Asset Allocation Concepts Session I

iFAST Financial (HK) Limited Sep Oct 2010

What is Asset Allocation?

Asset Allocation is
An investment strategy that aims to
balance risk and reward by apportioning a portfolio's assets according to an individual's goals, risk tolerance and investment horizon.

The main asset classes Equities fixed-income Cash Other investment vehicles such as commodities and hedge fund

Why Asset Allocation?

It is all about diversification!

Why Should You Diversify?

Why should you diversify?

I ve tripled my money this year! Sadly I still haven t got back my initial investment. I lost 70% in the financial tsunami . You ve outperformed many fund managers!

Managing Risks

It takes you more efforts to recover the initial investment when losses enlarge Warrant Buffet s famous quotes regarding to his value-investing philosophy
Rule 1: Never lose money Rule 2: Never forget rule No. 1 Source: The Story of Warren Buffett, 2006 Literary Edition

If investing is a football game, these are the rules .

Teamwork Correlation is the key In a well-diversified team, there are investments from different regions and asset classes. This helps lower the volatility of the team because when one player does not do well, other players could help him out.

Correlation is the Key

A portfolio of assets with low correlation
Low vitality, best risk-adjusted return

Correlation
Measured by Correlation Co-efficient
Correlation Co-efficient +1 0 -1 Correlation of assets Totally correlated Not Correlation Negatively Correlated Implication Two assets move perfectly together (same direction and amount) One asset s movement is independent from the other Two assets move in dofferent direction by the same amount

Correlation among different Markets

Diversification Effect:
Australia MSCI Asia USA (S&P (S&P/ASX Ex Japan 500) 200) Australia (S&P/ASX 200) MSCI Asia Ex Japan USA (S&P 500) MSCI World Japan (Nikkei 225) Hong Kong( HSI) Singapore (STI) India (SENSEX) Malaysia (KLCI) MSCI World Japan (Nikkei 225)

High

Medium

Low

Hong Singapore India Malaysia Kong( HSI) (STI) (SENSEX) (KLCI)

1 0.709 0.671 0.789 0.572 0.647 0.786 0.463 0.386

0.709 1 0.636 0.704 0.481 0.889 0.856 0.424 0.730

0.671 0.636 1 0.895 0.451 0.598 0.714 0.286 0.389

0.789 0.704 0.895 1 0.710 0.645 0.780 0.305 0.431

0.572 0.481 0.451 0.710 1 0.394 0.535 0.173 0.257

0.0647 0.889 0.598 0.645 0.394 1 0.764 0.292 0.592

0.786 0.856 0.714 0.780 0.535 0.764 1 0.709 0.604

0.463 0.424 0.286 0.305 0.173 0.292 0.706 1 0.273

0.386 0.730 0.389 0.431 0.257 0.592 0.604 0.273 1

Source: Bloomberg as from Sept 1989 to Sept 2009

Correlation among different Markets

Diversification Effect: High Medium Low
MSCI MSCI Asia Ex USA(S&P500) World Japan Japan (Nikkei 225) Equity FTSE Nareit Equity TR Index Bloomberg Asia REIT Index iBoxx USD Treasuries Total Return Index J.P. Morgan Global Aggregate Bond Index Golds RJ/CRB Commodity Price Index Moodys/REAL CPPI Index Liv-ex 100 Benchmark Fine Wine Index Bloomberg Football Index Hong Singapore India Kong(HSI) (STI) (SENSEX) Malaysia (KLCI)

0.737 0.082 0.651 0.151 0.050 0.092 0.311 0.014 0.536 0.217

0.056 0.827 0.208 -0.477 -0.234 0.005 0.293 0.011 0.754 -0.047

0.397 0.619 0.475

0.686 0.143 0.543

0.655 0.077 0.646

0.417 0.225 0.419

0.485 -0.023 0.514 -0.119 0.122 0.094 0.235 -0.086 0.516 0.181

-0.444 -0.145 -0.198 -0.095 -0.048 0.053 0.150 0.505 0.755 0.220 0.031 0.248 0.487 0.158 0.073 0.145 0.331 0.702 0.269 -0.047 0.06 0.269 0.154 0.435 0.198

Bond

Commodity Real Estate Thematic Tools

-0.068 -0.017 -0.117

Source: Bloomberg as from 1989 to 2009

If investing is a football game, these are the rules .

