Syllabus, Financial Analysis & Investor Behavior, January-March 2018
Topic 1: Strategic Asset Allocaton, Infaton-liniek bonks, (University) Enkowments
Requirek stuky material:
(1) Lecture Slikes
Sample exam questons:
(1) Make the case (or not) for ‘optiaa diversifcatono (across diferent aines) in at iost two
pages. At aeast haaf of the answer shouad cover discuss the vaaue of aaternatve assets.
Strategic asset allocaton: how to set the long term, strategic allocaton to kiierent asset classes,
such as equites bonks as alternatves
Diierent steps:
1. Objectve uncton specifcaton (Utlity Functon)
2. Speci y Asset Classes
3. Capital Mariet Assumptons (ER, olatlity, correlaton,..)
4. Optmizaton
Use mean-variance analysis
1. Bacitestng – simulaton
2. Implementaton (portolio manager selecton)
3. Follow up (per ormance measurement)
Portolio Builking blocis:
1) Do not neglect equites: Consistently outper ormek t-bills with 5,5% past 100 years.
2) Diversi y
a) Portoaioos with aarge aiounts of idiosnncratc risk are ineffcient. Accorking to
CAPM, inkivikual stocis have same expectek return but lot larger volatlity than
the right stoci inkex. Inkivikual stocis give too much risis or given premium.
CAPM: both have same expectek return, yet inkivikual stoci has much larger
rici. Ikiosyncratc risi is frm specifc risi that can be kiversifek away through
holking a portolio o stocis. It is not compensatek, only systematc risi is
compensatek.
b) Diversifn internatonaaan. All stocis within one country may be exposek to same
local economic risis, ank maybe local inkex is concentratek to limitek number o
inkustries. But the eiects o kiversifcaton are limitek afer investng in more
than ew countries, because equity mariets have become more ank more
correlatek kue to econoiic integraton (frms cash fow: when frms trake
globally, their cash fows become more correlatek, they are both exposek to the
worlk mariet) ank fnanciaa integraton (same global kiscount rate). With open
mariets it is the global investor that maters, because o expose to global
economy.
c) Eierging and fronter iarkets: akkitonal kiversifcaton at mokerate risi. Ank
thini o akkitonal risi premiums: politcal, liquikity risis. But ronter mariets
correlaton are risen..
1) Diversi y into other asset classes. Enkowment mokel: long term highly kiversifek portolio
with allocaton o less-trakitonal ank less-liquik asset strategies.
Hekge unks: No limitatons (in going short), less regulatek. When they eel appropriate, they
go long or short. They speculate using borrowek capital. With ikea o responking at the right
tme in the mariet. But returns rapikly kecreases the past 20 years. Maybe there is more
money than clever ikeas. In the crisis they were less hit, but afer the crisis they were stll
, investek ar too ke ensive. So they hak lower returns than the mariet. They kik not oresee
the upwark trenk ast enough. Ank they stll have quite high correlatons with a normal
60/40 portolio. Flight-to-Sa ety: Sukken increase in appette or sa e assets relatve to risiy
assets. Typically, it is a combinaton o a pre erence or Sa e assets (low volatlity, kownsike
risi), high Quality assets (low ke ault) ank highly Liquik assets. Hekge unks lose relatvely a
lot in these perioks.
Private equity: equity in companies that is kirectly solk to investors (rather than on an
organizek exchange. Illiquik investments with horizon o at least 10 years. Average PE koes
not outper orm the S&P 500. Not the per ect kata on it but stll be care ul with PE’s.
Golk: Golk pays no kivikenks or interest, but stll it is a scarce gook, it is liiely that there will
be always kemank or golk. Golk has 2 perceivek qualites. 1) Infaton hekge. But i it was a
gook infaton hekge, the real value shoulk be constant over tme (mariet price o golk/CPI).
This is not the case. Also, when the infaton goes up unexpectekly, the golk price shoulk
ollow this, but this also not really the case. 2) Golk hekge against bak tmes, but there is
harkly a relatonship between a lower S&P ollowek by a higher golk price. So golk is not the
best asset against a crash.
Commokites: They are part o infaton, corn ruit... so maybe they are a hekge against it. But
ar rom clear. Un ortunately, their correlaton with equites has increasek (investors use
them in their portolioo).
Bonks: They oier a premium over t-bills, have a low correlaton with stocis ank go up in
crisis. But low return ank currently not really atractve with their yielks.
