CHAPTER 5 OVERVIEW OF ASSET ALLOCATION William W. Jennings, PhD, CFA Eugene L. Podkaminer, CEA LEARNING OUTCOMES The candidate should be able to: describe elements of effective investment governance and investment governance considerations in asset allocation; prepare an economic balance sheet for a client and interpret its implications for asset allocation; compare the investment objectives of asset-only, libility-relative, and goals-based asset allocation approaches; contrast concepts of risk relevant to asset-only, liabilicy-relative, and goals-based asset allocation approaches; explain how asset classes are used to represent exposures to systematic risk and discuss criteria for asset class specification; + explain the use of tisk factors in asset allocation and their relation to traditional aser class= based approaches; select and justify an asset allocation based on an investor's objectives and constraints: describe the use of the global marker portfolio as a baseline portfolio in asset allocation: discuss strategic implementation choices in asset allocation, including passive/active choices and vehicles for implementing passive and active mandates discuss strategic considerations in rebalancing asset allocations. 1, INTRODUCTION Asset owners are concemed with accumulating and maintaining the wealch needed ro mets including individuals their needs and aspirations. In that endeavor, investment 5 PRD, CFA, and Eugene L. Podkaminet, portfolio Porfolio Management, Second Edition, by Wiliam W. Jenni CFA. Copyright © 2019 by CFA Institute. 191 Escaneado con CamScannerng Investment Porep ? fli, ay important roles. Ase allocation i state fli construction. Because it olds that porigas 2 cael anton. Among the uesiony agg portfolios and institutional funds—pl: often a first oF early—dlecision in port widely accepted as important and meriting in this chapter ate the following Ao governance contest for making ase allocation decisions 27h ond pore: te ech an ett onme?s mace ed labile ommending an a allocation? T ; in fe dng a al objeines and sensitvites C0 isk be eepresene ig, allocation? 7 P + What are the broad approaches availble in developing an asec allocation recom and when might one approach be mote of less appropriate than another + What ate the oplevel deco that need BE made in iplementng x chy allocation? : *+ How may asset allocations be rebalanced as asset prices change? + How broad a picture should a Stet Mendon, The strategic asset allocation decision determines return levels! in which allocations aye invested, inespecive ofthe degree of active management. Because ofits sate imponmee the investment committee, at the highest level of the governance hierarchy, typically Tetaing approval of the strategic asset allocation decision. Often a proposal is developed only afer formal asset allocation study that incorporates obligations, objectives, and constraints, simulates possible investment outcomes over an agreed-on investment horizon; and evalu, the risk and return characteristics of the possible allocation strategies. In providing an overview of asset allocation, this chapter's focus is the alignment of asset allocation with the asset owners investment objectives, constraints, and overall fnanca Condition, This is the first chapter in several sequences of chaprers that address, respect, asset allocation and porflio management of equities, fixed income, and altematia investments, Asst allocation is abo linked to other fces of pordlio management, including risk management and behavioral finance. As coverage of asset allocation progresses in the Sequence of chapters, various connections to these topics, covered in detal in other area of the curriculum, will be made? In the asset allocation sequence, the role ofthis chapter is the definitions that will provide a coordinated treatment of many management. The second chapter provides the basic “how” of devel and the third chapter explores various common, real asset allocation, ‘This chaprer is organized as follows: Section 2 explains the importance ofaset allocation in investment management. Section 3 address: asset allocation decisions are made, comprehensive perspective offered by th distinguishes three broad approaches to investment objective and risk. In Section Jevel in relation to three cases. “big picture.” Ie also offs later topics in portfolio loping an asset allocation, -world complexities in developing an es the investment governance context in which Section 4 considers asset allocation from the \€ asset owner's economic balance sheet, Section 5 6, these three approaches are discussed at a high Section 7 provides a top-level orientation to how a chosen ase "See Ibbotson and Kaplan (2000, p. 30) and Xiong, ‘gstegae follows from the premise that active management isa vero samy game overall (Sharpe 1991) ‘Among these chaprers, see Blanchett, Cordell, Finke, and Ideorele (2016) concerning human capital a longevity and other risks and Pompian (2011a and 20118) and Pompian, McLean, and Byrne (2011) concerning behavioral finance, Ibbotson, and Chen (2010). The conclusion forthe y] Escaneado con CamScannercpap 5_ Overview of Aset Allocation 193, ation may be implemented providin oer Section 8 discusses rebalancing co the chapret 1B a set of definitions tions that underlie subs nt nsiderations, soreness + and Section 9 provides a summary of >, ASSET ALLOCATION: IMPORTAN 2 ners ICE IN INVE! MANAGEMENT ESTM jbit 1 places asset allocation in a stylized model of the j xhibie 1 plac ina lel of the investment management pr sieved asan integrated set of activities aimed at attaining investor abjecives ee EXHIBIT 1_ The Portfolio Management Process Asset Owner Investment Objectives Opportunity Set en nd atte ovo apt market expecatons easel ovners betes ‘Seteplong ertom, ert seat af he ecotne Irom esc mc ieee shee ‘soviet pot tse ‘Sructre Sumas ast + Kee tges + Errata «Neste Reve beter yi vetiamesti a] [8 [emer soetemmantctntnse | i ‘rane progress tovardwleving tects . Fiemme win sly a fd el eons Mt Secon tN Pn trcern A that is in the asset owner's best interest rests on a roces ih includes the assignment of decision-making Exhibit 1 shows that an investment pt foundation of good investment governance, Escaneado con CamScannerInvestment Port on . Fe nt of processes. The balance at the an ‘ -” duals and ov st reconcile (bala and nent process must recone (bance) ing piliies to qualified indivi : reffered by the investment Opportunity set (og ilies hat the portal the poss respon ; the chart suggests th objectives (on the left) wit right). The investment asset owner's entire circumst r i ion “These factors, in conjunction with a fint step in portfolio construction sence of atvts that begins with understanding, ascites including any constraints; and preteen, nes Ort inputs, form ee basis for asset allocation shat ea sacar within which other dedons—i invest passively ‘or actively—take ee "a eo ae chart, thick lines sho, decision to inv . ¥ as the decison 10 Mons of logic) and thin line show feetback inal flows (or elations Oo ered tobe the most important decision in the investmen, Ase aloaton i we or cision completly determines return levels in whic, process, The strategie 0 ely and aso in the aggregae ofall investors, irrespective of, allocations are invested passively a ; degree of active management. In providing an overview of as allocation with the asset owner's ° condition, The presentation begins with an in context of asset allocation. It then moves £0 pi financial context for asset allocation itself process shows ances setallocation, this chapter’ focus is the alignment of ae vnvestment objectives, constraints, and overall financial troduction to the investment governance resent the economic balance sheet asthe 3, THE INVESTMENT GOVERNANCE BACKGROUND TO ASSET ALLOCATION Investment governance represents the organization of decision-making responsibilities and oversight activities. Effective investment governance ensures that assets are invested to achieve the asset owner's investment objectives within the asset owner's risk tolerance and constrains, and in compliance with all applicable laws and regulations. In addition, effective governance ensures that decisions are made by individuals or