regulatory or other considerations as constraints on asset allocation

• discuss tax considerations in asset allocation and rebalancing

• recommend and justify revisions to an asset allocation given change(s) in investment objectives and/or constraints

• discuss the use of short-term shifts in asset allocation

• identify behavioral biases that arise in asset allocation and recommend methods to overcome them

INTRODUCTION

This reading illustrates ways in which the asset allocation process must be adapted to accommodate specific asset owner circumstances and constraints. It addresses adaptations to the asset allocation inputs given an asset owner’s asset size, liquidity, and time horizon as well as external constraints that may affect the asset allocation choice (Sections 2–5). We also discuss the ways in which taxes influence the asset allocation process for the taxable investor (Sections 6–7). In addition, we discuss the circumstances that should trigger a re-evaluation of the long-term strategic asset allocation (Section 8), when and how an asset owner might want to make short-term shifts in asset allocation (Section 9), and how innate investor behaviors can interfere with successful long-term planning for the investment portfolio (Section 10). Throughout the reading, we illustrate the application of these concepts using a series of hypothetical investors.

CONSTRAINTS IN ASSET ALLOCATION AND ASSET SIZE

Learning Outcome

• discuss asset size, liquidity needs, time horizon, and regulatory or other considerations as constraints on asset allocation

General asset allocation principles assume that all asset owners have equal ability to access the entirety of the investment opportunity set, and that it is merely a matter of finding that combination of asset classes that best meets the wants, needs, and obligations of the asset owner. In practice, however, it is not so simple. An asset owner must consider a number of constraints when modeling and choosing among asset allocation alternatives. Some of the most important are asset size, liquidity needs, taxes, and time horizon. Moreover, regulatory and other external considerations may influence the investment opportunity set or the optimal asset allocation decision.

Asset Size

The size of an asset owner’s portfolio has implications for asset allocation. It may limit the opportunity set—the asset classes accessible to the asset owner—by virtue of the scale needed to invest successfully in certain asset classes or by the availability of investment vehicles necessary to implement the asset allocation.

Economies and diseconomies of scale are perhaps the most important factors relevant to understanding asset size as a constraint. The size of an asset owner’s investment pool may be too small—or too large—to capture the returns of certain asset classes or strategies efficiently. Asset owners with larger portfolios can generally consider a broader set of asset classes and strategies. On the one hand, they are more likely to have sufficient governance capacity—sophistication and staff resources—to develop the required knowledge base for the more complex asset classes and investment vehicles. They also have sufficient size to build a diversified portfolio of investment strategies, many of which have substantial minimum investment requirements. On the other hand, some asset owners may have portfolios that are too large; their desired minimum investment may exhaust the capacity of active external investment managers in certain asset classes and strategies. Although “too large” and “too small” are not rigidly defined, the following example illustrates the difficulty of investing a very large portfolio. Consider an asset owner with an investment portfolio of US$25 billion who is seeking to make a 5% investment in global small-cap stocks:

• The median total market capitalization of the stocks in the S&P Global SmallCap is approximately US$860 million as of November 2021.

• Assume a small-cap manager operates a 50-stock portfolio and is willing to own 3% of the market cap of any one of its portfolio companies. Their average position size would be US$26 million, and an effective level of assets under management (AUM) would be on the order of US$1.3 billion. Beyond that level, the manager may be forced to expand the portfolio beyond 50 stocks or to hold position sizes greater than 3% of a company’s market cap, which could then create liquidity issues for the manager.

• Now, our US$25 billion fund is looking to allocate US$1.25 billion to small-cap stocks (US$25 billion × 5%). They want to diversify this allocation across three or four active managers—a reasonable allocation of governance resources in the context of all of the fund’s investment activities. The average allocation per manager is approximately US$300 to US$400 million, which would constitute between 23% and 31% of each manager’s AUM. This exposes both the asset owner and the investment manager to an undesirable level of operational risk.

