ASSET ALLOCATION WITH REAL-WORLD CONSTRAINTS

discuss asset size, liquidity needs, time horizon, and regulatory or other considerations as
constraints on asset allocation
discuss tax considerations in asset allocation and rebalancing
recommend and justify revisions to an asset allocation given change(s) in investment
objectives and/or constraints
discuss the use of short-term shifts in asset allocation
identify behavioral biases that arise in asset allocation and recommend methods to
overcome them

Asset Size
Economies and diseconomies of scale
Size of Asset Owner’s Investment Pool – Too big or too small?
too large; their desired minimum investment may exhaust the capacity of active external
investment managers in certain asset classes and strategies
sufficient governance capacity—sophistication and staff resources—to develop the required
knowledge base for the more complex asset classes and investment vehicles
disadvantages from increasing scale: Growth in AUM leads to larger trade sizes, incurring
greater price impact; capital inflows may cause active investment managers to pursue ideas
outside of their core investment theses; and organizational hierarchies may slow down
decision making and reduce incentives. True alpha is rare, limiting the opportunity set. Asset
owners who find that they have to split their mandate into many smaller pieces may end up
with an index-like portfolio but with high active management fees; one manager’s active
bets may cancel out those of another active manager.
The gains are derived from a combination of cost savings related to internal management, a
greater ability to negotiate fees with external managers, and the ability to support larger
allocations to private equity and real estate investments. As fund size increases, the “per
participant” costs of a larger governance infrastructure decline and the plan sponsor can
allocate resources away from such asset classes as small-cap stocks, which are sensitive to
diseconomies of scale, to such other areas as private equity funds or co-investments where
they are more likely to realize scale-related benefits.
Asset size as a constraint is often a more acute issue for individual investors than
institutional asset owners. Wealthy families may pool assets through such vehicles as family
limited partnerships, investment companies, fund of funds, or other forms of commingled
vehicles to hold their assets. These pooled vehicles can then access investment vehicles,
asset classes, and strategies that individual family members may not have portfolios large
enough to access on their own.
Questions regarding the feasibility of the recommendation include the following:

 How many private equity funds do you expect to invest in to achieve the 15%
allocation to private equity?
 What is the anticipated average allocation to each fund?
 Are there a sufficient number of high-quality private equity funds willing to
accept an allocation of that size?
  What expertise exists at the staff or board level to conduct due diligence on
private equity investment funds?
 What resources does the staff have to oversee the increased allocation to private
equity?

Liquidity
Match liquidity needs of the asset owner and the liquidity characteristics of the asset classes
in the opportunity set. Long-term investors, such as sovereign wealth funds and endowment
funds, can generally exploit illiquidity premiums available in such asset classes as private
equity, real estate, and infrastructure investments.
Predictability of liability  can tolerate illiquidity e.g. life / auto insurer vs. property /
casualty reinsurer
Investments in private equity, infrastructure, and real estate may be unsuitable for pension
plan given their less liquid nature
Although rates of return may be mean-reverting, wealth is not. Losses resulting from panic
selling during times of stress become permanent losses; there are fewer assets left to earn
returns in a post-crash recovery.
too much liquidity in the market may lead to too high asset valuations as investors are trying
to invest their excess liquidity, eroding the expected future returns of various asset classes
Time Horizon
Assuming no change in the investor’s utility function, as human capital—with its
predominately bond-like risk—declines over time, the asset allocation for financial capital
would reflect an increasing allocation to bonds.
Nearer-term goals and liabilities move from partially funded to fully funded, while other,
longer-term goals and liabilities move progressively closer to funding. As the relative
weights of the goals to be funded shift and the time horizon associated with certain goals
shortens, the aggregate asset allocation must be adapted if it is to remain aligned with the
individual’s goals.
When the trust needed to support only his consumption requirements, a conservative asset
allocation was appropriate. However, the payment of college expenses will reduce his
margin of safety and the lengthening of the investment horizon suggests that he should
consider adding equity-oriented investments to the asset mix to provide for growth in assets
over time.
investors often align lower risk/lower return assets with short-term goals and liabilities and
higher risk/higher return assets with long-term goals and liabilities. It is generally believed
that longer-horizon goals can tolerate the higher volatility associated with higher risk/higher
return assets as below average and above average returns even out over time. This is the
notion of time diversification. assumption of mean-reverting risky asset returns would
support the conventional arguments for funding long-term goals and liabilities with higher
risk/higher return asset