groups with the necessary skills and capaciy Investment performance depends on asset allocation and its implementation. Sound westment governance practices seek to align asset allocation and implementation to achieve the asset owners stated goals. Investment governance structures are relevant to both institutional and individual investors, Because such structures are often formalized and articulated in detail for defined bene eee vlan, bal build our discussion using a pension plan governance framework. ca wen : Pan governance that ate nor directly related to the management of pln ancte— ign, funding policy, and communications to participants—are not discussed in this chay Ir or Tera, aad we fous on those aspecs of govermance that diecdy ae che at vee pte apo rortlgcontrution shown in Exhibie 1 ino exhaustive, Forex ®* A bona gh mnogement, invetmen manager! peformance nes a loca won and Kaplan (2000, p 30) Xiong, Toon, Ido and Chen 010, Tae con 1991). p St Sctive management is a zero-sum game overall (Shae Escaneado con CamScannerChapter 5 Overview of et Allocarion 195 Governance Structures creating a plan, and Whereas management «governing investment committee + investment staff + third-party resources be a committee of the ersight responsibilities to made up of staff. Investment staff may be large capabilities, or small—for example, external investment managers and co board of directors, or the board of an internal investment committee + with full in-house asset management two to five investment staf responsible for overseeing nsultants. It may even be part time—a treasurer or chief financial officer with many other, competing responsibilities. The term “third-party resources” is used to describe a range of professional resources—investment managers, investment consultants, custodians, and actuaries, for example. Although there are many governance models in use, most effective models share six common elements. Effective governance models perform the following tasks: 1. Articulate the long- and short-term objectives of the investment program, 2. Allocate decision rights and responsibilities among the functional units in the governance hierarchy effectively, taking account of theit knowledge, capacity, time, and position in the governance hierarchy. 3. Specify processes for developing and approving the investment policy statement that will govern the day-to-day operations of the investment program. 4, Specify processes for developing and approving the program’s strategic asset allocation. 5. Establish a reporting framework to monitor the program's progress toward the agreed-on goals and objectives. 6. Periodically undertake a governance audit. In the sections that follow, we will discuss selected elements from this list. 3.2. Articulating Investment Objectives cult Jecth investor first requires an understanding of Ariulating lang nd shore-serm objectives for an investor Ht ies nnn of Puspose-—that is, what the investor & eying to ach ea investment objective statements that can be clearly tied to purposes: i is sure that pli * Defined benefit pension fund. The investment objective of the fund is to ensure that plan ion liabilities. Bits are suficlene to meet current and farure pension Hibs, * Endowment nd. The investment objective ofthe endow ns fxcess of the return required to fund, after accounting for inflation, consistent with the endowment’s mission. Escaneado con CamScannerManag 196 scxive is to provide for retirement at the nn “The investment oe yets, subject to stated rit toleranee + India intone oe i desited retirement ape investment constraints he essence of an investment hy i considered objecs, i fien cee statement 10 be propely understood he ns the assets are expected 0 fund, the nage wwner’s willingness and ability to Withsaa ‘fund, and the asset one ; toe ie The ultimate goa sto find the best rsk/etum tae “seource constraints and risk olerance. ral context can affect deci kings the pension fang " i" icipants added as they ate hired, or it may be “frogs may be an active plan, with new pariipants he plan). The satus of he (no additional benefits are being accrued by parti i Pre, considered in conjunction with its funded ratio (the ratio of pension assets to penny liabilities) has a bearing on future contributions and benefit payments ‘The company offing the pension benefit may operate in a highly eytical industry, where revenues ebb and fy lover the course of the economic eycle. In this case, the plan sponsor may prefer a mon conservative asset allocation to minimize the year-to-year fluctuations in its pension contribution. a The nature of inflows and outflows for an endowment fund can be quite different from those of a pension fund. An endowment fund may be used to support scholarships, capil improvements, or university operating expenses. The fund sponsor has some degtee of control cover the outflows from the fund but very litde control over the timing and amounts of contributions to the fund because the contributions are typically coming from extemal donors. ‘These cash inflow and outflow characteristics must be considered when establishing the goals and objectives of the fund. A third, inter-related aspect of defining the sponsor's goals and objectives is determining and communicating rsk tolerance. There are multiple dimensions of risk to be considered: liquidity risk, volatility, risk of loss, and risk of abandoning a chosen course of action atthe wrong time, Effective investment governance requires considerati liquidi and heh a Even requis consideration ofthe ligudty needs ofthe fink See pie finds investment. For example, too large an alloca 0 relativel uid assets, such as real estate ot private equity, might impair mat Payouts in ime of marker ss. nen ac igh risk/ won i 1h eiskihigh expected rerum asset allocation is likely to lead to wider swings it a An " rae thresholds for funded status that, if breached, would pen siete — 3 pure the asset allocation decision, het pension insurance premiums, must be eonsdeed i For individual inv financial and psychol og Bi of substan losses may be unacceptable for a variety of cannot be repent ogi! sons. When such losses occur afer rearement, lot opt enced wih fare ings, owners have their own uni ; an investment program withour a dts Feturn requirements and risk sensitivities. Maraing me ay understanding of long- and short-term objectives similar to navigating wi i without a mapy Ari ' not compatible win, Ws : a Ee ett *compauble with leving much to chance SOE dstnatin on rime ad int # ‘A return requirement statement, but for that porto additional contest, including the o cash flows into and out of interim changes in portfolio valu consistent with the asset owner's ‘As an example of how the ove Escaneado con CamScannere rer 5__Overview of Asset Allocation 197 4.3 Allocation of Rights and Responsibilies aches and responsibilities necessa 7 The nee ac the highest level of inverenent governs Trees Program are generally mmbiiies among the governance units is likely to vary allocation of those rights and 1 program; the knowledge, ski ly to vary depending on the size of the investment Program} lge, skills, and abilities of the internal staff; inte staff can devote t0 the investment program if th Ls aad the amoune i pltes. Above all, good governance requires that decisions be de other, competing ed to make an informed decision, sions be delegated to these best ‘The resources available to an organization will affect the : wep nd tn oi pe a to program may rest in having a narrower opporcunity set because of either asc sz (00 small emdiversify across the range of asset classes and investment managers) or staffing constraints finsuficiene aset size to justify a dedicated internal staff). Complex strategies may be beyond the reach of entities that have chosen not to develop investment expertise internally or whose renight committee lacks individuals with sufficient investment ‘understanding. Organiza- ons willing to invest in attracting, developing, and retaining staff resources and in developing eong internal control processes, including risk management systems, ae better able to adopt more complex investment programs. The largest investors, however, may find their size ‘eates governance