Topic Two:

Overview of the Strategic and Tactical Asset Allocation Process

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Four Important Financial Concepts Underlying the Asset Allocation Process:

1. There are two basic ways in which investors can commit their capital in financial markets:

- Lending - Private Markets (e.g., bank deposits) - Public Markets (e.g., bonds) - Ownership - Public vs. Private Equity - Direct (e.g., common stock) vs. Indirect (e.g., derivatives) Note that there are many variations on these two basic investment

approaches, as well as many schemes that effectively combine the two (e.g., convertible bonds)

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Morningstar/Ibbotson Return & Risk Data: 1926 - 2015

Historical Stock (SPX) and Bond (SBBIG) Market Volatility

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Four Important Financial Concepts (cont.):

2. Investors perform two functions for capital markets: - Commit Financial Capital - Assume Risk so, Expected Return:

E(R) = (Risk-Free Rate) + (Risk Premium)

U.S. Equity Risk Premium Histogram (vs. U.S. T-bills) There has been a wide disparity in annual realized risk premia over time and the

values are frequently negative

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Four Important Financial Concepts (cont.):

3. Investors can receive their expected compensation (i.e., return) in either of two ways:

- Capital Gain - Periodic Cash Flow so,

0

1

0

01

PE(CF)

PP - E(P) E(R) +=

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Returns and Risk for Various Asset Classes (Source: Ibbotson Associates)

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Four Important Financial Concepts (cont.):

4. Diversifying an investment position across a set of asset holdings reduces the volatility (i.e., risk) of the resulting portfolio

- Diversification has been called the only “free lunch” available to investors

Total Risk

Portfolio Size 1 20 40

0.20

0.40

Systematic Risk

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Historical Volatility: Market Index (SPX) vs. Individual Stock (INTC)

Overview of the Asset Allocation Process 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, Bank Deposits, Commercial Paper) Alternative Assets (e.g., Private Equity, Hedge Funds, Real Assets) 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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Asset Allocation for Chilean Sistema: By AFP - June 2016

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Asset Allocation for Chilean Sistema: By Fund – June 2016

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Asset Allocation and the Total Investable Global Capital Market

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Overview of Global Capital Market Asset Allocation (Source: R. Doeswijk, T. Lam, L. Swinkels, Financial Analysts Journal, 2014)

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Overview of Global Capital Market Asset Allocation (cont.) (Source: R. Doeswijk, T. Lam, L. Swinkels, Financial Analysts Journal, 2014)

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Asset Allocation and the Endowment Investment Model

Historically, institutional investors such as university endowment and pension funds followed a fairly limited “plain vanilla” investment strategy which concentrated on a very narrow range of asset classes A “typical” long-term institutional asset allocation before 1985 would have been something like: 60% invested in domestic stocks and 40% invested in domestic bonds

Under the direction of David Swensen, in 1985 the Yale University

endowment fund began to develop an enhanced approach to investing—called the Yale Model or Endowment Model—based on the tenets of Modern Portfolio Theory. The most salient features of this approach are: Diversify the portfolio into several asset classes, concentrating on equity

investments Invest in private markets that offer increased long-term return potential per unit of

risk Use external investment managers for non-indexed investments

The Endowment Model approach has been quite successful over the past 25

years in building portfolio wealth From 1998-2008, the Yale endowment earned an average of 16.3% vs. 2.9% for the S&P 500 Due largely to significant recent losses (e.g., the Yale endowment lost approximately 25%--the

average fund lost almost 19%--in FY 2009), some critics are now saying that the Endowment Model is “broken”. The lack of liquidity in certain asset classes (e.g., Private Equity) has been cited as a particular challenge

Evolution of the Endowment Investment Model

Major Asset Allocation Trends for 800 University Endowment Funds: Shift away from US Equity, Fixed-Income and Cash toward Non-US Equity Increased use of Alternative Assets, particularly Hedge Funds and Private Equity

Portfolio Allocation (%): Asset Class: 1990 1995 2000 2005 2013 US Public Equity 47.5% 46.9% 50.7% 45.7% 32.7% Non-US Public Equity 2.3 7.9 11.6 12.7 17.9 Fixed-Income 35.6 30.0 23.4 21.4 17.9 Alternative Assets:

Hedge Funds 0.3 1.6 0.7 8.9 12.8 Private Equity 0.8 0.9 3.4 2.4 6.6 Real Estate/ Natural Resources

3.1 2.4 2.2 4.2 6.3

Cash/Other 10.3 10.4 8.0 4.8 5.8

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Endowment Asset Allocation Decision: Over Time Endowments have significantly increased Alternatives investments

over time by decreasing Cash and Fixed-Income investments

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Endowment Strategic Asset Allocation: By Category

