Level III

Overview of Asset Allocation

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Reproduced and republished with permission from CFA Institute. All rights reserved.
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Contents and Introduction
• Introduction
• Asset Allocation: Importance in Investment Management
• The Investment Governance Background to Asset Allocation
• The Economic Balance Sheet and Asset Allocation
• Approaches to Asset Allocation
• Strategic Asset Allocation
• Implementation Choices
• Rebalancing: Strategic Considerations

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1.1 Asset Allocation: Importance in Investment Management
Asset Owner Objectives Investment Opportunity Set

Develop capital market expectations

Identify and articulate objectives
for planning horizon

Investment Policy Statement

• Objectives and constraints
• Responsibilities Structure Portfolio
• Review frequency • SAA
• Rebalancing policy • Active risk budgets
• Other principles • Security selection
• Execution
Identify changes in economic balance • Rebalancing Monitor prices and markets
sheet, objectives or constraints

Evaluate progress toward achieving

objectives and compliance with IPS

Investment Governance

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2. The Investment Governance Background to Asset Allocation
Investment governance: organization of decision-making responsibilities and oversight activities.

Good investment governance ensures:

• Asset-owner’s risk and return objectives are met
• Asset-owner’s constraints are met
• Decision-makers have the required skill and ability

Governance structure hierarchy:

Elements of effective investment governance:
• Governing investment committee
• Articulate investment objectives
• Investment staff
• Allocate of rights and responsibilities
• Third-party resources
• Specify process for developing and approving IPS
• Specify process for developing and approving SAA
• Establish reporting framework
• Undertake periodic governance audits

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 Articulating Investment Objectives
Goal: find the best risk/return tradeoff given the client’s constraints and risk tolerance.

Sample investment objective statements:

• Defined benefit pension fund: ensure that plan assets are sufficient to meet current and future
pension liabilities.
• Endowment fund: earn a rate of return in excess of the inflation-adjusted return that is required to
fund ongoing distributions consistent with the endowment’s mission.
• Individual investor: earn a sufficient return to meet living expenses during retirement; investments
should be subject to risk tolerance and constraints.

“Managing an investment program without a clear understanding of the long and short-term
objectives is similar to navigating without a map. Arriving at the right destination on time and intact
requires minimizing the level of chance involved.”

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 Allocation of Rights and Responsibilities
Rights are responsibilities are allocated at the highest level

Allocation of rights and responsibilities depend on:

• Size of investment program
• Knowledge, skills and ability of internal staff
• Amount of time staff can devote to investment program

Staff and Scope and complexity of

resources Investment investment program

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 Investment Policy Statement (IPS)
The investment policy statement is the foundation of an effective investment program.

An IPS typically has the following features

• Introduction
• Investment objectives
• Investment constraints
• Duties and responsibilities
• Investment guidelines
• Frequency and nature of reporting
• Risk management framework

Overall IPS is revised slowly over time; variable aspects of the program are documented in
the appendix.

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 Asset Allocation and Rebalancing Policy
SAA is typically drafted by investment staff but approved by investment committee.
The IPS should contain information related to rebalancing.

Reporting Framework
Goal of reporting framework: enable overseers to quickly and clearly evaluate progress of the
investment program; the following questions should be addressed:
• Where are we now?
• Where are we relative to the goals and objectives?
• What value has been added?

Key elements of reporting framework:

• Benchmarking
• Management reporting
• Governance reporting

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 The Governance Audit
• Audit should be performed by independent third party

• Objective: ensure that established policies, procedures and

governance structures are effective

• Good investment governance ensures durability of the investment

program

• Good investment governance seeks to avoid

 Decision-reversal risk
 Key person risk

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3. The Economic Balance Sheet and Asset Allocation
• An economic balance sheet includes:
 Conventional (financial) assets and liabilities
 Extended portfolio assets and liabilities

• For individual investors, extended portfolio assets/liabilities include:

 Assets: human capital, PV of pension income, PV of expected inheritances
 Liabilities: PV of future consumption

