Archive for the 'Asset Allocation' Category

Inflation’s Effect on Asset Classes

Inflation has different effects on different types of assets. As a result, it is important both to diversify assets in terms of their response to inflation and to form expectations of inflation in order to overweight the assets that will respond best to future conditions.

Cash – inflation causes rising interest rates, and therefore cash tends to earn a higher return when inflation is higher.

Bonds – inflation erodes the fixed payments and terminal values of bonds. Therefore, bonds perform worse when inflation is higher.

Stocks – inflation can increase asset values but erode real cash flows. Rising interest rates can reduce the present value of future cash flows. Stocks tend to do best when inflation is low and predictable, and to fall in either high inflation or deflation.

Real estate – higher cash flows and asset values tend to result in a positive relationship between real estate and inflation.

Posted on 18th January 2009
Under: Asset Allocation, FInancial Planning, Portfolio Management | No Comments »

Business Cycles in the Economy

The typical business cycle can last as long as 10 years or more. It is typically represented by several stages.

In the recovery stage, there is still a large gap between output and capacity. Bond yields are bottoming and stocks often surge. Taking risk (cyclical and risky stocks, high yield bonds) tends to offer above-average rewards.

In the early upswing, the economy experiences robust growth without causing inflation because output is still below capacity. As the capacity utilization improves, so does profitability. Short rates begin to rise, though long-term rates remain stable.

In the later stages of the upswing, the output gap closes and overheating becomes a danger. Inflation can pick up, resulting in rising interest rates and stock market volatility.

In a slowdown, the slowing economy becomes sensitive to potential shocks. Interest rates are peaking, and interest-sensitive stocks tend to perform well.

In a recession, declining GDP leads to falling short-term interest rates and bond yields. The stock market bottoms out and often starts to rise well ahead of the business cycle recovery.

Posted on 18th December 2008
Under: Asset Allocation, Fundamental Analysis, Industry Analysis, Investment Returns, Portfolio Management | No Comments »

Strategy and Due Diligence for Private Equity Investments

When considering an investment in private equity, investors need to consider a number of factors.

  • Can a small investor obtain the diversification needed
  • Does the investor have liquidity needs that would prohibit tying up funds for 7-10 years
  • Will the investor be able to fund promised commitments to the private equity fund when called for
  • What mix of sector, stage and geography is required to provide the best diversification

In addition, selecting managers requires special due diligence considerations:

  1. Can the investor and manager evaluate prospects for market success
    • Understanding of the markets, competition and sales prospects
    • Experience and capabilities of management team
    • Management’s commitment – ownership, compensation structure, etc
    • Opinion of customers
    • Identity of current investors – do they have particular expertise that lends confidence to outsiders
  2. Operational review
    • Have experts validated the technology
    • Consideration of employment contracts
    • What intellectual property rights have been established
  3. Financial and legal review
    • Potential dilution of interest
    • Financial statement (or tax returns, or investor-conducted audit)

Posted on 27th November 2008
Under: Active Management, Alternative Assets, Asset Allocation, Investing in Private Equity, Investment Returns, Portfolio Management | No Comments »

Inventory Cycles in Business

Inventory cycles tend to last two to four years. As business improves, greater confidence in future sales cause management to build inventory in anticipation of those sales. At some point, the sales fall below expectations and the inventories form a glut.

In order to clear inventories, prices are cut and fewer inventories are ordered. Eventually the inventory gets worked down. When sales do finally pick up again, this can sometimes lead to shortages.

Posted on 18th November 2008
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Portfolio Rebalancing Strategies

Buy and Hold

Investors who use a buy and hold strategy set their initial allocation weights and then do nothing. Such allocations are directly related to the market performance of risky assets, and using them implies that risk tolerance is directly related to wealth and market returns.

Consider a 60/40 split between stocks and the risk-free asset. As the stock market rises (falls), stocks represent a larger (smaller) weight in the portfolio and The risk-free asset provides a floor value. Returns are directly related to market performance in a linear relationship.

When markets are trending, buy and hold methods can perform well because the better performing assets get increasingly larger weights and poor-performing assets have less impact.


Constant mix rebalancing is a dynamic process that requires rebalancing to the intial target allocation by trading whenever market conditions alter the ideal balance. The strategy ensures that the portfolio’s risk characteristics remain stable over time, consistent with a risk tolerance that varies proportionately to wealth.

Constant-mix strategies can be characterized as contrarian, as they sell the best-performing assets to buy the worst-performing. However, when markets are mean-reverting this will perform better than a buy and hold strategy. The shape of returns is concave – return increases at a decreasing rate in positive markets and decreases at an increasing rate in negative markets.

Constant Proportion

In a constant proportion strategy, the target allocation is a function of cushion, where cushion is the difference between the portfolio value and the floor value, and the allocation to risky assets is the product of the cushion and the proportion (m).  A buy and hold strategy represents a special case in which m = 1. This strategy is consistent with having no risk tolerance if there is no cushion.

If m > 1, the strategy is known as constant proportion portfolio insurance, or CPPI. CPPI strategies buy more stocks when markets are rising and sell stocks as markets fall. The dynamic allocations also affect the floor value, as changing the weight of the risky asset necessitates an opposite-direction change in the floor value.

In strong bull markets, CPPI performs well by continually allocating more to stocks. In strong bear markets, CPPI avoids large losses by rapidly reducing the allocation to stocks. Such returns can be described as having a convex shape as the return increases at an increasing rate when market returns are positive and decreases at a decreasing weight when market returns are negative.

