Name: Gabriel Manjonjo

Reg. Number: H160233F

Course: Portfolio Engineering (BFE 420)

Assignment 2
Abbreviations

SAA ………………….Strategic asset allocation

TAA …………………Tactical asset allocation

SP ……………………Sharpe Ratio
CHAPTER 1

Introduction

Many pension funds, endowment funds and other institutional investors are concerned that
equities typically their largest asset allocation will provide lower average returns over the next
decade. In this environment, many investors have questioned the wisdom of thinking about asset
allocation solely in strategic terms and have shown renewed interest in tactical approaches.

Tactical asset allocation (TAA) is a dynamic strategy that actively adjusts a portfolio’s strategic
asset allocation (SAA) based on short-term market forecasts. Its objective is to systematically
exploit inefficiencies or temporary imbalances in equilibrium values among different asset or sub
asset classes. Although the successful implementation of a TAA strategy is often portrayed as
simple, it is actually very difficult. Our results show that while some TAA strategies have added
value, on average TAA strategies have not produced statistically significant excess returns over
all time periods. However, TAA can add (or subtract) value, if designed, implemented and
evaluated appropriately.

This paper provides best practices for developing or selecting a TAA or SAA strategy.
Specifically we review the components of a robust model, relevant qualitative and quantitative
evaluation metrics and the tools and processes needed to make optimal decisions regarding TAA
and SAA strategies.

SAA, also known as policy asset allocation, is the establishment of a long-term target allocation
in major asset classes such as stocks, bonds and cash based on portfolio objective, risk tolerance
and time horizon. Over time, SAA is the most important determinant of the total return of a
broadly diversified portfolio with limited market timing. Studies support empirically the
dominance of SAA in determining total return and return variability.

In recent years, terms like ‘allocation funds’, ’blend funds’, ’mix funds’ and ’mixed products’
have become increasingly common in portfolio management. These terms cover funds that invest
in one or more asset classes, typically a mix of equities and various types of bonds. The basic
idea is that the majority of the fluctuations in a portfolio’s return can be explained by the overall
allocation of the portfolio - as opposed to the selection of individual securities. The advantage is
that investors can, by means of a single product/fund, obtain a very well-diversified portfolio of
equities and bonds with allocation into several thousand securities. Within this range of
‘combined asset class’ products, there are two distinct types: ‘strategic’ and ‘tactical’ allocation
funds. The principal difference between the two being their approach to market timing. In
strategic funds, timing and market expectations have limited influence on the allocation. Instead,
the risk profile of the funds is usually kept constant by having a relatively fixed allocation to
equities and bonds. These products are usually categorized as being ‘low-’, ‘medium-’ or ‘high-
risk’, whereby higher risk corresponds with a higher allocation to equities. This gives the
investor the opportunity to buy into a suitable risk level

The term asset allocation refers to the composition of an investor’s portfolio on different asset
classes. A central tenet of asset allocation is that this composition is the main determinant of the
risk and expected return of the portfolio, while the exposure to different asset classes constitutes
the main source of diversification. From the perspective of modern portfolio theory, asset
allocation represents the investor’s exposure to systematic risk which highlights its importance.
CHAPTER 2

Literature review

Asset allocation theories may be one of these innovations that have not reached their full
practical potential. Despite the original mean-variance model’s elegance, mathematical rigour
and intuitive appeal and the availability of computing power, there appears to be some evidence
that MPT is not being fully utilised in the investment environment (Michaud 1989). In an early
work, the aggregate market values of the major asset classes in the US namely common stocks,
fixed corporate securities, real estate, government bonds and municipal bonds were estimated
over the years to get a picture of the total market portfolio (Ibbotson & Fall 1979). Later
analysis of the data extended to more recent times showed that the evident asset allocation was
inconsistent with what would have been recommended by the original mean- variance model
(Baker & Filbeck 2013). Using a mean-variance model that acknowledges the time varying
nature of the covariances of asset returns improves the model’s fit with US stock market data
although Tobin’s portfolio balance model which relies on the trade-off between liquidity and
forgone interest still showed a better fit (Engel et al. 1995).

Acknowledging their significant influence on the aggregate market portfolio, there have been
studies on how financial advisers’ recommended asset allocations stack up against the original
mean-variance model. A study undertaken in the US context found that adviser-recommended
asset allocations are suboptimal and achieve on average only 80% to 98% of the theoretically
optimal portfolio returns (Huber & Kaiser 2003). Another study showed that the benchmark
asset allocations recommended by financial planning groups for Australian private investors are
also significantly sub-optimal. For each recommended asset allocation, a superior portfolio
having a higher expected return for the same level of risk could be obtained by adjusting the
recommended asset allocations (Santacruz & Phillips 2009).