Although many large asset owners have found effective ways to implement a small-cap allocation, this example illustrates some of the issues associated with managing a large asset pool. These include such practical considerations as the number of investment managers that might need to be hired to fulfill an investment allocation and the ability of the asset owner to identify and monitor the required number of managers.

Research has shown that investment managers tend to incur certain disadvantages from increasing scale: Growth in AUM leads to larger trade sizes, incurring greater price impact; capital inflows may cause active investment managers to pursue ideas outside of their core investment theses; and organizational hierarchies may slow down decision making and reduce incentives.1 Asset owners, however, are found to have increasing returns to scale, as discussed below.

A study of pension plan size and performance (using data spanning 1990–2008) found that large defined benefit plans outperformed smaller ones by 45–50 basis points per year on a risk-adjusted basis.2 The gains are derived from a combination of cost savings related to internal management, a greater ability to negotiate fees with external managers, and the ability to support larger allocations to private equity and real estate investments. As fund size increases, the “per participant” costs of a larger governance infrastructure decline and the plan sponsor can allocate resources away from such asset classes as small-cap stocks, which are sensitive to diseconomies of scale, to such other areas as private equity funds or co-investments where they are more likely to realize scale-related benefits.

Whereas owners of large asset pools may achieve these operating efficiencies, scale may also impose obstacles related to the liquidity and trading costs of the underlying asset. Above some size, it becomes difficult to deploy capital effectively in certain active investment strategies. As illustrated in Exhibit 1, owners of very large portfolios may face size constraints in allocating to active equity strategies. The studies referenced earlier noted that these asset owners frequently choose to invest passively in developed equity markets where their size inhibits alpha potential. The asset owner’s finite resources can then be allocated instead toward such strategies as private equity, hedge funds, and infrastructure, where their scale and resources provide a competitive advantage.

Exhibit 1:

Asset Size and Investor Constraints

Asset Class	Investor Constraints by Size
Cash equivalents and money market funds	No size constraints.
Large-cap developed market equity Small-cap developed market equity Emerging market equity	Generally accessible to large and small asset owners, although the very large asset owner may be constrained in the amount of assets allocated to certain active strategies and managers.
Developed market sovereign bonds Investment-grade bonds Non-investment-grade bonds Private real estate equity	Generally accessible to large and small asset owners, although to achieve prudent diversification, smaller asset owners may need to implement via a commingled vehicle.
Alternative Investments Hedge funds Private debt Private equity Infrastructure Timberland and farmland	May be accessible to large and small asset owners, although if offered as private investment vehicles, there may be legal minimum qualifications that exclude smaller asset owners. The ability to successfully invest in these asset classes may also be limited by the asset owner’s level of investment understanding/expertise. Prudent diversification may require that smaller asset owners implement via a commingled vehicle, such as a fund of funds, or an ancillary access channel, such as a liquid alternatives vehicle or an alternatives ETF. For very large funds, the allocation may be constrained by the number of funds available.

Even in these strategies, very large asset owners may be constrained by scale. In smaller or less liquid markets, can a large asset owner invest enough that the exposure contributes a material benefit to the broader portfolio? For example, a sovereign wealth fund or large public pension plan may not find enough attractive hedge fund managers to fulfill their desired allocation to hedge funds. True alpha is rare, limiting the opportunity set. Asset owners who find that they have to split their mandate into many smaller pieces may end up with an index-like portfolio but with high active management fees; one manager’s active bets may cancel out those of another active manager. A manager mix with no true alpha becomes index-like because the uncompensated, idiosyncratic return variation is diversified away. A much smaller allocation may be achievable, but it may be too small to meaningfully affect the risk and return characteristics of the overall portfolio. More broadly, a very large size makes it more difficult to benefit from opportunistic investments in smaller niche markets or from skilled investment managers who have a small set of unique ideas or concentrated bets. No hard and fast rules exist to determine whether a particular asset owner is too small or too large to effectively access an asset class. Greater governance resources more commonly found among owners of larger asset pools create the capacity to pursue the more complex investment opportunities, but the asset owner may still need to find creative ways to implement the desired allocation. Each asset owner has a unique set of knowledge and constraints that will influence the opportunity set.

