Research Review | 11.7.2011 | Asset Allocation

Strategic Allocation to Premiums in the Equity Market
David Blitz (Robeco Asset Management) | Oct 2011
Investors tend to focus on harvesting the risk premiums offered by traditional asset classes when making their strategic investment decisions. Some recent papers, however, argue that investors should also consider various other premiums for possible inclusion in the strategic asset allocation. Examples of such premiums that have been documented for the equity market are the size, value, momentum and low-volatility effects. In this paper we show that the theoretically optimal strategic allocation to these premiums is sizable, even when using highly conservative assumptions regarding their future expected magnitudes. We also discuss the pros and cons of two ways of obtaining the implied exposures in practice, specifically passively managed index funds versus actively managed quant funds.

(R)Evolution of Asset Allocation
Fabian Dori (Wegelin & Co.), et al. | Oct 2011
Asset allocation is at the heart of every portfolio construction process and crucial to its success. Though as diverse as they are innovative, the approaches used to pinpoint the optimal mix of assets mostly have common roots. In the following paper, we address this commonality in depth. First, we outline the portfolio construction process and highlight empirically the importance of asset allocation with respect to a portfolio’s return. Second, the evolution of portfolio theory is put into a historical perspective. Third, we present a unified optimization framework for asset allocation and show that most well-known asset allocation techniques fit exactly in that framework. Finally, an illustrative example brings to light the similarities and differences of three prevalent approaches and highlights implications for practitioners.
Dynamic Versus Static Asset Allocation: From Theory (Halfway) to Practice
Didier Maillard (Conservatoire National des Arts et Métiers) | March 2011
The aim of this paper is to assess, with parameter values as reasonable as possible, the order of magnitude of the extent by which the dynamic optimisation process dominates the static optimisation process; and to gauge whether the existence of transaction costs changes significantly the assessment… The main results are that for high risk adverse investors, the improvement provided by dynamic versus static optimisation is moderate; it may be huge for low risk adverse investors, but this comes principally from the fact that dynamic optimisation leads to a huge leverage, which is normally prohibited in a static framework. Reasonable values for transaction costs do not jeopardise the superiority of dynamic asset allocation.
Investors Care About Risk, But Can’t Cope with Volatility
Christian Ehm (University of Mannheim), et al. | October 2011
Following the classical portfolio theory all an investor has to do for an optimal investment is to determine his risk attitude. This allows him to find his point on the capital market line by combining a risk-free asset with the market portfolio. We investigate the following research questions in an experimental set-up: Do private investors see a relationship between risk attitude and the amount invested risky at all and do they adjust their investments if provided with different risk levels of the risky asset? To answer these questions we ask subjects in a between subject design to allocate a certain amount between a risky and a risk-free asset. Risky assets differ between conditions, but can be transformed into each other by combining them with the risk-free asset. We find that mainly investors risk attitude, but also their risk perception, and the investment horizon are strong predictors for risk taking. Indeed, investors do not appear to be naïve, but they do something sensitive. Nevertheless, we observe a strong framing effect: investors choose almost the same allocation to the risky asset independently of changes in its risk-return profile thus ending up with significantly different volatilities. Feedback does not mitigate the framing effect. The effect is somewhat smaller for investors with a high financial literacy. Overall, people seem to use two mental accounts, one for the risk-free and one for the risky investment with the risk attitude determining the percentage allocation to the risky asset and not the chosen portfolio volatility.
Choice Proliferation, Simplicity Seeking, and Asset Allocation
S. Iyengar (Columbia Business School) and E. Kamenica (University of Chicago) | March 2010
In settings such as investing for retirement or choosing a drug plan, individuals typically face a large number of options. In this paper, we analyze how the size of the choice set influences which alternative is selected. We present both laboratory experiments and field data that suggest larger choice sets induce a stronger preference for simple, easy-to-understand options. The first experiment demonstrates that, in seeming violation of the weak axiom of revealed preference, subjects are more likely to select a given sure bet over non-degenerate gambles when choosing from a set of 11 options than when choosing from a subset of 3. The second experiment clarifies that large choice sets induce a preference for simpler, rather than less risky, options. Lastly, using records of more than 500,000 employees from 638 institutions, we demonstrate that the presence of more funds in an individual’s 401(k) plan is associated with a greater allocation to money market and bond funds at the expense of equity funds.
Seasonal Asset Allocation: Evidence from Mutual Fund Flows
Mark J. Kamstra (York University), et al. | August 2011
This paper explores U.S. mutual fund flows, finding strong evidence of seasonal reallocation across funds based on fund exposure to risk. We show that substantial money moves from U.S. equity to U.S. money market and government bond mutual funds in the fall, then back to equity funds in the spring, controlling for the influence of past performance, advertising, liquidity needs, capital gains overhang, and year-end influences on fund flows. We find a strong correlation between mutual fund net flows (and within-fund-family exchanges) and the onset of and recovery from seasonal depression, consistent with the hypothesis that investor risk aversion varies with the seasons. Further, we find stronger seasonality in Canadian fund flows (a more northerly location relative to the U.S., where seasonal depression is more severe), and a reverse seasonality in fund flows for Australia (where the seasons are reversed). While prior evidence regarding the influence of seasonal depression on financial markets relies on seasonal patterns in asset returns, we provide the first direct trade-related evidence.