Financial advisers’ recommended asset allocations were also assessed against Tobin’s extension
of the original mean-variance model, the Portfolio Separation Theorem, which simplified asset
allocation into the choice of the mix of a risk free asset and a risky portfolio that is uniform for
all investors (Tobin 1958). Inconsistent with this theorem which implies that all investors should
hold the same allocation of risky assets, US financial advisers were found to be recommending
that conservative investors hold a higher ratio of bonds to stocks than aggressive investors
(Canner, Mankiw & Weil 1997). However, further analysis of the same data showed that
advisors’ recommendations are consistent with MPT under reasonable assumptions (Elton &
Gruber 2000). It was also shown that MPT supports advisors’ recommendation that the ratio of
bonds to stocks should vary directly with risk aversion when there are complete markets and
when an investor’s horizon exceeds the maturity of cash as this allows investors to synthesise
risk-free and risky assets (Bajeux-Besnainou, Jordan & Portait 2001). Inter-temporal hedging
was tested as an explanation for the “asset allocation puzzle” identified by Canner et al. (1997)
but was found insufficient (Lioui 2007).

CHAPTER 3

Methodology

The Asset Allocation Process

This process begins with an investor who has given a mandate to an investment manager to
manage a given capital which is initially in the form of cash. The investor will draft a policy or
The Investment Policy. This policy is the guidelines that the manager has to follow is formulated
either exclusively by the sponsor or in conjunction with the investment manager, and provides
overall guidelines for the manager to follow. Its elements will typically include:

1. The Investment Policy is formulated either exclusively by the sponsor or in conjunction

with the investment manager, and provides overall guidelines for the manager. Its
elements will typically include: 1. Investment objectives. While these can vary
considerably, a basic distinction can be made between an objective of capital preservation
and one of capital appreciation. While the former is associated with a conservative
investment profile, even this type of investor must aim for a return which is high enough
to match inflation in order to conserve the purchasing power of the capital. A pure capital
appreciation objective, on the other hand, would aim at growing the value of the capital
in real terms. The so called total return approach, used by some university endowments
and foundations, seeks a high capital growth over time by reinvesting income, having an
equity bias and paying out a proportion of this on an ongoing basis which is sufficiently
below the average expected return to be deemed sustainable.
2. Time horizon. All other things being equal, a longer time horizon will normally imply a
greater willingness to accept short-term volatility since the long-term investor has the
opportunity to match bad years with subsequent good years. A longer-term investor, on
the other hand, is more susceptible to the eroding effects of inflation. Knowledge of the
investor’s time horizon is relevant to other issues than risk in a narrow sense, however,
such as the maturity of fixed income securities in the portfolio and the degree of liquidity
of the financial instruments employed in general.
3. Risk tolerance can be formulated in various ways, such as a maximum volatility of the
overall portfolio (or of individual elements), measured over a given period or a maximum
drawdown within, say, any given month, quarter or year.
4. Constraints on the portfolio management include requirements like a minimum income
generation from the portfolio, a minimum level of cash holding at any given time or a
maximum holding(s) of individual securities (typically because of regulatory
restrictions).
 5. Tax status and other unique circumstances can often exclude certain investments or
concentrate the portfolio on certain investment instruments.

Strategic and Tactical Asset Allocation

Once the parameters of the investment policy was laid down, the SAA was formulated. This
asset allocation has a long time horizon (5–10 years or more) and is based on expectations
regarding long-term risk and return of the different asset classes and the correlation between
them. Optimization techniques from modern portfolio theory are often employed at this stage.
The SAA constitutes a policy asset allocation which is typically stated as a target weight for each
asset class with some permitted variation around the target.

TAA constitutes an active complement to the SAA which is essentially passive. In TAA,
deviations from the target weights in the SAA, but within the permitted ranges, are made
deliberately, on a discretionary basis. The central tenet of TAA is that such deviations of
portfolio weights, carried out over shorter periods (say three months to a year) can add value to
the portfolio. The deviations may be prompted by apparent pricing anomalies (inefficiencies) in
the market or by changes in economic fundamentals and monetary policy, which are of such
importance that they make short-term return forecasts differ significantly from those estimated
for the purposes of the SAA. The short-term view is expressed by going overweight against the
central target of those assets that are expected to outperform and going underweight those assets
which are expected to underperform, with a view to returning to benchmark levels once the out-
or underperformance has materialized.

The Asset Allocation

The investor will begin with $1,000,000 to invest in the portfolio. Using this amount two
different portfolios will be created one for the SAA and the other for the TAA. The manager can
invest in the following asset classes.

JP200,

USOIL,

Gold.
The assets classes are assigned weights in the portfolio based on the strategy used. This process
will be done in the monthly period of time 10 years.

