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LM5 Asset Allocation with Real World Constraints 2024 Level III Notes © IFT. All rights reserved 1 LM5 Asset Allocation with Real-World Constraints 1. Introduction .......................................................................................................................................................3 2. Constraints in Asset Allocation and Asset Size .....................................................................................3 Asset Size ............................................................................................................................................................3 3. Liquidity...............................................................................................................................................................7 4. Time Horizon .....................................................................................................................................................9 5. Regulatory and Other External Constraints........................................................................................ 10 Insurance Companies.................................................................................................................................. 10 Pension Funds................................................................................................................................................ 11 Endowments and Foundations ............................................................................................................... 11 Sovereign Wealth Funds............................................................................................................................ 11 6. Asset Allocation for the Taxable Investor and After-Tax Portfolio Optimization................ 13 After-Tax Portfolio Optimization ........................................................................................................... 13 7. Taxes and Portfolio Rebalancing and Strategies to Reduce Tax Impact.................................. 15 Strategies to Reduce Tax Impact............................................................................................................ 16 8. Revising the Strategic Asset Allocation................................................................................................. 19 9. Short-Term Shifts in Asset Allocation ................................................................................................... 22 Discretionary TAA........................................................................................................................................ 23 Systematic TAA ............................................................................................................................................. 23 10. Dealing with Behavioral Biases in Asset Allocation...................................................................... 25 Loss Aversion................................................................................................................................................. 26 Illusion of Control......................................................................................................................................... 26 Mental Accounting ....................................................................................................................................... 26 Representative Bias..................................................................................................................................... 27 Framing Bias................................................................................................................................................... 27 Availability Bias ............................................................................................................................................ 28 Summary ............................................................................................................................................................... 31 This document should be read in conjunction with the corresponding reading in the 2024 Level III CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2023, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights
LM5 Asset Allocation with Real World Constraints 2024 Level III Notes © IFT. All rights reserved 2 reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute. Version 1.0
LM5 Asset Allocation with Real World Constraints 2024 Level III Notes © IFT. All rights reserved 3 1. Introduction This reading is part of a sequence of three readings that cover asset allocation. The reading talks about the real-world challenges in developing an asset allocation and addresses the ways in which the asset allocation can be accommodated to the asset owner’s circumstances and constraints (including asset size, liquidity, time horizon, tax status, etc). This reading also discusses making short-term shifts in asset allocation and the impact of an investor’s behavioral biases on his investment portfolio. 2. Constraints in Asset Allocation and Asset Size The asset allocation choice of an asset owner must incorporate the asset owner’s constraints. Some of the most important constraints that may influence the investment opportunity set or the optimal asset allocation decision include the following: 1. Asset size 2. Liquidity needs 3. Taxes 4. Time horizon 5. Regulatory and other external considerations Asset Size The size of an asset owner’s portfolio may limit the investment opportunity set. Too small portfolio size: The portfolio might be too small to efficiently capture the returns of certain asset classes and strategies such as hedge funds, private equity, and real estate. The reasons for this include: • Smaller size portfolios do not have economies of scale. • Smaller size portfolios may not have enough resources for sophisticated governance. • Smaller size portfolios tend to have high management fees relative to AUM. • Asset owners of smaller size portfolios have low negotiation leverage. • The portfolio might be too small to effectively diversify across asset classes. • The portfolio might be too small to meet minimum investment requirements. • Asset owners of smaller size portfolios cannot invest in complex strategies due to a lack of investment expertise/knowledge. A workaround for these limitations is to invest via commingled vehicles, for example, using a fund-of-funds to invest in hedge funds. Too large portfolio size: The portfolio might be too large to efficiently capture the returns of asset classes with low market capitalization and certain active strategies. The reasons for this include:
LM5 Asset Allocation with Real World Constraints 2024 Level III Notes © IFT. All rights reserved 4 • The asset class may not be large enough to invest. • Large size portfolios tend to have large trades and thus, can lead to high price impact. • Large size portfolios tend to have liquidity issues. • Large size portfolios may have overexposure to some fund managers. • In larger size portfolios, fund managers may be forced to make investments outside their area of expertise. • In larger size portfolios, the decision-making process is slowed down owing to organizational hierarchies. Exhibit 1 from the curriculum provides a list of different asset classes and their size constraints. Asset Class Investor Constraints by Size Cash and money market funds No size constraints. Large-cap developed market equity Small-cap developed market equity Emerging market equity Generally accessible to large and small asset owners, although the very large asset owner may be constrained in the amount of assets allocated to certain active strategies and managers. Developed market sovereign bonds Investment-grade bonds Non-investment-grade bonds Private real estate equity Generally accessible to large and small asset owners, although to achieve prudent diversification, smaller asset owners may need to implement via a commingled vehicle. Alternative Investments • Hedge funds • Private debt • Private equity • Infrastructure • Timberland and farmland May be accessible to large and small asset owners, although if offered as private investment vehicles, there may be legal minimum qualifications that exclude smaller asset owners. The ability to successfully invest in these asset classes may also be limited by the asset owner’s level of investment understanding/expertise. Prudent diversification may require that smaller asset owners implement via a commingled vehicle, such as a fund of funds, or an ancillary access channel, such as a liquid alternatives vehicle or an alternatives ETF. For very large funds, the allocation may be constrained by the number of funds available. Embedded Curriculum Example: The following example illustrates some of the issues associated with managing a large asset pool. Consider an asset owner with an investment portfolio of US$25 billion who is seeking to make a 5% investment in global small-cap stocks. The median total market capitalization of the stocks in the S&P Global SmallCap is approximately US$860 million. Assume a small-cap manager operates a 50-stock portfolio and is willing to own 3% of the market cap of any one of its portfolio companies. • Their average position size would be US$26 million ($860 X 3%); • An effective level of assets under management (AUM) would be on the order of US$1.3 billion ($26 X 50 stocks). Beyond that level, the manager may be forced to expand the portfolio beyond 50 stocks or to hold position sizes greater than 3% of a company’s market cap, which could then create