Asset Allocation

Asset Allocation Chapter 13 Chapter 13: Asset Allocation

Introduction • Asset allocation: determining the mixture of securities that is most likely to provide an optimal combination of expected return and risk for the investor • For instance, should you have 50/50 allocation between stocks and bonds? • Or a 20/60/20 allocation among real estate, stocks and bonds? • Does not preclude market timing or security selection methods • Investor who prefers to not time the market or select securities can choose index funds in the desired asset classes Chapter 13: Asset Allocation

Asset Allocation Process • Begins with development of a strategic asset allocation (SAA) • Identifies asset classes and proportions that comprise the normal mix • Followed by tactical asset allocation (TAA) • Establishes policies to govern temporary reallocations • To begin the SAA and TAA process asset allocator should learn the client’s needs and wants • A written agreement about investment goals and policies completes Phase One of the asset allocation process • Phase 2 of the process involves actually managing the money and periodic performance reporting Chapter 13: Asset Allocation

Asset Allocation Process • Phase One—Create a Written Policy Statement • Step 1—Asset allocator and client continue to have discussions until the client’s financial position, goals, constraints and preferences’ are clearly understood • Step 2—Asset allocator uses market indexes to educate the client and develop realistic expectations; explains the style and methodologies used to manage the funds • Step 3—Client and asset allocator develop a written policy statement specifying goals and policies Chapter 13: Asset Allocation

Asset Allocation Process • Phase Two—Investment Management • Step 4—Asset allocator studies current conditions and prepares estimates • Step 5—Asset allocator allocates the portfolio's funds to asset classes • Step 6—Investment orders are issued and executed • Step 7—Asset allocator makes periodic performance reports, obtains feedback, and revises goals and policies as needed. The asset allocator returns to Step 1. Chapter 13: Asset Allocation

Asset Allocation Process • This chapter assumes asset allocator and client are different people • However, process can be helpful even if you are managing your own investments Chapter 13: Asset Allocation

Phase One—Create a Written Policy Statement • Step 1: Gain Understanding • Individual investors must be willing to discuss personal issues such as age, education, work experience, health, children, etc. • Institutional investors must be willing to discuss: • Large expected deposits/withdrawals • Strong personalities with organization • Hyper-sensitive clients • Criteria used to evaluate money manager • Investor should inquire about money manager’s investment philosophy and resources used • Databases, computer models Chapter 13: Asset Allocation

Phase One • Should also discuss • Investor’s financial situation • Size of portfolio, tax situation • Investor’s time horizon • Until/through retirement, any long-term dependents • Foundation/endowments may have infinite horizon • Investment goal(s) • May be to maximize average annual rate of return or simply to earn a real (inflation-adjusted) return of x% annually, etc. Chapter 13: Asset Allocation

Phase One • Foundations/endowments have more complicated goals, especially if under-funded • Defined-benefit pension funds are legally required to pay all benefits in full and on time • Defined-contribution pension fund has no legally defined liabilities (AKA: profit-sharing plans) • Employer is obligated to contribute x% of each year’s profits to fund, but in unprofitable years nothing is contributed—if sponsor of fund bankrupts fund, pensioners cannot sue Chapter 13: Asset Allocation

Phase One • Investor’s tax situation • Under progressive income tax system, some investment behavior is tax motivated • Estate taxes begin at 41% of estates exceeding $1 million and caps at 55% • Makes it worthwhile to consider tax lawyers/accountants and estate planning • Legal constraints • Founder of an organization may have ‘letter stock’ which cannot be sold until certain amount of time has passed • IRAs provide deferred income if investor abides by rules • Employer-sponsored pensions are governed by ERISA of 1974 • Foundations/endowments may be subject to constraints to receive tax exemptions Chapter 13: Asset Allocation

Phase One • Liquidity • Does client need it? • Does client expect large deposits/withdrawals and, if so, when? • Patience and planning necessary when dealing with illiquid assets such as art, real estate, etc. • Personal inventory • Existing investments Chapter 13: Asset Allocation