REGULATORY AND OTHER EXTERNAL CONSTRAINTS

Insurance
Risk considerations for an insurance company include the need for capital to pay
policyholder benefits and other factors that directly influence the company’s financial
strength ratings. Some of the key considerations are risk-based capital measures,
yield, liquidity, the potential for forced liquidation of assets to fund negative claims
development, and credit ratings.
Pension Fund
constrained by regulation and influenced by tax rules.7Some countries regulate
maximum or minimum percentages in certain asset classes.
choice among asset allocation alternatives is often influenced by funding and financial
statement considerations, such as the anticipated contributions, the volatility of anticipated
contributions, or the forecasted pension expense or income under a given asset allocation
scenario.
Endowments and Foundations
expectation that they will exist in perpetuity and thus can invest with a long
investment horizon. In addition, the sponsoring entity often has more flexibility over
payments from the fund than does a pension plan sponsor or insurance company.
As a result, endowments and foundations generally can adopt a higher-risk asset
allocation than other institutions.
tax incentives: min. distribution
credit-worthiness considerations. endowment or foundation assets are often used to
support the balance sheet and borrowing capabilities of the university or the
foundation organization. Lenders often require that the borrower maintain certain
minimum balance sheet ratios. Therefore, the asset allocation adopted by the
organization will consider the risks of breaking these bond covenants or otherwise
negatively affecting the borrowing capabilities of the organization.
SWFs
are government-owned pools of capital invested on behalf of the peoples of their
states or countries, investing with a long-term orientation. They are not generally
seeking to defease a set of liabilities or known obligations as is common with
pension funds and, to a lesser extent, endowment funds. SWFs are typically subject
to broad public scrutiny and tend to adopt a lower-risk asset allocation than might
otherwise be considered appropriate given their long-term investment horizon in
order to avoid reputation risk. cultural or religious factors
ESG goals

ASSET ALLOCATION FOR THE TAXABLE INVESTOR AND

AFTER-TAX PORTFOLIO OPTIMIZATION
Interest income is usually taxed in the tax year it is received, and it often faces the
highest tax rates. Therefore, assets that generate returns largely comprised of
interest income tend to be less tax efficient
Tax Rates on
Interest income > Dividend > ST Cap gain > LT Cap Gain
Cap loss can be used to offset cap gain
Entities and accounts can be subject to different tax rules. For example, retirement
savings accounts may be tax deferred or tax exempt - strategic asset location—
placing less tax-efficient assets in tax-advantaged accounts
After Tax Portfolio Optimization
approaches adjust the asset’s current market value for the value of the embedded
tax liability (asset) to create an after-tax value:
by subtracting the value of the embedded capital gains tax from the market value, as
if the asset were sold today.
assume the asset is sold in the future and discount the tax liability to its present
value using the asset’s after-tax return as the discount rate or the after tax risk free
rate (because the embedded tax liability is analogous to an interest-free loan from
the government, where the tax liability can be arbitraged away by dynamically
investing in the risk-free asset. )
goals-based investing facilitates more-precise tax adjustments - If the purpose of a
given pool of assets is to fund consumption in 10 years, then that 10-year holding
period may influence the estimated implied annual capital gains tax rate. If the
purpose of the specified pool of assets is to fund a future gift of appreciated stock to
a tax-exempt charity, then capital gains tax may be ignored altogether.
Taxes alter the distribution of returns by both reducing the expected mean return and
muting the dispersion of returns. Taxes truncate both the high and low ends of the
distribution of returns, resulting in lower highs and higher lows. The effect of taxes is
intuitive when considering a positive return, but the same economics apply to a
negative return: Losses are muted by the same (1 − t) tax adjustment. The investor
is not taxed on losses but instead receives the economic benefit of a capital loss,
whether realized or not. In many countries, a realized capital loss can offset a current
or future realized capital gain. An unrealized capital loss captures the economic
benefit of a cost basis that is above the current market value, making a portion of
expected future appreciation tax free.
Post tax Efficient Frontier
Taxes impose significant reduction in the allocation to high-yield bonds. This is
because of the heavier tax burden imposed on high-yield bonds. Although
investment-grade bonds receive the same tax treatment, they are less risky than
high-yield bonds and demonstrate a lower correlation with equity, so they continue to
play the important role of portfolio risk reduction.