issues: Manager capacity constraints might lead to so many managers that jr challenges the investor's oversight capacity. “Allocation of rights and responsibilities across the governance hierarchy is a key element in the success of an investment program. Effective governance requires that the individuals darged with any given decision have the required Anowledge and expertise to thoroughly caluate the alternative courses of action and the capacity to take on the ongoing responsibility Sf those decisions, and they must be able to execute those decisions in a timely fashion. {Individual investors engaging private wealth manager are delegating these expertise, capacity, and execution responsibilities.) Eshibic 2 presents a systematic way of allocating among governance units the primary jes of running an investment program. gut duties and responsibil EXHIBIT 2 Allocation of Rights and Responsibilities Investment. Investment Activity Committee Investment Staff Third-Party Resource Mission Craft and approve nla ala Investment Approve, Drift Consultants provide policy sarement mace Asset allocation policy Approve with input Draft with input Consultants provide from staff and from consulrants input consultants Research, evaluation, Consultants provide input Investment P ent manager Delegate to investment ey and selection of dod other service staff; approval authority Provider selection retained for certain service. investment mance™® providers and service providers Escaneado con CamScannerfaiagtrig'l Ot Porton, ee ‘managers, oF £0 manager sufficient internal (individual asset 1 resources in-house selection) ‘Assure that the sum Consultants and . staff within tants and eral ee Te te invenment ofall sub-portolios custodian provide inpy ices & portfolio uals the desired Poalancing policy statement asl onto positioning; approve and execute rebalancing Create risk manage- Investment manager ment infrastructure manages portfolio and design reporting within established risk guidelines; consultanes Provide input and suppor Ongoing assessment Consultants and Risk management Approve principles and conduct oversight Investment manager Oversight monitoring of managers custodian provide input Performance evaluation Oversight Evaluate manager's Consultants and and reporting continued suitability custodian provide input for assigned role; analyze sources of portfolio return Governance audit Commission and assess Responds and Investment Commitee corrects contracts with an independent thied parsy for the audit The available knowledge and expertise at each evel ofthe hierarchy, the resource capaciy of the decision makers, and the ability to act on a timely basis all influence the allocation of these rights and responsibilities, 3.4, Investment Policy Statement ‘The investment policy statement (IPS) isthe foundation of an effective investment program A wellenfcd IDS ‘can serve at a blueprint for ongoing fund management and aS stakeholders that program assets are managed with the appropriate care and diligence. Often, the IPS itself will be a foundation d is : : : wy over tim whereas information relating to more variable aspece of he gee alt policy and guidelines for individual rol ant oa investment m: Escaneado con CamScannerchapter S_Overview of Asset Allocation 3.5. Asset Allocation and Rebalancing. Policy pecause of Its strategic Importance, the + the investment commit govemance hierarchy typically retaing approval of she nee the highest level of the Foposl is often developed only afters franc hE MEIC asset aloexion desiion A formal asset allostig simulates posible ino ty that incorporates vestment 0) ae jutcomes over an tisk and return characteristics of the possible Mrigations, objectives, and constraints; sgreed-on investment horizon; and evalua allocation strategies Governance considerations inform not only the overall stratey; but also rebalancing decisions. The IPS should contain a least eee ation decision relevant to rebalancing. In an institutional least general orienting information responsibility of the investment committee, Likewise, individual investors might specify th th re it e liar investment adviser Specifcctog ot ha te have delegated rebalancing authority to ‘balancing responsibilities is good governance. 3,6. Reporting Framework The reporting framework in a well-run investment program should be designed in a m- that enables the oversees to evaluate quickly and cealy how well the investment program i progressing toward the agreed-on goals and objectives. The reporting should be clear and concise, accurately answering the following three questions: + Where are we now? + Where are we relative to the goals and objectives? + What value has been added or subtracted by management decisions? Key elements of a reporting framework should address performance evaluation, compliance with investment guidelines, and progress toward achieving the stated goals and objectives. * Benchmarking is necessary for performance measurement, attribution, and evaluation. Effective benchmarking allows the investment committee to evaluate staff and external managers. Two separate levels of benchmarks are appropriate: onc that measures the success of the investment managers relative to the purpose for which they were hired and another to measure the gap between the policy portfolio and the portfolio as actually implemented. * Management reporting, typically prepared by staff with input from consultants and custodians, provides responsible parties with the information necessary to understand which parts of the portfolio are performing ahead of or behind the plan and why, as well as whether assets are being managed in accordance with investment guidelines. : * Governance reporting, which addresses strengths and weaknesses in program execution, should be structured in such a way that regular commitcee meetings can efficiently 7 any concerns, Although a crisis might necessitate calling an extraordinary meeting, governance structures minimize this need. 3.7. The Governance Audit cctus nt The purpose ofthe governance audit sro ensure thatthe established es cs poses amvetnance sruestes ae effective. The ait shoul be performed by an Unespatict Puy The govemance sudo examines the fans governing dovumens see TS a Of the organization to execute effectively within the confines 4 Doh yovernance constraints. valuates the existing portfolio for its “efficiency” given He Bove ivabliy of the investment Effective investment governance ensues the durbilty oF OE semi, and Program. An investment program must be able to survive Escaneado con CamScannerManaging Investment Porgfoy: 200 folios ses crsin that the consequences of sch cura mance mal Goal governance secks (0 avoid decision-reversal rig - We of action at exactly the wrong time, the poiny op Koeemance aso considers the effect oF neuen marimam low Good imvesnert Tee on the durbility of the investment program, committee member and staff WITTE gembers and proper documentation of investinen, Osean sesion fo es commie TN Te chosen course of action wi beef pce and econ nha ince members sould be cient rime to succeed, Ne ment program and be able to continue and intent ofthe invest * rae tment governance prevents Rey person risk—overreliance oq 4 investments dependent on a staff member, good investment gove! ‘considered before itis experiene the risk of reversing a chosen cou Good investment given suff to perceive easily the d exceute it. Similarly, good y one st ber or long-term, illiquis ‘ 7 oa Soke aeevare accountability. O'Barr and Conley (1992, p. 21), why studied investment management orga blame avoidance (not accepting personal ‘common feature of institutional investors. nizations using anthropological techniques, found thay responsibility when appropriate to do so) ig 4 Good governance works to prevent such behaviog EXAMPLE 1 _ Investment Governance: Hypothetical Case 1 In January 2016, the Caflandia Office Workers Union Pension (COWUP) made the following announcement: “COWUP will fully exit all hedge funds and funds of funds. Assets currently amounting to 15% ofits investment program are involved. Although hedge funds are a viable strategy for some, when judged against their complexity and cost, hedge fund investment is no longer warranted for COWUP.” ‘One week later, a nancial news service reported the following: “The COWUP decision on hedge funds was precipitated by an allegation of wrongdoing by a senior executive with hedge fund selection responsibilities in COWUP's alternative investments strategy group.” 