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ASSET MIX DETERMINATION
Quantitative Techniques for Portfolio Construction
         Over a long time horizon the most important consideration in meeting investment goals is the structure of the portfolio, specifically its asset-mix.
         At Vantage we help our clients understand the risk-reward tradeoffs offered by the various capital markets, while enhancing the understanding of their tolerance for bearing different types of risk. Together we build a comprehensive investment strategy, custom-fit to achieve the return objectives and match the risk profile that has been established.
Rigorous analytical testing of insights into financial markets can produce discrete quantitative models designed to take advantage of distinct opportunities in the capital markets.
        Specially developed proprietary computer models in concert with a litany of evaluative tools are used to determine a robust asset-mix that minimizes the correlation between asset classes and lowers the overall portfolio risk.
        Vantage makes extensive use of quantitative modeling techniques in all facets of our business. Techniques like Monte Carlo resampling, Black-Litterman Optimization, Portfolio Stress Testing, and elements from Statistical Process Control help us understand the potential range of outcomes from a given asset manager or a given asset allocation. The past represents one outcome from a wide range of outcomes that were possible. Likewise the future cannot be captured by a single expected return or volatility number. To properly understand the prospective risk and return characteristics of an asset mix requires modeling the distribution of future outcomes, from return and volatility, to drawdowns, funding requirements and cashflows. Probabilistic modeling and resampling techniques are well suited to this challenge.
        We not only balance and control risk and return parameters among asset classes, but among various types of managers within each class. As markets are not static, the asset mix must be flexible enough to take advantage of changing market conditions over the course of business cycles and various economic conditions. Computer modeling is used to measure the relative value of asset classes, and assets are then reallocated to take advantage of shorter and intermediate-term trends.
         In order to more easily and quickly adapt to ever-changing markets, Vantage offers several clients a Manager of Managers (MoM) structure tailored to the risk tolerances and return objectives of the client. The MoM is actively managed by Vantage according to a carefully designed set of objectives. The Manager of Managers structure can incorporate an entire plan or be a piece of larger asset allocation, giving plan sponsors and trustees increased flexibility in administering their charge.

Asset Allocation Background – January 2005  
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Investment policy is made real by allocating assets among available investment categories or “asset classes.” The number of asset classes considered is typically between 6 and 15. Ideally, each asset class’s return could be tracked by some index return. Within each asset class, this index would explain a material percentage of return for individual investment opportunities within the class, but at the same time, have low correlation with indexes of other asset classes.

A primary list of asset classes would typically include: stocks, bonds, cash, real estate, private equity and “other” (e.g., venture capital and/or alternative investments/hedge funds). Many investors further subdivide stocks into domestic vs. foreign. In the domestic category one can differentiate large vs. small market capitalization stocks, growth stocks vs. value stocks. In the international (foreign) category one can divide developed country vs. emerging market stocks. In the bond category, one can sub-classify by maturity or by credit quality: e.g., high quality vs. low quality/ high yield bonds. “TIPS” or Treasury Inflation Protected Securities has become a separate asset class. While real estate, venture capital and private equity have long been part of most pension portfolios; hedge funds are a somewhat more recent addition. This new category of investments has sprung up in the last 10 years or so, and is sometimes called “alternative assets” or “absolute return funds” or simply “hedge funds.” These too can be divided into sub-classes. The product of these various divisions takes the number of asset classes from 6 to 8, 12 or higher.

The final determination of asset class number involves a balancing of risk/return objectives and operational considerations. We must capture the distinct capital market alternatives not only in a policy statement but also in the real world. We must have enough asset classes represented to effectively mitigate risk if the plan is to maintain fully funded status. If there are too few asset classes and risks will be unacceptably high; too many classes and operational complexity becomes an issue. Fortunately, structural flexibility can help significantly to maximize the return potential and risk benefits of the investment managers hired to manage the portfolio assets entrusted to them.

An important distinction in defining asset allocation policy is to separate the long term or strategic policy from a shorter-term view or tactical asset allocation policy. The strategic allocation policy attempts to find an “optimal” asset mix that blends the desire for enhanced return over the long run with the pension sponsor’s conflicting need to control risk. The strategic policy will be denoted by a set of target asset class percentages adding to 100%. A stated long-term expected return (a 5-10 year or longer expectation), a volatility measure or a reward-to-risk ratio to represent risk controls is also needed . . . .

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