A. “ASSET ALLOCATION” (STUDY SESSION 11) E) CONTRAST ASSET-ONLY AND...

1. A. “Asset Allocation” (Study Session 11) e) contrast asset-only and asset-liability management (ALM) approaches to asset allocation; f) explain an advantage and a disadvantage of implementing a dynamic versus a static approach to strategic asset allocation; l) compare and contrast the following approaches to asset allocation: mean- variance, resampled efficient frontier, Black-Litterman, Monte Carlo simulation, ALM, and experience based; n) determine and justify a strategic asset allocation, given an investment policy statement and capital market expectations. B. “Managing Individual Investor Portfolios” (Study Session 9) p) determine the strategic asset allocation that is most appropriate given an individual’s investment objectives and constraints; q) compare and contrast traditional deterministic versus Monte Carlo approaches in the context of retirement planning. 2006 Level III Guideline Answers Morning Session - Page 6

Question: 2 Topic: Portfolio Management – Individual Asset Allocation Minutes: 12 Guideline Answer: Part A By taking Kennedy’s future liabilities and/or quasi-liabilities into account, the asset-liability approach controls risk better than the asset-only method by providing an asset allocation that (1) meets her retirement spending needs and (2) focuses on not outliving her assets. Part B The Monte Carlo simulation takes into account the cash flows into and out of the portfolio over time while standard mean–variance analysis does not. Because investment returns can vary significantly from year to year, the timing of these inflows and outflows can create major differences in the final result. In a situation where there will be varying cash flows over the investment period, the ending value of the portfolio is path dependent. (The sequence of the returns and the sequence of the changes in liabilities can be considered in a Monte Carlo simulation, demonstrating the probable range of results. Multiple scenarios can be considered.) Part C Moderate Portfolio. The foremost objective of the portfolio is to have funds available to provide for the spending needs for Kennedy’s 20-year planning horizon. It is not necessary to achieve the lowest level of risk or the highest return. The Moderate Portfolio is the only portfolio that gives a positive terminal value under all scenarios. Morning Session - Page 7Reading References: