The New Science of Asset Allocation: Risk Management in a Multi-Asset World

Preface xi

Acknowledgments xix

Chapter 1 A Brief History of Asset Allocation 1

In the Beginning 3

A Review of the Capital Asset Pricing Model 4

Asset Pricing in Cash and Derivative Markets 6

Models of Return and Risk Post-1980 11

Asset Allocation in the Modern World 14

Product Development: Yesterday, Today, and Tomorrow 15

Notes 17

Chapter 2 Measuring Risk 20

What is Risk? 22

Traditional Approaches to Risk Measurement 24

Classic Sharpe Ratio 26

Other Measures of Risk Assessment 28

Portfolio Risk Measures 30

Other Measures of Portfolio Risk Measurement 33

Value at Risk 34

Notes 37

Chapter 3 Alpha and Beta, and the Search for a True Measure of Manager Value 39

What is Alpha? 39

Issues in Alpha and Beta Determination 46

Problems in Alpha and Beta Determination 48

Multi-Factor Return Estimation: An Example 50

Tracking Alternatives in Alpha Determination 54

Notes 56

Chapter 4 Asset Classes: What They are and Where to Put Them 58

Overview and Limitations of the Existing Asset Allocation Process 59

Asset Allocation in Traditional and Alternative Investments: A Road Map 61

Historical Return and Risk Attributes and Strategy Allocation 66

Traditional Stock/Bond Allocation versus Multi-Asset Allocation 70

Risk and Return Comparisons Under Differing Historical Time Periods 71

Extreme Market Sensitivity 74

Market Segment or Market Sensitivity: Does It Matter? 82

How New is New? 84

Notes 88

Chapter 5 Strategic, Tactical, and Dynamic Asset Allocation 91

Asset Allocation Optimization Models 92

Strategic Asset Allocation 99

Tactical Asset Allocation 101

Dynamic Asset Allocation 107

Notes 109

Chapter 6 Core and Satellite Investment: Market/Manager Based Alternatives 110

Determining the Appropriate Benchmarks and Groupings 111

Sample Allocations 117

Core Allocation 119

Satellite Investment 120

Algorithmic and Discretionary Aspects of Core/Satellite Exposure 120

Replication Based Indices 122

Peer Group Creation—Style Purity 126

Notes 132

Chapter 7 Sources of Risk and Return in Alternative Investments 134

Asset Class Performance 135

Hedge Funds 139

Managed Futures (Commodity Trading Advisors) 143

Private Equity 148

Real Estate 153

Commodities 160

Notes 166

Chapter 8 Return and Risk Differences among Similar Asset Class Benchmarks 167

Making Sense Out of Traditional Stock and Bond Indices 168

Private Equity 170

Real Estate 173

Alternative REIT Investments Indices 179

Commodity Investment 179

Hedge Funds 185

Investable Manager Based Hedge Fund Indices 185

CTA Investment 189

Index versus Fund Investment: A Hedge Fund Example 189

Notes 194

Chapter 9 Risk Budgeting and Asset Allocation 195

Process of Risk Management: Multi-Factor Approach 195

Process of Risk Management: Volatility Target 200

Risk Decomposition of Portfolio 202

Risk Management Using Futures 203

Risk Management Using Options 206

Covered Call 206

Long Collar 208

Notes 210

Chapter 10 Myths of Asset Allocation 212

Investor Attitudes, Not Economic Information, Drive Asset Values 213

Diversification Across Domestic or International Equity Securities is Sufficient 214

Historical Security and Index Performance Provides a Simple Means to Forecast Future Excess Risk-Adjusted Returns 215

Recent Manager Fund Return Performance Provides the Best Forecast of Future Return 215

Superior Managers or Superior Investment Ideas Do Not Exist 216

Performance Analytics Provide a Complete Means to Determine Better Performing Managers 216

Traditional Assets Reflect “Actual Values” Better Than Alternative Investments 217

Stock and Bond Investment Means Investors Have No Derivatives Exposure 217

Stock and Bond Investment Removes Investor Concerns as to Leverage 218

Given the Efficiency of the Stock and Bond Markets, Managers Provide No Useful Service 218

Investors Can Rely on Academics and Investment Professionals to Provide Current Investment Models and Theories 218

Alternative Assets are Riskier Than Equity and Fixed Income Securities 219

Alternative Assets Such as Hedge Funds are Absolute Return Vehicles 220

Alternative Investments Such as Hedge Funds are Unique in Their Investment Strategies 221

Hedge Funds are Black Box Trading Systems Unintelligible to Investors 222

Hedge Funds are Traders, Not Investment Managers 222

Alternative Investment Strategies are So Unique That They Cannot Be Replicated 223

It Makes Little Difference Which Traditional or Alternative Indices are Used in an Asset Allocation Model 223

Modern Portfolio Theory is Too Simplistic to Deal with Private Equity, Real Estate, and Hedge Funds 223

Notes 225

Chapter 11 The Importance of Discretion in Asset Allocation Decisions 226

The Why and Wherefore of Asset Allocation Models 226

Value of Manager Discretion 230

Manager Evaluation and Review: The Due Diligence Process 232

Madoff: Due Diligence Gone Wrong or Never Conducted 233

Notes 239

Chapter 12 Asset Allocation: Where is It Headed? 240

An Uncertain Future 241

What is the Definition of Order? 243

Costs and Benefits 246

Today’s Issue 246

Possible Governmental and Private Fund Responses to Current Market Concerns 247

Note 249

Appendix: Risk and Return of Asset Classes and Risk Factors Through Business Cycles 251

Glossary: Asset Class Benchmarks 271

Bibliography 279

About the Authors 285

Index 287