• For institutional investors, examples of extended portfolio assets/liabilities include:

 Assets: underground mineral resources, PV of future intellectual property royalties
 Liabilities: PV of prospective payouts for foundations

• Extended portfolio assets and liabilities should be considered in making asset

allocation decisions

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Example 3: The Economic Balance Sheet of Auldberg University Endowment
Assets: Endowment assets include CAF$100 million in domestic equities, CAF$60 million in domestic government debt, and
CAF$40 million in Class B office real estate. The present value of expected future contributions (from real estate and provincial
subsidies) is estimated to be CAF$400 million.
Liabilities: These include CAF$10 million in short-term borrowings and CAF$35 million in mortgage debt related to real estate
investments. Although it has no specific legal requirement, AUE has a policy to distribute to the university 5% of 36-month
moving average net assets. In effect, the endowment supports $10 million of Auldberg University’s annual operating budget. The
present value of expected future support is CAF$450 million.

Assets Liabilities and Net Worth

Financial Assets Financial Liabilities
Domestic equities 100 Short-term borrowing 10
Domestic fixed income 60 Mortgage debt 35
Class B office real estate 40

Extended Assets Extended Liabilities

PV of expected future contributions to AUE 400 PV of expected future support 450
Economic net worth 105
Total 600 600

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4. Approaches to Asset Allocation
• Asset-only approach
 Focus is on the asset side; liabilities are not considered
 Example: Mean-variance optimization (MVO)

• Liability-relative approach
 Asset allocation is done with objective of funding liabilities (pay liabilities when they come due)
 Example: Surplus optimization
 Liability-driven investing (LDI)

• Goals-based approach
 Used primarily for individuals and families
 Sub-portfolios aligned with specific goals
 Specific asset allocation for each goal
 Goal-based investing (GBI)

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Distinctions between liabilities for an institutional investor and goals for
an individual investor
Institutional Investor Liabilities Individual Investor Goals

• Legal obligations or debts • Goals, such as meeting lifestyle or aspirational

objectives, are not obligations
• Institutional liabilities, such as life insurer
obligations or pension benefit obligations, are • An individual’s goals may be many and varied
uniform in nature

• Liabilities of institutional investors of a given

type (e.g., the pension benefits owed to • Individual goals are not subject to the law of
retirees) are often numerous and so, through large numbers and averaging
averaging, may often be forecast with
confidence

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4.1 Relevant Objectives
Asset Allocation Relation to Economic
Approach Balance Sheet Typical Objective Typical Uses and Asset Owner Types
Asset only Does not explicitly Maximize Sharpe ratio for Liabilities or goals not defined and/or
model liabilities or goals acceptable level of volatility simplicity is important
• Some foundations, endowments

• Sovereign wealth funds

• Individual investors
Liability relative Models legal and quasi- Fund liabilities and invest Penalty for not meeting liabilities high
liabilities excess assets for growth
• Banks

• Defined benefit pensions

• Insurers

Goals based Models goals Achieve goals with specified Individual investors
required probabilities of
success

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4.2 Relevant Risk Concepts
Asset Allocation Relation to Economic
Approach Balance Sheet Relevant Risk Concepts
Asset only Does not explicitly Primary risk measure is volatility of portfolio returns which depend
model liabilities or goals on asset class volatilities and correlation
Risk relative to benchmark (tracking error)
Downside risk
Monte Carlo simulations
Liability relative Models legal and quasi- Shortfall risk: risk of having insufficient assets to pay obligations
liabilities when due

Goals based Models goals Risk of failing to achieve goals

Risk limits: maximum acceptable probability of not achieving goals
Overall portfolio risk is the weighted sum of the risks associated with
each goal

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5. Modeling Asset Class Risk
Asset class: “a set of assets that bear some fundamental economic similarities to each other, and that
have characteristics that make them distinct from other assets that are not part of that class.”