Smaller asset owners (typically institutions with less than US$500 million in assets and private wealth investors with less than US$25 million in assets) also find that their opportunity set may be constrained by the size of their investment portfolio. This is primarily a function of the more limited governance infrastructure typical of smaller asset owners: They may be too small to adequately diversify across the range of asset classes and investment managers or may have staffing constraints (insufficient asset size to justify a dedicated internal staff). Complex strategies may be beyond the reach of asset owners that have chosen not to develop investment expertise internally or where the oversight committee lacks individuals with sufficient investment understanding. In some asset classes and strategies, commingled investment vehicles can be used to achieve the needed diversification, provided the governing documents do not prohibit their use.

Access to other asset classes and strategies—private equity, private real estate, hedge funds, and infrastructure—may still be constrained for smaller asset owners. The commingled vehicles through which these strategies are offered typically require high minimum investments. For successful private equity and hedge fund managers, in particular, minimum investments can be in the tens of millions of (US) dollars, even for funds of funds.

Regulatory restrictions can also impose a size constraint. In the United Kingdom, for example, an asset owner in a private investment vehicle must qualify as an elective professional client, meaning they must meet two of the following three conditions:

1. The client has carried out transactions, in significant size, on the relevant market at an average frequency of 10 per quarter over the previous four quarters.

2. The size of the client’s financial instrument portfolio exceeds €500,000.

3. The client works or has worked in the financial sector for at least one year in a professional position, which requires knowledge of the transactions or services envisaged.

In the United States, investors must be either accredited or qualified purchasers to invest in many private equity and hedge fund vehicles. To be a qualified purchaser, a natural person must have at least US$5 million in investments, a company must have at least US$25 million in investable assets, and an investment manager must have at least US$25 million under management. In Hong Kong SAR, the Securities and Futures Commission requires that an investor must meet the qualifications of a “Professional Investor” to invest in certain categories of assets. A Professional Investor is generally defined as a trust with total assets of not less than HK$40 million, an individual with a portfolio not less than HK$8 million, or a corporation or partnership with a portfolio not less than HK$8 million or total assets of not less than HK$40 million. The size constraints related to these asset classes suggest that smaller asset owners have real challenges achieving an effective private equity or hedge fund allocation.

Asset size as a constraint is often a more acute issue for individual investors than institutional asset owners. Wealthy families may pool assets through such vehicles as family limited partnerships, investment companies, fund of funds, or other forms of commingled vehicles to hold their assets. These pooled vehicles can then access investment vehicles, asset classes, and strategies that individual family members may not have portfolios large enough to access on their own.

Where Asset Size Constrains Investment Opportunity

As of early 2021, the 10 largest sovereign wealth funds globally each exceed US$350 billion in assets. For a fund of this size, a 5% allocation to hedge funds (the average sovereign wealth fund allocation) would imply US$17.5 billion to be deployed. The global hedge fund industry manages approximately US$4.3 trillion in total as of the second quarter of 2021. With about 10,000 hedge funds globally, the average asset size of a hedge fund thus would be US$430 million. At the same time, approximately 60% of the funds manage less than US$100 million, and the remaining 40% of the funds have an average size of near US$1 billion. If we assume that the asset owner would want to be no more than 20% of a firm’s AUM, we can infer that the average investment might be approximately US$86 million considering the full hedge fund universe or about US$200 million if we limit the choice to larger sized hedge funds. With US$17.5 billion to deploy, the fund would need to invest with nearly 90 (bigger size hedge funds universe) to 200 (total universe) funds to achieve a 5% allocation to hedge funds.

Sources: Sovereign Wealth Fund Institute, BarclayHedge, and Preqin.

EXAMPLE 1

Asset Size Constraints in Asset Allocation

Describe asset size constraints that Aromdee might encounter in implementing this asset allocation. Discuss possible means to address them.