Step Two: Expectations • May need to educate investor as to what is realistic and achievable • Must discuss risk/return relationship • Market volatility and the difficulty of timing the market should be discussed • Be wary of charts/tables that present a securities broker/mutual fund in a favorable light Chapter 13: Asset Allocation

Step Three: The Policy Statement • Sets forth investment goals and policies to be used • Provides continual guidance through asset allocation process • Important to commit to paper • Writing process forces writer to think! Chapter 13: Asset Allocation

Step Three: The Policy Statement • Should specify • Benchmark • Serves as standard for evaluating performance • Constraint policies • Example • “The portfolio should be managed very conservatively. Margin accounts, leverage, and derivative instruments should not be employed.” • Minimizes possibility that misunderstanding will arise Chapter 13: Asset Allocation

Step Three • Asset allocation policies • Client and asset allocator should also develop numerical policy statement, which includes normal proportions for each of portfolio’s asset classes • Panic attack • Some investors panic when faced with adverse market movements • To address this problem some asset allocators may • Supplement their tactical asset allocation policy with dynamic guidelines • Under-estimate portfolio’s expected returns • Overstate the portfolio’s standard deviation Chapter 13: Asset Allocation

Phase Two—Managing Money • Step 4—Forecasting • Before allocating assets the money manager should study current conditions, analyze alternative and forecast likely outcomes • Different forecasting methods • Fundamental analysis • Study financial ratios, security issuer’s products, competition, relevant laws and regulation, etc. • May analyze several dozen securities, generally one at a time Chapter 13: Asset Allocation

Phase Two—Managing Money • Technical analysis • Study historical market data, preparing graphs and statistics, attempting to discern repeatable patterns • Typically analyze dozens of assets and market indexes, generally one at a time • Risk-Return analysis • Study historical means and probability distributions of returns, and correlations of different investments • Generally analyze various indexes rather than individual assets Chapter 13: Asset Allocation

Step Four--Forecasting • Many asset allocators do not heavily use technical and/or fundamental analysis • They invest in market indexes rather than individual stocks and bonds • Research suggests this is a more productive method of asset allocation than either market timing or security selection • Many analysts begin with historical statistics and make adjustments reflecting their view of the future Chapter 13: Asset Allocation

Step Five—Allocating Assets • If markets are in equilibrium, asset allocator can follow the normal asset mix, or strategic asset allocation • If asset allocator perceives some disequilibrium, may make a tactical asset allocation • Simple asset allocation • If no constraints, asset allocation is accomplished, the asset allocator’s responsibility is to align portfolio’s expected return and risk with the client’s goal Chapter 13: Asset Allocation

Step Five—Allocating Assets • Constrained asset allocation • Many investors have constraints for various reasons • Asset allocator must examine the make-up of the portion of the portfolio that is subject to constraints prior to allocating the non-constrained portion Chapter 13: Asset Allocation

Markowitz Portfolio Theory • Some money managers use Markowitz portfolio theory to allocate assets • Example: You forecast the following statistics • An optimizing computer program computes the most desirable investment (the weights to place in each asset) based on the above inputs Chapter 13: Asset Allocation

Figure 13-1:An Efficient Frontier of Asset Allocations • The efficient frontier for this group of assets is shown below Asset allocator then selects an optimal portfolio on the efficient frontier. Chapter 13: Asset Allocation

Step Six—Investing the Allocated Funds • May be a simple or more complicated task • Do old assets need to be liquidated? • Most clients arrive with an assortment of investments and may be reluctant to liquidate • Are large transactions involved? • May need to enlist aid of a securities trading firm specializing in large transactions • Market impact costs may occur • Large sales tend to drive down a security’s price, while large purchases tend to drive up the price • Work the order over several days in an attempt to avoid this Chapter 13: Asset Allocation

