New Science of Asset Allocation

THOMAS SCHNEEWEIS, PHD, is the Michael and Cheryl Philipp Professor of Finance at the University of Massachusetts, Amherst and is the founding director of the Center for International Securities and Derivatives Markets. He is also the founding editor of the Journal of Alternative Investments, cofounder of the Chartered Alternative Investment Analyst Association, and a founding Director of the Institute for Global Asset and Risk Management. During his almost forty years of investment management experience, he has been associated with the development of alpha transfer and fund replication products, the creation and development of the Zurich Hedge Fund Indices and the Dow Jones Hedge Fund Benchmark Series, as well as being instrumental in the creation of the Bache Commodity Index. Schneeweis publishes widely in the area of investment management and is often quoted in the financial press. GARRY B. CROWDER, JD, MBA, is a noted expert in the development and creation of multi-asset portfolio solutions and products. He has designed and implemented asset allocation solutions for leading multinational banks, insurance companies, and family offices. Crowder created and was managing partner of one of the first and largest hedge fund platforms based on managed accounts. In this capacity, he formed and led the team that created the Zurich Hedge Fund Indices and the Dow Jones Hedge Fund Benchmark Series. With over twenty years of investment experience, he is a founding Director of the Institute for Global Asset and Risk Management and has also served in managing director positions at Morgan Stanley Asset Management and Tiger Management LLC. HOSSEIN KAZEMI, PHD, CFA, is regarded as a leader in the area of asset allocation, and has published over thirty academic and practitioner articles in the area of asset pricing and asset allocation. He is a founding partner of Alternative Investment Analytics, LLC, and White Bear Partners, LLC. Kazemi is a professor of finance at the University of Massachusetts, Amherst and is the Associate Director of the Center for International Securities and Derivatives Markets. He is the current Program Director of the Chartered Alternative Analyst Investment Association.

• Preface xiAcknowledgments xixChapter 1 A Brief History of Asset Allocation 1In the Beginning 3A Review of the Capital Asset Pricing Model 4Asset Pricing in Cash and Derivative Markets 6Models of Return and Risk Post-1980 11Asset Allocation in the Modern World 14Product Development: Yesterday, Today, and Tomorrow 15Notes 17Chapter 2 Measuring Risk 20What is Risk? 22Traditional Approaches to Risk Measurement 24Classic Sharpe Ratio 26Other Measures of Risk Assessment 28Portfolio Risk Measures 30Other Measures of Portfolio Risk Measurement 33Value at Risk 34Notes 37Chapter 3 Alpha and Beta, and the Search for a True Measure of Manager Value 39What is Alpha? 39Issues in Alpha and Beta Determination 46Problems in Alpha and Beta Determination 48Multi-Factor Return Estimation: An Example 50Tracking Alternatives in Alpha Determination 54Notes 56Chapter 4 Asset Classes: What They are and Where to Put Them 58Overview and Limitations of the Existing Asset Allocation Process 59Asset Allocation in Traditional and Alternative Investments: A Road Map 61Historical Return and Risk Attributes and Strategy Allocation 66Traditional Stock/Bond Allocation versus Multi-Asset Allocation 70Risk and Return Comparisons Under Differing Historical Time Periods 71Extreme Market Sensitivity 74Market Segment or Market Sensitivity: Does It Matter? 82How New is New? 84Notes 88Chapter 5 Strategic, Tactical, and Dynamic Asset Allocation 91Asset Allocation Optimization Models 92Strategic Asset Allocation 99Tactical Asset Allocation 101Dynamic Asset Allocation 107Notes 109Chapter 6 Core and Satellite Investment: Market/Manager Based Alternatives 110Determining the Appropriate Benchmarks and Groupings 111Sample Allocations 117Core Allocation 119Satellite Investment 120Algorithmic and Discretionary Aspects of Core/Satellite Exposure 120Replication Based Indices 122Peer Group Creation—Style Purity 126Notes 132Chapter 7 Sources of Risk and Return in Alternative Investments 134Asset Class Performance 135Hedge Funds 139Managed Futures (Commodity Trading Advisors) 143Private Equity 148Real Estate 153Commodities 160Notes 166Chapter 8 Return and Risk Differences among Similar Asset Class Benchmarks 167Making Sense Out of Traditional Stock and Bond Indices 168Private Equity 170Real Estate 173Alternative REIT Investments Indices 179Commodity Investment 179Hedge Funds 185Investable Manager Based Hedge Fund Indices 185CTA Investment 189Index versus Fund Investment: A Hedge Fund Example 189Notes 194Chapter 9 Risk Budgeting and Asset Allocation 195Process of Risk Management: Multi-Factor Approach 195Process of Risk Management: Volatility Target 200Risk Decomposition of Portfolio 202Risk Management Using Futures 203Risk Management Using Options 206Covered Call 206Long Collar 208Notes 210Chapter 10 Myths of Asset Allocation 212Investor Attitudes, Not Economic Information, Drive Asset Values 213Diversification Across Domestic or International Equity Securities is Sufficient 214Historical Security and Index Performance Provides a Simple Means to Forecast Future Excess Risk-Adjusted Returns 215Recent Manager Fund Return Performance Provides the Best Forecast of Future Return 215Superior Managers or Superior Investment Ideas Do Not Exist 216Performance Analytics Provide a Complete Means to Determine Better Performing Managers 216Traditional Assets Reflect “Actual Values” Better Than Alternative Investments 217Stock and Bond Investment Means Investors Have No Derivatives Exposure 217Stock and Bond Investment Removes Investor Concerns as to Leverage 218Given the Efficiency of the Stock and Bond Markets, Managers Provide No Useful Service 218Investors Can Rely on Academics and Investment Professionals to Provide Current Investment Models and Theories 218Alternative Assets are Riskier Than Equity and Fixed Income Securities 219Alternative Assets Such as Hedge Funds are Absolute Return Vehicles 220Alternative Investments Such as Hedge Funds are Unique in Their Investment Strategies 221Hedge Funds are Black Box Trading Systems Unintelligible to Investors 222Hedge Funds are Traders, Not Investment Managers 222Alternative Investment Strategies are So Unique That They Cannot Be Replicated 223It Makes Little Difference Which Traditional or Alternative Indices are Used in an Asset Allocation Model 223Modern Portfolio Theory is Too Simplistic to Deal with Private Equity, Real Estate, and Hedge Funds 223Notes 225Chapter 11 The Importance of Discretion in Asset Allocation Decisions 226The Why and Wherefore of Asset Allocation Models 226Value of Manager Discretion 230Manager Evaluation and Review: The Due Diligence Process 232Madoff: Due Diligence Gone Wrong or Never Conducted 233Notes 239Chapter 12 Asset Allocation: Where is It Headed? 240An Uncertain Future 241What is the Definition of Order? 243Costs and Benefits 246Today’s Issue 246Possible Governmental and Private Fund Responses to Current Market Concerns 247Note 249Appendix: Risk and Return of Asset Classes and Risk Factors Through Business Cycles 251Glossary: Asset Class Benchmarks 271Bibliography 279About the Authors 285Index 287