ENGINEERING CLIENT-TAILORED SOLUTIONS: APPLYING PORTFOLIO RESTRICTIONS

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ENGINEERING CLIENT-TAILORED SOLUTIONS: APPLYING PORTFOLIO RESTRICTIONS

The discussion so far has focused on asset allocation as generally applicable to a broad cross-section of investors. In reality, the vast majority of individual investors face special restrictions that limit their flexibility to implement optimal portfolios. For example, many investors hold real estate, con- centrated stock holdings, VC or LBO partnerships, restricted stock, or incentive stock options that for various reasons cannot be sold. For these investors, standard MV optimization is still appropriate and they are well advised to target the prescribed optimum portfolio. They should then utilize deriv- ative products such as swaps to achieve a synthetic replication.

Synthetic rebalancing cannot always be done, however. This is likely to be the case for illiquid assets and those with legal covenants limiting transfer. For example, an investor may own a partner- ship or hold a concentrated stock position in a trust whose position cannot be swapped away. In these situations, MV optimization must be amended to include these assets with their weights re- stricted to the prescribed levels. The returns, risk, and correlation forecasts for the restricted assets must then be incorporated explicitly in the analysis to take account of their interaction with other assets. The resulting constrained optimum portfolios will comprise a second-best efficient frontier but may not be too far off the unconstrained version.

An interesting problem arises when investors own contingent assets. For example, incentive stock options have no liquid market value if they are not yet exercisable, but they are nonetheless worth

something to the investor. Because banks will not lend against such options and owners cannot realize value until exercise, it can be argued that they should be excluded from asset allocation, at least until the asset can be sold and income received. Proceeds should then be invested consistent with the investor’s MV portfolio. An alternative is to probabilistically discount the potential value of the option to the present and include the delta-adjusted stock position in the analysis. To be complete, the analysis must also discount the value of other contingent assets such as income flow after taxes and living expenses.

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