INTRODUCTION
Last updated
Last updated
Learning Outcome
describe elements of effective investment governance and investment governance considerations in asset allocation
Asset owners are concerned with accumulating and maintaining the wealth needed to meet their needs and aspirations. In that endeavor, investment portfoliosâincluding individualsâ portfolios and institutional fundsâplay important roles. Asset allocation is a strategicâand often a first or earlyâdecision in portfolio construction. Because it holds that position, it is widely accepted as important and meriting careful attention. Among the questions addressed in this reading are the following:
What is a sound governance context for making asset allocation decisions?
How broad a picture should an adviser have of an asset ownerâs assets and liabilities in recommending an asset allocation?
How can an asset ownerâs objectives and sensitivities to risk be represented in asset allocation?
What are the broad approaches available in developing an asset allocation recommendation, and when might one approach be more or less appropriate than another?
What are the top-level decisions that need to be made in implementing a chosen asset allocation?
How may asset allocations be rebalanced as asset prices change?
The strategic asset allocation decision determines return levels1 in which allocations are invested, irrespective of the degree of active management. Because of its strategic importance, the investment committee, at the highest level of the governance hierarchy, typically retains approval of the strategic asset allocation decision. Often a proposal is developed only after a formal asset allocation study that incorporates obligations, objectives, and constraints; simulates possible investment outcomes over an agreed-on investment horizon; and evaluates the risk and return characteristics of the possible allocation strategies.
In providing an overview of asset allocation, this readingâs focus is the alignment of asset allocation with the asset ownerâs investment objectives, constraints, and overall financial condition. This is the first reading in several sequences of readings that address, respectively, asset allocation and portfolio management of equities, fixed income, and alternative investments. Asset allocation is also linked to other facets of portfolio management, including risk management and behavioral finance. As coverage of asset allocation progresses in the sequence of readings, various connections to these topics, covered in detail in other areas of the curriculum, will be made.2
In the asset allocation sequence, the role of this reading is the âbig picture.â It also offers definitions that will provide a coordinated treatment of many later topics in portfolio management. The second reading provides the basic âhowâ of developing an asset allocation, and the third reading explores various common, real-world complexities in developing an asset allocation.
This reading is organized as follows: Section 1 explains the importance of asset allocation in investment management. Section 2 addresses the investment governance context in which asset allocation decisions are made. Section 3 considers asset allocation from the comprehensive perspective offered by the asset ownerâs economic balance sheet. Sections 4 and 5 distinguish three broad approaches to asset allocation and explain how they differ in investment objective and risk. In Sections 6â9, these three approaches are discussed at a high level in relation to three cases. Section 10 provides a top-level orientation to how a chosen asset allocation may be implemented, providing a set of definitions that underlie subsequent readings. Section 11 discusses rebalancing considerations.
Asset Allocation: Importance in Investment Management
Exhibit 1:
The Portfolio Management Process
The investment process shows a sequence of activities that begins with understanding the asset ownerâs entire circumstance; objectives, including any constraints; and preferences. These factors, in conjunction with capital market inputs,3 form the basis for asset allocation as a first step in portfolio construction and give a structure within which other decisionsâsuch as the decision to invest passively or activelyâtake place. In the flow chart, thick lines show initial flows (or relations of logic) and thin lines show feedback flows.
Asset allocation is widely considered to be the most important decision in the investment process. The strategic asset allocation decision completely determines return levels4 in which allocations are invested passively and also in the aggregate of all investors, irrespective of the degree of active management.
In providing an overview of asset allocation, this readingâs focus is the alignment of asset allocation with the asset ownerâs investment objectives, constraints, and overall financial condition. The presentation begins with an introduction to the investment governance context of asset allocation. It then moves to present the economic balance sheet as the financial context for asset allocation itself.
places asset allocation in a stylized model of the investment management process viewed as an integrated set of activities aimed at attaining investor objectives.
shows that an investment process that is in the asset ownerâs best interest rests on a foundation of good investment governance, which includes the assignment of decision-making responsibilities to qualified individuals and oversight of processes. The balance at the top of the chart suggests that the portfolio management process must reconcile (balance) investor objectives (on the left) with the possibilities offered by the investment opportunity set (on the right).