1. Considering only the first statement, state what facts would be relevant in evaluating whether the decision to exit hedge funds was consistent with effective investment governance, 2. Considering both statements, identify deficiencies in COWUPS investment govemance. Solution to 1: The knowledge, ‘capacity, and time available within COWUP to have an cffective hedge fund investment program would need to be assessed against the stated concen for complexity and cost. The investment purpose served by hedge funds in COWUP’s investment program before it exited them needs to be analyzed. Solution to 2: The second statement raises these concems about the decision described in the first statement: Escaneado con CamScannerpaper §_Orerow of Ase Aloction Capi 2 tn EXAMPLE 2 _ Investment Governance: Hypothetical Case 2 ‘The imaginary country of Caflandia has a sovere billion. A. governance audit includes the followi “The professional chief investment officer (CIO) rey i ie ecobites sey ee rd lirector. Investment si members draft asset allocation policy in conjunction with ! with tecommendation to the investment commit ee ign wealth fund with assets of CAFS40 ing: 7 the investment commit flews anc approve policy and any changes in policy, including the suatepie noe allocaion te investment committee makes manager structure, conducts manager analysis, and makes manager selection decisions. The CIO has built a staf organization, which includes heads for each major asset clas. In examining decisions over the las five years, we have noted several instances in which political or non-economic considerations appear to have influenced the investment program, including the selection of local private equity investments, Generally, the board spends much of its time debating individual manager strategies for inclusion in the portfolio and in evaluating investment managers’ performance ee Based on this information and that in Exhibit 2, identify sound and questionable governance practices inthe management of the Cflanda sovereign wealth fund. Solution: Sound practices The allocation of responsibilities for asset allocation between investment staff and the investment committee is sound practice. Staff investment expertise should be reflected in the process of asset allocation policy and analysis. The investment committee assumes final responsibility for choices and decisions, which is appropriate given its position in receiving information from all parts of the organization and from all interested parties. Questionable practices: The investment committee’ level of involvement in individual manager selection and evaluation is probably 00 deep. Exhibit 2 indicates that these fanctions more effectively reside with staff. Individual manager selection is an implementation and execution decision designed to achieve strategic decisions made by the investment committee and is typically not a strategic decision itself. Manager evaluation has substantial data analysis and technical elements that can be efficiently provided by staff experts and consultants. The finding about polical/non-economic influences indicates multiple problems. It confirms chat the investment manager analysis and selection processes. were misplaced, Te also suggests that the investment committee has an inadequate set of governance principles or checks and balances as relates tothe investment commie itself, 4. THE ECONOMIC BALANCE SHEET AND ASSET ALLOCATION point-in-time snapshot of an organization's financial er and owners’ equity recognized by accountants. An : i liabilities (called “Financial assets is—known as An accounting balance sheet reflect Condition and shows the assets, lial fconomic balance sheet includes conventional assets an and “financial liabilities” in this chapter) as well as ‘additional assets and liabil Escaneado con CamScannerManaging Investment P, ofl, 202 1d Hiabilities—that are om in making asset Allocation ional balance sheets. - comet afloat include HUMAN CPI (he yg serge of pension income, and the present yay. ™ value of future consumption is an exten, ca extended portfolio assets an decisions but do not appear on For individual Pee ne ire earnings), the pres ee “i betes “Likewise, the present a orefolio assets might include unde _ For an insinudonl Inna, oem pe Oe toon propery royalien eo 7 vents ales cmighe include the present valle of prospeive payouts for founda ‘vhereas grants payable would appear as conventional ae san bel “Theory and, increasingly, practice sugges that ase allocation shoud consider the fy range of asets and labilties—both the financial porfolio and extended portfolio asses ang Tiabilices-—to arrive at an appropriate aset allocation choice. For example, an asst allocation process that considers the extended balance sheet, including the sensitivity of an indvidyy investors earnings to equity market risk (and thac of the industry in which the individual i working), may result in a more appropriate allocation to equities than one that does nor, Life-cycle balanced funds (aso known as target date funds) are examples of investmens that seck to coordinate asset allocation with human capital. A 2040 life-cycle balanced fund seeks to provide a retirement investment vehicle appropriate for many individuals retiring in 2040. Exhibit 3 illustrates 2 typical path for the composition of an individual’ economic balance sheet from age 25 through age 65. ions, EXHIBIT 3 _ Human Capital (HC) and Financial Capital (FC) Relative to Total Wealth Percent 100 0 25 us MB DSS Age a “eet 25s wih so of the individuals working life ahead of him, human apis! ome balance sheet. As the individual progresses through lif, the P= a Escaneado con CamScannerol sa aveed build financial capital balances, humat average son among industries.> Making the simp ecimately constant tisk tolerance through Ie ah ; ah Gncuding human capital and financial capital) should be 9 tel overall tine In his case, the asst allocation chosen for financial capital should fog a ‘oction ro bonds as human capital declines to age 65, holding all eke sonnarn eatane sho the lide path for che equiy/bond allocation chosen by one US mutual und lp ‘The increasing allocation to bonds is consistent with i it preponderant bond:-like characteristics, ee EXHIBIT 4 Glide Path of Target Date Investment Funds in One Family Assumed Age Equity Allocation Bond Allocation B 85% 15% % 2 18 % 7 2B 8 6 37 6 49 51 ‘Nae. Allocations as of 31 December 2009. Source: Based on data in Idzorek, Stempien, and Voris (2013). Although estimating human capital is quite complex, including human capital and other extended portfolio assets and economic liabilities in asset allocation decisions is good practice.‘ EXAMPLE 3. The Economic Balance Sheet of Auldberg University Endowment + Name: Auldberg University Endowment (AUE) ; * Narrative: AUE. was established in 1852 in Caflandia and largely serves the tiny’ province of Auldberg. AUE supports about one-sixth of Auldberg University's CAF $60 million operating budger; rea estate income and provincial subsidies provide the >— {Se Blacher and Stach! (2015) and Blanchett and Stachl (2017). aad isa function luman capitis non-tradable, cannot be hedged, i subject o unspecified Furs th he ‘fan individuals morcalcy. Human capital is technically defined as the nes PISEM! TATE ture expected labor income weighted by the probability of surviving 0 et oil Mi be valued Mien Chen, and Zhu 2007) Ts, che presen vale of fare ning nd PENRO ‘onality-weighted probabilities of receiving furure cxh pales ol semen ers There is meaningful extra value from the low-odds evento Te ics but not [BPerane porto implication in that individual investors can curve time annuity payments. a Escaneado con CamScannerManaging Investment Pont, wT lly hada pono Je The endowment has historically hada pong, remainerand nbs ae olin tha pci unr cama limited to domestic equities DoT (not the endowment) has a CAFS350 million review. Auldberg University TOT. estate