Asset Allocation Strategy Analysis - Essay Example

Asset Allocation Strategy Introduction Strategic asset allocation policy is the heart of a sound investment program. Defining a precise line between asset allocation policy and its implementation can present a difficult task, but in general terms, asset allocation involves determining how much of an investment portfolio is to be allocated to specific broad asset categories, such as real estate, equities, fixed income and so on. Implementation of such an investment portfolio which is broad in all aspects requires a lot of money to be put into it. This paper presents an outline that will drive private University Endowment Fund in order to meet the spending requirements of the University. Modern Portfolio Theory developed by Nobel Prize winner Professor Harry Markowitz demonstrates how the risk-adjusted returns of a portfolio can be improved by diversification of investments across assets with varied correlations. This paper takes this theory philosophy, and it will be the foundation in which portfolios will be constructed (Riley, 21-38). Investment Policy Considering that investment management involves much of art as science, qualitative considerations will play a critical role in this portfolio development (Reilly, 47). Precise distinctions among asset classes is subjective, therefore no clear distinctions exists. Returns and correlations are difficult to forecast, though historical data may provide a guide, which will be modified to incorporate structural changes and compensate for anomalous periods. Taking into account the prevailing market conditions, this paper makes the below judgment on market returns and their associated risks. SMALL CAP EQUITIES IVV ACWI EFA SCZ EEM return % return % return % return % return % return % Return 0.00 0 0.00 0 0.00 0 9.27 15 3.35 15 6.31 30 Risk 0.00 0 0.00 0 0.00 0 14.39 15 15.13 15 14.76 30 Allocation 0.00 1 0.00 1 0.00 1 0.00 1 0.00 0 - 4 TOTAL EQUITIES IVV ACWI EFA SCZ EEM return % return % return % return % return % return % Return 15.61 25 10.03 20 6.45 25 9.27 15 3.35 15 9.41 100 Risk 13.17 25 12.19 20 14.25 25 14.39 15 15.13 15 13.72 100 Allocation 100.00 5 50.30 5 0.00 5 0.00 10 0.00 15 18.79 40 LARGE CAP EQUITIES IVV ACWI EFA SCZ EEM return % return % return % return % return % return % Return 15.61 25 10.03 20 6.45 25 0.00 0 0.00 0 10.74 70 Risk 13.17 25 12.19 20 14.25 25 0.00 0 0.00 0 13.28 70 Allocation 100.00 5 50.30 10 0.00 6 0.00 15 0.00 0 27.86 36 ICF REM IFAS IFGL return % return % return % return % return % Return 15.26 10 7.18 10 6.84 50 7.54 30 7.93 100 Risk 14.21 10 14.45 10 18.19 50 15.36 30 16.57 100 Allocation 0.00 15 100.00 20 100.00 10 0.00 10 36.36 55 Input Security Return Risk US Large Cap Equities 70.0% 70.0% US Small Cap Equities 30.0% 30.0% MSCI EAFE Non-US Developed Mkts. 6.5% 14.3% MSCI Non-US Emerging Mkt Equity 5.0% 10.0% US and Non-US Fixed Income (bonds) 100.0% 100.0% Emerging Markets Fixed Inc (bonds) 7.2% 7.8% Global REITS 7.9% 15.8% Commodities 8.2% 28.0% Private Equity 6.5% 26.1% Hedge Funds 7.3% 7.2% Mixing the above assets will produce a real return of 11.5%, with an expected growth of 6.3% annually, and a standard deviation (risk) of 10.2%. Available resources for current operations will utter the purchase power of assets, and this pushes this impacts investment policy. The above mix of assets is defined by their differences expected in their response to economic conditions, among them price inflation, interests rates and economic growth. MSCI EAFE Developed and Emerging Markets Over the past few decades, most of the University’s endowment funds invested highly on US marketable securities, and were there core factors in their investments. Taking into account the prevailing economic times, this paper finds that it will be wiser to commit some of it assets to developed markets outside the United State with a percentage of 6.5% and a standard deviation of 14.3%. These markets are given preference taking into account the globalization of trade, where these markets operate village centers of a small town. In addition, there exist much scrutiny of these markets, and cases of unethical practices cannot take place. Consequently, probability of returns to be achieved over and above the set targets is higher, than in domestic markets. Alternatively, investing in emerging markets equity is preferred. These markets are estimated to have returns of 4.5% with a standard deviation of 17.2%. Not ignoring the high levels of risks observed in these markets, it should be noted that these markets presents highest growth potential in few years to come, and they are predicted to perform better than developed markets. Investments in these markets provides opportunity to exploit inefficiencies presented by them, by employing active management team suited to exploit illiquid aspects of these markets in terms of venture capital and leveraged buyouts. MSCI EAFE Non-US developed markets and MSCI Non-US emerging market equity provide very low returns compared to the risk associated with them, thus a maximum of 2% of overall investment funds available should be allocated to them to minimize cases of financial distress being experienced by the institution owing to failure of these assets to deliver results. Equities Cap Equities According to financial theory, US Large Cap Equities creates a situation where investors receive superior returns, usually higher than those expected form US Small Cap Equities. US Large Cap Equities represents a huge, liquid, and heavily regulated market. However, being a domestic market, only a small percentage should be invested here, due to the over population of this market by other endowment funds which impacts the expected returns, mostly resulting to lower actual returns in comparison to the expected returns. This however, does not imply that US Cap Equities are inefficient, it is only a market judgment based on principles of financial theory where investments should be allocated to assets whose returns are higher than the estimated risks. Thus, an allocation of 7% should be made to these investments. Fixed Income Fixed income assets relate to government bonds and securities, where their risks are much lower than the expected returns (Reilly 89). US and Non-Us Fixed income assets created an opportunity where the expected returns are much higher that is 4.0% in comparison of their associated risk of 2.7%. This makes these investments attractive in comparison to equity market, because regardless of the economic shocks, returns are