• Greer’s three super classes of assets

 Capital assets
 Consumable/transformable assets
 Store of value assets

Example 4: Classify the following investments based on Greer’s (1997) framework, or explain how they do not fit
in the framework:
1. Precious metals
2. Petroleum
3. Hedge funds
4. Timberland
5. Inflation-linked fixed-income securities
6. Volatility

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Criteria for Asset Class Specification
The following five criteria help in effectively specifying asset classes for the purpose of asset allocation:

1. Assets within an asset class should be relatively homogeneous.

2. Asset classes should be mutually exclusive.

3. Asset classes should be diversifying.

4. The asset classes as a group should make up a preponderance of world investable wealth.

5. Asset classes selected for investment should have the capacity to absorb a meaningful proportion
of an investor’s portfolio.

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Asset Classes In Practice
• Global public equity: domestic and non-domestic; developed, emerging, and frontier markets; large-
cap, mid-cap, and small-cap.

• Global private equity: venture capital, growth capital, and leveraged buyouts.

• Global fixed income: developed and emerging market debt; sovereign, investment-grade, and high-
yield bonds; inflation-linked bonds; cash and short-duration securities.

• Real assets: assets that provide sensitivity to inflation, such as private real estate equity, private
infrastructure, and commodities.

Note: Sometimes, global inflation-linked bonds are included as a real asset rather than fixed income
because of their sensitivity to inflation.

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Exhibit 6: Examples of Asset Classes and Sub-Asset Classes

Sources of risk for broadly defined asset classes (equity versus debt) are better distinguished than sources
of risk for narrowly defined subgroups (large cap versus small cap equity).

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Exhibit 7: Common Factor Exposures across Asset Classes

• Even broadly defined asset classes (US equity and US Corporate Bonds) have some common risk factor
exposures  non-zero correlation between asset classes
• Risk factors are associated with non-diversifiable (systematic)  expected return premium
• Portfolios with specific factor exposure can be constructed

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Factor Representation
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 short Treasuries/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:
• The desire to shape the asset allocation based on goals and objectives that cannot be expressed by asset classes
• An intense focus on portfolio risk in all of its various dimensions, helped along by availability of commercial
factor-based risk measurement and management tools.
• The acknowledgment that many highly correlated so-called asset classes are better defined as parts of the same
high-level asset class.
• The realization that equity risk can be the dominant risk exposure even in a seemingly well-diversified portfolio.

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6. Strategic Asset Allocation
Strategic asset allocation or policy portfolio: asset allocation that is expected to be effective in
achieving investment objectives given investment constraints and risk tolerance.
Optimal asset allocation maximizes utility of ending wealth subject to constraints.

Selection of strategic asset allocation general involves the following steps:

1. Determine and quantify the investor’s objectives.
2. Determine the investor’s risk tolerance and how risk should be expressed and measured.
3. Determine the investment horizon(s).
4. Determine other constraints and the requirements they impose on asset allocation choices.
5. Determine the approach to asset allocation that is most suitable for the investor.
6. Specify asset classes, and develop a set of capital market expectations for the specified asset classes.
7. Develop a range of potential asset allocation choices for consideration.
8. Test the robustness of the potential choices.
9. Iterate back to Step 7 until an appropriate and agreed-on asset allocation is constructed.

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7. Asset Only
• Asset-only allocation is based on mean-variance optimization: maximize expected (mean) return at
a given level of risk (variance)
• Key measure is the Sharpe ratio

Key points from GPFC (sovereign wealth fund) case study

• Promote a fair sharing of the benefits between current and future generations; no clear liabilities
• Willing to bear volatility of up to 17% and a 5% chance of losing 22% or more of portfolio value in a
given year
• Central consideration: expected return in relation to volatility and VaR
• Other possible considerations:
 diversification across global asset classes
 correlations with the petroleum sources of income to GPFC
 the potential positive correlation of future spending with inflation and population growth in Cafastan
 long investment horizon
 return outcomes in severe financial market downturns

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Exhibit 9: GPFC Strategic Asset Allocation Decision

