1. Strategic Asset Allocation vs Tactical Asset Allocation Strategic Asset Allocation | Tactical Asset Allocation | Strategic asset allocation aims to provide investor with long term target returns, and then choose an appropriate asset mix to achieve that returns. The allocation will be reviewed and adjusted periodically (usually from 3-5 years), according to the change in investor's goals and needs overtime. | Tactical asset allocation aims to take advantage of inefficiencies in asset pricing in short term. It involves short term return forecast or valuation. The process will be revised in 1 or 3 months, or even shorter time, and the adjustments will be made within given ranges around target asset-class weights. |
Because we know that security will have a high chance of getting the target long-term return, so if the short-term return is not as high as expected, that means the security is undervalued, so it makes sense to buy more, in order to achieve larger returns in long-term.
Using Sharpe ratio, investor can determine whether or not to add an alternative asset class to current portfolio. So if Sharpe ratio of new portfolio is greater than that of the current portfolio, or in the other way, if Sharpe Rationew asset > (Sharpe Ratiocurrent portfolio * ρ(new asset, current portfolio)) then the new asset will be added.
In our case, if the Sharpe ratio of new asset is greater than 0.4 * 0.35 = 0.14, it will be added. But its predicted Sharpe ratio is only 0.12, so the fund should not add new asset to existing portfolio.
We can use Roy's safety-first ratio
With RL = 3.5% to help Gareth Foundation to choose the asset allocation, the one with the highest ratio is the one that has minimum probability of return not meeting the threshold.
So the ratios of 3 allocations are as follow: Allocation A: 0.444 Allocation B: 0.321 Allocation C: 0.25
So Gareth Foundation should choose allocation A to meet its objective.
5. a. Client's objective is to achieve the expected returns of 5% (inflation + 2%), with the volatility no greater than 6% (below average). So the suggested portfolio mix for the client is as below: Asset | Expected Return (annual) | Volatility (annual) | Weights | Cash | 4% | 0% | 10% | Equities | 8% | 7% | 30% | Fixed Interests | 5% | 3% | 30% | Inflation indexed Bonds | 5% (inflation + 2%) | 4% | 30% | Overall portfolio | 5.8% | | |
b. The funding ratio is 1.1, which means that the client has more assets than liabilities. So if the liabilities are expected to grow at inflation + 1%, the expected return of assets also has to grow, in order to fund more liabilities the client has to pay. The adjusted asset mix will be Asset | Weights | Cash | 5% | Equities | 45% | Fixed Interests | 25% | Inflation indexed bonds | 25% | Overall portfolio | 6.3% |
c. If the funding ratio is 0.6, which means the client has even more liabilities than assets, the expected return of asset has to grow even more in order to fund the payment.