The Endowment Investment Model: Large vs. Small Funds The largest endowment funds (over $1 billion) are primarily responsible for implementing

these asset allocation trends The move to diversify the portfolio with Non-US Equity and Alternative Assets is particularly notable

for large endowment funds

Portfolio Allocation (%): Large Funds (Top Quartile) Small Funds (Bottom Quartile)

Asset Class: 1995 2005 1995 2005 US Public Equity 45.2% 37.0% 45.3% 52.4%

Non-US Public Equity 10.4 16.6 5.6 8.3

Fixed-Income 25.8 16.3 34.8 26.6

Alternative Assets:

Hedge Funds 3.7 15.2 0.5 3.1

Private Equity 2.3 6.0 0.2 0.6

Real Estate/ Natural Resources

3.1 5.6 1.8 2.4

Cash/Other 9.4 3.3 11.8 6.6

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Asset Allocation Decision: By Fund Size Largest endowments have reduced traditional Fixed-Income and

increased Alternatives investments by the most

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Case Study #1: University of Texas Investment Management Company - 2016

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Example of Relative Performance: UTIMCO - 2016

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Up/Down Capture: UTIMCO - 2016

Case Study #2: Texas Teachers Retirement System – March 2016

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What is “Normal” in Economic and Financial Markets? (1948 – 2011)

Translating Economic Scenario Diversification to Asset Allocation

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TRS Asset Allocation (as of December 2015)

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Evolution of the Texas TRS Asset Allocation: 2007 - 2012

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The Importance of the Asset Allocation Decision

In an influential article published in Financial Analysts Journal in 1986, G. Brinson, R. Hood, and G. 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:

R. Ibbotson and P. Kaplan (Financial Analysts Journal, 2000) support this conclusion, but argue that the importance of the strategic allocation decision depends on how you look at return variation (i.e., 40%, 90%, or 100%).

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Which Perspective?: Time-Series vs. Cross-Sectional Evaluation

Fund:

A B .. J .. Z 1 RA,1 RB,1 .. RJ,1 .. RZ,1 2 RA,2 RB,2 .. RJ,2 .. RZ,2 3 RA,3 RB,3 .. RJ,3 .. RZ,3 : : : .. : .. : : : : .. : .. :

Period: t RA,t RB,t .. RJ,t .. RZ,t : : : .. : .. : : : : .. : .. : : : : .. : .. : : : : .. : .. : : : : .. : .. :

N-1 RA,N-1 RB,N-1 .. RJ,N-1 .. RZ,N-1

N RA,N RB,N .. RJ,N .. RZ,N

Time-Series Perspective: Focus on a single fund over several periods in time

Cross-Sectional Perspective: Focus on a group of funds at one period in time

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Measuring Gains from Strategic Asset Allocation and Active Management

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

Stock Bond Allocation: 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 Strategic Allocation & Active Management (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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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 = α + βRk + ε, where k is: Benchmark (B), Timing (T), or Selection

(S)

When evaluating a single fund over several years, the vast majority (74.4%) of the variation in total returns is explained by the strategic asset allocation decision.

However, when the evaluating the cross-sectional performance of a group of funds during a single year, the security selection decision is almost seven times more important that the asset allocation decision (74.7% vs. 11.1%).

Asset Allocation and Building an Investment Portfolio

1. Global Market Analysis - Asset Class Allocation - Country Allocation Within Asset Classes 2. Industry/Sector Analysis - Sector Analysis Within Asset Classes 3. Security Analysis - Security Analysis Within Asset Classes and Sectors

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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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Factor-Based Asset Allocation: A Brief Overview

A recent trend in forming broad-based, diversified investment portfolios is to allocate capital to create desired exposures to the underlying risk factors that generate investment returns, rather than to traditional asset classes themselves For instance, instead of investing a certain percentage of their

funds in the “Equity” asset class, investors might instead invest in specially designed portfolios of securities intended to mimic the underlying drivers of the returns to equity holdings, such as general stock market exposure, market capitalization of the stock, value vs. growth orientation, stock price momentum, etc.

This sort of strategy-based (i.e., focusing on committing

capital to investable versions of risk factors instead of traditional asset class categories) is sometimes referred to the “Smart Beta” approach to investing

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Comparing Traditional Asset Classes vs. Risk Factors

To consider a simple comparison, the following table shows a simple “Stocks, Bonds, Cash” traditional asset allocation could be broken down into more specific sub-categories of those traditional asset definitions as well as some of the underlying risk factors that are often thought to be responsible for producing returns over time

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Traditional Asset Classes vs. Risk Factors: Empirical Evidence

So, a relevant question is: Do traditional asset classes or factor-based classes produce the best (i.e., most efficient) investment portfolios?

A recent study by T. Idzorek and M. Kowara (“Factor-Based Asset Allocation vs. Asset-Class-Based Asset Allocation,” Financial Analysts Journal, 2013) investigated this issue using the following asset class and factor definitions over the period Jan 1979-Dec 2011

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Traditional Asset Classes vs. Risk Factors: Empirical Evidence (cont.)