assets, including office buildings ieee ar temps AUE els el aiid ay sn he iti in Ie, estate, aiherntaldivese experience in equities, Fxed income, an inelude CAFS100. million in domestic equities * Auer: Endewnene government debt, and CAFS4O milion in Clas che Frestate, The present value of expected future contributions (from re setae and provincial subsidies) is estimated 0 be CAF$400 milion © Liabilities: These incude CAF$10 million in short-term borrowings anc CARS35 million in mortgage debt related to real estate investments. Although it has no specific legal requirement, AUE has a policy to distribute co the university 596 of 36-month moving average net asets. In effec, the endowment support $10 million of Auldberg University annual operatingbudget. The present value of expected future supportis CAFS450 milion, 1, Prepare an economic balance sheet for AUE. ; 2, Describe elements in Auldberg University’s investments that might affect AUE’s asset allocation choices. ‘Solution to 1: The economic balance sheet for the endowment (given in the following table) does not include the real estate owned by Auldberg University. The economic net worth is found as a plug item (600 — 10 - 35 ~ 450 = 105), AUE Economic Balance Sheet (in CAFS millions) 31 December 20x6 SS Assets Liabilities and Economic Net Worth Financial Agen ee Financial Asets Financial Liabilities Domestic equities 100 Short-term borrowing 10 Domestic fixed income 6 Morrgage debt 35 Class B office real estate 40 Banded fae te Extended Liabilities resent value of expected future 400 Present value of exy 450 contributions to AUE one . future support Ezonomie Net Worth Economic net worth (Economic 105 assets ~ Economic liabilities) ifying than it may appear and the imilar considerations apply to AUES iversity’s, Te-examined, to Auldberg Uni Escaneado con CamScannerChapter 5_ Overview of Asset Allocation 205 5, APPROACHES TO assert ALLOCATION We can identify three broad ay relative, and (3) goals-based. These are deco Emphasize different aspects of the inven oem Asset-only approaches to asset allocation et balance sheet. Liabilities are not expliily mote ot rand deeply studied assevonh sn returns, risks, and correlations of the asset classes relative and ae approaches explicitly balance sheet, dedicating assets to m the | needs that ae not stctly lables butane eee penne Liabileytelative approaches to ast allocation chen oe eo the objective of fundi ilies The phon honky allocation in relation to money £0 pay liabilies when they come due. An example is spl ane ae er te variance optimization applied to surplus (defined a the value of thevmnestr weeny value of the i enter the value of the investors assets minus the present investor’ liabilities). In modeling, liabilities might be san be ies might be represented by a short position in a bond or series of bonds matched to the present value and duration ‘of the rar es apihes approach involves constructing a labiliy-hedging portfolio focused on moms ie wily or peas balance of assets, a risky-asset portfolio (so called cit or isies ition to liablities—often also called a “return-seeking portfolio” because it explicitly seeks return above and beyond the liability benchmark). Liability-driven investing (LDI) is an investment industry term that generally encompasses asset allocation that is focused on funding an investor's liabilities. Related fixed-income techniques are covered in the fixed-income sequence under liability-based mandates. All approaches to asset allocation can be said to address goals. In investment practice and literature, however, the term “goals based” has come to be widely associated with a particular type of approach to asset allocation and investing. Goals-based approaches to asset allocation, as discussed here, are used primarily for individuals and families, and involve specifying asset allocations for sub-portfolios, each of which is aligned to specified goals ranging from supporting lifestyle needs to aspirational. Each goal is associated with regular, ieregulas, or bulleted cash flows; a distinct time horizon: and a tisk tolerance level expressed as a required probability of achieving the goal.” For ‘example, a middle-aged individual might specify a goal of maintaining his current lifeseyle and require high level of confidence that this goal will be tained. That same individual might express a goal of leaving a bequest to his alma mater. This would be very long-term goal and might have a low required probability. Each goal is assigned 0 its own sub-portfolio, ee 2 asst allocation strategy specific ro that sub-portoio is derived. The sum ofall eub-porio asset allocations results in an overall strategic asset allocation for the total portfolio. Goal based investing (GBI) is an investment industry term that encompasses the asset allocation focused on addressing an investor's goals. cation: (1) asset-onl i only, (2) liability- 6 frameworks that take account of or ly on the asset side of the investor's ‘an-variance optimization (MVO) is liabilities (other See Shefin and Statman (2000) and Brunel (2015). Escaneado con CamScannering Ii — Managing Ivesimen Ponty, Institutions and Goals-Based Asset Allocation i iced by some life insurers has some similarities to account assets into subportios associated with specific lines of business or bloce sp Tabilives. On one hand, such an approach may be distinguished from goals-based ayer allocation for individual investors in being ecm ’y cones coin i ing competitive crediting rates on groups of contracts) rather Ceca es Gn the other hand, Fraser and Jennings (2006) described 4 behaviorally motivated goal-based approach to asset allocation for foundations anf endowments. Following their approach, components of an overall appropriate mean variance optimal portfolio are allocated to time-based sub-portfolis such thy uncomfortably novel or risky positions for the entity’ governing body are made acceptable by being placed in longer-term sub-portfolios. Although any asset allocation approach that considers the liabilities side of the economic balance sheet might be termed “liability relative,” there are several important distinction, between liabilities for an institutional investor and goals for an individual investor. These distinctions have meaningful implications for asset allocation:® Liabilities of institutional investors are legal obligations or debts, whereas goals, such a meeting lifestyle or aspirational objectives, are not. Failing to meet chem does not eiggr similar consequences. ‘Whereas institutional liabilities, such as life insurer obligations or pension benefit obligations, are uniform in nature (all of a single type), an individual’s goals may be many and vatied. Liabilities of institutional investors of a given type (e.g., the pension benefits owed to retires) are ofien numerous and so, through averaging, may often be forecast with confidence. In Contrast individual goals are not subject to the law of large numbers and averaging. Contrast an estimate of expected death benefits payable fora group of life insurance policies against an individual’s uncertainty about the resources needed in retirement: For a 65-year-old individual, the number of remaining years of life is very uncertain, but insurers can estimate the average for a group of 65-year-olds with some precision, ‘See Rudd and Siegel (2013), which cussion hich recognizes goals-based planningas a distinct approach. This die draws on Brunel (2015). Planningas adi PP a Escaneado con CamScannerLiability Relative and Goals-Basee Approaches to Investing ‘Various perspectives exist concerning the relationshi s oncern ionship between liability-relative and als-based approaches to investing, Professor Lionel Martellini ee es perspective in the following three statements.” f | Goals-based investing is related to rad This new investment solutions paradigm translates into goals-based investing (GBI) approaches in individual money management, in which investors’ problems can be summarized in terms of their goals, and it translates into liability-driven investing (LDI) approaches in institutional money management, where the investors’ liability is treated a8 a proxy for their goal, . GBI and LDI are therefore related, but each of these approaches has its own specific characteristics. For example, GBI implies the capacity to help individual investors identify a hierarchical list of goals, with a distinction between different types of goals (affordable versus non-affordable, essential versus aspirational, etc.) for which no exact counterpart exists in institutional money management. 