Hey Guys I need help answering this assignment. Thanks!

Assignments 1 ASSIGNMENT 01 Due date: 22 June 2016 Unique number: Aim: To evaluate your knowledge of some of the fundamental aspects of study units 1 to 4, which deal with the portfolio management process and the Investment Policy Statement (IPS), capital market expectations and asset allocation. a) Chiriro Case study (25) Fortune Chiriro, aged 60 will retire 5 years from now as marketing manager of Eagle Amor Management Company (EAMC). At retirement Chiriro will receive R500, 000 tax-exempt lump sum from her retirement savings plan and a R80, 000 taxable cash payment from EAMC. Upon retirement, Chiriro will also receive R5, 000,000 as proceeds from sell of stock in EAMC. Her original investment in EAMC was R1, 000,000. Chiriro is a divorcee and has a daughter, Rungano, who will be attending a university in five years time. She intends to pay all expenses associated with this three year undergraduate education. Chiriro estimates the first year's expenses will be R135, 000 payable 5 years from now and these expenses will increase approximately 4% annually resulting from inflation in educational costs. Chiriro has a money market fund that is currently valued at R1,000,000 and earning 4% annually. as part of community engagement she decides to donate R120,000 annually, beginning five years from now. Chiriro's current after tax salary is equal to her current living expenses of R200,000 annually. Chiriro and her daughter resides in a R1,200,000 and she intends to give it to her daughter as part of her estate upon her death. Chiriro is taxed at 25% on salary, benefits, and investment income. Assume capital gains are not taxed in South Africa. She has expressed a desire to maintain the purchasing power of her investable assets. Her living expenses are expected to grow at an annual inflation rate of 5% throughout her retirement period, which is expected to be 20 years given her family's mortality history. Rudo Marava, CFA is Chiriro's financial advisor. During their meeting with Marava, Chiriro admitted to having little knowledge about investing. She also said that she views the money market fund as a way to safe guard the wealth that she has worked so hard for. Quite often Chiriro failed to take advantage of potentially attractive investment opportunities because she was not certain of the outcomes. She also said that she is habitually conservative in most of the decision except for situations she believes she is in control. (i) 2 Formulate the return objective in Chiriro's investment policy statement. Calculate the after tax nominal rate of return that is required to achieve this objective for the first year of retirement. Show all your calculations (5) INV4801/101 (ii) (iii) Evaluate and justify each of the three components of the risk objective in Chiriro investment policy statement : a. Ability to take risk (1) b. Willingness to take risk (1) c. Overall risk tolerance (1) Formulate each of the following constrains in Chiriro's investment policy statement and justify each of your responses with one reason based on Chiriro's specific circumstances. a. Time horizon (2) b. Tax (1) c. Liquidity (2) Seven years later Marava is exploring a change in Chiriro's strategic asset allocation. She gathers data on the expected return, standard deviations, and correlations for four assets. Using these market expectations, she derives an efficient frontier. Marava uses the following Information in her construction of asset allocation: Estimate of future inflation: 3.5% Chiriro's asset base: R5,000,000 Amount Chiriro will donate to charity in one year: R750,000 Portfolio management costs: 0.8% per year. Chiriro's income tax rate: 25% Chiriro's risk aversion value: 3 Marava forms four corner portfolios from her efficient frontier and calculates the following expected return and standard deviation for each. 3 Corner Portfolio Expected Return Expected Std. Dev. Sharpe Ratio Weight in assets 1 to 4 1 2 3 4 1 6.5% 4.1% 0.854 0% 30% 70% 0% 2 8.5% 4.8% 1.146 05% 30% 65% 0% 3 9.7% 7.8% 0.859 50% 20% 30% 0% 4 13.5% 10.6% 0.991 100% 0% 0% 0% (iv) Calculate the required return for Chiriro's portfolio and Chiriro's expected utility from holding each of the corner portfolios. (4) (v) Calculate the weights of the appropriate corner portfolios and resulting standard deviation that will be used if Marava combines two corner portfolios to meet the return objective calculated in part (iv). Assume no short selling. (3) (vi) Calculate the weights of the appropriate corner portfolio and the risk free asset and the resulting portfolio standard deviation that will be used if Marava combines a corner portfolio and a risk free asset to meet Chiriro's desired return objective calculated in part (iv). (5) b) Investec case study (25) Chipo Gumbo is a market forecaster with Investec Investment Management. Gumbo is asked to review the current economic conditions and market outlook for South Africa (RSA) and to set longterm market return expectations for domestic equities. These expectations will form the basis of Investec's future client asset allocations. Gumbo gathers RSA capital market data displayed below. Equity compounded annual growth rate: Equity risk premium: Dividend yield: Equity repurchase yield Real earnings growth return: 9.0% 4.3% 6.0% -0.5% 2.6% Current and Forward Looking Data Current equity price-to-earnings ratio Expected equities real earnings growth rate: Expected long-term inflation rate: 12.2 3.5% 3.1% Using Grinold-Kroner model determine the component sources of the historical nominal return for South African equities: 4 INV4801/101 (i) Income return (2) (ii) Earnings growth (2) (iii) Repricing return (2) The South Africa Reserve Bank (SARB) has been raising the short-term interest rate. Business confidence is starting to decline. Gumbo is asked to analyze the South African economy and consider how SARB might respond in the short term to economic conditions. She gathers the economic data below: Yield to maturity on 10-year government bond: Yield to maturity on 1-year government bond: Neutral value of the short-term interest rate: Forecast RSA GDP growth rate: SARB short-term interest rate Trend RSA GDP growth rate: Forecast RSA inflation rate Target RSA inflation rate 3.7 7.7 4.2 0.6 3.0 0.2 4.4 5.5 (iv) Determine the target short-term interest rate for SARB using the Taylor rule. Show your calculations. (3) (v) Describe the most likely potential negative economic result if SARB bases its interest rate policy on the Taylor rule. (6) Gumbo has been asked to develop an estimate of the aggregate operating profit margin for the companies in the FTSE/JSE Index. He is using the FTSE/JSE Index as a representation of the overall South African economy. She first reviews the South African economic data presented below: South Africa Economic Data 2013 2014 2015 Variables Capital expenditures growth rate (%) Inflation rate (%) Corporate tax rate (%) Capacity utilization rate (%) Three-month Treasury bill rate (%) Depreciation expense (% of fixed assets) Unit labor costs (% change) (vi) 6.9 6.4 3.3 3.4 32.0 32.0 76.1 76.5 2.2 3.9 14.0 14.2 1.0 -0.1 7.0 3.7 33.0 76.9 4.8 15.1 -0.3 2016 Forecast 7.4 3.0 33.5 70.3 5.0 16.0 -0.5 Identify four variables from the table above that are used to estimate the FTSE/JSE aggregate operating profit margin. (4) 5 (vii) Determine, for each identified variable, the expected effect of the 2016 forecast on the FTSE/JSE aggregate operating profit margin. Justify your answer with one reason for each identified variable. (6) Note: Consider each variable independently and assume all other variables remain constant. Godfrey Marozva, CFA DEPARTMENT OF FINANCE, RISK MANAGEMENT AND BANKING UNISA 2016 6 1. TOPIC 1: The portfolio Management Process and the Investment Policy statement 1.1 Mind map The portfolio management process Introduction Investment Objectives and constrains Planning Objective Policy statement Capital markets expectations Execution Constraints Implement the plan by constructing the portfolio Return Risk Feedback Liquidity Time Horizon Legal and regulatory Monitor and update investor needs Managing institutional Investors Summary Defined benefit plan Defined-contribution plan Profit-sharing plan Foundations Endowment Insurance companies Banks Managing Individual Investors Situational profiling Psychological profiling Individual investor return objectives Individual investor investment constraints Individual investor asset allocation concepts When managing either individual or institutional investors, the steps of the portfolio management process you have to go through is the same, and you need to formulate the investment policy statement for the investor in the planning phase of the process. 