Investment Course III – November 2007

Topic Two:

Asset Allocation: Decisions & Strategies

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The Asset Allocation Decision

A basic decision that every investor must make is how to distribute his or her investable funds amongst the various asset classes available in the marketplace:

Stocks (e.g., Domestic, Global, Large Cap, Small Cap, Value, Growth) Fixed-Income (e.g., Government, Investment Grade, High Yield) Cash Equivalents (e.g., T-bills, CDs, Commercial Paper) Alternative Assets (e.g., Private Equity, Hedge Funds) Real Estate (e.g., Residential, Commercial) Collectibles (e.g., Art, Antiques)

The Strategic (or Benchmark) allocation is the proportion of wealth the investor decides to place in each of these asset classes. It is sometimes also referred to as the investor’s long-term normal allocation because it is presumed to be the “baseline” allocation that will remain in place until the investor’s life circumstances change appreciably (e.g., retirement)

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Examples of Strategic Asset Allocations

University Endowments (Average):

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Examples of Strategic Asset Allocations (cont.)

University Endowments (Large (Q4) vs. Small (Q1) AUM):

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Examples of Strategic Asset Allocations (cont.) Public Retirement Fund:

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Examples of Strategic Asset Allocations (cont.)

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The Importance of the Asset Allocation Decision

In an influential article published in Financial Analysts Journal in July/August 1986, Gary Brinson, Randolph Hood, and Gilbert Beebower examined the issue of how important the initial strategic allocation decision was to an investor

They looked at quarterly return data for 91 pension funds over a ten-year period and decomposed the average returns as follows: Actual Overall Return (IV) Return due to Strategic Allocation (I) Return due to Strategic Allocation and Market Timing (II) Return due to Strategic Allocation and Security Selection (III)

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The Importance of the Asset Allocation Decision (cont.)

Graphically:

In terms of return performance, they found that:

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The Importance of the Asset Allocation Decision (cont.) In terms of return variation:

Ibbotson and Kaplan support this conclusion, but argue that the importance of the strategic allocation decision does depend on how you look at return variation (i.e., 40%, 90%, or 100%).

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Components of University Endowment Returns

Notice that over time, university endowment returns (R) exceed their benchmark (RB) by 165 basis points.

Of this 165 basis points of outperformance, 148 is due to security selection (RS) and 17 is due to market timing (RT)

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Components of University Endowment Returns (cont.)

To see how much of the overall endowment return is explained by the various components, consider several versions of the following regression: R = + Rk + , where k = B, T, or S

When this regression is run for a single fund over several years, the vast majority (74.2%) of the variation in total returns is explained by the strategic asset allocation decision. This is comparable to the Brinson et al result for pension funds

However, when the evaluating the cross-sectional performance of a group of funds during a single year, the security selection decision is almost five time more important that the asset allocation decision (72.8% vs. 15.3%).

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Asset Allocation and Building an Investment Portfolio

I. Global Market Analysis

- Asset Class Allocation

- Country Allocation Within Asset Classes

II. Industry/Sector Analysis

- Sector Analysis Within Asset Classes

III. Security Analysis

- Security Analysis Within Asset Classes

and Sectors

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Asset Allocation Strategies

Strategic Asset Allocation: The investor’s “baseline” asset allocation, taking into account his or her return requirements, risk tolerance, and investment constraints.

Tactical Asset Allocation: Adjustments to the investor’s strategic allocation caused by perceived relative mis-valuations amongst the available asset classes. Ordinarily, tactical strategies overweight the undervalued asset class. Also known as market timing strategies.

Insured Asset Allocation: Adjustments to the investor’s strategic allocation caused by perceived changes in the investor’s risk tolerance. Usually, the asset class that experiences the largest relative decline is underweighted. Portfolio insurance is a well-known application of this approach.

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Sharpe’s Integrated Asset Allocation Model

C1 Capital Market Conditions

C2 Prediction Procedure

C3 Expected Returns, Risk

and Correlations

I1 Investor Assets, Liabilities

and Net Worth

I2 Investor's Risk Tolerance

Function

I3 Investor's Risk Tolerance

M1 Optimizer

M2 Investor's Asset Mix

M3 Returns

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Sharpe’s Integrated Asset Allocation Model (cont.)

Notice that the feedback loops after the performance assessment box (M3) make the portfolio management process dynamic in nature.

