{"id":39784,"date":"2024-08-05T12:29:13","date_gmt":"2024-08-05T12:29:13","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=39784"},"modified":"2024-08-05T12:30:39","modified_gmt":"2024-08-05T12:30:39","slug":"traditional-and-risk-based-approaches-to-asset-classification-2","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-iii\/traditional-and-risk-based-approaches-to-asset-classification-2\/","title":{"rendered":"Traditional and Risk Based Approaches to Asset Classification"},"content":{"rendered":"<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/FPTmUodFq98\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><\/iframe> <\/p>\n<p>To effectively analyze a portfolio or potential investment opportunities, investors must establish a comprehensive and mutually exclusive categorization scheme, known as the &#8216;opportunity set.&#8217; This is crucial to ensure that all investments are considered and prevent double-counting or missed opportunities. Two common approaches are:<\/p>\n<ul>\n<li>Liquidity-based approach.<\/li>\n<li>Performance expectation approach.<\/li>\n<\/ul>\n<p>The liquidity-based approach typically starts by distinguishing between public and private investments, with private investments being less liquid. This approach further subdivides categories, as illustrated in the table below:<\/p>\n<p>$$ \\textbf{Major Asset Class Categories} \\\\<br \/>\n \\small{\\begin{array}{c|c|c|c}<br \/>\n&#038; \t{\\textbf{Equity &#038;} } &#038; \t{\\textbf{Fixed Income &#038;} } &#038; \t\\textbf{Real Estate} \\\\<br \/>\n&#038; \\textbf{Equity-Like} &#038; \\textbf{Fixed Income-Like} &#038; \\\\ \\hline<br \/>\n\\textbf{Marketable\/Liquid} &#038;\t\\text{Public Equity}\t&#038; \\text{Fixed Income} &#038; \\text{Public Real Estate} \\\\<br \/>\n&#038; \t\\text{Long\/Short Equity} &#038;\t\\text{Cash} &#038;\t\\text{Commodities} \\\\<br \/>\n&#038; \t\\text{Hedge Funds} &#038; &#038; \\\\ \\hline<br \/>\n\\textbf{Private\/Illiquid} &#038;\t\\text{Private Equity} &#038;\t\\text{Private Credit} &#038;\t\\text{Private Real Estate} \\\\<br \/>\n &#038; &#038; &#038;\t\t\t\\text{Private Real Estate} \\\\ \\end{array} }$$<\/p>\n<p>Investors can also categorize asset classes based on their expected behavior in different economic conditions:<\/p>\n<ol type=\"1\">\n<li>Capital growth assets tend to rise in value during periods of economic growth. This category includes both public and private equities.<\/li>\n<li>Inflation-hedging assets, such as real estate, commodities, natural resources, and inflation-linked bonds, are expected to perform well when inflation expectations increase or if inflation surpasses expectations.<\/li>\n<li>Deflation-hedging assets, like nominal government bonds, may outperform most other asset classes during periods of slow economic growth and low inflation.<\/li>\n<\/ol>\n<h4>Main strengths of traditional approaches: <\/h4>\n<p><em>Easy to communicate<\/em><\/p>\n<p>Traditional asset-class-based approaches are widely understood by investors, making communication and comprehension straightforward.<\/p>\n<p><em>Relevance for liquidity management and operational considerations<\/em><\/p>\n<p>These approaches are particularly useful for managing liquidity due to the significant differences in liquidity profiles between public and private asset classes.<\/p>\n<h4>Main limitations of traditional approaches: <\/h4>\n<p><em>Over-estimation of portfolio diversification<\/em><\/p>\n<p>Investors might overestimate the level of diversification in their portfolio without a proper analytical framework.<\/p>\n<p><em>Obscured primary drivers of risk<\/em><\/p>\n<p>Different investments may be grouped together under the same asset class, potentially obscuring the primary drivers of risk.\u2003<\/p>\n<h2>Risk-Based Approach<\/h2>\n<p>A more precise way to define investment opportunities is through a risk-based approach. This method categorizes investments based on their exposure to specific risk factors, making it less subjective and more quantitative. Risk factors often considered for alternative investments include:<\/p>\n<ul>\n<li><em>Equity market return:<\/em> It reflects the overall trend of global equity markets and is often considered the most accurate market indicator for &#8216;growth&#8217; <\/li>\n<li><em>Size: The additional return of small-cap stocks compared to large-cap stocks.