Aggressive vs Defensive Do you want the excitement brought by the daily price volatility ? Or do you want to invest successfully over the longterm? Football competitions have proved that a team that does not know how to defense can never be the champion.
This suggests that the long-term winner is likely the one who is able to manage risks effectively. Only to take appropriate risk

If investing is a football game, these are the rules .

Investment requires a whole lot of patience and commitment! Whilst many people proclaim themselves as investors , few of them truly understand and practise the philosophy of investing. While modern football tactic has much emphasis on defense, investment has a similar rule-ofthumb: patience and steady wins the race - remember Aesop's popular fable about the Tortoise and the Hare .

The Long Team Objectives of Doing Asset Allocation

To lower portfolio s volatility
To maximize gain, and To minimize loss

To increase the risk adjusted return

Increase return + decrease volatility (risk)

Okay, I understand the power of diversification

But how?

The Tools for Asset Allocation

The main asset classes Equities Fixed-income Cash Other investment vehicles such as commodities and hedge fund

The Tools for Asset Allocation

To further break down .
Equities funds Bonds funds Money market funds Other parking facilities Currency Alternative Investment

Main Instrument - Equity funds

Equity funds are funds that invest into stocks There is a large variety of such funds They offer easier access to foreign stock markets along with the advantage of professional management and diversification They are ideal for the investor who wants less hassle compared to stocks

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Main Instrument Fixed Income

Bonds are issued to borrow money Issuers include
Companies based on needs Governments based on issuance calendar

Risky?

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Why invest in bonds?

Especially since returns from equities beat returns from bonds? Suppose a 2-year bond pays $20 semi-annually and returns $1,000 at maturity. Bond
Fixed income Capital preservation Risk Yes

Equity
Usually not

Predictable Unpredictable Lower Higher

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Key things for bond investors

Credit ratings
- investment grade or sub-investment grade - Credit rating agencies include S&P & Moody s

Yield Duration Currency

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Bonds - Credit rating

Reflects independent opinion of issuer s ability to pay interest and principal
Investment-Grade Bonds

Considered suitable for prudent investors such as insurance companies, banks, and pension funds that must maintain a certain level of credit quality in their bond portfolios.
Moody's S&P

Aaa

Aa A Baa

AAA Judged to be the best quality, carrying the smallest credit risk. U.S. government and U.S. agency bonds carry these ratings. AA Regarded as high quality. Together with Aaa and AAA bonds, they're known as high-grade bonds. A Possess many favorable investment attributes and are considered to be high medium-grade bonds. BBB Considered medium-gradeneither highly protected nor poorly secured.
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Credit rating
Speculati e r Junk nds

i l fi
Moody's

r it l f r i l tilit f t i t r f l i l tr t .
S&P

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iti i

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J G

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t l ti l i r ll r . r ll l r t ri ti f i r r lit it r r l ti i t r ti , i r t t, t t i r f lt.

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l i t t. f lt. ft i f lt. r t f i i t r t.

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Why are credit ratings important?

Bond funds that focus on investment grade bonds are less volatile and less risky than bond funds that focus on sub-investment grade bonds High yield bond funds that buy into sub investment grade corporate bonds tend to have higher returns but higher risk Improvements in credit ratings can raise the price of a bond
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Types of bonds
HKSAR Government Bond Mass Transit Railway (MTR) Corporate Bond Bond issued by other governments or foreign companies Within Hong Kong, it is not easy to access foreign bonds. An easier way via bond funds

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Types of bond funds

Global bond funds Regional bond funds (e.g. Asian Bonds Fund) High yield bond funds Emerging market bond funds

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Main Instrument - Money market funds

Funds that invest into deposits and short term fixed income products Advantages

Can be redeemed without penalties Higher returns than fixed deposits Tax free Low risk

A type of fund with a slightly higher risk and better returns would be a cash management fund
Returns are higher because the fund manager has the option to invest into bonds > 1 year duration.