1.2 Introduction In setting out to master the concepts and tools of portfolio management, students need to understand the process of portfolio management. The portfolio management process is an integrated set of steps undertaken in a in a consistent manner to create and maintain an appropriate portfolio to meet client's stated goals. The portfolio management process moves through the following steps: From planning, through execution, and then to feedback. The investment policy statement serves as the foundation for the process, there need for an understanding of its components. An investments policy statement (IPS) is a written document that clearly states out clients' objectives and risk tolerance over that client's time horizon, along with applicable constrains such as liquidity, tax consideration, regulatory requirements and unique circumstances. In the same perspective of portfolio management process we notice that the broad classes of investors active in capital markets internationally are individual and institutional. EXHIBIT 2-1 The Portfolio Construction, Monitoring, and Revision Process Specifications and quantifications of investor objectives, 2.2 constrains, and preferences. Portfolio policies and strategies Specifications and quantifications of investor objectives, Portfolio construction and revision Asset allocation, portfolio optimisation, security selection, implementation and execution Relevant economic, social, political and sector considerations Capital markets expectations Monitoring economic and market input factors Attainment of investor objectives Performance measurement 2.2 Specific outcome The analysis of Portfolio management process and the investment Policy Statement will be demonstrated by: Formulating the elements of portfolio management as an ongoing process Justifying the importance of the portfolio perspective. Evaluating the role of investment policy statement in the portfolio management process. Formulating individual and institutional investments policy statements. 2.3 Study unit 1: The Portfolio management process. Portfolio management is a process, an intergraded set of activities that combine in a logical, orderly manner to produce a desired outcome. It is a continuous and systematic process complete with feedback loops for monitoring and rebalancing. The processes presented in the diagram in Exhibit 2-2. The process view is a dynamic and flexible concept that applies to all types of portfolio investments i.e. bonds, stocks, real estate, commodities, collectables, to various organization types, to a full range of investors, and is independent of manager, location, investment philosophy, style, or approach. The portfolio management process is the same in every application: an integrated set of steps undertaken in a consistent manner to create and maintain appropriate combination of investments assets. Planning, execution, and feedback form the basis of portfolio management process. Planning involves Indentifying and specifying the investor's objectives and constrains. Investments objectives are desired investments outcomes and these chiefly pertain to return and risk. Constrains are limitations on the investor's ability to take full or partial advantage of particular investments. Constrains are either internal, such as client's specific liquidity needs, time horizon, and unique circumstances, or external, such as tax issues and legal and regulatory requirements. Once the client has specified a set of objectives and constrains, the manager's next task is to formulate the investment policy statement (IPS) which serves as a governing document for all investments decision making. The IPS generally details reporting requirements, rebalancing guidelines, frequency and format of investment communication, manager fees, investment strategy, and the desired investments style or styles of investment managers. Execution step is a second step in portfolio management process. The execution step is represented by the portfolio construction and revision. At this stage the manager integrates investment strategies with capital market expectation to select the specific asset for the portfolio. Portfolio managers initiate portfolio decisions based on analyst's inputs, and trading desks the implement these decisions. Subsequently, the portfolio is revised as investor circumstances or capital markets expectations change, thus the execution stage interacts constantly with the feed back stage. Feedback step is the third and final stage in portfolio management process. Like in any business endeavor, feedback and control are essential elements in reaching a goal. I portfolio management process feedback stage can be broken down to two components and these are: Monitoring and rebalancing, and performance evaluation. Monitoring and rebalancing involve the use of feedback to manage the ongoing exposure to available investment opportunities, so that the client's objectives and constrains continue to be satisfied. Performance evaluation implies that investments performance must be periodically be evaluated by the investor to assess progress toward the achievement of investment objectives as well as to assess portfolio management skill. EXHIBIT 2-2 The Portfolio management process 1. Policy Statement Focus: Investor's short-term and long-term needs, familiarity with capital market history, and expectations 2. Examine current and projected financial, economic, political, and social conditions Focus: Short-term and intermediate-term expected conditions to use in constructing a specific portfolio 3. Implement the plan by constructing the portfolio Focus: Meet the investor's needs at minimum risk levels 4. Feedback Loop: Monitor and update investor needs, environmental conditions, evaluate portfolio performance EXHIBI To understand the portfolio management process you should study your text book, chapter 1. Once you have completed the study unit you should be able to: Justify the importance of the portfolio perspective. Formulate the steps of the portfolio management process and the three components of those steps. Compare and contrast the type of investment objectives. Contrast the types of investment constrains. Justify the central role of the investment policy statement in the portfolio management process. Review the elements of investment policy statements and distinguish among components within (1) the risk objective (2) the return objective (3) the time horizon constraint. Compare and contrast passive, active, and semi active approaches to investing. Discuss the role of capital markets expectations in the portfolio management process. Discuss the role of strategic asset allocation in the portfolio management process. Discuss the components of portfolio selection/composition and portfolio implementation in the portfolio management process. Contrast the elements of performance evaluation. Explain the purpose of monitoring and rebalancing. Key concepts Investment management Portfolio management Portfolio management process Investment objectives Investment constrains Dynamics in portfolio management process Investment Policy Statement (IPS) Self assessment You can use the following self assessment questions to assist you in your studies: a) Why should individual investments judged in the context of how much risk they add to portfolio rather than on how risky they are on a stand-alone basis? b) Evaluate the three steps involved in portfolio management process. c) What do you understand by the investment policy statement and what role does it play in portfolio management process? d) List and explain the elements of an investment policy statement. e) Compare and contrast passive, active and semi active approaches to investing. f) What role do capital markets expectations play in portfolio management g) State and explain components feedback step in portfolio management process. 