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FIN5PMT

Faculty of Business, Economics and Law

FIN5PMT

Faculty of Business, Economics and Law

Key learning outcomes
• Summarize the function of strategic asset allocation in portfolio management

Topic 2 Asset Allocation
Presented by: Dr. Jing Zhao Department of Finance

• Di Discuss the role of strategic asset allocation in relation to h l f i ll i i l i exposures to systematic risk • Compare and contrast strategic and tactical asset allocation • Appraise the importance of asset allocation for portfolio performance

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FIN5PMT Portfolio Management, Dr. Robin Luo FIN5PMT Portfolio Management, Dr. Robin Luo

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FIN5PMT

Faculty of Business, Economics and Law

FIN5PMT

Faculty of Business, Economics and Law

Function of Strategic Asset Allocation in Portfolio Management Strategic asset allocation
- integrates an investor’s return objectives, risk tolerance, and investment constraints with long-run capital market expectations to long run establish exposures to IPS-permissible asset classes. Purpose is to satisfy investor’s objectives and constraints. Process of strategic asset allocation leads to a set of portfolio weights for asset classes, called the policy portfolio. 3

FIN5PMT Portfolio Management, Dr. Robin Luo

Function of Strategic Asset Allocation in Portfolio Management

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FIN5PMT Portfolio Management, Dr. Robin Luo

FIN5PMT

Faculty of Business, Economics and Law

FIN5PMT

Faculty of Business, Economics and Law

Strategic Asset Allocation and Systematic Risk
 In the long run, investors expect compensation for bearing risk they cannot diversify away. (non-diversifiable/systematic risk)  Distinct asset classes have distinct risk exposures to different factors.  A key economic role of strategic asset allocation: specifies the investor’s desired exposures to systematic risk.  Strategic asset allocation: indicates the appropriate asset mix to be g pp p held under long-term or “normal” conditions;

Strategic versus Tactical Asset Allocation
 Tactical asset allocation (TAA) involves making short-term adjustments to asset weights based on short-term predictions of relative p performance among asset classes. g  TAA is an active and ongoing investment discipline, whereas strategic asset allocations are revisited only periodically or when an investor’s t ll ti ii d l i di ll h i ’ needs and circumstances change significantly.

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FIN5PMT Portfolio Management, Dr. Robin Luo FIN5PMT Portfolio Management, Dr. Robin Luo

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FIN5PMT

Faculty of Business, Economics and Law

FIN5PMT

Faculty of Business, Economics and Law

Asset/Liability Management Approach to Strategic Asset Allocation  Asset/Liability Management (ALM) approach involves explicitly modeling liabilities and adopting the optimal asset allocation in relationship to funding liabilities. liabilities E.g., a DB pension plan may want to maximize the future risk-adjusted value of pension surplus (the value of pension assets minus the present fp p ( fp p value of pension liabilities). Investors other than those with significant future liabilities may adopt an ALM approach by treating future needs (such as for income) as if they were liabilities. (Those needs is called “quasi liabilities”.) liabilities quasi-liabilities ) 7

FIN5PMT Portfolio Management, Dr. Robin Luo

Asset-Only Approach to Strategic Asset Allocation
 Asset-only (AO) approach does not explicitly involve modeling liabilities. Any impact of the investor’s liabilities on policy portfolio selection is indirect. (e.g., through the level of return requirement) indirect (e g p pp p  Compared to ALM, an AO approach affords much less precision in controlling risk related to the funding of liabilities.

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FIN5PMT Portfolio Management, Dr. Robin Luo

FIN5PMT

Faculty of Business, Economics and Law

FIN5PMT

Faculty of Business, Economics and Law

Dynamic versus Static Approaches to Asset Allocation
 Dynamic Approach (applied...
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