TAXES AND PORTFOLIO REBALANCING

more frequent rebalancing exposes the taxable asset owner to realized taxes that
could have otherwise been deferred or even avoided. Whereas the tax burden
incurred by liquidating assets to fund-required consumption cannot be avoided,
rebalancing is discretionary; thus, the taxable asset owner should consider the trade-
off between the benefits of tax minimization and the merits of maintaining the
targeted asset allocation by rebalancing. The decision to rebalance and incur taxes
is driven by each asset owner’s unique circumstances.
after-tax volatility is less than pre-tax volatility but correlations are same  larger
asset class movements to materially alter the risk profile of the taxable portfolio. 
rebalancing ranges for a taxable portfolio can be wider than those of a tax-exempt
portfolio with a similar risk profile. The equivalent rebalancing range for the taxable
investor is derived by adjusting the permitted 10% deviation (up or down) by the tax
rate, Rat=Rpt/(1 − t) 10% rebalancing range for a tax-exempt investor becomes a
13.3% rebalancing range for a taxable investor (when ranges are viewed and
monitored from the same gross return perspective):0.10/(1 − 0.25) = 13.3% Broader
rebalancing ranges for the taxable investor reduce the frequency of trading and,
consequently, the amount of taxable gain

Tax-loss harvesting is intentionally trading to realize a capital loss, which is then

used to offset a current or future realized capital gain in another part of the portfolio,
thereby reducing the taxes owned by the investor.
Strategic asset location refers to placing (or locating) less tax-efficient assets in
accounts with more favorable tax treatment, such as retirement savings accounts.
Assets held in tax-exempt accounts require no tax adjustment to their market values.
Assets in tax-deferred accounts grow tax free but are taxed upon distribution.
Because these assets cannot be distributed (and consumed) without incurring the
tax, the tax burden is inseparable from the economic value of the assets. Thus, the
after-tax value of assets in a tax-deferred account is defined by Equation 5:vat = vpt(1
− ti) 5where
vat = the after-tax value of assets
vpt = the pre-tax market value of assets
ti = the expected income tax rate upon distribution

As a general rule, the portion of a taxable asset owner’s assets that are eligible for
lower tax rates and deferred capital gains tax treatment should first be allocated to
the investor’s taxable accounts.
assets held for near-term liquidity needs. Because tax-exempt and tax-deferred
accounts may not be immediately accessible without tax penalty, a portion of the
bond allocation may be held in taxable accounts if its role is to fund near-term
consumption requirements.
high-yield bond and common stock–dividend income strategies are tax
disadvantaged in a taxable portfolio. (Although investment-grade bonds are also tax
disadvantaged, they maintain the role of controlling portfolio risk
Revisiting the strategic Asset Allocation (Long Term)
The circumstances that might trigger a special review of the asset allocation policy
can generally be classified as relating to a change in goals, a change in constraints,
or a change in beliefs.
less liquid asset classes—high-yield bonds, hedge funds, and private equity.
SHORT-TERM SHIFTS IN ASSET ALLOCATION (Tactical)
TAA has the objective of increasing return, or risk-adjusted return, by taking
advantage of short-term economic and financial market conditions that appear more
favorable to certain asset classes. In generating alpha, TAA decisions is dependent
on successful market or factor timing rather than security selection. TAA is an asset-
only approach. Although tactical asset allocation shifts must still conform to the risk
constraints outlined in the investment policy statement, they do not expressly
consider liabilities (or goals in goals-based investing).
he most common risk constraint is a pre-established allowable range around each
asset class’s policy target. Other risk constraints may include either a predicted
tracking error budget versus the SAA or a range of targeted risk (e.g., an allowable
range of predicted volatility).

The success of TAA decisions can be evaluated in a number of ways. Three of the
most common are

 a comparison of the Sharpe ratio realized under the TAA relative to the Sharpe
ratio that would have been realized under the SAA;
 evaluating the information ratio or the t-statistic of the average excess return of
the TAA portfolio relative to the SAA portfolio; and
 plotting the realized return and risk of the TAA portfolio versus the realized return
and risk of portfolios along the SAA’s efficient frontier. This approach is
particularly useful in assessing the risk-adjusted TAA return. The TAA portfolio
 may have produced a higher return or a higher Sharpe ratio than the SAA
portfolio, but it could be less optimal than other portfolios along the investor’s
efficient frontier of portfolio choices.

attribution analysis, evaluating the specific overweights and underweights that led to
the performance differential.