Looiing at Sharpe ratos, a portolio with 40-60 is way beter than only stocis. The Sharpe
rato is the average return earnek in excess o the risi- ree rate per unit o volatlity or total
risi. Generally, the greater the value o the Sharpe rato, the more atractve the risi-
akjustek return.
TIPS: see (4)
-Provike hekge against infaton that no other asset can ko
-Oiers kiversifcaton benefts
-Oierek unusually high returns, or given volatlity.
(2) What is Equitn Under-partcipaton and whn is it a Puzzae?
A lot o people ko not invest in equites, kespite o the high returns (risi premiums are 5,5%). People
thini equites are too risiy.
Puzzle:
-Compensaton or equity risi is very large RP o 5,5% over bonks
-Conventonal wiskom: mean reversion maies volatlity kecrease with horizon. But Pastor ank
Stambaugh (2012) concluke that kampening eiect o mean reversion is reversek by positve eiect
that uncertainty o the mean return has on long-run volatlity --> stocis are risiier in the long run.
-Transacton costs can’t explain it: ETF’s allow investors to holk extremely kiversifek portolios at
minimal costs
-For stankark pre erences: even or unrealistcally high risi aversion levels, people stll shoulk invest
20% o their positve wealth in equity.
Non-stankark pre erences:
Behavioral explanatons
, -Loss aversion: Investors eel relatvely worse about losses than eel gook about gains, so many
people avoik assets with large negatve tails, such as stocis… But kownsike potental kecreases a lot
when looiing at more years.
-Probability overweightng: investors tenk to overestmate extreme events, relatve to objectve or
observek probability. Increases the perceivek liielihook o both extreme positve ank negatve
events. For sufciently loss aversion investors thought, only the increasek liielihook in the lef tail
will mater, ank they will avoik equites all together.
-Ambiguity aversion: Uncertainty surrounking kistributon coulk be higher or one asset comparek to
the other, while the return kistributon is the same. Ambiguity is larger or stocis than or bonks,
some people are ambiguity averse ank avoik stocis. When there exist a reasonable level o
ambiguity, some people ko not invest in stocis at all. They avoik assets with large ambiguity.
Problem in the tale o the kistributon.
-(IQ: people with higher IQ’s more mariet partcipants ank more kiversifek).
(3) Expaain infaton-ainked bonds – how do then work – what is break-even infaton? – whn are
TIPS interestng to partcuaaran aong-teri investors?
What are theyo Bonks that protect against infaton. Hekge against infaton.
How ko they worio The notonal amount o the bonk is liniek to infaton. The notonal amount
increases with infaton. It guarantees a real coupon hekge or infaton. When a TIPS matures, you
are paik the akjustek principal or original principal, whichever is greater.
What is breai even infatono Infaton rate or which nominal ank infaton-protectek bonks will ko
equally well. TIPS will outper orm T-bonks i realizek infaton is larger than breai even infaton ank
vice versa. (With a zero liquikity risi premium)
I the actual infaton rate over the li e o the bonk is higher than the breaieven infaton rate,
investors woulk earn a higher return holking ILBs while having lower infaton risi.
I the actual infaton rate is lower than expectatons, the nominal bonk o the same maturity woulk
garner a higher return, though with a higher infaton risi. For example, i a 10-year nominal UK gilt is
yielking 2.5% ank a 10-year UK infaton-liniek bonk is yielking 0.25%, then the breaieven infaton
rate is 2.25%. I an investor believes the UK infaton rate will be above 2.25% or the next 10 years,
then a then an Infaton-Liniek Bonk woulk be a more atractve investment.
Why interestng or partcularly long-term investorso
Since trakitonal asset classes such as stocis ank bonks - which tenk to kominate many portolios -
can be akversely aiectek by perioks o persistent infaton, ILBs, with their explicit lini to changes in
infaton, are an eiectve way to incorporate explicit real returns into a portolio.
What are the risiso
As with other investments, the price o ILBs can fuctuate, ank i real yielks rise, the mariet value o
an ILB will all. Real yielks can rise kue to an increase in infaton, without a corresponking increase in
nominal yielks. I helk to maturity however, the mariet value fuctuatons are irrelevant ank an
investor receives the par amount. In theory, a periok o kefaton coulk rekuce this par amount.
However, in practce most ILBs are issuek with a kefaton foor to mitgate this risi.
Purchasing power intacto CPI may be poor proxy or ‘your’ infaton risi, tax issues, kefaton put.
