STRATEGIC ASSET ALLOCATION: ASSET ONLY

Learning Outcomes

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

• describe the use of the global market portfolio as a baseline portfolio in asset allocation

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The strategic asset allocation process, particularly in the context of an asset-only approach, is a critical component of portfolio management for institutions like the Government Petroleum Fund of Caflandia (GPFC), a sovereign wealth fund. This process is designed to align investment decisions with the fund's long-term objectives and risk tolerance, leveraging principles of mean-variance optimization to select portfolios that optimally balance expected returns against portfolio volatility. The case of GPFC provides a comprehensive example of how strategic asset allocation can be tailored to meet specific institutional needs, taking into account factors such as intergenerational equity, exposure to specific economic sectors (like petroleum), and the broader economic indicators of Caflandia.

Key Considerations in Strategic Asset Allocation:

1. Mean-Variance Optimization and the Efficient Frontier: At the heart of asset-only allocation is the mean-variance optimization, which seeks to map out an efficient frontier. This frontier represents portfolios that offer the highest expected return for a given level of risk (volatility). The Sharpe ratio, which measures the return per unit of risk, is a crucial metric in this analysis, guiding the selection of an efficient portfolio by comparing the expected return to the portfolio's volatility.

2. Global Market Portfolio as a Baseline: Utilizing the global market portfolio as a baseline in asset allocation introduces a disciplined approach to ensuring diversification and mitigating investment biases, such as home-country bias. It serves as a reference point for a diversified portfolio and encourages investors to articulate reasons for any deviations from this benchmark. This is particularly relevant for GPFC, given its significant domestic equity allocation in contrast to Caflandia's relatively small share of the global equity market.

3. Investor-Specific Objectives and Constraints: The case of GPFC highlights the importance of tailoring the asset allocation to the specific objectives and constraints of the investor. Factors such as the fund's risk tolerance, the correlation of its assets with its income sources (petroleum), and the impact of inflation and population growth on future spending needs are crucial in shaping the strategic asset allocation.

4. Alternatives to Current Allocation: GPFC's review of its strategic asset allocation, considering alternatives that range from diversifying into global equities and diversifying strategies to adjusting the balance between equities and bonds, underscores the dynamic nature of asset allocation. It involves continuously evaluating market conditions, the fund's financial position, and its long-term objectives to ensure that the allocation remains optimal.

5. Limitations of the Sharpe Ratio and Other Considerations: While the Sharpe ratio is a valuable tool for comparing the efficiency of different asset allocations, it is not without limitations. It does not account for all risk aspects, such as the potential for extreme losses (captured by metrics like VaR) or the liquidity of investments. Moreover, strategic decisions should also consider the fund's liquidity needs, legal and tax considerations, and the broader economic impact of its investments.

6. Home-Country Bias and Global Diversification: The example of GPFC, with its heavy tilt towards domestic equities, illustrates the common issue of home-country bias. Overweighting domestic investments relative to the global market portfolio can limit diversification benefits and potentially expose the portfolio to higher systemic risk. Addressing this bias requires a deliberate strategy to align more closely with global capitalization weights, unless specific liabilities or investment objectives justify such a bias.

Conclusion

The strategic asset allocation process, particularly within an asset-only framework, is crucial for institutions like GPFC to navigate the complexities of the investment landscape effectively. It requires a careful balance between theoretical optimization models and practical considerations unique to the investor's situation. By considering a broad range of factors, from global diversification to specific economic exposures and risk metrics, investors can craft a strategic allocation that aligns with their objectives, maximizes efficiency, and manages risk in a comprehensive manner.

Asset-only allocation is based on the principle of selecting portfolios that make efficient use of asset risk. The focus here is mean–variance optimization, the mainstay among such approaches. Given a set of asset classes and assumptions concerning their expected returns, volatilities, and correlations, this approach traces out an efficient frontier that consists of portfolios that are expected to offer the greatest return at each level of portfolio return volatility. The Sharpe ratio is a key descriptor of an asset allocation: If a portfolio is efficient, it has the highest Sharpe ratio among portfolios with the same volatility of return.

An example of an investor that might use an asset-only approach is the (hypothetical) Government Petroleum Fund of Caflandia (GPFC) introduced next.

Investor Case Facts: GPFC, A Sovereign Wealth Fund

• Name: Government Petroleum Fund of Caflandia (GPFC)

• Narrative: The imaginary emerging country of Caflandia has established a sovereign wealth fund to capture revenue from its abundant petroleum reserves. The government’s goal in setting up the fund is to promote a fair sharing of the benefits between current and future generations (intergenerational equity) from the export of the country’s petroleum resources. Caflandia’s equity market represents 0.50% of global equity market capitalization. Economists estimate that distributions in the interest of intergenerational equity may need to begin in 20 years. Future distribution policy is undetermined.

• Tax status: Non-taxable.

• Financial assets and financial liabilities: Financial assets are CAF$40 billion at market value, making GPFC among the largest investors in Caflandia. GPFC has no borrowings.