When markets are characterized by frequent reversals, the constant changes in allocation result in high transaction costs that erode performance.

Posted on 4th November 2008
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The Role of Private Equity Investments in a Portfolio

Private equity investments typically have a low correlation to the returns on stocks and bonds, which provides a diversification benefit. Investors should understand, however, that the use of appraisals can result in a stale valuation and could partially explain the low correlation. If annual returns are used for both private equity and traditional assets, the correlations appear higher.

Although the risk reduction benefits may be modest, the expertise required to invest in private equity usually results in a higher return on investments. Therefore, a modest inclusion in the portfolio may still be merited.

Posted on 27th October 2008
Under: Alternative Assets, Asset Allocation, Institutional Investing, Investing in Private Equity, Investment Returns, Portfolio Management | No Comments »

Tools for Setting Capital Market Expectations

When estimating the risk and return characteristics of various asset classes, there are a number of tools available to analysts.

  1. Statistical methods can be descriptive (classify past results) or inferential (used for predicting results.)
    • Sample estimators estimate the future mean and variance based on the sample’s past mean and variance.
    • Shrinkage estimators rely on judgment to weight historical estimates with other parameters in order to reduce the impact of extreme values
    • Time series estimators forecast a variable based on the lagged values of either the variable itself or other variables
    • Multi-factor models explain returns for an asset in terms of the values of a set of return drivers or risk factors
  2. Discounted cash flow models express current value in terms of the future cash flows an asset will generate
  3. The risk premium approach expresses expected return as the risk free rate plus a risk premium that reflects the uncertainty surrounding future results
  4. Financial market equilibrium models describe relationships between expected return and risk in which supply and demand are in balance

Posted on 18th October 2008
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Portfolio Rebalancing: Setting Optimal Asset Class Target Corridors

One way to balance the costs and risks associated with portfolio rebalancing is to set target corridors for asset class weights rather than specific weights. At least five factors should be considered when setting the tolerance ranges:

  1. Transaction costs – higher transaction costs should result in a wider corridor so that rebalancing occurs less frequently
  2. Risk tolerance – higher risk tolerance also justifies wider corridors
  3. Correlation with the rest of the portfolio – when assets move in the same direction as the rest of the portfolio they are unlikely to drift further from target weight. This, in turn, allows for a wider target corridor.
  4. Asset class volatility – the more volatile the asset class, the more likely a wider divergence from the optimal weight. This requires a tighter corridor.
  5. Volatility of the rest of the portfolio can also lead to large divergences from optimal weights and the need for tighter corridors.

Once a target corridor is breached, the portfolio may be rebalanced to the target weight or to some level within the target corridor. The latter methods allow for more control, particularly with regard to illiquid assets. The alignment to strategic asset allocations would be less, but transaction costs would be lower.

Posted on 4th October 2008
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Characteristics of Managed Futures Investments and Their Role in a Portfolio

Derivative markets are zero-sum games, with each long position offset by a corresponding short. As such, the aggregate return to all participants in the futures market is the risk-free rate, less any management fees. In order for managed accounts to earn a positive risk-adjusted return after fees implies other market participants who systematically earn less than the risk-free rate. This is possible because many participants in the futures markets are hedgers, who may be willing to accept the lower return as an insurance premium protecting them from outlying events.

Managed futures managers can also exploit mispricing opportunities that arise when certain contracts are not trading at the proper relationship to other contracts.

Even with limited return opportunities, managed futures may play a role in the portfolio due to a low correlation of returns with those of traditional investments such as stocks and bonds. The diversification benefits have been shown to accrue even for portfolios that include other alternative assets such as hedge funds.

The Sharpe ratios of portfolios that include managed futures dominate those that do not. However, the benefits may be specific to the investment vehicle, time period and strategy under consideration. Managers have been shown to demonstrate short-term persistence in returns and a manager’s beta relative to his benchmark is often a good indicator of future returns.

Since futures involve leverage and derivatives, particular consideration should be paid to risk management strategies.

Posted on 28th September 2008
Under: Active Management, Alternative Assets, Asset Allocation, Futures, Investing in Commodities, Investment Returns, Personal Finance | No Comments »

Portfolio Rebalancing: Cost/Benefit Analysis

Portfolio rebalancing requires a trade-off between the cost of rebalancing and the cost of not rebalancing. Costs of rebalancing include trading costs and taxes, which must be weighed against:

  • the reduction in expected portfolio value resulting from suboptimal asset allocation
  • exposure to greater risk as the riskier assets typically earn more and become a larger percentage of the portfolio
  • shifting risk factors as asset weights change
  • using rebalancing to reduce exposure to the assets that have risen most and may be overvalued

To reflect this trade-off, rebalancing is typically performed in a disciplined fashion, based either on the calendar or on tolerance corridors.

Calendar rebalancing takes place at specific times, and as such does not require constant monitoring. However, it is insensitive to market conditions and may allow weights to drift substantially between rebalancings.

Tolerance corridors call for rebalancing whenever an asset class drifts out of proportion to a pre-specified range around the target weight. It allows tighter control as it is directly related to market performance, but also requires continuous monitoring.

Posted on 4th September 2008
Under: Active Management, Asset Allocation, FInancial Planning, Investment Returns, Passive Management, Portfolio Management, Risk Management | No Comments »