Tactical investment decisions may incur additional costs—higher trading costs and
taxes (in the case of taxable investors). Tactical investment decisions can also
increase the concentration of risk relative to the policy portfolio.

approaches to TAA. The first is discretionary, which relies on a qualitative

interpretation of political, economic, and financial market conditions. The second is
systematic, which relies on quantitative signals to capture documented return
anomalies that may be inconsistent with market efficiency.
Term spreads provide information about the business cycle, inflation, and potential
future interest rates. Credit spreads gauge default risk, borrowing conditions, and
liquidity.
Data points considered in gauging market sentiment include margin borrowing, short
interest, and a volatility index.

 Margin borrowing measures give an indication of the current level of bullishness,

and the capacity for more or less margin borrowing has implications for future
bullishness. Higher prices tend to inspire confidence and spur more buying;
similarly, more buying on margin tends to spur higher prices. The aggregate level
of margin can be an indicator that bullish sentiment is overdone, although the
level of borrowing must be considered in the context of the rate of change in
borrowing.
 Short interest measures give an indication of current bearish sentiment and also
have implications for future bearishness. Although rising short interest indicates
increasing negative sentiment, a high short interest ratio may be an indication of
the extreme pessimism that often occurs at market lows.
 The volatility index, commonly known as the fear index, is a measure of market
expectations of near-term volatility. VDAX-NEW in Germany, V2X in the United
Kingdom, and VIX in the United States each measure the level of expected
volatility of their respective indexes as implied by the bid/ask quotations of index
options; it rises when put option buying increases and falls when call buying
activity increases.

Systematic TAA
Valuation ratios have been shown to have some explanatory power in predicting
variation in future equity returns. Predictive measures for equities include dividend
yield, cash flow yield, and Shiller’s earnings yield (the inverse of Shiller’s P/E
Carry in currencies uses short-term interest rate differentials to determine which
currencies (or currency-denominated assets) to overweight (or own) and which to
underweight (or sell short). Carry in commodities compares positive (backwardation)
and negative (contango) roll yields to determine which commodities to own or short.
And for bonds, yields-to-maturity and term premiums (yields in excess of the local
risk-free rate) signal the relative attractiveness of different fixed-income markets.
Trend following is an investment or trading strategy based on the expectation that
asset class (or asset) returns will continue in the same upward or downward trend
that they have most recently exhibited

Behavioral Biases
Loss Aversion
In goals-based investing, loss-aversion bias can be mitigated by framing risk in terms
of shortfall probability or by funding high-priority goals with low-risk assets. by
segregating assets into sub-portfolios aligned to goals designated by the client as
high-priority and investing those assets in risk-free or low risk assets of similar
duration, the adviser mitigates the loss-aversion bias associated with this particular
goal—freeing up other assets to take on a more appropriate level of risk. Riskier
assets can then be used to fund lower-priority and aspirational goals.

In institutional investing, loss aversion can be seen in the herding behavior among
plan sponsors. Adopting an asset allocation not too different from the allocation of
one’s peers minimizes reputation risk.