• Extended assets and liabilities: Cash inflows from petroleum exports are assumed to grow at inflation + 1% for the next 15 years and may change depending on reserves and global commodity demand. The present value of expected future income from state-owned reserves is estimated to be CAF$60 billion. Future spending needs are positively correlated with consumer inflation and population growth. In Exhibit 8, the amount for the present value (PV) of future spending, which GPFC has not yet determined, is merely a placeholder to balance assets and liabilities; as a result, no equity is shown.

Exhibit 8:

GPFC Economic Balance Sheet (in CAF$ billions) 31 December 20x6

Assets		Liabilities and Economic Net Worth
Financial Assets			Financial Liabilities
Investments (includes cash, equities, fixed income, and other investments)	40
Extended Assets			Extended Liabilities
PV of expected future income	60		PV of future spending	100
			Economic Net Worth
			Economic net worth	0
Total	100			100

For GPFC, the amount and timing of funds needed for future distributions to Caflandia citizens are, as yet, unclear. GPFC can currently focus on asset risk and its efficient use to grow assets within the limits of the fund’s risk tolerance. In addition to considering expected return in relation to volatility in selecting an asset allocation, GPFC might include such considerations as the following:

• diversification across global asset classes (possibly quantified as a constraint on the proportion allocated to any given asset classes);

• correlations with the petroleum sources of income to GPFC;

• the potential positive correlation of future spending with inflation and population growth in Caflandia;

• long investment horizon (as a long-term investor, GPFC may be well positioned to earn any return premium that may be associated with the relatively illiquid asset classes); and

• return outcomes in severe financial market downturns.

Suppose GPFC quantifies its risk tolerance in traditional mean–variance terms as willingness to bear portfolio volatility of up to 17% per year. This risk tolerance is partly based on GPFC’s unwillingness to allow the fund to fall below 90% funded. GPFC’s current strategic asset allocation, along with several alternatives that have been developed by its staff during an asset allocation review, are shown in Exhibit 9. The category “Diversifying strategies” consists of a diversified allocation to hedge funds.

Exhibit 9:

GPFC Strategic Asset Allocation Decision22

	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%

Notes: The government bond rate is 3%. The acceptable level of volatility is ≤ 17% per year. The value at risk (VaR) is stated as a percent of the initial portfolio value over one year (e.g., −16% means a decline of 16%).

GPFC decides it is willing to tolerate a 5% chance of losing 22% or more of portfolio value in a given year. This risk is evaluated by examining the one-year 5% VaR of potential asset allocations.

Let us examine GPFC’s decision. The current asset allocation and the alternatives developed by staff all satisfy the GPFC’s tolerance for volatility and VaR limit. The staff’s alternatives appear to represent incremental, rather than large-scale, changes from the current strategic asset allocation. We do not know whether capital market assumptions have changed since the current strategic asset allocation was approved.

Mix A, compared with the current asset allocation, diversifies the equity allocation to include non-domestic (global ex-domestic) equities and spreads the current allocation to real estate over real estate and diversifying strategies. Given GPFC’s long investment horizon and absence of liquidity needs, an allocation to diversifying strategies at 10% should not present liquidity concerns. Because diversifying strategies are more liquid than private real estate, the overall liquidity profile of the fund improves. It is important to note that given the illiquid nature of real estate, it could take considerable time to reallocate from real estate to diversifying strategies. Mix A has a lower volatility (by 133 bps) than the current allocation and slightly lower tail risk (the 5% VaR for Mix A is −15%, whereas the 5% VaR for the current asset mix is −17%). Mix A’s Sharpe ratio is slightly higher. On the basis of the facts given, Mix A appears to be an incremental improvement on the current asset allocation.

Compared with Mix A and the current asset allocation, Mix B increases the allocation to equities by 15 percentage points and pulls back from the allocation to bonds and, in relation to Mix A, diversifying strategies. Although Mix B has a higher expected return and its VaR is within GPFC’s tolerance of 22%, Mix B’s lower Sharpe ratio indicates that it makes inefficient use of its additional risk. Mix B does not appear to deserve additional consideration.

Compared with the current asset allocation and Mix A, Mix C’s total allocation to equities, at 55%, is higher and the mix is more diversified considering the allocation of 25% non-domestic equities. Mix C’s allocation to fixed income is 20% compared with 30% for Mix A and the current asset mix. The remaining fixed-income allocation has been diversified with an exposure to both nominal and inflation-linked bonds. The diversifying strategies allocation is funded by a combination of the reduced weights to fixed income and real estate. The following observations may be made:

• Mix C’s increase in equity exposure (compared with the equity exposure of Mix A and the current mix) has merit because more equity-like choices in the asset allocation could be expected to give GPFC more exposure to such a factor as a GDP growth factor (see Exhibit 9); population growth is one driver of GDP.

• Within fixed income, Mix C’s allocation to inflation-linked bonds could be expected to hedge the inflation risk inherent in future distributions.