Asset Allocation
Proposed
Current A B C
Investment
Equities
Domestic 50% 40% 45% 30%
Global ex-domestic 10% 20% 25%
Bonds
Nominal 30% 30% 20% 10%
Inflation linked 10%
Real estate 20% 10% 15% 10%
Diversifying strategies 10% 15%

Portfolio statistics
Expected arithmetic return 8.50% 8.25% 8.88% 8.20%
Volatility (standard deviation) 15.57% 14.24% 16.63% 14.06%
Sharpe ratio 0.353 0.369 0.353 0.370
One-year 5% VaR -17.11% -15.18% -18.48% -14.93%

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Example 6: Asset-Only Asset Allocation
1. Describe how the Sharpe ratio, considered in isolation, would rank the asset allocation in Exhibit 9.
2. State a limitation of basing a decision only on the Sharpe ratio addressed in Question 1.
3. An assertion is heard in an investment committee discussion that because the Sharpe ratio of
diversifying strategies (0.55) is higher than real estate’s (0.50), any potential allocation to real
estate would be better used in diversifying strategies. Describe why the argument is incomplete.

Current A B C
Portfolio statistics
Expected arithmetic return 8.50% 8.25% 8.88% 8.20%
Volatility (standard deviation) 15.57% 14.24% 16.63% 14.06%
Sharpe ratio 0.353 0.369 0.353 0.370
One-year 5% VaR -17.11% -15.18% -18.48% -14.93%

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Global Market Portfolio
Global market-value weighted portfolio should be the baseline asset allocation
• Represents all investable assets  minimizes diversifiable risk
• Investing in the global market portfolio helps mitigate investment biases such as home country bias

Investing in the global market portfolio is done in two phases:

• Allocate assets in proportion to the global portfolio of stocks, bonds, and real assets.
• Disaggregate each broad asset class into regional, country, and security weights using capitalization weights.

Implementation hurdles:
• Size of each asset class on a global basis can’t be precisely determined
• Not practical to invest proportionately in residential real estate
• Private commercial real estate and global private equity assets are not easily carved into pieces of a size that is
accessible to most investors

Proxies for the global market portfolio are often based only on traded assets, such as portfolios of exchange-traded
funds (ETFs).

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8. Liability Relative
Narrative: GPLE is a machine tool manufacturer with a market value of $2 billion. GPLE is the sponsor of a $1.25
billion legacy DB plan, which is now frozen (i.e., no new plan participants and no new benefits accruing for existing
plan participants). GPLE Pension has a funded ratio (the ratio of pension assets to liabilities) of 1.15. Thus, the plan
is slightly overfunded. Responsibility for the plan’s management rests with the firm’s treasury department (which
also has responsibility for GPLE Corporation treasury operations).
Financial assets and financial liabilities: Assets amount to $1.25 billion at market values. Given a funded ratio of
1.15, that amount implies that liabilities are valued at about $1.087 billion. Projected distributions to pension
beneficiaries have a present value of $1.087 billion at market value.

Recommendation A: Based on asset-only analysis, 65% allocation to global equities and 35% allocation to global
fixed income. This asset allocation is mean–variance efficient and has the highest Sharpe ratio among portfolios
that meet the pension’s assumed tolerance for asset return volatility.

Recommendation B: Allocation of $1.125 billion to a fixed-income portfolio that is very closely matched in interest
rate sensitivity to the present value of plan liabilities (and to any other liability factor risk exposures) and a $0.125
allocation to equities

Liability Glide Paths

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9. Goals Based
As goals-based asset allocation has advanced, various classification systems for goals have been
proposed. Two of those classification systems are as follows.