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Main Instrument - Cash investments

Cash investments
Commercial Paper Mature < 1 year at time of issue

Risk vs return
Principal is safe Interest is low

Advantage ready source of emergency funds Disadvantage long time horizon to earn the little bit of interest
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Risk Rating for Different Asset Classes

Other Instrument - Alternative Investment

A hedge fund is a fund mainly open only to accredited investors (high net worth individuals)
Difficult to precisely define hedge funds when many of them are hidden from view

In considering whether a particular fund is a hedge fund, we can look at whether

Non-traditional strategies such as leverage, short selling and arbitrage are used Investments are beyond usual stocks and bonds like options and convertibles
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How do hedge funds hedge?

Hedging actually means to manage risk Hedge funds hedge in different ways
Lower Risk - Market neutral funds invest equally on long and short side through use of derivatives or non-correlated securities
As result, they are in theory immune to fall (or rise) in overall market

Moderate Risk - More common are "long bias funds

They are invested more on long side than on short

Higher Risk - At other extreme, some funds do not hedge at all

They may be 100 percent long Some make heavy use of leverage Some concentrate on arbitrage opportunities from security mispricing

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Are all hedge funds high risk?

Risk can be
Higher risk: More aggressive. Try to profit in many market environments such as macro/global, market timing, opportunistic and short-selling strategies Moderate risk: Combine long and short positions using various asset types to hedge portfolio risk. Usually a net long or net short position, which implies only a portion of portfolio is hedged Lower risk: Emphasize consistent, but moderate returns. They avoid risk and seek low volatility Strategies used include fully hedged long/short positions, convertible arbitrage, distressed securities and special situations
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Hedge funds
Why buy hedge funds?
Incentive-based fee: Manager s compensation is tied to fund s performance. Best talent are drawn to hedge funds. Diversification: Hedge funds strategies far exceeds what traditional unit trusts offer. They go for absolute returns and can earn when market is going down

Drawbacks
Large initial investment amount of USD$50,000 for funds of funds Valuation difficulties: Problems may occur in the valuation of illiquid and distressed assets. Higher risk: Hedge funds can privately use various nontraditional techniques to boost performance and investors may not know about this till after.

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I have got the tools

But, how to execute?

Modern Portfolio Theory

Portfolio A: All Bonds Portfolio X: All Equity Portfolio B: 90% in Bond and 10% in Equity Portfolio C: 70% in Bond and 30% in Equity

Which combination suits me?

Sleeping well and living well don t have to be mutually exclusive

Source: Alliance Bernstein

Components of Total Return for Stock and Bond

Sources: Standard & Poor s; Barclays Capital, 1980-2009. Stocks are represented by Standard & Poor s Composite Index of 500 Stocks, an unmanaged index of common stocks considered representative of the stock market. Bonds are represented by the Barclays U.S. Aggregate Bond index. The performance shown is for illustrative purposes only and is not indicative of the performance of any specific investment.

Bonds help balance performance in market downturns

S&P 500 Stock Returns Dec 68 - Jun 70 Jan 73 - Sep 74 Jan 77 - Feb 78 Dec 80 - Jul 82 Sep 87 - Nov 87 Jun 90 - Oct 90 May 98 - Aug 98 Apr 00 - Mar 09 Oct 07 - Nov 08 -29.20% -42.60% -14.30% -16.50% -29.60% -14.70% -13.40% -36.10% *-42.15% Bond Returns 4.70% 7.10% 3.20% 21.60% 2.20% 3.00% 3.60% 32.40% 6.27%

Source: Lehman Brothers, Standard & Poor's, AllianceBernstein & JP Morgan S&P 500 Returns with monthly dividends reinvested. *Dividends not invested. US Bonds are represented by 10-year U.S Treasury bond for periods before 1977, by the Lehman Brothers U.S. Aggregate Bond Index from 1977 to 2003 and by JP Morgan US Aggregate Bond Index thereafter.