Step Seven—Performance Reports and Feedback • Quarterly reports showing current market value of assets are typically prepared • Potential problems • An inexperienced investor • May wonder why TAA weights and SAA weights differ • May wonder why annualized three-month return doesn’t equal long-run goal Chapter 13: Asset Allocation

Why Asset Allocations Can Vary • As long as TAA has not varied outside dynamic guidelines set forth in policy statement, client should not be surprised • Discussion about deviations offer opportunity to discuss different asset allocations Chapter 13: Asset Allocation

Different Asset Allocations • Strategic asset allocation (SAA) • Used to derive long-term asset allocation weights • These weights are not changed when capital markets change • Tactical asset allocation (TAA) • Used to derive temporary weights used in response to temporary changes in capital market weights • Passive allocation will not have TAA weights Chapter 13: Asset Allocation

Different Asset Allocations • Dynamic asset allocation (DAA) • Refers to a number of different changes in asset weights due to either an investor's circumstances or market conditions • TAA is one type of DAA • Integrated asset allocation (IAA) • Considers • Investor's goals and policies • Capital market conditions • Then uses this information as inputs to some optimizer Chapter 13: Asset Allocation

Missing the Long-Run Goal • Inexperienced investors may be upset when short-run returns do not equal long-run returns • Mean reversion can be offered as an explanation • When security returns, interest rates, and standard deviations tend to fluctuate randomly in short-run but revert to long-run means after reaching extreme values Chapter 13: Asset Allocation

Using Indexes to Explain Investment Behavior • Fundamental and technical analysis are not extremely important when performing the asset allocation process • Because process focuses on homogeneous classes of assets, not individual securities • Asset allocators have conducted research demonstrating power of pure asset allocation • Research studies large pension funds and mutual funds Chapter 13: Asset Allocation

Analyzing Large Pensions • Brinson, Hood & Beebower (BHB) broke down the asset mixes of 91 pension funds into: cash equivalents, bonds, common stocks and other • Created a ‘shadow asset mix’ using returns from market indexes to represent the cash equivalent, bonds and common stock portion of funds • Decided to ignore ‘Other’ category Chapter 13: Asset Allocation

Analyzing Large Pensions • Calculated weight of each asset class for each fund • Predicted each fund’s quarterly return based on weight and market index returns (no market timing or security selection skills needed) • Compared predicted returns to actual returns and found high goodness-of-fit statistics • Average correlation coefficient: 0.976 • Average R2: 95.3% • Results suggest • Asset allocation is main determinant of returns for large, diversified pension funds Chapter 13: Asset Allocation

Ibbotson-Kaplan Study • Ibbotson-Kaplan (IK) analyze 94 balanced mutual funds and 58 pension funds • When analyzing individual funds separately find  90% of variability in portfolio’s return can be explained by asset allocation policy (results similar to BHB) • When examining cross-sectional difference between portfolios’ returns find about 40% of variation in returns across portfolios can be explained by the difference in portfolios’ asset allocations • Remaining 60% can be explained by security selection, market timing, and other factors • When examining the level of portfolio’s returns, find that  100% can be explained by asset allocation policies Chapter 13: Asset Allocation

The Bottom Line • Asset allocation process focuses on achieving investor's risk-return goals by allocating funds among different risk classes • Phase One of the process involves creating a written policy statement • Phase Two involves the actual money management • Empirical studies offer support for the asset allocation process Chapter 13: Asset Allocation

Appendix: Personal Taxes • Individuals are not taxed on their gross income, but rather their taxable income • Gross income less adjustments, deductions and personal exemptions • However, you may have to calculate the alternative minimum tax (which is not indexed for inflation like ordinary income tax tables) • Taxpayer must pay the higher of AMT or ordinary tax • Wealthiest 1 million Americans are subject to AMT Chapter 13: Asset Allocation