The authors used historical return, standard deviation, and correlation data over this time period to produce mean-variance efficient frontiers They concluded that neither approach dominated the other and that both approaches may be

superior over a given time period

Subsequent research supports this view and also shows that the answer depends on whether investors can engage in short-selling activity (i.e., factor-based investing does better when short-selling is allowed)

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Factor Allocation vs. Asset Allocation: Additional Evidence

Consider a comparison of the allocation schemes produced by asset class-based portfolios versus factor-based portfolios over the period January 1989 – December 2014 - These comparisons used annual return data to establish the mean-variance efficient optimal portfolios for a given return goal

The asset classes used were: US Large Stocks, US Small Stocks,

Non-US Stocks, US Corporate Bonds, US Government Bonds, and US Cash

The risk factors were based on Fama-French definitions, but with the embedded portfolios positions separated: - Size: Large Stocks and Small Stocks - Relative Value: Value Stocks and Growth Stocks - Profitability: Robust Stocks and Weak Stocks - Firm Investment: Aggressive Stocks and Conservative Stocks - Momentum: Winner Stocks and Loser Stocks - US Cash

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Factor Allocation vs. Asset Allocation (cont.) We considered the allocation schemes for a variety of expected return goals

under two conditions: - Short Selling Allowed vs. No Short Selling Allowed

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Factor Allocation vs. Asset Allocation (cont.) The “best” approach to allocating a portfolio appears to depend on whether or not

the investor can employ short selling techniques - Asset classes produce superior results when no short selling is allowed

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Portfolio Management Strategy: Broad View

Passive Management Attempt to generate “normal” returns over time for investor risk tolerance Typically achieved through diversified asset class selection

Active Management Attempt to generate above-normal returns over time relative to acceptable risk level Typically achieved either through periodic asset class or security portfolio adjustments

Two Ways to Create Abnormal Returns (i.e., Add “Alpha”)

Tactical Allocation Decisions - Asset Class Timing - Style/Sector Timing

Security Selection Decisions - Stock or Bond Picking

An Illustrated Overview of the Investment Management Process

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Specification and quantification of investor objectives,

constraints and preferences

Portfolio Policies and Strategies

Capital Market Expectations

Relevant economic, social, political, sector, and security

considerations

Monitoring investor-related input factors

Portfolio construction and revision

- Asset allocation and

portfolio optimization - Security selection,

implementation, and execution

Monitoring economic and market input factors

Attainment of investor objectives

Performance Measurement

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Allure of Tactical Market Timing Suppose that on January 1st each year from 1986-2015,

you invested 100% of your money in what turned out to be the best asset class (stocks, bonds, or cash) at the end of the year.

This is equivalent to owning a perfect lookback option that entitles you to receive the return for the best performing asset class each year.

What difference would that type of tactical portfolio rebalancing make to your investment performance?

Compounded Returns in the U.S. Capital Market: 1986-2015

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Allure of Tactical Market Timing (cont.)

Growth of $1

Avg. Ann. Ret.

Std. Dev.

Sharpe Ratio

100% Stock $19.27 11.82% 17.23% 0.487

100% Bond $11.35 8.75 8.35 0.637

100% Cash $2.73 3.43 2.56 nm

“60-30-10” Mix

$15.30 10.06 10.85 0.611

“Perfect Foresight” $112.77 17.46 9.93 1.412

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Danger of “Missing the Boat”:

S&P 500 Annualized Average Return:

Decade: 2000-2009 1990-1999 1980-1989 1970-1979

Day Count 2515 2528 2528 2526

Return Period: Entire Decade -0.3% 15.3% 13.4% 2.5% Less: 10 Best Days -7.5% 11.5% 8.9% -1.4% Less: 20 Best Days -12.2% 8.8% 6.0% -4.2% Less: 30 Best Days -16.3% 6.4% 3.4% -6.5% Less: 40 Best Days -20.1% 4.2% 1.0% -8.7% Less: 10 Worst Days 6.7% 19.3% 20.3% 5.5% Less: 20 Worst Days 11.6% 22.1% 23.3% 8.0% Less: 30 Worst Days 15.7% 24.5% 25.9% 10.1% Less: 40 Worst Days 19.3% 26.8% 28.3% 12.2% Source: Center for Research in Security Prices, FactSet

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Another View: “Missing the Boat” After a Recession (Source: Hewitt Ennis Knupp)

Example of Tactical Asset Allocation: Fidelity Investments

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TAA at Fidelity Investments (cont.)

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TAA at Fidelity Investments (cont.)

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Example of Tactical Asset Allocation: UTIMCO - 2013

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Attribution Analysis Example: UTIMCO Tactical Allocation

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UTIMCO: Value-Added Over Time (as of February 2016)