Use the Core & Supplementary Method

The larger core portion will consist of the more broadlydiversified regional funds The smaller supplementary portion will be made up of more narrowly-focused funds, such as the singlecountry funds and sectorbased funds.

The Core Portion

Funds in the core portfolio invest in different regions Typically have a low correlation with each other. This means that this portion of the portfolio is likely to be able to weather volatility well, as it allows for diversification when put together.

The Supplementary Portion

the supplementary portion allows you invest in funds which are your best bets in the medium term. These are the funds which may experience larger price movements (or volatility), but may possibly offer you higher returns. This method will help to reduce the overall volatility of a portfolio in both periods of market upturns and downturns.

Two extreme ends

In between

Moderately Aggressive Investor?

Asia ex Japan equity 4% Global Agriculture 2%

Asian Balanced 16%

GEM Bond 20%

Global Balanced 8%

Global Bond 17%

Asian Bond 33%

Too diversify?
Technology 3% Eastern Europe Equtiy 5% Russia Equity 6% Brazil Equity Global Bond 3% 7% High Yield 5%

Korea Equity 5% India Equity 3%

Asian Bond 2%

Asia ex Japan equity 6%

Greater China Equity 4%

GEM Equity 19%

China Equity 27%

Latin America 5%

Conservative Portfolio

30% Equity and 70% Bond :MSCI World Cap Unhedged Net Index; fixed income: Lehman Global Aggregate (hedged) Index from 1990 2006 and the Citigroup WGBI for 1985 1989.
Source: Alliance Bernstein

2 Negative Period! But the lowest returns

Balance Portfolio

10 Negative Period
50% Equity and 50% Bond :MSCI World Cap Unhedged Net Index; fixed income: Lehman Global Aggregate (hedged) Index from 1990 2006 and the Citigroup WGBI for 1985 1989.
Source: Alliance Bernstein

Aggressive Portfolio

19 Negative Period. But the highest returns!

100% Equity :MSCI World Cap Unhedged Net Index
Source: Alliance Bernstein

Mean-variance optimization

Mean-variance optimization
Associate with CAPM Capital Asset Pricing Model by William Sharpe in the 60 s He received a Nobel prize in 1990 for the work

Mean-variance optimization
Optimization looks at the expected risk and return of each asset class along with the correlation among asset classes, and determines which combination of asset classes will provide the highest expected return for any risk level. The goal of optimization is to identify asset allocations that maximize returns for a given level of risk or minimize risk for a given level of return.

Introduction to Efficient Frontier

Efficient Frontier
Capital Allocation Line (CAL)

Limitations of Asset Allocation

It based on both quantitative and behavioral:
Quantitative is inherently backward looking Standard deviation may not be best model to investment Behavioral in practice a critical consideration

There is no best asset allocation, but the most suitable

Limitations of Asset Allocation

Parameters change from time to time
Investor s needs and change in risk appetite Time horizon Market Condition

Change in actual allocation

Can we overcome the limitation?

1. How to deal with the change in market condition?

Keep Track on Key Indicator

Risk Aversion Investor Sentiment Leading Economic Indicator

Risk Aversion Indicators

85 75 65 55 45 35 25 15 Aug-07 Feb-08 Aug-08 Feb-09 Aug-09 Feb-10 Aug-10 The Collapse of Lehman Brothers

VIX Index
European Debt Woes

Risk Aversion Indicators

Investor Sentiment Indicators

Leading Economic Indicators

Actively Manage the Allocation

Asset allocation strategy should modify whenever there is a change of economic situation Overweight Bond when the market is going crazy Overweight Equity when most of the investors fear Be Contrarian!

Suggested Allocation
Natural Overweight Equity Overweight Bond

Bond Conservative M. Conservative Balance M. Aggressive 90% 70% 50% 30% 10%

Equity 10% 30% 50% 70% 90%

Bond 80% 60% 40% 20% 0%

Equity 20% 40% 60% 80% 100%

Bond 100% 80% 60% 40% 20%

Equity 0% 20% 40% 60% 80%

Aggressive

Can we overcome the limitation?