Given the asset size of the fund, formulate a set of questions regarding the feasibility of this recommendation that you would like staff to address at the next Investment Committee meeting.

The new president of the University has stated that he feels the current policy is overly restrictive, and he would like to see a more diversified program that takes advantage of the types of investment strategies used by large endowment programs. Choosing from among the following asset classes, propose a set of asset classes to be considered in the revised asset allocation. Justify your response.

Cash equivalents and money market funds Large-cap developed market equity Small-cap developed market equity Emerging market equity Developed market sovereign bonds Investment-grade bonds	Non-investment-grade bonds Private real estate equity Hedge funds Private debt Private equity

1. Akkarat Aromdee is the recently retired President of Alpha Beverage, a producer and distributor of energy drinks throughout Southeast Asia. Upon retiring, the company provided a lump sum retirement payment of THB880,000,000 (equivalent to €20 million), which was rolled over to a tax-deferred individual retirement savings plan. Aside from these assets, Aromdee owns company stock worth about THB70,000,000. The stock is infrequently traded. He has consulted with an investment adviser, and they are reviewing the following asset allocation proposal:

   Global equities	40%
   Global high-yield bonds	15%
   Domestic intermediate bonds	30%
   Hedge funds	10%
   Private equity	5%

   Solution to 1:

   With a THB88 million (€2 million) allocation to hedge funds and a THB44 million (€1 million) allocation to private equity funds, Aromdee may encounter restrictions on his eligibility to invest in the private investment vehicles typically used for hedge fund and private equity investment. To the extent he is eligible to invest in hedge funds and/or private equity funds, a fund-of-funds or similar commingled arrangement would be essential to achieving an appropriate level of diversification. Additionally, it is essential that he and his adviser develop the necessary level of expertise to invest in these alternative assets. To achieve a prudent level of diversification, the allocation to global high-yield bonds would most likely need to be accomplished via a commingled investment vehicle.

2. The CAF$40 billion Government Petroleum Fund of Caflandia is overseen by a nine-member Investment Committee. The chief investment officer has a staff with sector heads in global equities, global bonds, real estate, hedge funds, and derivatives. The majority of assets are managed by outside investment managers. The Investment Committee, of which you are a member, approves the asset allocation policy and makes manager selection decisions. Staff has recommended an increase in the private equity allocation from its current 0% to 15%, to be implemented over the next 12 to 36 months. The head of global equities will oversee the implementation of the private equity allocation.

   Solution to 2:

   Questions regarding the feasibility of the recommendation include the following:

   • How many private equity funds do you expect to invest in to achieve the 15% allocation to private equity?

   • What is the anticipated average allocation to each fund?

   • Are there a sufficient number of high-quality private equity funds willing to accept an allocation of that size?

   • What expertise exists at the staff or board level to conduct due diligence on private equity investment funds?

   • What resources does the staff have to oversee the increased allocation to private equity?

3. The Courneuve University Endowment has US$250 million in assets. The current allocation is 65% global large-capitalization stocks and 35% high-quality bonds, with a duration target of 5.0 years. The University has adopted a 5% spending policy. University enrollment is stable and expected to remain so. A capital spending initiative of US$100 million for new science buildings in the next three to seven years is being discussed, but it has not yet been approved. The University has no dedicated investment staff and makes limited use of external resources. Investment recommendations are formulated by the University’s treasurer and approved by the Investment Committee, composed entirely of external board members.

   Solution to 3:

   Asset size and limited governance resources are significant constraints on the investment opportunity set available to the Endowment. The asset allocation should emphasize large and liquid investments, such as cash equivalents, developed and emerging market equity, and sovereign and investment-grade bonds. Some small portion of assets, however, could be allocated to commingled investments in real estate, private equity, or hedge funds. Given the University’s limited staff resources, it is necessary to ensure that the board members have the level of expertise necessary to select and monitor these more complex asset classes. The Endowment might also consider engaging an outside expert to advise on investment activities in these asset classes.