CFA Level 3 Asset Allocation

Below, you’ll find my personal CFA level 3 asset allocation notes…

You can find a list of the other categories here: CFA Level 3 Notes, Formulas, and Weights.

For institutional investors, Economic Balance Sheets can include underground mineral resources, present value of IP royalties, etc.

Three Asset Allocation Approaches

1. Asset-Only: Mean Variance Optimization (MVO) is most common asset-only approach
2. Liability-Relative
3. Goals-Based

Five Asset Class Specification Criteria

1. Relatively Homogeneous
2. Mutually Exclusive (avoid overlap)
3. Diversifying
4. Asset Classes make up Preponderance of World Investable Wealth
5. Investable (access to investors)

Optimal Weight Choice (One Risky Asset and Risk Free)

Sharpe Ratio doesn’t consider VaR and funded ratio.

Liability Glide Path is a plan for underfunded pensions to set future desired liability-hedging assets and return-seeking assets.

Goal-Based Investing Classification Systems

• Personal Goals
• Dynastic Goals
• Philanthropic Goals

• Personal Risk Bucket
• Market Risk Bucket
• Aspirational Risk Bucket

Tactical Asset Allocation (TAA) is short-term deviations from Strategic Asset Allocation (passive investing). Dynamic Asset Allocation (DAA) is similar to TAA but the changes are motivated by long-term valuation signals or economic views.

Risk Budgeting sets types of risks and how much risk to take. Active Risk Budgeting is how much risk relative to a benchmark an investor will take to try to outperform.

Rebalancing is countercyclical and fundamentally contrarian. Rebalancing can also earn a return from being short volatility.

Types of Asset Allocation Rebalancing

• Calendar Rebalancing
• Percent-Range Rebalancing
• Range Rebalancing (corridor)

Rebalancing Range Considerations

• Higher Transaction Costs -> Wider Rebalancing Ranges
• More Risk-Averse -> Tighter Rebalancing Ranges
• Less Correlated Assets -> Tighter Rebalancing Ranges
• Momentum Investors -> Wider Rebalancing Ranges
• Illiquidity complicates rebalancing but derivatives can synthetically rebalance
• Higher Taxes discourage rebalancing -> Wider Rebalancing Ranges
• Higher Volatility of Asset -> Wider Ranges
• Higher Volatility of Rest of Portfolio -> Tighter Ranges

Asset-Only Asset Allocation

Mean-Variance Optimization (MVO)

Adjust 0.005 to 0.5 if expected return and variance are input as decimals.

Lambda component is investors risk aversion and a lambda of zero shows indifference to risk. A lambda of four represents a moderately risk-averse investor.

MVO Criticisms

• Single-period framework that doesn’t account for rebalancing (costs/taxes)
• Output highly sensitive to small input changes
• Leads to concentrated asset allocations
• Mean and variance aren’t investors’ only concerns
• Sources of risk might not be diversified

MVO portfolios more sensitive to expected return measurement errors than to measurement errors in correlation and risk.

Reverse Optimization assumes starting given weights are optimal (usually take market cap weightings)

Black-Litterman Model improves MVO and reverse optimization by including an investor’s views.

Resampling MVO with Monte Carlo simulation helps to counter that MVO forward-looking inputs are subject to error.

Risk Budgeting seeks to maximize return per unit of risk.

Marginal Contribution to Total Risk (MCTR) = (Asset Class Beta) * (Portfolio Return Volatility)

Absolute Contribution to Total Risk (ACTR) = (Asset Class Weight) * (MCTR)

Excess Return Ratio to MCTR = (Expected Return – Rf) / MCTR
* For portfolio use Sharpe for ERR to MCTR

With risk budgeting, asset allocation is optimal when the excess return ratio to MCTR is the same across all assets.

Liability-Relative Asset Allocation Approaches

• Surplus Optimization
• Hedging/Return-Seeking Portfolios (Two Portfolio Approach) Assumes Surplus
• Integrated Asset-Liability

Asset Allocation Heuristics and Other Approaches

• 120 Minus Your Age
• 60/40 Stocks/Bonds
• Endowment Model (large allocations to non-traditional investments)
• Risk Parity
• 1/N Rule (equal weighting)

After-Tax Portfolio Standard Deviation

No need to change correlation assumptions for taxes.

Rebalancing Range After-Tax

Discretionary TAA is based on manager skill in predicting and acting upon short-term market moves.

Systematic TAA is based on movements made based on predictable and persistent return anomalies (value and momentum).

Investment Governance Steps

1. Set Long- and Short-Term Goals
2. Allocate Decision Rights and Responsibilities
3. Establish IPS Development and Approval Process
4. Specify Strategic Asset Allocation Development and Approval Process
5. Monitor and Report Program’s Progress
6. Periodic Governance Audits

Currency Management Notation

Standard currency exchange notation is Price/Base. Where it takes X units of the price currency to buy one unit of the base.

Base Currency Precedent

EUR -> GBP -> AUD -> NZD -> USD

Example: 1.6180 USD/EUR

Integer and first two decimal places (1.61) are called the Big Figure or Handle

Third and fourth decimal places (80) are called Pips

Bid/Offer Example: 1.6150/1.6210
“Hit the Bid” = Selling the Base Currency
“Pay the Offer” = Buying the Base Currency
Spot Delivery is T + 2 Days

Marking to Market Forward Positions

1. Create offsetting forward position
2. Determine all-in forward rate
3. Calculate cashflow at settlement date
4. Calculate PV of cashflow using 360 days

FX Swaps are packaged offsetting spot and forward transactions. They don’t have interim interest payments.

Domestic Currency Return

Variance of Two Currencies

Efficient currency markets should be a zero sum game.

Research (and PPP) shows that in the long-run currencies mean revert. Currency risk in the long-run is lower and hedging shouldn’t be necessary.

Currency Overlay Programs outsource currency management.

Technical Analysis is worthless for the average individual investor (opinion) but need to know basics for exam.

Carry Trade involves buying a high yield currency and shorting the low yield currency. Lower volatility is better for a carry trade… and the strategy is compared to picking up nickels in front of a steamroller.

Covered Interest Rate Parity

Absolute Return Benchmarks are common for market neutral (long-short) funds.

Cap-weighted indexes are usually adjusted for free float. Price-weighted indexes include the Dow Jones Averages and Nikkei Stock Average.

Both cap weighting and price weighting are counter contrarian. The indexes overweight companies that have run up in price and underweight beaten down companies.

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Please comment below if you have any suggestions or questions. Also, the next category in my CFA level 3 study list is Fixed Income Portfolio Management.

Invest mindfully,

Brian Kehm