The Investment Process

When the investment policy has been formulated, and the parameters of the SAA and the TAA
have been fixed, then we can begin the actual investment process. The first step is to decide on
the specific securities that will constitute the portfolio and then to execute the relevant trades. At
professional asset management firms, the execution desk will typically provide useful
information about flows and market liquidity to help the portfolio manager optimize the timing
and size of each trade until the full portfolio has been constructed. Deviations from the Target
Weights of the SAA

Rebalancing

A different performance among the different asset classes in the portfolio will automatically
imply a shift away from the central targets in the SAA.  Whether or not this will prompt a
portfolio adjustment from the manager depends on the rebalancing strategy followed. Perold and
Sharpe (1988) did a study on the strategies used for rebalancing a portfolio. The preferable
strategy in principle depends on our assumptions about future market behavior. The rebalancing
methods include:

Buy-and-Hold,

Constant Mix , and

Constant Proportion Portfolio Insurance (CPPI)

Software used

The researcher used R studio for analyzing the performance of the portfolio and used excel for
producing and storing the data.
CHAPTER 4

RESULTS AND INTERPRETATION

In this chapter, we address the following questions. Which benchmark should be used to assess
the performance of active managers? How can we measure the risk-adjusted performance of
portfolio managers? Finally, how do we measure how an active manager achieved a given
return?

Benchmarks

A benchmark is clearly necessary for assessing the skills of a manager. It also plays an important
role in defining the sponsor’s investment universe and risk tolerance. The choice of benchmarks
is therefore an important initial part of the asset allocation process. The effective benchmark
generally has the following criteria:

• Unambiguous. Identities and weights of securities or investment styles are clearly defined.

• Investable. The benchmark represents a viable passive alternative to the active portfolio.

• Measurable. Returns can be calculated with a high frequency

• Appropriate. The benchmark reflects the manager’s investment style or area of expertise.

• Reflective of current investment opinions. The manager has current knowledge of the
securities or factor exposures in the benchmark.

• Specified in advance. The benchmark is specified prior to the start of an evaluation period.

• Owned. The investment manager is aware of and accepts accountability for the constituents
and performance of the benchmark.

Risk-Adjusted Performance Measurement

How can sponsors rank portfolio managers? It is clear that even if the benchmark is chosen with
care, this constitutes no guarantee that the risk of the portfolio and that of the benchmark will be
identical. Indeed, if active management is about diverting from the benchmark, measures of the
risk that this involves are called for. As we will see, this is not without its complications,
however. This study will look at three commonly used measures.

Returns

Strategic allocation performance

Return Annualized return

JP200 $17520 10.2%
USOIL $13200 9.5%
GOLD $7690 8.8%

Return Annualized return

JP200 $12500 9.2%
USOIL $9450 6.15%
GOLD $3250 4.08%
Tactical allocation performance

Standard deviation of the portfolios

This measure of performance is calculated based on the standard deviation of returns of each
asset in the portfolio. It is calculated as:

Standard deviation for SAA portfolio:

Standard deviation
JP200 0.190
USOIL 0.256
GOLD 0.159

Standard deviation for TAA portfolio:

Standard deviation
JP200 0.320
USOIL 0.458
GOLD 0.269

This means that the returns for the TAA are risky and volatile than that of the SAA strategy.

Sharpe ratio
The Sharpe Ratio William Sharpe (1966) proposed what he originally termed the reward-to
variability ratio, but is now commonly referred to as the Sharpe ratio (SR):

Sharpe Ratio (SR) relates the excess returns on a portfolio to its risk. The SR represents the slope
of the ex post capital market line (CML) connecting the risk-free rate and the standard deviation
of returns. Portfolios lying above the ex post CML have outperformed the market portfolio while
portfolios below it have underperformed it. The fact that the SR includes idiosyncratic risk
makes it more suitable for the ranking of less than perfectly diversified portfolios, and this ratio
is more commonly used in the investment industry. The risk free rates were obtained from the
USA treasury department website.

Sharpe ratio for SAA strategy

0.402

Sharpe ratio for TAA strategy

0.267

The greater the portfolio’s Sharpe ratio the better its risk adjusted performance. If the analysis
results in a negative Sharpe ratio, it either means the risk-free rate is greater than the portfolio’s
return, or the portfolio’s return is expected to be negative. This means the SAA strategy has
better risk adjusted performance than the TAA strategy portfolio.
CHAPTER 5

CONCLUSION

Generally the SAA was better than the TAA strategy using the three performance measurement
which were return, standard deviation and also Sharpe ratio. This study supports the efficient
market hypothesis EMH which states that markets are perfect and reflect information available in
the market, therefore it I impossible to predict movement of the trends. Therefore TAA would
perform poorly that the SAA strategy. The other reason why the TAA performed worse was that
the SAA was because of the transaction costs. More rebalancings were done during the term of
10 years meaning that more transaction costs and taxation costs which reduced the incomes.
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