Brunel (2012):
• Personal goals—to meet current lifestyle requirements and unanticipated financial needs
• Dynastic goals—to meet descendants’ needs
• Philanthropic goals

Chhabra (2005):
• Personal risk bucket—to provide protection from a dramatic decrease in lifestyle (i.e., safe-haven
investments)
• Market risk bucket—to ensure the current lifestyle can be maintained (allocations for average risk-
adjusted market returns)
• Aspirational risk bucket—to increase wealth substantially (greater than average risk is accepted)

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Case Study
Name: Ivy and Charles Lee
Narrative: Ivy is a 54-year-old life sciences entrepreneur. Charles is 55 years old and employed as an orthopedic
surgeon. They have two unmarried children aged 25 (Deborah) and 18 (David). Deborah has a daughter with
physical limitations.
Financial assets and financial liabilities: Portfolio of $25 million with $1 million in margin debt as well as residential
real estate of $3 million with $1 million in mortgage debt.
Other assets and liabilities:
• Pre-retirement earnings are expected to total $16 million in present value terms (human capital).
• David will soon begin studying at a four-year private university; the present value of the expected parental
contribution is $250,000.
• The Lees desire to give a gift to a local art museum in five years. In present value terms, the gift is valued at
$750,000.
• The Lees want to establish a trust for their granddaughter with a present value of $3 million to be funded at
the death of Charles.
• The present value of future consumption expenditures is estimated at $20 million.

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Lee Family Economic Balance Sheet (in US$ millions) 31 December
Assets Liabilities and Net Worth
Financial assets Financial liabilities
Investment portfolio 25 Margin debt 1
Real estate 3 Mortgage 1
Extended assets Extended liabilities
Human capital 16 David’s education 0.25
Museum gift 0.75
Special needs trust 3
PV of future consumption 20
Economic net worth 18
Total 44 44

Goal Required Probability of Achieving Time Horizon

Lifestyle—minimum Extremely high Short to distant
Lifestyle—baseline Very high Short to distant
Lifestyle—aspirational Moderate Distant
Education Very high Short
Trust High Long
Charitable Moderate Short

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Example 7: Goals-Based Asset Allocation (1/2)
The Lees are presented with the following optimized asset allocations:

Asset Allocation Cash Global Bonds Global Equities Diversifying Strategies

A 40% 50% 10% 0%
B 10% 30% 45% 15%

Assume that a portfolio of 70% global equities and 30% bonds reflects an appropriate balance of
expected return and risk for the Lees with respect to a 10-year time horizon for most moderately
important goals. Based on the information given:
1. What goal(s) may be addressed by Allocation A?
2. What goal(s) may be addressed by Allocation B?

Goal Required Probability of Achieving Time Horizon

Lifestyle—minimum Extremely high Short to distant
Lifestyle—baseline Very high Short to distant
Lifestyle—aspirational Moderate Distant
Education Very high Short
Trust High Long
Charitable Moderate Short
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Example 7: Goals-Based Asset Allocation (2/2)
Because of her industry connections in the life sciences, Ivy Lee is given the opportunity to be an
early-stage venture capital investor in what she assesses is a very promising technology.
3. What insights does goals-based asset allocation offer on this opportunity?

Goal Required Probability of Achieving Time Horizon

Lifestyle—minimum Extremely high Short to distant
Lifestyle—baseline Very high Short to distant
Lifestyle—aspirational Moderate Distant
Education Very high Short
Trust High Long
Charitable Moderate Short

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10. Implementation Choices

1. Passive/Active Management of Asset Class Weights

2. Passive/Active Management of Allocations to Asset Classes

3. Risk Budgeting Perspectives in Asset Allocation and Implementation

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10.1 Passive/Active Management of Asset Class Weights

• Passive strategy: do not deviate from strategic asset allocation (SAA)

• Tactical asset allocation (TAA): deliberate short-term deviations from the strategic
asset allocation
 Deviations generally kept within a certain range or within risk budget
 Stock-bond-cash allocation versus comprehensive multi-asset approach

• Deviating from SAA represents a source of risk

 Potential outperformance versus tracking error
 Trading costs, higher short-term capital gains taxes

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10.2 Passive/Active Management of Allocations to Asset Classes
• Passive management: portfolio composition does not react to changes in the investor’s capital
market expectations

• Active management: portfolio composition does react to changes in the investor’s capital market
expectations; objective: achieve positive excess risk-adjusted returns relative to a passive
benchmark

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Factors that influence where to invest on the passive/active
spectrum

• Available investments

• Scalability of active strategies being considered

• The feasibility of investing passively while incorporating client-specific constraints

• Beliefs concerning market informational efficiency

• The trade-off of expected incremental benefits relative to incremental costs and risks of active
choices

• Tax status

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Example 8: Implementation Choices (1)
1. Describe two kinds of passive/active choices faced by investors related to asset allocation.

