STRATEGIC ASSET ALLOCATION
Last updated
Last updated
Learning Outcome
recommend and justify an asset allocation based on an investor’s objectives and constraints
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 ������=��0, ��, asset class return distributions, degree of risk aversion
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
�*=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
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?
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)?
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?
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?
Determine the approach to asset allocation that is most suitable for the investor.
Specify asset classes, and develop a set of capital market expectations for the specified asset classes.
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.
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.
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.