The strategic asset allocation process can be viewed as going through the model once and then removing boxes (C2) and (I2), thus removing any temporary adjustments to the baseline allocation.

Tactical asset allocation effectively removes box (I2), but allows for allocation adjustments due to perceived changes in capital market conditions (C2).

Insured asset allocation effectively removes box (C2), but allows for allocation adjustments due to perceived changes in investor risk tolerance conditions (I2).

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Measuring Gains from Tactical Asset Allocation

Example: Consider the following return and allocation characteristics for a portfolio consisting of stocks and bonds only.

Stock BondAllocation: Strategic 60% 40%

Actual 50 50

Returns: Benchmark 10% 7% Actual 9 8

The returns to active management (i.e., tactical and security selection) are:

Policy Performance: (.6)(.10) + (.4)(.07) = 8.80% Actual Performance: (.5)(.09) + (.5)(.08) = 8.50%

Active Return = - 30 bp

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Measuring Gains from Tactical Asset Allocation (cont.)

Also: (Policy & Timing): (.5)(.10) + (.5)(.07) = 8.50%

(Policy & Selection): (.6)(.09) + (.4)(.08) = 8.60%

so: Timing Effect: 8.50 – 8.80 = -0.30%

Selection Effect: 8.60 – 8.80 = -0.20%

Other: 8.50 – 8.60 – 8.50 + 8.80 = +0.20%

Total Active = -0.30%

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Example of Tactical Asset Allocation: Fidelity Investments

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Example of Performance & Tactical Asset Allocation: Texas Teacher Retirement System

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Texas TRS Peer Group Ranking: March 2007

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Texas TRS Attribution Analysis: 7/1/06 – 6/30/07

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Performance and Attribution Analysis Example: UTIMCO Endowment Funds

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Example of Tactical Asset Allocation: UTIMCO

Recommended 2005 Asset Allocation Policy

Asset Category Policy Targets Policy Ranges Benchmark

US Equities 20.0 10 to 30 Russell 3000 Index

Global ex US Equities 17.0 10 to 30Policy target-weighted composite of the sub-indices in this category

Non-US Developed Equity 10.0 MSCI EAFE Index with net dividends Emerging Markets Equity 7.0 MSCI Emerging Markets Index with net dividends

Hedge Funds 25.0 15 to 30Policy target-weighted composite of the sub-indices in this category

Directional Hedge Funds 10.0Combination index: 50% S&P Event-Driven Hedge Fund Index plus 50% S&P Directional/Tactical Hedge Fund Index

Absolute Return Hedge Funds 15.0Combination index: 66.7% S&P Event-Driven Hedge Fund Index plus 33.3% S&P Arbitrage Hedge Fund Index

Private Capital 15.0 5 to 20 Venture Economics' Periodic IRR Index Venture Capital 4.0 Private Equity 11.0

Inflation Linked 13.0 0 to 20Policy target-weighted composite of the sub-indices in this category

REITS 5.0 Wilshire Associates Real Estate Securities Index Commodities 3.0 GSCI Index minus 1% TIPS 5.0 Lehman Brothers US TIPS IndexFixed Income 10.0 5 to 15 Lehman Brothers Aggregate IndexCash 0.0 -10 to 10 91 Day T-Bills

Expected Return> 8.34%1 Year Downside Risk> 7.6%

Standard Deviation> 10.8%95% 1 Year VaR> -13.8%

Illiquidity> 32.4%

Percent of Portfolio (%)

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Attribution Analysis Example: UTIMCO Tactical Allocations

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UTIMCO Attribution Analysis: 3/1/06 – 2/28/07 (cont.)

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UTIMCO Cumulative Alpha: 9/1/02 – 1/31/06

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The MBA Investment Fund Attribution Analysis: 3/1/05 – 2/28/06

Over this period, both the Growth (+814 bp) and Value (+548) Portfolios outperformed their respective benchmarks by a significant amount

Notice that this Attribution Analysis is calculated in a slightly different way; it isolates the Allocation Effect more precisely by including a third term (i.e., Interaction Effect)

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The MBA Investment Fund Attribution Analysis: 3/1/06 – 2/28/07

Over this period, both the Growth (-219 bp) and Value (-442 bp) Portfolios underperformed their respective benchmarks by a significant amount