Illusion of Control
is a cognitive bias—the tendency to overestimate one’s ability to control events. It
can be exacerbated by overconfidence, an emotional bias
They may perceive information in what are random price movements, which may
lead to more frequent trading, greater concentration of portfolio positions, or a
greater willingness to employ tactical shifts in their asset allocation. The following
investor behaviors might be attributed to this illusion of control:
 Alpha-seeking behaviors, such as attempted market timing in the form of extreme
tactical asset allocation shifts or all in/all out market calls—the investor who
correctly anticipated a market reversal now believes he has superior insight on
valuation levels.
 Alpha-seeking behaviors based on a belief of superior resources—the institutional
investor who believes her internal resources give her an edge over other investors
in active security selection and/or the selection of active investment managers.
 Excessive trading, use of leverage, or short selling—the long/short equity investor
who moves from a normal exposure range of 65% long/20% short to 100%
long/50% short.
 Reducing, eliminating, or even shorting asset classes that are a significant part of
the global market portfolio based on non-consensus return and risk forecasts—the
chair of a foundation’s investment committee who calls for shortening the
duration of the bond portfolio from six years to six months based on insights
drawn from his position in the banking industry.
 Retaining a large, concentrated legacy asset that contributes diversifiable risk—
the employee who fails to diversify her holding of company stock.
Hindsight bias—the tendency to perceive past investment outcomes as having been
predictable—exacerbates the illusion of control
illusion of control can be mitigated by using the global market portfolio as the starting
point in developing the asset allocation.
A formal asset allocation process that employs long-term return and risk forecasts,
optimization constraints anchored around asset class weights in the global market
portfolio, and strict policy ranges will significantly mitigate the illusion of control bias
in asset allocation.
Mental Accounting
information-processing bias in which people treat one sum of money differently from
another sum based solely on the mental account the money is assigned to.
Goals-based investing incorporates mental accounting directly into the asset
allocation solution. Each goal is aligned with a discrete sub-portfolio, and the investor
can specify the acceptable level of risk for each goal. Provided each of the sub-
portfolios lies along the same efficient frontier, the sum of the sub-portfolios will also
be efficient.
Concentrated stock positions e.g. of a founder in his company mental accounting
bias is further reinforced by the endowment effect—the tendency to ascribe more
value to an asset already owned rather than another asset one might purchase to
replace it.

Representativeness Bias
Recency
Tactical shifts in asset allocation, those undertaken in response to recent returns or
news—perhaps shifting the asset allocation toward the highest or lowest allowable
ends of the policy ranges—are particularly susceptible to recency bias. Return
chasing is a common manifestation of recency bias, and it results in overweighting
asset classes with good recent performance.
If, however, asset class returns exhibit trending behavior, the recent
past may contain information relevant to tactical shifts in asset allocation. And if
asset class returns are mean-reverting, comparing current valuations to historical
norms may signal the potential for a reversal or for above-average future returns.
A formal asset allocation policy with pre-specified allowable ranges will constrain
recency bias. A strong governance framework with the appropriate level of expertise
and well-documented investment beliefs increases the likelihood that shifts in asset
allocation are made objectively and in accordance with those beliefs.
Framing Bias
information-processing bias in which a person may answer a question differently
based solely on the way in which it is asked
framing effect can be mitigated by presenting the possible asset allocation choices
with multiple perspectives on the risk/reward trade-off. The most commonly used risk
measure—standard deviation—can be supplemented with additional measures, such
as shortfall probability (the probability of failing to meet a specific liability or goal)24 and
tail-risk measures (e.g., VaR and CVaR). Historical stress tests and Monte Carlo
simulations can also be used to capture and communicate risk in a tangible way.
Availability Bias (Recall)
mental shortcut when estimating the probability of an outcome based on how easily
the outcome comes to mind. Easily recalled outcomes are often perceived as being
more likely than those that are harder to recall or understand. For example, more
recent events or events in which the investor has personally been affected are likely
to be assigned a higher probability of occurring again
Familiarity bias stems from availability bias: People tend to favor the familiar over the
new or different because of the ease of recalling the familiar. In asset allocation,
familiarity bias most commonly results in a home bias—a preference for securities
listed on the exchanges of one’s home country. However, concentrating portfolio
exposure in home country securities, particularly if the home country capital markets
are small, results in a less diversified, less efficient portfolio. Familiarity bias can be
mitigated by using the global market portfolio as the starting point in developing the
asset allocation, where deviations from this baseline portfolio must be thoughtfully
considered and rigorously vetted.
Familiarity bias may also cause investors to fall into the trap of comparing their
investment decisions (and performance) to others’, without regard for the
appropriateness of those decisions for their own specific facts and circumstances. By
avoiding comparison of investment returns or asset allocation decisions with others,
an organization is more capable of identifying the asset allocation that is best tailored
to their needs.
A strong governance structure, such as that discussed in the overview reading on
asset allocation, is a necessary first step to mitigating the effect that these behavioral
biases may have on the long-term success of the investment program. Bringing a
diverse set of views to the deliberation process brings more tools to the table to
solve any problem and leads to better and more informed decision making. A clearly
stated mission—a common goal—and a commitment from committee members and
other stakeholders to that mission are critically important in constraining the
influence of these biases on investment decisions