2.4 Study unit 2: Investments objectives and constrains. Since the IPS is the cornerstone in portfolio management process, its components are identified and introduced in this section. The two broad categories of IPS are investment objectives and investment constrains. Although objectives are discussed first and then constrains, the actual process of delineating these for any investor may appropriately starts with an examination of investor constrains. For example, a short time horizon affects the investor's ability to take risk. There are two objectives in this framework which are risk and return objectives. These objectives are interdependent i.e. one cannot be discussed without reference to the other. The risk objective limits how high the investor can set the return objective. The investor's objectives are set within the context of several constrains and these include: liquidity, time horizon, tax concerns, legal and regulation factors, and unique circumstances. Although all these factors influence portfolio choice, the first two constrains bear directly on the investor's ability to take risk and thus constrain both risk and return objectives. To understand investment objectives and constrains you should study your text book, chapter 1. Once you have completed the study unit you should be able to: Formulate and justify a risk objective of an investor. Formulate and justify a return objective of an investor. Determine the liquidity requirement of an investor and evaluate the effects of liquidity requirements on portfolio choice. Contrast the types of time horizons, determine the time horizon for an investor and evaluate the effects of the investor's time horizon on portfolio choice. Determine the tax concerns, legal and regulatory factors, and unique circumstances for an investor and evaluate their effects on portfolio choice. Key concepts Risk objective of an investor Return objective of an investor Liquidity constraint Time horizon constraint Tax concerns Legal and regulatory factors Unique circumstances Self assessment Work through the problems found at the end of chapter 1 in the work book (Solutions on pages 135 -139) 2.5 Study unit 3: Managing individual investor portfolios. The study session addresses the process of private wealth management and the construction of an investment policy statement for individual investor. The universe of private investor is heterogeneous, burdened by taxes, and less well suited to the simplifying assumption of modern financial theory. Individual investors have diverse investment objectives, time horizons, and perceptions of risk, all subject to tax schedule that have varying degrees of stability and logic. The increasing attention to private asset management reflects both a rising demand for financial services and an increased interest in empirical investor behavior. At the same time, increased personal responsibility for investing retirement assets, evidenced by the growth in the self-directed segment of defined contribution pensions and savings plans, as well as the portability of fully vested retirement assets, has further increased the need for professional investment management at the individual level. To understand the principles of managing individual investor portfolios you should study your text book, chapter 2. Once you have completed the study unit you should be able to: Review situational profiling for individual investors and discuss source of wealth, measure of wealth, and stage of life as approaches to situational profiling. Prepare an elementary situational profile for an individual investor Discuss the role of psychological profiling in understanding individual investor behaviour. Formulate the basic principles of the behavioural finance investment framework. Discuss the influence of investor psychology on risk tolerance and investments choices. Review the process involved in creating an investment policy statement for a client. Distinguish between an investor's ability to take risk and willingness to take risk. Formulate and justify an investment policy statement for an individual. Determine the strategic asset allocation that is most appropriate given an individual investor's investments objectives and constrains. Compare and contrast traditional deterministic versus Monte Carlo approaches in the context of retirement planning. Discuss the advantages of Monte Carlo approach to retirement planning. Key concepts Situational profiling Source of wealth Measure of wealth Stage of life Psychological profiling Traditional finance Behavioural finance Loss aversion Biased expectations Asset segregation Personality typing Cautious investors Methodical investors Spontaneous investors Individualist investors Income requirements Growth requirement Required return Desired return Ability to take risk Willingness to take risk Asset allocation Self assessment Work through the problems found at the end of chapter 2 in the work book (Solutions on pages 141 -151) 2.6 Study unit 4: Managing Institutional investor portfolios Institutional investors are corporations or other legal entities that ultimately serves as financial intermediaries between individuals and investments markets. Frequently representing large pools of money, institutional investors have attained great importance. Institutional investors have also made important contributions to the advancement of investment knowledge and techniques, spurred by the challenges of effectively managing the large sums of money. This section present the portfolio management process from the perspective five different groups of institutional investors: pension funds, foundations, endowments, insurance companies, and banks. These five classes cover a wide spectrum of investments policy considerations and are well suited to illustrating the challenges and complexity of the institutional portfolio managers' task. To understand the principles of managing institutional investor portfolio management you should study your textbook, chapter 3. Once you have completed the study unit you should be able to: Contrast a defined-benefit plan to a defined contribution plan from the perspective of both the employee and the employer. Discuss investments objectives and constrains for defined benefits plan. Evaluate pension fund risk tolerance when the risk is considered from the perspective of the (1) plan surplus, (2) sponsor financial status and profitability, (3) sponsor and pension fund common risk exposures, (4) plan features, and (5) work force characteristics. Formulate an investment policy statement for defined-benefit plan. Evaluate the risk management considerations in investing pension plan assets Formulate an investment policy statement for a defined contribution plan Discuss investments objectives and constrains for foundations, endowments, insurance companies, and banks. Formulate investment policy statement for a foundation. Endowment, insurance company, and a bank. Compare and contrast the asset liability management needs for pension funds, foundations, endowments, insurance companies, and banks. Key concepts Defined benefit plan Defined-contribution plan Cash balance plan Profit-sharing plan Funded status Fully funded status Pension surplus Underfunded plan Accumulated benefit obligation (ABO) Projected benefit obligation (PBO) Total future liability Asset liability management Foundations Endowments Simple spending rule Rolling three year average spending rule Geometric smoothing Insurance Stock companies Mutual Demutualising Valuation concerns Reinvestment risk Credit risk Cash-flow volatility Net interest spread Segmentation Disintermediation Asset marketability risk Eligible investments Prudent investor rule Underwriting profitability cycle Banks