<\/li>\n<li><em>Value: The surplus return of value stocks compared to growth stocks (negative factor sensitivity indicates a preference for growth stocks).<\/li>\n<li><em>Liquidity: Refers to the Pastor-Stambaugh liquidity factor, a market-wide metric based on the disparity in returns between stocks that are highly responsive to changes in overall liquidity (less-liquid stocks) and stocks that are less affected by shifts in liquidity conditions (more-liquid stocks) <\/li>\n<li><em>Duration: Responsiveness to fluctuations in the 10-year government bond yield.<\/li>\n<li><em>Inflation: Reactivity to adjustments in 10-year breakeven inflation rates derived from the inflation-linked bond markets..\n<li><em>Credit spread: Responsiveness to fluctuations in the high-yield spread.<\/li>\n<li><em>Currency: Responsiveness to fluctuations in the domestic currency in comparison to a collection of foreign currencies.<\/li>\n<\/ul>\n<h4>Main strengths of risk-based approaches: <\/h4>\n<p><em>Identify common risk factors<\/em><\/p>\n<p>This approach allows investors to identify common risk factors across different types of investments, whether they are public or private, passive or active.<\/p>\n<p><em>Integrated risk framework <\/em><\/p>\n<p>By developing an integrated risk management framework, it becomes easier to accurately quantify portfolio-level risk.<\/p>\n<h4>Main limitations of risk-based approaches: <\/h4>\n<p><em>Sensitivity to historical data <\/em><\/p>\n<p>The historical data used to determine risk factor exposures can impact the results. For example, an equity portfolio&#8217;s beta may remain relatively stable over time, but its sensitivity to inflation could vary significantly. Analysts must be cautious when interpreting risk factor sensitivity measures, such as &#8220;inflation beta.&#8221;<\/p>\n<p><em>Implementation challenges <\/em><\/p>\n<p>Setting strategic targets for different risk factors is a high-level decision. However, translating these targets into specific investment mandates involves additional considerations, including liquidity planning, manager selection, and rebalancing policies.<\/p>\n<blockquote>\n<h2>Question<\/h2>\n<p>Using an approach based on expected returns under various economic regimes, private real estate falls under which of the following categories?<\/p>\n<ol type=\"A\">\n<li>Capital Growth.<\/li>\n<li>Inflation-hedging.<\/li>\n<li>Deflation-hedging.<\/li>\n<\/ol>\n<p><strong>Solution<\/strong><\/p>\n<p><strong>The correct answer is B.<\/strong><\/p>\n<p>Private real estate is primarily known for its inflation-hedging properties. This is because, during periods of higher-than-expected inflation, private real estate can offer two significant advantages:<\/p>\n<ol type=\"1\">\n<li>Rental rates often increase, leading to higher cash flow for property owners.<\/li>\n<li>Property prices may also rise, increasing the overall asset value.<\/li>\n<\/ol>\n<p><strong>A and C are incorrect.<\/strong> Capital growth assets encompass both public and private equities, while deflation-hedging assets typically include nominal government bonds.<\/p>\n<\/blockquote>\n<p><strong>Portfolio Construction: Learning Module 3: Asset Allocation to Alternative Investments;<\/strong> Los 3(c) Compare traditional and risk-based approaches to defining the investment opportunity set, including alternative investments<\/p>\n","protected":false},"excerpt":{"rendered":"<p>To effectively analyze a portfolio or potential investment opportunities, investors must establish a comprehensive and mutually exclusive categorization scheme, known as the &#8216;opportunity set.&#8217; This is crucial to ensure that all investments are considered and prevent double-counting or missed opportunities&#8230;.<\/p>\n","protected":false},"author":3,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[571],"tags":[],"class_list":["post-39784","post","type-post","status-publish","format-standard","hentry","category-cfa-level-iii","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v27.4 - 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