Principles of Asset Allocation

4.
Principles of Asset Allocation

The candidate should be able to:
 describe and evaluate the use of mean–variance optimization in asset allocation

 recommend and justify an asset allocation using mean–variance optimization
 interpret and evaluate an asset allocation in relation to an investor’s economic
balance sheet
 recommend and justify an asset allocation based on the global market portfolio
 discuss the use of Monte Carlo simulation and scenario analysis to evaluate the
robustness of an asset allocation
 discuss asset class liquidity considerations in asset allocation
 explain absolute and relative risk budgets and their use in determining and
implementing an asset allocation
 describe how client needs and preferences regarding investment risks can be
incorporated into asset allocation
 describe the use of investment factors in constructing and analyzing an asset
allocation
 describe and evaluate characteristics of liabilities that are relevant to asset
allocation
 discuss approaches to liability-relative asset allocation
 recommend and justify a liability-relative asset allocation
 recommend and justify an asset allocation using a goals-based approach
 describe and evaluate heuristic and other approaches to asset allocation
 discuss factors affecting rebalancing policy
This reading has surveyed how appropriate asset allocations can be determined to meet the
needs of a variety of investors. Among the major points made have been the following:
The objective function of asset-only mean–variance optimization is to maximize the

expected return of the asset mix minus a penalty that depends on risk aversion and the
expected variance of the asset mix.
Criticisms of MVO include the following:

1. The outputs (asset allocations) are highly sensitive to small changes in the inputs.
2. The asset allocations are highly concentrated in a subset of the available asset
classes.
3. Investors are often concerned with characteristics of asset class returns such as
skewness and kurtosis that are not accounted for in MVO.
4. While the asset allocations may appear diversified across assets, the sources of risk
may not be diversified.
5. MVO allocations may have no direct connection to the factors affecting any liability
or consumption streams.
6. MVO is a single-period framework that tends to ignore trading/rebalancing costs and
taxes.
Deriving expected returns by reverse optimization or by reverse optimization tilted toward
an investor’s views on asset returns (the Black–Litterman model) is one means of
addressing the tendency of MVO to produce efficient portfolios that are not well
diversified.
Placing constraints on asset class weights to prevent extremely concentrated portfolios
and resampling inputs are other ways of addressing the same concern.
For some relatively illiquid asset classes, a satisfactory proxy may not be available;
including such asset classes in the optimization may therefore be problematic.
Risk budgeting is a means of making optimal use of risk in the pursuit of return. A risk
budget is optimal when the ratio of excess return to marginal contribution to total risk is the
same for all assets in the portfolio.
Characteristics of liabilities that affect asset allocation in liability-relative asset allocation

include the following:
1. Fixed versus contingent cash flows

2. Legal versus quasi-liabilities
3. Duration and convexity of liability cash flows
4. Value of liabilities as compared with the size of the sponsoring organization
5. Factors driving future liability cash flows (inflation, economic conditions, interest
rates, risk premium)
6. Timing considerations, such longevity risk
7. Regulations affecting liability cash flow calculations
Approaches to liability-relative asset allocation include surplus optimization, a

hedging/return-seeking portfolios approach, and an integrated asset–liability approach.
1. Surplus optimization involves MVO applied to surplus returns.

2. A hedging/return-seeking portfolios approach assigns assets to one of two portfolios.
The objective of the hedging portfolio is to hedge the investor’s liability stream. Any
remaining funds are invested in the return-seeking portfolio.
3. An integrated asset–liability approach integrates and jointly optimizes asset and
liability decisions.
4. A goals-based asset allocation process combines into an overall portfolio a number
of sub-portfolios, each of which is designed to fund an individual goal with its own
time horizon and required probability of success.
In the implementation, there are two fundamental parts to the asset allocation process. The
first centers on the creation of portfolio modules, while the second relates to the
identification of client goals and the matching of these goals to the appropriate sub-
portfolios to which suitable levels of capital are allocated.
Other approaches to asset allocation include “120 minus your age,” 60/40 stocks/bonds,
the endowment model, risk parity, and the 1/N rule.
Disciplined rebalancing has tended to reduce risk while incrementally adding to returns.
Interpretations of this empirical finding include that rebalancing earns a
1. diversification return,
2. return from being short volatility,
3. and return to supplying liquidity to the market.
Factors positively related to optimal corridor width include transaction costs, risk tolerance,
and an asset class’s correlation with the rest of the portfolio. The higher the correlation, the
wider the optimal corridor, because when asset classes move in sync, further divergence
from target weights is less likely.
The volatility of the rest of the portfolio (outside of the asset class under consideration) is
inversely related to optimal corridor width.
An asset class’s own volatility involves a trade-off between transaction costs and risk
control. The width of the optimal tolerance band increases with transaction costs for
volatility-based rebalancing.

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4.

Principles of Asset Allocation

 describe and evaluate the use of mean–variance optimization in asset allocation

The objective function of asset-only mean–variance optimization is to maximize the

Criticisms of MVO include the following:

Characteristics of liabilities that affect asset allocation in liability-relative asset allocation

1. Fixed versus contingent cash flows

Approaches to liability-relative asset allocation include surplus optimization, a

1. Surplus optimization involves MVO applied to surplus returns.

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