2. An equity index is described as “a rules-based, transparent index designed to provide investors

with an efficient way to gain exposure to large-cap and small-cap stocks with low total return
variability.” Compared with the market-cap weighting of the parent index (with the same
component securities), the weights in the low-volatility index are proportional to the inverse of
return volatility, so that the highest-volatility security receives the lowest weight. Describe the
active and passive aspects of a decision to invest an allocation to equities in ETFs tracking such
indices.

3. Describe how investing in a GDP-weighted global bond index involves both active and passive
choices.

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Example 9: Implementation Choices (2)
Describe characteristic(s) of each of the following investors that are likely to influence the decision to
invest passively or actively. See Exhibit 5 for Questions 1–3 and Example 3 for Question 4.
1. Cafastan sovereign wealth fund
2. GPLE corporate pension
3. The Lee family
4. Auldberg University Endowment

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10.3 Risk Budgeting Perspectives in Asset Allocation and
Implementation
Risk budgeting: which types of risks to take and how much of each to take

Risk budgets can be stated in absolute or in relative terms and in money or percent terms

Asset allocation can be done based on a risk budgeting approach

Active risk budgeting: how much benchmark-relative risk an investor is willing to take in seeking to
outperform a benchmark; two levels of active risk budgeting
• Overall asset allocation level
• Individual asset class level

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11. Rebalancing: Strategic Considerations
Rebalancing: discipline of adjusting portfolio weights to more closely align with the
strategic asset allocation

Without rebalancing the overall

portfolio risk rises

IPS should specify:

• Rebalancing policy
• Who is responsible for rebalancing

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11.1 A Framework for Rebalancing
• Calendar rebalancing

• Percent-range rebalancing
 How frequently is the portfolio valued?
 What size deviation triggers rebalancing?
 Is the deviation from the target allocation fully or partially corrected?

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11.2 Strategic Considerations in Rebalancing
• Higher transaction costs for an asset class imply wider rebalancing ranges.
• More risk-averse investors will have tighter rebalancing ranges
• Less correlated assets have tighter rebalancing ranges
• Beliefs in momentum favor wider rebalancing ranges, whereas mean reversion
encourages tighter ranges

• Illiquid investments complicate rebalancing

• Derivatives create the possibility of synthetic rebalancing
• Taxes discourage rebalancing and encourage asymmetric and wider rebalancing
ranges.

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Example 10: Different Rebalancing Ranges
The table shows a simple four-asset strategic mix along with rebalancing ranges created under different
approaches. Explain why the international equity range is wider than the domestic equity range under
proportional ranges using the cost–benefit approach.

Strategic Fixed Width Proportional Ranges Cost–Benefit

Asset Class Target Ranges (±1,000 bps) Ranges
Domestic equity 40% 35%–45% 36%–44% 35%–45%
International equity 25% 20%–30% 22½%–27½% 19%–31%
Emerging markets 15% 10%–20% 13½%–16½% 12%–18%
Fixed income 20% 15%–25% 18%–22% 19%–21%