5.1, Relevant Objectives [Allthree of the asset allocation approaches listed here seek to make optimal use of the amount of risk that the asset owner is comfortable bearing to achieve stated investment objectives, although they generally define risk differently. Exhibit 5 summarizes typical objectives. EXHIBIT 5 Asse Allocation Approaches: Investment Objective ‘Asset Allocation Relation to Economic Typical ‘Typical Uses and Asset ‘Approach Balance Sheet Objective Owner Types Asset only Does not explicitly Maximize Sharpe ratio Liabilices or goals not ‘model liabilities or goals for acceptable level of defined andor simplicity volatility is important * Some foundations, endowments © Sovereign wealth funds + Individual investors Liability relative Models legal and Fund liabilities and Penalty for not meeting quasi invest excess assets liabilities high for growth + Banks + Defined benefit pensions + Insurers *Communication of 3 June 2016, used with permission. Escaneado con CamScannerManaging Investment Pont, 208 Typical Uses and Typical Asst Allocation Raion 0 Fem Objective Orne Type Approach Balance S Tchieve goals with Individual inveseo, cauien ‘Models goals specified required probabilities of sucess the objective is (0 maximize expected pony lig nevariance aset-otl time horizon, consistent with the in In a mea e ran ‘over some so it of portfolio volatility ; in the IPS. A lio’ tory Te ee rak and consent *avconssints tated the IPS. porto Shape tolerance for isk on Juating portfolios in an asset-only mean-variance approar, is a characteristic metric for eval The basic objective of a liabil liabilities when they are due. an . hin te; ‘y se eimil liability-relative approach in that it also seeks s-based approach is similar t0 4 rc . ens Sepa ofiient aes fo met the ia peyous Tn seebad ‘Pprade, sey moda wth individual sub-portolios, and an ar alexgg eee ere vtbeponolo thar cfs the time orion and required proba eee che the sum ofthe sub-portolios addresses the totality of goals saistacriy eave ae allocation approach ito ensue paymen 5.2. Relevant Risk Concepts Asset-only approaches focus on asset class risk and effective combinations of asset clases, The baseline asset-only approach, mean-variance optimization, uses volatility (standard deviation) of portfolio return as a primary measure of risk, which is a function of component asset class volatilities and the correlations of asset class returns. A mean-variance asset allocation can also incorporate other risk sensitivities, including risk relative to benchmarks and downside risk. Risk relative to benchmarks is usually measured by tracking risk (tracking error). Downside risk can be represented in various ways, including semi-variance, peak-to-trough maximum drawdown, and measures that focus on the extreme (tail) segment of the downside, such as value at risk, ‘Mean-variance results, although often the starting point for understanding portfolio rik, are regularly augmented by Monte Carlo simulation. By providing information about how an asset allocation performs when one ot more variables are changed—for example, to values representing conditions of financial market stress—simulation helps complete the picture of risk, including downside and tail risk. Insights from simulation can then be incorporated as refinements t0 the asset allocation. Liability-relative approaches focus on the risk of having insufficient assets to pay obligations when due, which is a kind of shortfall risk. Other risk concerns include the volatility of contributions needed to fund liabilities. Risk in a liability-relative context is generally underpinned by the differences between asset and liability characteristics (eg. thet relative size, their interest rate sensitivity, their sensitivity to inflation). Goals-based approaches are concemed with the risk of failing to achieve goals."? ‘The rik Jimits can be quantified as the maximum acceptable probability of not achieving 2 goal"! The plural in “liabilities” and “goals” underscores that these risks are generally elated to multiple farue points in time. Overall portfolio riskis thus the weighted sum of the risks associated with each go Generally, a given statistical risk measure may be relevant in any of the three approaches. For example, standard deviation can be used to assess overall portfolio volatility in asset-o "Das Man Shed nd Seman (010) whol ab : Ngee Brnel 2015), ), who call goals “mental accounts. Escaneado con CamScanner5_Overiew of Aset Alar ion roaches, and i€ may be used veen the vals of assets ancl Me of asets and Tabs) 43. Modeling Asset Class Rik + it Aa one fouce of value ( capital asets can be valued by net presen value (such as interest or dividends); Chuntenenira duets Asse, neh ‘commodi _ tase Pur ofthe production paces intr ne neo which do not yield an ongoing stream of value iething else of economic value, but + Sure of value asets, Neither income generatn economic input; examples include currencies a Grough sale ot exchange art, whose economic value is realized of something EXAMPLE 4 Asset Classes (1) ee ee Classify the following investments based on Greets i they 4 nor Bin the frameworks 1957) Ramenork, or expen bow Precious metals Petroleum Hedge funds Timberland Inflation-linked fixed-income securities Volatilicy Solutions: 1. Precious metals are a store of value asset except in certain industrial applications (eg,, palladium and platinum in the manufacture of catalytic converter). 2. Petroleum is a consumable/transformable asset; it can be consumed to generate power or provide fuel for transport. 3. Hedge funds do not fie into Greers (1997) super dass framework; a hedge fund strategy invests in underlying asset classes - 4. Timberland is a capital asset or consumable/transformable asset. Iisa capital asset in the sense that timber can be harvested and replanted cyclically to generate @ stream of eash flows; it is a consumable asset in that imber can be used to produce building materials/packaging or paper. 5. Inflation-linked fixed-income securities e a e determined based on the characteristics of the security. ; 6. Volatility does not fir; it is a measurable investment characteristic Because equity vous derivath ts and an investable risk volatility is che underlying for various derivative congas Wc 40 UT premium may be asociated with it ie is mensioned by some Cc asset because cash flows can be Escaneado con CamScannerManaging Investment Portfolio, 210 jon of aset cases in an abstract OF een, siticat he dase supp ae Puose of : sion i bow 10 9007 28 opecher very diffrent investments, such Tree emg man a gt cle “hence oeig allocation.'” For secut 0 isk, Furthermore, the investor need, sere ret and Treasury eeu AN ing isk, F A : tre ve in avers and as fom an investment strategy. The flog Pa amework ord ng png et case fr he ures of et alain eee p in effectiv cae are five criteria tha will help in se rliely homageeont ASE WitN 31 asset dy should be re le just given, defining equities to include boy, In the ea non-homogencous asset clas, ul ; real esate and common stock ee Overlapping asset classes will reduce the ‘Aset classes should be mutually ae min controlling risk and could introduce problem, eecvenes of satel set soca por example, if one aset cas fora Us . a return expect A -US i 3, ee eats Oe chen wld equtes US 1 mor Ppp investor is domest : include US equities. m bal equities, which include L aie aes a oo scone purposes, an included aset clas shoulg 3. Ascet ees Tigh epee coeaons with other asset castes of witha line not have i ase, the included asset class will be effectivel combination oe OT deplone risk exposures already present. I ae eae aT above 0.95 is undesirable a a sufficient number of us i tion estimate). So cl eh “oe peapeate SFpblio eon selecting an ase allocation fom a group of at case satisfying this criterion should tend to increase expected return or a given