2. How to deal with a bear market?

First of all, look for the the Crisis Winner

The CBOE Volatility Index

85 75 65 55 45 35 25 15 Aug-07 Feb-08 Aug-08 Feb-09 Aug-09 Feb-10 Aug-10 The Collapse of Lehman Brothers

VIX Index
European Debt Woes

Flight to Safe-Heaven Assets

USD to JPY Exchange Rate 125 120 115 110 105 100 95 90 85 80 The Collapse of Lehman Brothers

Weaker Yen Stronger Yen

Double-dip Recession Fears Feb-08 Aug-08 Feb-09 Aug-09 Feb-10 Aug-10

Aug-07

Flight to Safe-Heaven Assets

Spot Gold
1300 1200 1100 1000 900 800 700 600 Aug-07 Feb-08 Aug-08 Feb-09 Aug-09 Feb-10 Aug-10 BUT . Gold dropped after the Collapse of Lehman Brothers!!! US Subprime Woes Gold hit all-time high on Double-dip Recession Fears

Flight to Safe-Heaven Assets

The Dollar Index Spot
95 90 Weaker Dollar 85 80 75 70 Aug-07 Feb-08 Aug-08 Feb-09 Aug-09 Feb-10 Aug-10 European Debt Woes Stronger Dollar Despite US subprime woes, the Dollar strengthened sharply following the collapse of Lehman Brothers

A good hedge!
US Dollar Japanese Yen Gold They are all the winner in the crisis Can consider to add them into your portfolio during a crisis

Can we overcome the limitation?

3. What if the actual allocation deviates from the initial plan?

Rebalancing
It is a method of making certain adjustments to the portfolio to make sure that its asset allocation remains constant

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Why rebalance?
To further enhance the power of asset allocation Example:
2007 Fund A Fund B +20% +3 2008 -70% +5% 2009 +80% +1%

Without Rebalancing
Weighting 2007 Fund A 50% Fund B 50% +20% +3% 2008 -70% +5% 2009 +80% +1% Return -35.2% +6.05%

Portfolio s return from 2007 to end 2009 =-11.55%

If Rebalanced - I
Initial 2007 Weighting by Weighting at Weighting the end of the 2007 beginning of 2008 50% Fund A 50% +20% 53.8% Fund B 50% +3% 46.2% 50%

If Rebalanced - II
Initial 2008 Weighting by Weighting at Weighting the end of the 2008 beginning of 2009 50% Fund A 50% -70% 22.2% Fund B 50% +5% 77.8% 50%

If Rebalanced - III
Initial 2009 Weighting by Weighting the end of 2009 Fund A 50% +80% 64.1% Fund B 50% +1% 35.9%

Portfolio s return from 2007 to end 2009 =5.74%

-11.55% VS +5.74% !!!

Why? Rebalancing forces you to take profit from the best performer and invest the proceed into the laggard Historically, from back testing to 20 years ago, it has been shown that this method delivers consistently higher returns than a pure buy-and-hold method It takes the guesswork out of trying to time the stock market movements It essentially forces you to buy low and sell high
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Key Takeaway
Why Asset Allocation
Diversification

Limitations to Note
How to overcome

Mean-variance optimization
Efficient Frontier

Disclaimer
Investment involves risk. The price of securities may go down as well as up, and under certain circumstances an investor may sustain a total or substantial loss of investment. Past performance is not necessarily indicative of the future or likely performance of the fund. Investors should read the relevant fund's prospectus for further details including the risk factors before making any investment decision. An Investor should make an appraisal of the risks involved in investing in these products and should consult their own independent and professional advisors, to ensure that any decision made is suitable with regards to their circumstances and financial position. The above materials are issued by iFAST Financial (HK) Limited and have not been reviewed by the SFC. When the investment returns of a fund are denominated in a foreign currency other than the USD/HKD, US/HK dollar-based investors are exposed to exchange rate fluctuations. Funds which are invested in emerging markets may involve a higher degree of risk, and may be more sensitive to price movements relative to the developed markets. For professionals only.