Global Classification of Asset Classes

The global market portfolio is the weighted sum of every asset globally. It represents a well-diversified asset allocation that can serve as a baseline approach and help mitigate concentrated outputs often arrived at by MVO. The asset mix is adjusted as specific client needs to deviate from the optimal global market portfolio.

This method has the distinct advantage of avoiding highly concentrated positions, as can sometimes be recommended by MVO. For example, even though the return and risk metrics fit the investor’s parameters, an MVO allocation might be almost all real estate (90+%), with little else in the portfolio. This allocation does not meet common-sense diversification standards.

There may be differences in the classification of asset classes within the universe of investments available based on local practices. Equities are usually classified by market capitalization in the United States and other larger markets. In contrast, outside of the United States, equities are more likely to be classified by valuation (“growth” versus “value”).

Concerning fixed income, some asset allocators may categorize bonds according to various attributes – nominal versus inflation-linked, corporate versus government-issued, investment grade versus non-investment grade (high yield) – and/or maturity/duration.

To control the typically high sensitivity of efficient portfolio composition to expected return estimates, we use a reverse-optimization procedure based on asset class market values to generate expected return estimates using the non-negativity constraint. It is often the case that efficient portfolios are highly concentrated in a subset of asset classes without such precautions.

Question

An analyst is creating an asset allocation for a high-net-worth individual. The analyst begins with the global market portfolio without knowing where to start. After deriving this first allocation, the analyst adjusts the allocation to equity down 5%. He then notices the yield curve inverting and believes equity will likely underperform in the months ahead, adding an extra 5% to short-term fixed income.

The preceding explanation most likely describes:

1. resampling.
2. reverse optimization.
3. Black-Litterman approach.

Solution

The correct answer is C:

The Black-Litterman approach combines equilibrium returns (implicit returns that eliminate outstanding market allocations) with analysts’ views to generate an optimal allocation. According to the scenario described in the question, the analyst starts with the global market portfolio and adjusts it based on his views about equity underperformance and yield curve inversion.

A is incorrect. In asset allocation, resampling is used to minimize estimation error. Unlike traditional mean-variance optimization, it considers data stochastic rather than deterministic. Data are repeatedly drawn from the return distribution to estimate input parameters to create statistically equivalent samples. The scenario described in the question does not mention this technique.

B is incorrect. A reverse optimization solves for expected returns by taking an optimally weighted asset allocation as inputs and adding covariances and risk aversion coefficients. The scenario described in the question does not mention this process either.

Asset Allocation: Learning Module 4: Principles of Asset Allocation; Los 4(d) Recommend and justify an asset allocation based on the global market portfolio