guaranteed at fixed amounts. However, a relatively small percentage should be allocated here, owing to the fact that these returns take long to mature, thus they may not be efficient in providing needed funds, in accordance to University recurring financial needs. In addition, these assets performance has not outperformed market index for the last few decades, therefore care should be exercised in determining the percentage to allocate to them due to financial instability of the government. Furthermore, these assets affirm a consistent and reliable flow of income. An allocation of 23% should also be made to both markets of fixed income. Regardless of the inefficiencies observed in these markets, it should also be noted that they present the highest return potential, once the right active managers are put into action. Through pursuing active management strategies, these markets are estimated to outperform developed market indices by year 2030, and it is this same time that developed markets are expected to start their menopause. Of key importance of fixed income from emerging markets is that they are cheap to buy, and their returns are more than double by the time they mature. Both U.S and Non-US fixed income combined with emerging markets fixed income assets ensures stable cash flows than any other financial asset in the market. Global REITS Global REITS will give the investment portfolio an exposure to global economy (Reilly, 112), providing an opportunity to earn outsized returns of 7.9% at a standard deviation of 15.8%, attributed to the uncertainties of global market response to economic shocks from a particular economic situation arising from any parts of the economy. Opportunistic foreign positions with high expectations compel this paper to suggest an allocation of 15% of funds to this class of asset. Natural Resources Equity investments in natural resources such s gas, oil, mining, timber and metals both domestic and foreign offers protection against unanticipated global inflation, high and visible current cash flows, and opportunities to exploit inefficiencies (Reilly, 179). Investments in natural resources promise attractive and higher returns, and they add into the diversification of assets because they are many, with each having it own response to economic changes. Furthermore, they provide long-term real returns expected to be 7.9% with a standard deviation of 6.75%. The real market data predicts an impressive market growth of these assets at 16.0% per annum. Investment in foreign and domestic equity offer a long-term risk-adjusted returns, which necessities employment of strong and stable value-adding managers to exploit inherent market inefficiencies and deliver superior returns. 31% of the fund investment needs to be directed to these funds, with domestic taking a lower portion of 11% and foreign equity taking a higher portion of 20%. This is because the risk-adjusted returns for domestic and foreign equity are 6.0% and 11.0% with a standard deviation of 4.9% and 9.8% respectively. Furthermore, these equity investments should be directed to firms that pursue value-adding investing approach. This is because such firms work in partnerships with portfolio companies to create fundamentally more valuable entities, therefore relying on financial engineering to generate funds as a secondly option. Real Estate Real estate’s will provide additional useful diversification to the endowment fund. Real estate investments normally provide a natural circumvent against unforeseen inflation, without sacrificing the anticipated returns (Reilly, 243). This class of asset has expected returns of 20.2% with a risk of 19.0%. These higher risks are attributed to historical data where some of the real estate investments provide cyclical returns, attributed to inefficiencies in the asset class invested in, and the fact that value-adding managers will require long time horizons to generate superior returns. However, the illiquid nature of real estate investments should be taken into account, plus the time consuming transactions required to reap value. Distinctively, this class should be allocated 17% of the overall investment portfolio, because it helps in creation of strong, long-term partnerships with various stakeholders, a critical needed aspect in ensuring growth of the endowment. Commodities Hedge Funds and Private Equity Hedge funds are risky investments, and there returns are almost equal to the risk associated with them due to their volatile nature, and that they are highly affected by changes in the economy (Reilly, 193). Their predicted returns are 7.3% with an associated risk of 7.2%. Owing to this observable trend, a small fraction of 5% of the overall investment should be allocated to them, for they are like a gambling game of money where the outcome can be great or worse. Private equity is an attractive long-term investment offering risk-adjusted returns that allow investment managers to exploit inefficiencies of a particular market. This endowment fund should incorporate leveraged buyouts partnerships in its private equity investment together with venture capital to achieve returns of 6.5% at a risk of 26.1%. Notably, high levels of risks are associated with this investment due to volatility in it returns in response to economic shocks. Commodities are another asset to be included in this assets allocation strategy to achieve returns of 8.2% at a high risk of 28.0%, owing to their perishable nature and seasonal fluctuations. Consequently, an allocation of 2% on overall available funds for investments should be directed to hedge fund and 5% to all equity investments and divided appropriately. Conclusions Spending rule for the institution remains at the heart of the fiscal discipline. The above discusses investment portfolio defines the institution conflicting goals of providing support for its current operations and preserving purchasing power of endowment assets. Therefore, the institution should clearly redefine its spending rule consistently applying the concept of a balanced budget for the asset allocation portfolio to have a meaning. Competing objectives so as to ensure stable flow of income and protect the real value of endowment over time, and trade-offs of competing objectives should ensure a smooth running rule in adjusting spending levels in response to changes in endowment market values. Work Cited Reilly, Frank K, and Keith C. Brown. Investment Analysis and Portfolio Management. Mason, Ohio: South-Western Cengage Learning, 2012. Print. Read More