Net interest margin Interest spread Leverage adjusted duration gap Pledging requirement Money markets Self assessment Work through the problems found at the end of chapter 3 in the work book (Solutions on pages 152 -159) 2.7 Summary In the first section, we have presented the portfolio management process and the elements of the investments policy statement. The second section presented an overview of portfolio management for individual investors, including the information gathering process, situational and psychological profiling of clients, formulation of an investment policy statement, strategic asset allocation, and the use of Monte Carlo simulation in personal retirement planning. The last section has described the investment contexts in which institutional investors operate. Our chief focus has been the development of an investment policy statement for defined-benefit pension plan, defined contribution plan, endowments, foundations, life insurance companies, no-life insurance companies, and banks. We have discussed the specific considerations that enter into the development of appropriate return and risk objectives. We then addressed liquidity requirements, time horizon, tax concerns, legal and regulatory factors, and unique circumstances. (Also read pages 4-6, 13-14, and 26-28 of the workbook) 2. TOPIC 2: Capital Market Expectations 3.1 Mind map Introduction Economic Analysis Inventory and business cycles Inflation and business cycles Taylor rule Yield curve as the economic predictor Economic growth trend Emerging markets and developed economies Approaches to forecasting exchange rates Organising the task -Framework and challenges Macro expectation Micro expectations Challenges in forecasting Tools for formulating capital markets expectations Statistical tools(Sample estimators, Shrinkage estimators, Time series estimators, Multifactor models) Discounted cash flow models The risk premium approach Financial equilibrium models Survey and panel methods Judgement Summary 3.2 Introduction After identifying the clients' objectives and constrains and creating an investment policy statement, the manager's next task in the planning process is to formulate capital markets expectations. These forecasts of risk and return characteristics for various asset classes from the basis for constructing portfolios that maximise expected return for given levels of risk. A noted investment authority has written that the fundamental law of investing is the uncertainty of the future. Yet investors have no choice but to forecast at least elements of the future because nearly all investments decisions look toward it. Specifically, investments decisions incorporate the decision maker's expectations concerning factors and events believed to affect investment values. The decision maker finally integrates these views into expectations about the risk and return prospects of individual assets and group of assets. The particular concern of this section is capital market expectations (CME) and Asset allocation. Capital market allocations are an essential input in formulating a strategic asset allocation. For example if the investor's investment policy statement specifies and defines eight permissible asset classes, the investor will need to have formulated long term expectations concerning these asset classes and develop a strategic asset allocation. The investor may also act on short term expectations. Capital markets expectations are expectations about classes of assets, or macro expectations. By contrast, micro expectations are expectations concerning individual assets. Micro expectations are key ingredients in security selection and valuation. Insights into capital markets gleaned during capital markets expectations setting should help in formulating accurate micro expectations in security selection and valuations. Under CME, the theme of this section is that a disciplined approach to expectations setting will be rewarded. Therefore, much of the reading is devoted to explaining a widely applicable expectations-setting process. A second theme of this section is that skillful economic analysis can contribute to expectations setting. That theme is supported by the observations that securities markets trade claims on the cash flows of the business sector and that other markets the macro economy too. 3.3 Assessment Criteria An understanding of the Capital market expectation will be demonstrated by: Explaining the role of capital market expectations in the portfolio management process. 3.4 Study unit 1: Organising the task - Framework and challenges. In this section, we provide a guide to collecting, organising, combining and interpreting information. After illustrating the process, we turn to a discussion of typical problems and challenges to formulating the most informed judgements possible. Disciplined capital market expectations setting requires experience and expertise in investments and economics. Through superior forecast, asset managers seek to better control risk and improve the results of actively managed accounts. The development of capital markets expectations is bte research (research related to systematic risk and returns to systematic risk). As such, it is usually centralised so that the CME inputs used across all equity and fixed income products are consistent. On the other hand, alpha research (research related to capturing excess risk adjusted returns by a particular strategy) is typically conducted within particular product group with the requisite investment-specific expertise. The first step in the framework for developing CME requires that analysts set boundaries to focus their attention on the expectations most relevant for their investment situation. The second and third step in expectations setting process involves understanding the historical performance of the asset classes and researching their return drivers. The analyst can approach these tasks by collecting macroeconomic and market information. In the third step the analyst need to be sensitive to the fact that the effectiveness of forecasting approaches and relationships among variables may be related to investor's time horizon. As an example discounted cash flow approach to developing equity market expectations is usually considered the most appropriate to long-range forecasting. The fourth step involves determining the best sources for information needs. Executing this step well requires that the analyst research the quality of alternative data sources. Factors such as data collection principles and definitions, error rates in collection, calculation formulas, and for asset class indices qualities such as investability, correction for free float, turnover in index constituents, and biases in the data are relevant. The cost of data may also be relevant. In short the analyst must understand everything they can about the data they will use for analysis. Furthermore, analyst should constantly be alert to new, superior sources for their data needs. Besides taking care with data sources, the analysts must select the appropriate data frequency. The fifth step involves interpreting the current investment environment using the selected data and methods, applying experience and judgement. In the sixth step, we take all our analyses of the economic and market environment into forwardlooking views on capital markets, developing any required quantitative forecasts. In other words the questions formulated in the first step are answered in the sixth step. Finally the analyst has to use experience to improve the expectations setting process. The analyst should measure his previously formed expectations against actual results to assess the level of accuracy that the expectations-setting process is delivering. Generally, good forecasts are: Unbiased, objective, and well researched; Efficient, in the sense of reducing the magnitude of forecast errors to a minimum; and Internally consistent. To understand the framework and challenges of CME you should study chapter 4 of your textbook. Once you have completed the study unit you should be able to: Discus the role of capital market expectations in the portfolio management process. Review a framework for setting capital market expectations. Identify and discuss the following as they affect the setting of capital markets expectations: the limitations of economic data, data measurement errors and biases, the limitations of historical estimates, ex post risk as biased measure o ex ante risk, biases in analysts' methods, the failure to account for conditioning information, the misinterpretations of correlations, psychological traps and model uncertainty. Key concepts Capital markets expectations (CME) Macro expectations Micro expectations Beta research Alfa research Forecasting Economic data Data measurement errors and biases Historical estimates Ex post risk Conditioning information Misinterpretation of correlations Psychological traps Model uncertainty Self assessment You can use the following self assessment questions to assist you in your studies: a) What is the role of capita market expectations in the portfolio management process? b) Discuss the approaches used in setting capital markets expectations. c) Discuss all the factors that affect the setting of capital markets expectations. 