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 Summary 1/2
An economic balance sheet includes: Global market-value weighted portfolio should be the baseline asset allocation
• Conventional (financial) assets and liabilities • Represents all investable assets  minimizes non-diversifiable risk
• Extended portfolio assets and liabilities • Investing in the global market portfolio helps mitigate investment biases such as
• For individual investors, extended portfolio assets/liabilities include: home country bias
• Assets: human capital, PV of pension income, PV of expected inheritances • Investing in the global market portfolio is done in two phases:
• Liabilities: PV of future consumption • Allocate assets in proportion to the global portfolio of stocks, bonds, and real assets.
• For institutional investors, examples of extended portfolio assets/liabilities • Disaggregate each broad asset class into regional, country, and security weights using
include: capitalization weights.
• Assets: underground mineral resources, PV of future intellectual property royalties • Implementation hurdles:
• Liabilities: PV of prospective payouts for foundations • Size of each asset class on a global basis can’t be precisely determined
Extended portfolio assets and liabilities should be considered in making asset • Not practical to invest proportionately in residential real estate
allocation decisions. • Private commercial real estate and global private equity assets are not easily carved
Criteria for Asset Class Specification into pieces of a size that is accessible to most investors
• Assets within an asset class should be relatively homogeneous. Passive/active management of asset class weights:
• Asset classes should be mutually exclusive. • Passive strategy: stick to strategic asset allocation (SAA)
• Asset classes should be diversifying. • Active strategy: allow deviation from SAA
• The asset classes as a group should make up a preponderance of world investable  Called tactical asset allocation (TAA)
wealth. • Passive/active management of allocations to asset classes:
• Asset classes selected for investment should have the capacity to absorb a • Passive strategy: each asset class based on relevant benchmark
meaningful proportion of an investor’s portfolio. • Active strategy: deviate from asset class benchmark
Use of risk factors in asset allocation
Factors impacting active vs passive investment decision:
• Risk factors are associated with non-diversifiable (i.e., systematic) risk and are
associated with an expected return premium. • Available investments
• At times an investor’s goals and objectives cannot be met through traditional asset • Scalability of active strategies being considered
classes. • Feasibility of investing passively given constraints
• Risk factor approaches to asset allocation focus on assigning investments to the • Beliefs concerning market informational efficiency
investor’s desired exposures to specified risk factors. • Cost-benefit trade-off
• Tax status
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 Summary 2/2
Asset Allocation Approaches: Investment Objective
Asset Allocation Relation to Economic Typical Objective Relevant Risk Concepts Typical Uses and Asset Owner Types
Approach Balance Sheet
Asset only Does not explicitly Maximize Sharpe ratio  Primary risk measure is volatility of portfolio returns Liabilities or goals not defined and/or
model liabilities or for acceptable level of which depend on asset class volatilities and correlation simplicity is important
goals volatility  Risk relative to benchmark (tracking error) • Some foundations, endowments
 Downside risk • Sovereign wealth funds
 Monte Carlo simulations • Individual investors
Liability relative Models legal and Fund liabilities and  Shortfall risk: risk of having insufficient assets to pay Penalty for not meeting liabilities high
quasi-liabilities invest excess assets for obligations when due • Banks
growth • Defined benefit pensions
• Insurers
Goals based Models goals Achieve goals with  Risk of failing to achieve goals Individual investors
specified required  Risk limits: maximum acceptable probability of not
probabilities of achieving goals
success  Overall portfolio risk is the weighted sum of the risks
associated with each goal

Risk budgeting refers to which risks to take and to what extent; Strategic considerations in rebalancing include the following:
• Can be stated in absolute or relative terms • Transaction costs: Higher transaction costs for an asset class imply wider rebalancing ranges.
• Active risk budgeting: how much benchmark-relative risk an • Risk aversion: More risk-averse investors will have tighter rebalancing ranges
investor is willing to take in seeking to outperform a benchmark; • Correlations among asset classes: Less correlated assets have tighter rebalancing ranges
two levels of active risk budgeting • Beliefs concerning momentum: Beliefs in momentum favor wider rebalancing ranges, whereas
o Overall asset allocation level mean reversion encourages tighter ranges
o Individual asset class level
• Asset class liquidity: Illiquid investments complicate rebalancing;
• Volatility: The higher an asset class’ volatility, the narrower should be the corridors;
• Derivatives create the possibility of synthetic rebalancing
• Taxation: Taxes discourage rebalancing and encourage asymmetric and wider rebalancing ranges.
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