STRATEGIC ASSET ALLOCATION

Learning Outcome

• recommend and justify an asset allocation based on an investor’s objectives and constraints

ChatGPT Summary

Strategic asset allocation plays a crucial role in investment management by aligning an investor's portfolio with their long-term financial goals and risk tolerance. Here's how the process unfolds, based on the learning outcomes you've shared:

1. Objective and Constraint Identification: The first step is to clearly define the investor's objectives (such as retirement funding, education expenses, or wealth accumulation) and constraints (like liquidity needs, time horizon, legal and regulatory considerations, tax circumstances, and unique preferences such as ESG considerations). This helps in crafting an investment strategy that is tailored to the investor's specific needs and circumstances.

2. Risk Tolerance Assessment: Understanding the investor's risk tolerance is essential to determine the appropriate asset allocation. This involves evaluating the investor's capacity to absorb losses, investment horizon, and emotional tolerance for market volatility. Risk tolerance will influence the mix of riskier assets (like stocks) versus more stable assets (like bonds) in the portfolio.

3. Investment Horizon Determination: The investment time frame plays a significant role in strategic asset allocation. Longer horizons typically allow for a greater allocation to riskier assets, given the potential for higher returns over time and the ability to recover from short-term market fluctuations.

4. Constraint Analysis: Analyzing other constraints involves considering factors such as tax implications, legal restrictions, and any specific investor requirements documented in the Investment Policy Statement (IPS). This step ensures that the asset allocation complies with all external and self-imposed limitations.

5. Asset Allocation Methodology Selection: Choosing the right approach to asset allocation involves deciding between various methods such as mean-variance optimization, factor-based models, or more heuristic approaches. The selection depends on the investor's objectives, the complexity of their situation, and the degree to which liabilities or specific goals need to be funded.

6. Asset Class Specification and Capital Market Expectations: This involves defining the asset classes to be included in the portfolio and developing expectations for their future returns, volatilities, and correlations. This step is critical for constructing a diversified portfolio that is expected to meet the investor's objectives at an acceptable level of risk.

7. Development and Optimization of Asset Allocation Choices: Using the information and constraints identified in earlier steps, potential asset allocations are developed, often through optimization processes. This involves finding the asset mix that is expected to offer the best trade-off between risk and return, given the investor's unique circumstances.

8. Robustness Testing: The proposed asset allocations are tested for their sensitivity to various economic and financial scenarios. This step involves stress testing and scenario analysis to ensure that the chosen allocation is likely to perform well across a range of possible futures.

9. Iteration and Finalization: The asset allocation process is iterative. Based on the outcomes of robustness testing, the asset allocation may be refined until an optimal mix is identified that meets the investor's goals and fits within their risk tolerance and constraints.

10. Application and Thematic Considerations: The process of strategic asset allocation is applied differently based on the type of investor (such as sovereign wealth funds, corporate pension plans, or ultra-high-net-worth individuals). Each investor type might require a different focus, whether it's an asset-only approach, liability-relative allocation, or goals-based allocation.

Strategic asset allocation is a dynamic process that requires regular review and adjustment to reflect changes in the investor's life circumstances, financial markets, and economic outlook. It's a foundational component of a disciplined investment strategy, designed to help investors achieve their long-term financial goals.

An asset 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

$Maximizeby choice of asset class weights wiE(U(WT))=f⎛⎝⎜⎜⎜W0, wi, asset class return distributions, degree of risk aversion⎞⎠⎟⎟⎟$Maximizeby choice of asset class weights ������=��0, ��, asset class return distributions, degree of risk aversion

$subject to∑i=1nwi=1and any other constraints on wi$subject to∑�=1���=1and any other constraints on ��

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 or portfolio yield may be targeted). With W0 and WT (the values of wealth today and at time horizon T, respectively) the investor’s problem is to select the asset allocation that maximizes the expected utility of ending wealth, E[U(WT)], subject to the constraints that 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,19 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.

Optimal Choice in the Simplest Case

The simplest asset allocation decision problem involves one risky asset and one risk-free asset. Let λ, μ, rf, and σ2 represent, respectively, the investor’s degree of risk aversion, the risk asset’s expected return, the risk-free interest rate, and the variance of return. With mean–variance utility, the optimal allocation to the risky asset, w*, can be shown to equal

$w*=1λ(μ−rfσ2)$�*=1� (�−���2)

The allocation to the risky asset is inversely proportional to the investor’s risk aversion and directly proportional to the risk asset’s expected return per unit of risk (represented by return variance).20

Selection of a strategic asset allocation generally involves the following steps:21

1. Determine and quantify the investor’s objectives. What is the pool of assets meant for (e.g., paying future benefit payments, contributing to a university’s budget, securing ample assets for retirement)? What is the investor trying to achieve? What liabilities or needs or goals need to be recognized (explicitly or implicitly)? How should objectives be modeled?

2. Determine the investor’s risk tolerance and how risk should be expressed and measured. What is the investor’s overall tolerance for risk and specific risk sensitivities? How should these be quantified in the process of developing an appropriate asset allocation (risk 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?

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. These choices are often developed through optimization exercises. Specifics depend on the approach taken to asset allocation.

8. Test the robustness of the potential choices. This testing often involves conducting simulations to evaluate potential results in relation to investment objectives and risk tolerance over appropriate planning horizon(s) for the different asset allocations developed in Step 7. The sensitivity of the outcomes to changes in capital market expectations is also tested.

9. Iterate back to Step 7 until an appropriate and agreed-on asset allocation is constructed.

Subsequent readings on asset allocation in practice will address the “how.” The following sections give an indication of thematic considerations. We use investors with specific characteristics to illustrate the several approaches distinguished: sovereign wealth fund for asset-only allocation; a frozen corporate DB plan for liability-relative allocation; and an ultra-high-net-worth family for goals-based allocation. In practice, any type of investor could approach asset allocation with varying degrees of focus on modeling and integrating liabilities-side balance sheet considerations. How these cases are analyzed in this reading should not be viewed as specifying normative limits of application for various asset allocation approaches. For example, a liability-relative perspective has wide potential relevance for institutional investors because it has the potential to incorporate all information on the economic balance sheet. Investment advisers to high-net-worth investors may choose to use any of the approaches.