3.5 Study unit 2: Tools for formulating capital market expectations. In this section range of tools that have been used in professional forecasting of capital market returns are introduced. Although an analyst may have distinct preferences among these approaches, familiarity with all these major tools will be helpful in addressing the widest variety of forecasting problems according to their particular characteristics. To understand tools for formulating capital market expectations you should study chapter 4 of your textbook. Once you have completed the study unit you should be able to: Review and demonstrate formal tools for setting capital markets expectations, including statistical tools (sample estimators, shrinkage estimators, time series estimators, and multifactor models), discounted cash flow models, the risk premium approach, and financial equilibrium models. Explain the use of survey and panel methods and judgement in setting capital market expectations. Key concepts Descriptive statistics Inferential statics Sample estimators Shrinkage estimators Target core-variance matrix Time series estimators Volatility clustering Multifactor models Discounted cash flow models Gordon (constant) growth model Grinold-Kroner model Equity risk premium Bond yield plus risk premium method Financial equilibrium models Capital asset pricing model (CAPM) International Capital asset pricing model (ICAPM) Survey and panel method Self assessment Work through the problems 1- 5 found at the end of chapter 4 in the work book (Solutions on pages 160 -162) 3.6 Study unit 3: Economic analysis. History has shown that there is a direct yet fluid relationship between actual realised asset returns, expectations for future asset returns, and economic activity. The linkages are consistent with asset pricing theory, which predicts that the risk premium of an asset is related to the correlation of its payoffs with the marginal utility of consumption in future periods. Assets with low expected payoffs in the periods of weak consumption (e.g. business cycle troughs) should bear higher risk premiums than assets with high expected payoffs when their income may be depressed they should be willing to pay relatively high prices for them (implying lower risk premiums). Analysts need to be familiar with the historical relationships that empirical research has uncovered concerning the direction, strength, and lead-lag relationships between economic variables and capital markets returns. The analyst who understands which economic variables may be most relevant to the current economic environment has a competitive edge, as does the analyst who can discern or forecast a change in trend or point of inflection in economic activity To understand economic analysis you should study chapter 4 of your textbook. Once you have completed the study unit you should be able to: Distinguish between the inventory cycle and the business cycle. Identify and interpret business cycle phases and their relationships to short and longterm capital markets returns. Review the relationship of inflation to business cycle and characterise the relationship between inflation/deflation and cash, bonds, equity and real estate. Discuss the effects on the business cycle of the following factors: consumer spending business investment and spending on inventories, and monetary and fiscal policy. Demonstrate the use of the Taylor rule to predict central bank behaviour. Review the shape of yield curve as an economic predictor and the relationship between the yield curve and the fiscal and the monetary policy. Distinguish between business cycle and economic growth trends and demonstrate the application of business cycle and economic growth trend analysis to the formulation of capital markets expectations. Identify and interpret components of economic growth trends and explain how government policies and exogenous shocks can affect economic growth trends. Indentify and interpret macroeconomic and interest and exchange rate linkages between economies. Review the difference between emerging markets and developed economies and explain the country risk analysis techniques used to evaluate emerging markets. Compare and contrast the major approaches to economic forecasting. Demonstrate the use of economic information in forecasting returns for cash and equivalents, nominal default-free bonds, defaultable debt, emerging markets debt, inflation indexed bonds, common shares (developed and emerging markets), real estate, and currencies. Evaluate how economic and competitive factors affect investment markets, sectors, and specific securities. Identify and interpret the major approaches to forecasting exchange rates. Recommend and justify changes in the component weights of global investment portfolio based on trends and expected changes in macro economic factors. Key concepts Business cycle Inventory cycle Real GDP Output gap Potential output Recession Monetary policy Fiscal policy Exogenous shocks International interactions Emerging markets Economic forecasting Econometric modelling Economic indicators Checklist approach Self assessment Work through the problems 6- 19 found at the end of chapter 4 in the work book (Solutions on pages 162 -169) Activities Activity 1 Capital Market Expectations Setting: Information Requirements (1) Consider the tasks facing two investment managers, John Pearson and Michael Wu. Pearson runs U.S. balanced separately managed accounts (SMAs) for high-net-worth individuals within a bank trust department. The mandates of these accounts restrict investments to U.S. equities, U.S. investment- grade fixed-income instruments, and prime U.S. money market instru- ments. These balanced accounts have an investment objective of long-term capital growth and income. In contrast, Wu is the chief investment officer of a large Hong Kong- based, internationally focused asset manager that uses the following types of assets within its investment process: Equities Fixed Income Alternative Investments Hong Kong equities Eurozone sovereign debt Eastern Europe venture capital Eurozone equities U.S. government debt New Zealand timber assets U.S. large-cap equities U.S. apartment properties U.S. small-cap equities Canadian large- cap equities Note: Venture capital is equity investment in private companies. Wu runs SMAs with generally long-term time horizons and global tactical asset allocation (GTAA) programs. Compare and contrast the information and knowledge requirements of Pearson and Wu. Activity 2 Capital Market Expectations Setting: Information Requirements (2) Following the practice of his employer, Pearson uses the results of constrained mean-variance optimization (MVO) and information from clients' investment policy statements to develop strategic asset allocations for the balanced accounts. Pearson is now addressing the first step in the framework given in the text for a client whose investment time horizon is five years. What set of final expectational