level of risk. Furthermore, the inclusion of more markets expands the opportunities for applying active investment strategies, asuming the decision to invest actively has been made. However, such factors as regulatory restrictions on investments and government-imposed limitations om investment by foreigners may limit the aset clases an investor can invest in, 5. Ase clases selected for investment should have the capacity to absorb a meaningful proportion of «an investor’ porgfalio. Liquidity and transaction costs are both significant considerations. IF liguidiey and expected transaction costs for an investment of a size meaningful for an investor are unfavorable, an asset class may not be practically suitable for investment. Greer (1997) approaches th Assets within an asset class should have similar attributes. Note that Criteria 1 through 3 strictly focus on assets chemselves, while Criterion 5, and to some extent Criterion 4, involve potential investor-specific considerations. Asset Classes Should Be Diversifying Pairwise asset class correlations are ofien useful information and are readily obtained. However in evaluating an investments value as a dvesifer a the portfolio lev, iti ‘important to consider an asset in relation to all other: ‘assets as a group rather than in a one-by- one (pairwise) fashion. Ie is possible to reach limited or incorrect conclusions by solely considering Pairwise correlations. To give an example, denote the returns to three assets by X * and Z, respectively. Suppose that Z = aX + b¥; aand b are constants, not both equal t0 See Kriszman (1999). ¥ i ‘As opposed ro criteria for asset class definition in an absolce sense Escaneado con CamScannerchapter S_Ovemiew of Ase Aecaryn wt act sued to a portfolio consitin eof Vand “05, itcan be shown that Zag ne Yeu Fthecanaaa aes denier Examining return series’ correlation no ist 05 eee with Xs well ti well si provide practically valable insight inna mes of fi cae feats ta verge all ghee FP dee ions, fons during ti iB inancial market stress can on benefits beyond typical In current professional practice, the listing of 1B OF asset classes often j ; + Global public cq composd of developed, emerging and ten includes the following: and lage mid, and smal-cap ast cases, gore g ee 384 sometimes Frontier markers (egn domestic and non-domestic), weated as several sub-asset clases divided into sovereign, invertment grade, ie ieee inflaion-linked bonds (unles included in real asets; se the fale age mines short-duration securities can be included here, nO ballet) Cash and + Real asets—inchudes assets that provide sen equity, private infrastructure, and commode, are included as a ral asset rather than fved inca ty to inflation, such as private real estate Sometimes, global inflaion-linked bonds me because of ther sensitivity to inflation Emerging Market Equities and Fixed Income Investment practice distinguishes berween developed and emerging market equities and ied income within global equities. The distinction is based on practical differences in investment characteristics, which can be related to typical marker differences including the following: + diversification potential, which is related to the degree to which investment factors driving market returns in developed and emerging markets are not identical (a ropic known as “market integration”); + perceived level of informational eficiencys and * corporate governance, regulation, taxation, and currency convertibility. As of mid-2016, emerging markets represent approximately 109% of word equity value based on MSC indices.”* In fixed income, investment opportunities have expanded as governments and corporations domiciled in emerging markets have increasingly issued debt in their own currency, Markets in local currency inflation-indexed emerging market sovereign debt have become more common." Jing and frontier: 1) economic i i eres i ed, emer 'MSCI uses three broad definitions ro sore countries into developed: e eves (gee the MSCI Market development, 2) size and liquidity requirements, aad 3 euskal Chssification Framework at wivw.msci.com/market-lasifcation). ; 7 Tre dustnof ae pocnl enefa, sex Bure, Warnock ad Wark 2012, Pay O11 7 Swinkls (2012). Kodhemiskin (2011) disses how emerging maser bonds SY ER ee representation than an equity-only portfolio because some countries (65 ‘atkets but larger bond markets. Escaneado con CamScannerManaging Investment Ponto, assets Investment vehicles, such a hy ion, groupings ©! " ath “Ave clases” ae by definition! OT dlr individual investments with the objec catgies 0 28 fads, chan apply semen sk or providing 7 om Ve of eg acractve risk characteristics may be yey gies.” When that is the case, this ca, caring a rer 0 a a ng at se, thi as a category called “strategies ier Similar to a true set ls. Economical. is assigned a percentage allocatic Ti fering, in general an inherent, non-skil-based gy gy clases contrast with “strategies ter rete opi sation and construction may be hindered by excessive ase ca, Effective portfolio optimi granularity: Consider Exhibit 6. Classes EXHIBIT 6 Examples of Asset Classes and Sub-Asset —— Asset Clase Level . a Few common tik fists Equity reslt in model | onlin. Non- Non us us vs us Sub-Asset Class Level ‘Many common risk factors result in substantially positive comelations. padlojonact ppadojanacy Sutton 2p) ausDauy As more and more sub-asset classes are defined, they become less distinctive. In particular, the sources of risk for more broadly defined asset classes are generally better distinguished than those for narrowly defined subgroups. For example, the overlap in the sources of risk of US large-cap equity and US small-cap equity would be greater than the overlap berween US and non-US equity. Using broadly defined assee classes with fewer risk source overlaps in optimization is consistent with achieving a diversified portlio. Additionally, historical data for broadly defined asset classes may be more readily available ot more reliable. The question of how much to allocate to equity versus fixed income versus other asses is far more important in strategic asset allocation than precisely how much 10 allocate to the various sub-classes of equity and fixed income. However, when the investor moves from the strategic asset allocation phase to policy implementation, sub-asset cass choices become relevant. "See Idzorck and Kowara (2013), p. 20, Escaneado con CamScannerptt 5 Overview of Asset Allocation EXAMPLE 5 Asset Classes (2) uss specification of asset classes th Dis ane duration fixed income” and “domestic relevance in asset-only and liability-rela tive contexts, juin: These 0 BrOUpS share Key rs = achieving diversifica Ecos, gation wig domes aed icone, wih ‘ould be efectve and simple, Subsequently, al : : cmd adtess other considerations, sich as inte nag income fed income selon to liabilities, distinctions by duration could be of iemanice Ce et igectcation could be relevant order importance and the cludes intermediate and long duration, asset allocation, by whatever i peng ns ae Train aed sal eet ety a see of taser dass the unit of analysis Thus, mean-vanee opinion bal fon ee issts (¢» global public equity, global private equity, global fixed income, and real assets) would be based on expected return, return volatility, and return correlation estimates for these aset disses. (The development of such capital market assumptions isthe subject of another chapter.) Factot-based approaches, discussed in more detail later, do not use asset classes as the basis for portfolio construction. Technically, the set of achievable investment outcomes cannot be enlarged simply by developing an asset allocation by a different means (for instance, tuing asec classes as the unit of analysis), all else being equal, suchas constraints against short selling (non-negativity constraints).'” Pur another way, adopting a factor-based asset allocation approach does not, by default, lead to superior investment outcomes. There are allocation methods that focus on assigning investments to the investors desired ‘exposures to specified risk factors. These methods are premised on the observation that asset cases ofen exhibie some overlaps in sources of risk, as illustrated in Exhibic 7."