INTRODUCTION

Determining a strategic asset allocation is arguably the most important aspect of the investment process. This reading builds on the “Introduction to Asset Allocation” reading and focuses on several of the primary frameworks for developing an asset allocation, including asset-only mean–variance optimization, various liability-relative asset allocation techniques, and goals-based investing. Additionally, it touches on various other asset allocation techniques used by practitioners, as well as important related topics, such as rebalancing.

The process of creating a diversified, multi-asset class portfolio typically involves two separate steps. The first step is the asset allocation decision, which can refer to both the process and the result of determining long-term (strategic) exposures to the available asset classes (or risk factors) that make up the investor’s opportunity set. Asset allocation is the first and primary step in translating the client’s circumstances, objectives, and constraints into an appropriate portfolio (or, for some approaches, multiple portfolios) for achieving the client’s goals within the client’s tolerance for risk. The second step in creating a diversified, multi-asset-class portfolio involves implementation decisions that determine the specific investments (individual securities, pooled investment vehicles, and separate accounts) that will be used to implement the targeted allocations.

Although it is possible to carry out the asset allocation process and the implementation process simultaneously, in practice, these two steps are often separated for two reasons. First, the frameworks for simultaneously determining an asset allocation and its implementation are often complex. Second, in practice, many investors prefer to revisit their strategic asset allocation policy somewhat infrequently (e.g., annually or less frequently) in a dedicated asset allocation study, while most of these same investors prefer to revisit/monitor implementation vehicles (actual investments) far more frequently (e.g., monthly or quarterly).

Sections 2–9 cover the traditional mean–variance optimization (MVO) approach to asset allocation. We apply this approach in what is referred to as an “asset-only” setting, in which the goal is to create the most efficient mixes of asset classes in the absence of any liabilities. We highlight key criticisms of mean–variance optimization and methods used to address them. This section also covers risk budgeting in relation to asset allocation, factor-based asset allocation, and asset allocation with illiquid assets. The observation that almost all portfolios exist to help pay for what can be characterized as a “liability” leads to the next subject.

Sections 10–14 introduce liability-relative asset allocation—including a straightforward extension of mean–variance optimization known as surplus optimization. Surplus optimization is an economic balance sheet approach extended to the liability side of the balance sheet that finds the most efficient asset class mixes in the presence of liabilities. Liability-relative optimization is simultaneously concerned with the return of the assets, the change in value of the liabilities, and how assets and liabilities interact to determine the overall value or health of the total portfolio.

Sections 15–18 cover an increasingly popular approach to asset allocation called goals-based asset allocation. Conceptually, goals-based approaches are similar to liability-relative asset allocation in viewing risk in relation to specific needs or objectives associated with different time horizons and degrees of urgency.

Section 19 introduces some informal (heuristic) ways that asset allocations have been determined and other approaches to asset allocation that emphasize specific objectives.

Section 20 addresses the factors affecting choices that are made in developing specific policies relating to rebalancing to the strategic asset allocation. Factors discussed include transaction costs, correlations, volatility, and risk aversion1