data does Pearson need? Solution: Pearson needs the following final set of expectations: the expected U.S. broad market annual equity total return over a five-year horizon; the expected U.S. investment-grade bond annual total return over a five-year horizon; the standard deviation of annual returns of U.S. broad market equities; the standard deviation of annual returns of U.S. investment-grade bonds; and the correlation of annual U.S. stock and U.S. bond returns. In total, Pearson needs two expected returns, two standard deviations, and one correlation for the MVO. Activity 3 Historical Analysis As Peter L. Bernstein (2004) has written, forecasters who make predictions without regard to past experience have no benchmarks to distinguish between what is new about their expectations and what may be a continuation of past experience. Dimson, Marsh, and Staunton (2006), in a rigorous study covering the 106-year period from 1900 to 2005, found that equities achieved higher annualized geometric mean real returns than did bonds or bills in seventeen major national markets. It would be appropriate for an analyst forecasting that bonds would outperform equities over some (probably shorter-term) horizon to supply supporting analysis that recognizes the tension between the forecast and past long-term experience. Activity 4 Incorporating Economic Analysis into Expected Return Estimates Michael Wu has gathered information on consensus expectations in equity and fixed-income markets. On the basis of his economic analysis, Wu is optimistic relative to the consensus on the prospects for Hong Kong equities. On the other hand, Wu is pessimistic relative to the consensus on the prospects for U.S. large-cap equities. Depending on the model chosen, Wu's views might be reflected in his quantitative expectations in several ways, including the following: Historical mean return with adjustments. If Wu takes a historical mean return as his baseline for each asset class, he may make an upward adjustment to that mean for Hong Kong equities and a downward adjustment for U.S. large-cap equities. Risk premium approach. Wu may frame his analysis in terms of the equity risk premium (the expected return on equities in excess of the long bond expected return). After translating his views into equity risk premium estimates for Hong Kong and U.S. largecap equities, his return expectation for each asset class is the expected equity risk premium in each market plus the long bond expected return in each market (which he can estimate directly from the term structure of interest rates). Discounted cash flow (DCF) model estimates. Wu may use his economic analysis to forecast the growth rates of corporate profits for the United States and Hong Kong and input those forecasts into a DCF model solved for the required return on equities in each country. Implied market estimates of expected return with adjustment. Making use of a world market benchmark and a methodology known as the Black-Litterman model, Wu may infer the equilibrium expected returns on asset classes as reflected by their values in the allocated world market benchmark. Wu can then incorporate his own views on Hong Kong and U.S. large-cap equities using a procedure specified by Black-Litterman.3 For a Hong Kong-based client, Hong Kong dollar returns are relevant, so Wu will also need to make exchange rate forecasts to arrive at his conclusions. Activity 5 Inconsistency of Correlation Estimates: An Illustration Frequently, the expected correlations between asset classes form part of the final expectational data that an analyst needs. If the number of asset classes is n, the analyst will need to estimate (n- n)/2 distinct correlations (or the same number of distinct covariances). In doing so, the analyst must be sure that his or her estimates are consistent. For example, consider the correlation matrix for three assets shown in the table below Inconsistent Correlations Market 1 Market 2 Market 3 Market 1 1 -1 -1 Market 2 -1 1 -1 Market 3 -1 -1 1 According to the table above, the estimated correlation between each asset and each other asset is -1. These estimates are internally inconsistent but, in fact, not possible. If Markets 1 and 2 are perfectly negatively correlated and Markets 2 and 3 are as well, then Markets 1 and 3 should be perfectly positively correlated rather than perfectly negatively correlated. Other cases of an inconsistent correlation matrix are not so obvious. Activity 6 A Change in Focus from GNP to GDP In the late 1980s, expanding international trade caused economists to favour the use of Gross Domestic Product (GDP) over Gross National Product (GNP). Basically, GDP measures production within national borders regardless of whether the labour and property inputs are domestically or foreign owned. In contrast, GNP makes an adjustment to GDP equal to the receipts of factor income from the rest of the world to the country, less the payments of factor income from a country to the rest of the world. This change in preference reflected the fact that product sub- components, such as automobile parts, were being created in various regions of the world. Thus, measuring economic activity according to what nation was responsible for activities in various regions of the world was becoming more difficult and less useful than being able to measure what was being made within a nation or particular region. Consistent with this observation, the United Nations System of National Accounts (known as UNSNA or SNA for short) emphasizes GDP. The perception of alternative investments is that they yield high returns with low risk and that they barely correlate with traditional asset classes. At least in some cases, this perception results from the uncritical use of flawed historical statistics because alternative assets are not traded on exchanges with continuously observable markets. First, risk is underestimated. Consider the following analogy: A bat is flying through a dark tunnel. While it is in the tunnel, you cannot see it. The bat may exit from the tunnel at about the same height it entered the tunnel. However, the bat's flight within the tunnel, if it could be viewed, would be seen to go up and down: In this analogy, the time in the tunnel corresponds to the time between trades (or fund valuations) and the bat's height of flight corresponds to the true price of the asset. In measuring the bat's height only at the points of entry and exit from the tunnel, we would underestimate the real volatility of price. Asset liquidity corresponds to the end of the tunnel, when the true price is first clearly visible. In the context of venture capital, for instance, the end of the tunnel is analogous to the initial public offering date. Data for alternative investments tend to overly smooth return variation because they are often appraisal-based rather than transaction- based. Many indices, such as those for real estate, private equity, and natural resources, were created with a focus on measuring return rather than risk. Unfortunately, these indices have been used to derive risk and correlation estimates that are biased downward. For alternative investments, the issue is not only whether the past is a good indicator of the future, but also whether the past is even correctly recorded. As an illustration, consider the quarterly returns on the S&P 500 between 1981 and 1999, which include the crash of 1987. The period contains 18 negative quarters and has an annual standard deviation of returns of 16.1 percent. Venture capital also represents equity claims, but on less seasoned and riskier companies. Nevertheless, based on venture economics data, the index-based quarterly venture capital returns over the same period are considerably smoother. Venture capital also seems unaffected by the crash, with a reported 5.2 percent return in the fourth quarter of 1987. Only six negative quarters are reported. The reported annual standard deviation of returns is 9.1 percent, and correlation with the S&P 500 is 0.28. Activity 7 Smoothed Data: The Case of Alternative Investments (2) How might an analyst address the biases resulting