• Mix C has the lowest volatility and the lowest VaR among the asset allocations, although the differences compared with Mix A are very small. Mix C’s Sharpe ratio is comparable to (insignificantly higher than) Mix A’s.

Based on the facts given, Mix A and Mix C appear to be improvements over the current mix. Mix C may have the edge over Mix A based on the discussion. As a further step in the evaluation process, GPFC may examine the robustness of the forecasted results by changing the capital market assumptions and simulating shocks to such variables as inflation. The discussion of Mix C shows that there are means for potential liability concerns (the probable sensitivity of spending to inflation and population growth) to enter decision making even from a mean–variance optimization perspective.

EXAMPLE 6

Asset-Only Asset Allocation

1. Describe how the Sharpe ratio, considered in isolation, would rank the asset allocation in Exhibit 9.

   Solution to 1:

   The ranking by Sharpe ratios in isolation is C (3.70), A (3.69), and current and B (both 3.53). Using only the Sharpe ratio, Mix C appears superior to the other choices, but such an approach ignores several important considerations.

2. State a limitation of basing a decision only on the Sharpe ratio addressed in Question 1.

   Solution to 2:

   The Sharpe ratio, while providing a means to rank choices on the basis of return per unit of volatility, does not capture other characteristics that are likely to be important to the asset owner, such as VaR and funded ratio. Furthermore, the Sharpe ratio by itself cannot confirm that the absolute level of portfolio risk is within the investor’s specified range.

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.

   Solution to 3:

   It is true that the higher the Sharpe ratio of an investment, the greater its contribution to the Sharpe ratio of the overall portfolio, holding all other things equal. However, that condition is not usually true. Diversification potential in a portfolio (quantified by correlations) may differ. For example, including both diversifying strategies and real estate in an allocation may ultimately decrease portfolio-level risk through favorable correlation characteristics. Also, as in the solution to Question 2, other risk considerations besides volatility may be relevant.

Financial theory suggests that investors should consider the global market-value weighted portfolio as a baseline asset allocation. This portfolio, which sums all investable assets (global stocks, bonds, real estate, and so forth) held by investors, reflects the balancing of supply and demand across world markets. In financial theory, it is the portfolio that minimizes diversifiable risk, which in principle is uncompensated. Because of that characteristic, theory indicates that the global market portfolio should be the available portfolio that makes the most efficient use of the risk budget.23 Other arguments for using it as a baseline include its position as a reference point for a highly diversified portfolio and the discipline it provides in relation to mitigating any investment biases, such as home-country bias (discussed below).

At a minimum, the global market portfolio serves as a starting point for discussion and ensures that the investor articulates a clear justification for moving away from global capitalization market weights. The global market portfolio is expressed in two phases. The first phase allocates assets in proportion to the global portfolio of stocks, bonds, and real assets. The second phase disaggregates each of these broad asset classes into regional, country, and security weights using capitalization weights. The second phase is typically used within a global equity portfolio where an asset owner will examine the global capitalization market weights and either accept them or alter them. Common tilts (biases) include overweighting the home-country market, value, size (small cap), and emerging markets. For many investors, allocations to foreign fixed income have been adopted more slowly than allocations to foreign equity. Most investors have at least some amount in non-home-country equity.

Home-Country Bias

A given for GPFC was that Caflandia’s equity markets represent only 0.50% of the value of world equity markets. However, in all asset allocations in Exhibit 9, the share of domestic equity ranged from 50% for the current asset allocation to 30% for Mix C. The favouring of domestic over non-domestic investment relative to global market value weights is called home-country bias and is very common. Even relatively small economies feature pension plans, endowments, and other funds, which are disproportionately tilted toward the equity and fixed-income offerings in the domestic market. The same tendency is true for very large markets, such as the United States and the eurozone. By biasing toward the home market, asset owners may not be optimally aligning regional weights with the global market portfolio and are implicitly implementing a market view. Investment explanations for the bias, such as offsetting liabilities that are denominated in the home currency, may be relevant in some cases, however.

For reference, the MSCI All Country World Portfolio (ACWI), a proxy for the public equities portion of the global equity market portfolio, contains the following capitalization weights as of 31 December 2015:

• Developed Europe and the Middle East: 22.8%

• Developed Pacific: 11.7%

• North America: 55.9%

• Emerging markets: 9.6%

Investing in a global market portfolio faces several implementation hurdles. First, estimating the size of each asset class on a global basis is an imprecise exercise given the uneven availability of information on non-publicly traded assets. Second, the practicality of investing proportionately in residential real estate, much of which is held in individual homeowners’ hands, has been questioned. Third, private commercial real estate and global private equity assets are not easily carved into pieces of a size that is accessible to most investors. Practically, proxies for the global market portfolio are often based only on traded assets, such as portfolios of exchange-traded funds (ETFs). Furthermore, some investors have implemented alternative weighting schemes, such as GDP weight or equal weight. However, it is a useful discipline to articulate a justification for any deviation from the capitalization-weighted global market portfolio.