Appendix: Capital Gains Tax • Capital assets include stocks, bonds and real estate held for personal investment purposes • Capital gains represent difference between sales proceeds and cost basis • Long-term capital gains (if asset held for > 1 year) have a maximum tax rate of 20% vs a maximum ordinary income tax rate of 39.6% • Short-term capital gains are taxed as ordinary income • Taxes can be a large expense; therefore some mutual funds offer ‘tax-managed’ funds Chapter 13: Asset Allocation

Appendix: Capital Gains Tax • To determine your capital gains tax • Net all short-term gains and losses • Net all long-term gains and losses • Make certain you include all loss carryovers from prior years for both short-term and long-term • Combine the net short-term and long-term totals to obtain overall capital gains and losses • You will pay 20% tax rate only on net long-term capital gain • If you have a net overall loss, you may deduct up to $3,000 against ordinary income • If net losses exceed $3,000 may carryforward Chapter 13: Asset Allocation

Appendix: Capital Gains • Income from assets inside retirement plans is not taxed until distributed • Then taxed as ordinary income • Capital gains realized by mutual funds are taxable income to the shareholder • Wash sales occur if an investor sells a security that dropped in value relative to purchase price to claim a tax loss and immediately buys it back (because they still want security in portfolio) • Under current law, taxpayer is not allowed to claim a loss if with 30 days of sale the taxpayer acquired either the substantially same securities or an option to acquire the security Chapter 13: Asset Allocation

Appendix: Tax-Exempt Investing • Most municipal bonds are free from federal income taxes • However, municipals generally subject to state income tax (if they are not issued in taxpayer’s state) • Because munis are generally tax-exempt, an equivalent investment in a taxable security must have a higher return • For instance, if you are in a 15% tax bracket, a taxable investment must earn 9.4% to be equivalent to a non-taxable investment earning 8% • 9.4%  (1-0.15) = 8% • If you are in a 39.6% bracket the taxable investment must earn 13.3% Chapter 13: Asset Allocation

Appendix: Tax-Exempt Investing • For most investors home ownership is tax-exempt • Up to $250,000 of the gain from the sale of a house is tax exempt for the single taxpayer ($500,000 for married) • Must occupy house as principal residence for at least 2 of 5 preceding years • Cannot use this exemption more frequently than once every 2 years Chapter 13: Asset Allocation

Appendix: Unified Transfer Tax • Estate tax • Much criticized because, even though a taxpayer pays taxes on income as s/he earns it, the assets acquired with after-tax income are taxed again at the taxpayer’s death • Rates reach a maximum of 55% on estates in excess of $3 million • Unified Transfer Tax actually involves • Estate taxes (following death) • Gifts (during one’s lifetime) • Generation-skipping transfers (whether during life or death) Chapter 13: Asset Allocation

Appendix: Estate Taxes • An exclusion of $1 million (by 2002) is available at which point the rate starts at 41% and increases to 55% • Not indexed for inflation • Technically not a tax on assets (which is unconstitutional) but on the transfer of assets • Lifetime gifts are added back into one’s estate at death • So doesn’t matter if assets are transferred after or before taxpayer’s death Chapter 13: Asset Allocation

Appendix: Estate Taxes • When a person dies and his/her estate transfers to heirs, the value of the portfolio for income tax purposes becomes a stepped-up cost basis • Example: Sam, 95 years old, has a portfolio with a market value of $1 million and a cost basis of $100,000. However, when he dies the cost basis of the portfolio will be much greater than $100,000 (say $900,000 is the stepped-up cost basis). If his heirs were to immediately liquidate the portfolio their capital gains would be $1,000,000 - $900,000 or $100,000. Chapter 13: Asset Allocation

Appendix: Gift Taxes & Generation-Skipping Transfer Tax • A gift tax was added to combat the practice of taxpayers making gifts during their life (in an attempt to reduce the estate taxes upon their death) • An annual gift tax exclusion currently allows each person to give up to $10,000 a year to any number of people without affecting the $1 million estate tax exclusion • A flat tax of 55% is assessed on transfers skipping a generation • $1,000,000 life-time exclusion per donor/decedent Chapter 13: Asset Allocation

Asset Allocation