from smoothed data? To continue with the case of venture capital return data, one approach would be to rescale the reported data so that dispersion is increased but the mean is unchanged. The point is that the larger the rescaling, the larger the number of negative quarterly returns, because the frequency distribution is centered in the same place but there is more probability in the tails as dispersion is larger. For example: The venture returns rescaled by a factor of 1.4 provide 18 negative quartersthat is, as many as the S&P 500. The estimated standard deviation of the rescaled data is 13 percent. The venture returns rescaled by a factor of 4.1 provide 36 negative quarters, which is twice as many as the S&P 500. The estimated standard deviation of the rescaled data is 37 percent. The venture returns rescaled by a factor of 4.4 provide 38 negative quarters, 2.1 times as many as the S&P 500. The estimated standard deviation of the rescaled data is 40 percent. Using these data in conjunction with other analyses, one might pro- pose risks of 43 percent for early-stage venture capital, 34 percent for late-stage venture capital, 29 percent for leveraged buyouts (largely debt- financed purchases of established companies), and 20 percent for distressed debt (the debt of companies that are under financial distress or in or near bankruptcy).6 The key is to model the risks of alternative investments as if they were frequently traded, focusing not on statistical observations but on the underlying fundamental and economic drivers of returns. Activity 8 Using Regression Analysis to Identify a Change in Regime The effects of specific events on a time series (e.g., the announcement by a central bank of a new monetary policy) can be most simply modelled in a regression framework using a dummy explanatory variable z(t), where z(t) =0 for t before the intervention (change) date and z(t) = 1 for t at and subsequent to the intervention date. This dummy variable approach models a simple shift in the mean of the dependent variable. Activity 9 Causality Relationships That one event follows another is not sufficient to show that the first event caused the second. For example, a decrease in the number of new accountants following an increase in tax rates would be association without cause-and-effect relationship. But seasonal incoming tax receipts probably bear a direct cause-and-effect relationship to the needs of governments to borrow funds in some months versus others. If an increase in income tax rates causes individuals to be more concerned with minimizing taxes, one might discern an indirect cause-and-effect relationship between the tax rate increase and a subsequent jump in sales of tax preparation software. Activity 10 Traps in Forecasting Cynthia Casey is a Canada-based investment adviser with a clientele of ultra-high-net-worth individuals. The Canadian equity allocation of client Philip Lasky's portfolio had favourable riskadjusted performance from 1999 to 2001 but nevertheless lost 20 percent of its year-end 2000 value by the end of 2001. In a phone call prior to a quarterly portfolio review at the end of 2001, Lasky expressed the thought that the pain of the recent and continuing bear market had made him very cautious about investing in the stock market. Although his equity allocation results with Casey showed healthy appreciation over the entire period he had invested with her, his conversation dwelled mostly on the experience of the past year. Lasky told Casey that he had read a variety of financial reports containing predictions by investment notables on the equity risk premium ranging from near zero to 6 percent. During the call, he repeated to Casey, sometimes inaccurately, the arguments of the most bearish prognosticator. At the time of the call, Casey was preparing to share with clients relatively optimistic forecasts for Canadian equities, developed with an assistant who was well grounded in capital market analysis. Perceiving that Lasky and many of her other clients held more pessimistic viewpoints and that she might lose their trust if her own view- point turned out to be wrong, after the phone call, Casey decided to revise downward some of the economic growth assumptions she had previously made. Critique the forecasts of A) Lasky and B) Casey with respect to psychological traps in forecasting. Activity 11 Adjusting a Historical Covariance Cynthia Casey has estimated the covariance between Canadian equities and U.S. equities as 230 using historical data. Using a factor model approach based on a proxy for the world market portfolio, she estimates the covariance as 190. Casey takes a shrinkage estimator approach to estimating covariances and determines that the optimal weight on the historical estimate is 0.30. 1. Calculate the shrinkage estimate of the covariance between U.S. and Canadian equities. 2. Describe the theoretical advantage of a shrinkage estimate of covariance compared to a raw historical estimate. Activity 12 The Grinold-Kroner Forecast of the U.S. Equity Risk Premium The details of the Grinold-Kroner (GK) forecast of the U.S. equity risk premium (as of early 2002) are instructive. Their forecast horizon was 10 years. Expected Income Return The forecast dividend yield was 1.75 percent (somewhat above the then-current yield of 1.4 percent but below the historical mean of over 4 percent for 1926-2001). The repurchase yield was forecast to be 0.5 percent, down from the 1-2 percent rate of the 1990s, which was viewed as an unusual period. The expected income return was there- fore 1.75% + 0.5% = 2.25%. Expected Nominal Earnings Growth Return Economic theory suggests that the real GDP growth rate is the sum of labour productivity growth and labour supply growth. GK took the historical 2 percent per year U.S. labour productivity growth rate as their fore- cast. Using a U.S. population growth forecast of 0.8 percent and assuming a 0.2 percentage point increase in the labour force participation rate, the forecast of the labour supply growth rate was 1 percent per year. The overall real GDP growth estimate of 2% + 1%=3% was within the 2.7 percent to 3.6 percent range of forecasts by economists. Viewing the S&P 500 companies as having a slightly higher growth profile than the overall economy, GK added a 0.5 percent excess corporate growth return for a 3.5 percent real earnings growth return estimate. GK expected an inflation rate of 2.5 percent, 0.3 percentage points above the contemporaneous consensus estimate of economists (viewed by GK as slightly optimistic). Thus, the expected nominal earnings growth return was 3.5% + 2.5% = 6%. Expected Repricing Return This component was perhaps the hardest to forecast. Viewing the contemporaneous P/E of 28 as a slight overreaction to the positive factors of decreased inflation, technological advances (positive productivity shocks), and an expected increase in growth rates from globalization, over a 10-year horizon, GK forecast downward repricing equal to -0.75 percent per year. The GK forecast of the expected return on U.S. equities was therefore 2.25% + 6% - 0.75% = 7.5%. Subtracting the 10-year government bond yield of 5 percent, the GK forecast of the U.S. equity risk premium was 2.5 percent. The 2.5 percent estimate put GK in a middle position between the predictions of the risk premium is dead and the rational exuberance camps. Activity 13 Forecasting the Return on Equities Using the Grinold-Kroner Model Cynthia Casey employs the Grinold-Kroner model in forecasting long- term developed market equity returns. Casey makes the following forecasts: a 2.25 percent dividend yield on Canadian equities, based on the S&P/TSE Composite Index; a repurchase yield of 1 percent for Canadian equities; a long-term inflation rate of 2 percent per year; long-term corporate real earnings growth at 4 percent per year, based on a 1 percentage point premium for corporate growth over her expected Canadian GDP growth rate of 3.0 percent; and an expansion rate for P/E multiples of 0.25 percent per year. Based only on the information given, determine the expected rate of return on Canadian