° EXHIBIT 7 Common Factor Exposures across Asset Classes Us Eniy Us Corporat Beds ope Growin =—— 1Sited more formally and demonstrated in Idzorek an ‘ee Podkaminer (2013). .d Kowara (2013). Escaneado con CamScannering | aa Managing Investment Por . “The overlaps seen in Exhibit 7 help explain the correlation of equity and credie ysis tends to obscure the portfolio 7 ses as the unit of analysis tend ot sen Moding wing ast le a eon ski this example. As a result controll to overlapping risk factors, such as inflation roling exposures may be problematic, Multifactor risk models, which have a histo, ik, individual asset selection, have been brough| sures in asset allocation. | ; mae ‘when using factors as the units of analysis, we begin with SPeciffn risk factors and the desired exposure to each factor. Asset classes can be described with respect to their sensitivities to each of the factors. Factors, however, are Not directh investable. On that basis, asset class portfolios that isolate exposure C0 the risk facoe Y constructed these factor portfolios involve both long and short postions. A choice of exposutes in factor space can be mapped back to asset class space for implementation, yet of multifictor risk models in asset allocation have been labeled “factor-based ay allocation” in contrast o “ast cast-bated asset allocation,” which uss ase clases dit of 10 bear on the issue of controlling systemann’, tisk, as the unit of analysis, Factor Representation Although risk factors can be thought of as the basic building blocks of investments, most are not directly investable. In this context, risk factors are associated with expected return premiums. Long and short positions in assets (spread positions) may be needed to isolate the respective risks and associated expected return premiums. Other tisk factors may be accessed through derivatives. The following are a few examples of how risk factor exposures can be achieved. * Inflation. Going long nominal Treasuries and short inflation-linked bonds isolates the inflation component. * Real interest rates. Inflation-linked bonds provide a proxy for real interest rates, * US volatility. VIX (Chicago Board Options Exchange Volatility Index) futures provide a proxy for implied volatility. * Credit spread. Going long high-quality credit and shore Treasuties/government bonds isolates credit exposure, * Duration. Going long 10+ year Treasuries and short 1-3 year Treasuries isolates the duration exposure being targeted. Factor Models in Asset Allocation The interest in using factors for asset allocation stems from a number of considerations, including the following: * The desire to shape the asset allocation based on goals and objectives that cannot be expressed by asset classes (such as matching liability characteristics in a liability relative approach), Escaneado con CamScanner215 «An intense focus on one tisk in all of its various dimensions, helped along by commercia | A a ed y a of commercial factor-based risk measurement and management tools. + The acknowledgment that many highly correlated so-called ase defined as parts of the same high-level asset class, Fo: eae equity may be better seen as sub-classes of global «+ The realization that equity risk can be the domi ceemingly well-diversified portfolio, example, domestic and foreign ublic equity. inant tisk exposure even in a 6, STRATEGIC ASSET ALLOCATION ‘Anasset allocation that arises in long-term investment planning is often called the “strategic asset allocation” or “policy portfolio”: It is an asset allocation that is expected to be effective in achieving an asset owner's investment objectives, given his or her investment constraints and risk tolerance, as documented in the investment policy statement. A theoretical underpinning for quantitative approaches to asset allocation is utility theory, which uses a utility function as a mathematical representation of preferences that incorporates, the investor's risk aversion. According to utility theory, the optimal asset allocation is the one that is expected to provide the highest utility to the investor at the investor's investment time horizon. The optimization program, in broad terms, is Maximize w,E(U(Wr)) ~1( Wo, wj, asset class return distributions, bycoice of ser ass weights degree of risk aversion subject to.) 1; = 1 and any other constraints on 1; ro “The first line is the objective function, and the second line consists of constraints on asset class weights; other constraints besides those on weights can also be incorporated (for example, specified levels of bond duration o portfolio yield may be targeted). With Wo and W (the values of wealth today and at time horizon 7, respectively) the investor’ problem is to select the asset allocation that maximizes the expected utility of ending wealth, ETU(W2)], subject to the constraints thar asset class weights sum to 1 and that weights observe any limits the investor places on them. Beginning wealth, asset class weights, and asset class returns imply a distribution of values for ending wealth, and the utility function assigns a value to each of them; by weighting these values by their probability of occurrence, an expected utility for the asset allocation is determined. An expected utility framework underlies many, but not all, quantitative approaches to asset allocation. A widely used group in asset allocation consists of power utility functions,"” which exhibit the analytically convenient characteristic that risk aversion does not depend on the level of wealth, Power utility can be approximated by mean-variance utility, which underlies mean— variance optimization. >~———__ "Power utility has the form U = "E>, where A> Oi the parameter ofrisk aversion (iFA0, the investor is tisk neutral) Escaneado con CamScannerManaging Investment Pong, 216 smplest CAS , ice in the Simplest Optimal Choice i Tem involves one rsky asset and one risky « ision probl hy a8 ‘ “The simplest asset allocation dees res Seer ies ee or - m tht ral the variance asset. Let As Hh 6 md the riskefree interest rate, an fra the risk asser's expected ‘ean-variance allocat the risky asset, w*, can be i iy, the optimal allocation t0 y With mean-varian 7 be st to equal L (icy w=3(G i he investor’ gi j ersely proportional to the investors ra, fon to the risky asset is ; HOF ea ee the risk sets expected return per unit of eh aversion and directly props i (represented by return variance). erally involves the following ste Selection of a strategic asset allocation gen 1. Determine and quantify the investors objectives. What is the pool o oem meant for (ees paying faure benef payments, conibuting to a universiy’s budget, secuing ample ases for retirement)? What isthe investor trying to achieve? What lables o needs or goals need to be recognized (explicitly or implicitly)? How should objectives be jcled? 2, Deranine ihe ier ik lean and how shouldbe expressed and measured, What is the investor's overall tolerance for tisk and specific risk sensitivities? How should these be quantified in the process of developing an appropriate asset allocation (isk measures, factor models)? 3. Determine the investment horizon(s). What are the appropriate planning horizons to use for asset allocation; that is, over what horizon(s) should the objectives and risk tolerance be evaluated? 4, Determine other constraints and the requirements they impose on asset allocation choices. What is the tax status of the investor? Should assets be managed with consideration given to ESG issues? Are there any legal and regulatory factors that need to be considered? Are any political sensitivities relevant? Are there any other constraints that the investor has imposed in the IPS and other communications? Determine the approach to asset allocation that is most suitable for the investor. Sees asset classes, and develop a set of capital market expectations for the specified aset classes, 7. Develop a range of ‘often developed thi to asset allocation. ay Potential asset allocation choices for consideration, ‘These choices are rough optimization exercises, Specifics depend on the approach taken See Ang (2014), Chapter 4, for futher analysis, ‘Arjan Berkelaar, CFA, conttibuted to this formulation of steps, Escaneado con CamScanner