equities consistent with Casey's assumptions. Activity 14 The Long-Term Real Risk-Free Rate The real risk-free rate is compensation for forgoing current consumption in exchange for certain future consumption. Historical real cash rates exhibit high volatility and differ through time and between countries. We distinguish between the current real rate (driven by cyclical factors) and the long-term real rate assumption (based on sustainable equilibrium conditions). In a free economy, the real rate equilibrates the productivity of the economy and society's time preference for consumption. On a forward-looking basis, we can form opinions about the size of the real rate by analyzing societal consumption time preferences and studying the economy's productivity. For developed countries, a range for the long-term real risk-free rate is 2.0 percent to 2.8 percent. Obviously, variation around this estimate has been and is likely to be substantial, but 2.4 percent is an indication of central tendency over the long term. Activity 15 The Real Interest Rate and Inflation Premium in Equilibrium The expected return to any asset or asset class has at least three components: the real risk-free rate, the inflation premium, and the risk premium. In equilibrium and assuming fully integrated markets, the real risk-free rate should be identical for all assets globally. Similarly, from the frame of reference of any individual investor, the inflation premium should be the same for all assets. For investors with different base currency consumption baskets, different inflation premiums are required to compensate for different rates of depreciation of investment capital. The inflation premium is the compensation for the depreciation of invested principal because of expected price inflation. In equilibrium, we use the inflation rate that each market is using to compensate it for the loss of purchasing power. Activity 16 The Risk Premium: Some Facts The term risk premium is often used to refer to the total premium above the nominal defaultrisk-free interest rate. Some points to keep in mind: In comparing risk premium estimates, the analyst should make sure that a common benchmark for the risk-free rate is being used; if not, the estimates should be adjusted to a common risk-free-rate reference point. Some analysts do not view illiquidity as a kind of risk and may refer to an illiquidity premium in addition to the risk premium when estimating the required return on an illiquid asset. Modelling any risk premium requires an assessment of the degree of capital market integration. Capital market integration will be discussed in Section 3.1.4. Activity 17 Justifying Capital Market Forecasts Samuel Breed, CIO of a university endowment, is presenting the capital market expectations shown in Exhibit 10 to the endowment's board of trustees. Capital Market Projections Asset Class Projected 5-Year Annual Return (%) Proxy Equities 1. Large-cap U.S. equity S&P 500 8.8 2. Small/mid-cap U.S. equity Russell 2500 9.8 3. Ex-U.S. equity MSCI EAFE 9.2 Fixed income 4. Domestic fixed income LB Aggregate 4.7 5. Non-U.S. fixed income Citi Non-U.S. Govt 4.6 Other Assets 6. U.S. real estate NCREIF 7.6 7. Private equity VE Post Venture Cap. 12.0 8. Cash equivalents 90-day T-bill 3.3 Inflation CPI-U 2.6 Correlations: 1. Large-cap U.S. equity 2. Small/mid-cap U.S. equity 3. Ex-U.S. equity 4. Domestic fixed income 5. Non-U.S. fixed income 6. U.S. real estate 7. Private equity 8. Cash equivalents 1 1.0 0.85 0.74 0.27 0.03 0.64 0.63 -0.10 Projected Standard Deviation (%) 16.5 22.0 20.0 4.5 9.5 14.0 34.0 1 1.4 2 3 4 5 6 7 1.0 0.61 0.20 -0.03 0.52 0.57 -0.15 1.0 0.21 0.22 0.47 0.63 -0.25 1.0 0.32 0.20 0.20 0.30 1.0 0.03 1.0 0.10 0.45 1.0 -0.05 -0.06 0.07 8 1.0 Assume the following: The Sharpe ratio of the global investable market portfolio (GIM) is 0.28, and its standard deviation is 7 percent. The beta of private equity with respect to the GIM is 3.3, and the beta of small/mid-cap U.S. equity is 2.06. William Smyth, a trustee, questions various projections for private equity, as follows: A. I have seen volatility estimates for private equity based on appraisal data that are much smaller than the one you are presenting, in which the volatility of private equity is much larger than that of small/mid-cap U.S. equity. Your volatility estimate for private equity must be wrong. B. The premium of private equity over small/mid-cap U.S. equity is not justifiable because they both represent ownership interests in U.S. business. C. Using the ICAPM, the forecast correlation between private equity returns and small/mid-cap U.S. equity returns is lower than your estimate indicates. 1. Evaluate whether Smyth's Comment A is accurate. 2. Evaluate whether Smyth's Comment B is accurate. 3. Evaluate whether Smyth's Comment C is accurate. 3.7 Summary In this section we have discussed how investment professionals address the setting of capital market expectations. Capital markets expectations are essential inputs to deciding on strategic asset allocation. The process of capital market expectation setting involves the following steps: 1. Specify the final set of expectations that are needed, including the time horizon to which they apply. 2. Research the historical record. 3. Specify the method(s) and/or model(s) that will be used and the information needs for developing expectations. 4. Determine the best sources for information needs. 5. Interpret the current investment environment using the selected data and methods, applying experience and judgment. 6. Formulate the set expectations that are needed, documenting conclusions. 7. Monitor actual outcomes and compare the expectations, providing feedback to improve the expectations-setting process (Also read pages 36 - 38 of the workbook) 3. Topic 3: Asset Allocation 1.1 Mind map Asset allocation and the investor's risk and return objectives function of strategic asset allocation Introduction role of tactical allocation Optimisation Mean variance approach importance of asset allocation for portfolio performance asset only approach to asset allocation Monte Carlo simulation Asset liability approach asset liability management approach to asset allocation Experience based Dynamic Vs Static asset allocation Constrained mean variance approach The selection of asset classes and steps in asset allocation Specification of asset classes Selection of appropriate asset class for an investor Effects of including additional asset classes Asset allocation process Implementing the strategic asset allocation Strategic asset allocation for individual investor Strategic asset allocation for institutional investor Summary Tactical asset allocation 1.2 Introduction Asset allocation is a process and a result. Strategic asset allocation is an integrative element of the planning step in portfolio management. For investors, selecting the types of assets for a portfolio and allocating funds among different asset classes are major decisions. A 70/30 stock/bond portfolio has different return, risk, and cash flow pattern than a 30/70 stock/bond portfolio. Which asset allocation is more appropriate for a particular investor will depend on how well the allocation's characteristics matchup with the investments objectives and circumstances described in the investor policy statement (IPS). This section will also deal with the principles of determining an appropriate asset allocation for an investment client. The questions we will address include the following: How does asset allocation function in controlling risk? What are major approaches to asset allocation and the strengths and weaknesses of each? How should asset classes be defined, and how can one evaluate the benefits from including additional asset classes? What are the pitfalls in asset allocation according to practice? What are the current choices in optimisation? How may a portfolio manager use prior investments experience in selecting asset allocation? What are the special considerations in determining an asset allocation for individual and institutional investors? Target asset allocation Fixed income 7.5% RSA fixed income securit