CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 CFA 2018 r16 introduction to asset allocation IFT notes

R16 Introduction to Asset Allocation

IFT Notes

Introduction to Asset Allocation
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1. Introduction .............................................................................................................................................. 3
2. Asset Allocation: Importance in Investment Management ...................................................................... 3
3. The Investment Governance Background to Asset Allocation .................. Error! Bookmark not defined.
3.1 Governance Structures ........................................................................ Error! Bookmark not defined.
3.2 Articulating Investment Objectives..................................................................................................... 4
3.3 Allocation of Rights and Responsibilities ............................................. Error! Bookmark not defined.
3.4 Investment Policy Statement ............................................................... Error! Bookmark not defined.
3.5 Asset Allocation and Rebalancing Policy .............................................. Error! Bookmark not defined.
3.6 Reporting Framework .......................................................................... Error! Bookmark not defined.
3.7 The Governance Audit ........................................................................................................................ 7
4. The Economic Balance sheet and Asset Allocation................................................................................... 8
5. Approaches to Asset Allocation ................................................................................................................ 9
5.1 Relevant Objectives .......................................................................................................................... 10
5.2 Relevant Risk Concepts ..................................................................................................................... 11
5.3 Modeling Asset Class Risk ................................................................................................................. 12
6. Strategic Asset Allocation ....................................................................................................................... 15
6.1 Asset Only ............................................................................................ Error! Bookmark not defined.
6.2 Liability Relative ................................................................................... Error! Bookmark not defined.
6.3 Goals Based ....................................................................................................................................... 20
7. Implemention Choices ............................................................................... Error! Bookmark not defined.
7.1 Passive/Active Management of Asset Class Weights .......................... Error! Bookmark not defined.
7.2 Passive/Active Management of Allocations to Asset Classes .............. Error! Bookmark not defined.
7.3 Risk Budgeting Perspectives in Asset Allocation and Implementation Error! Bookmark not defined.
8. Rebalancing: Strategic Considerations....................................................... Error! Bookmark not defined.

8.1 A Framework for Rebalancing .............................................................. Error! Bookmark not defined.
8.2 Strategic Considerations in Rebalancing .............................................. Error! Bookmark not defined.
Summary from the Curriculum ..................................................................................................................... 8
Examples from the Curriculum ................................................................................................................... 31
Example 1. Investment Governance: Hypothetical Case (1)................................................................... 31
Example 2. Investment Governance: Hypothetical Case (2)...................... Error! Bookmark not defined.
Example 3. The Economic Balance Sheet of Auldberg University Endowment ...................................... 30
Example 4. Asset Classes (1) ................................................................................................................... 31
Example 5. Assset Classes (2) ..................................................................... Error! Bookmark not defined.
Example 6. Asset-Only Asset Allocation..................................................... Error! Bookmark not defined.
Example 7. Goals-Based Asset Allocation .................................................. Error! Bookmark not defined.
Example 8. Implementation Choices (1) .................................................... Error! Bookmark not defined.
Example 9. Implementation Choices (2) .................................................... Error! Bookmark not defined.
Example 10. Different Rebalancing Ranges ............................................... Error! Bookmark not defined.

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R16 Introduction to Asset Allocation

IFT Notes

This document should be read in conjunction with the corresponding reading in the 2018 Level III CFA®
Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright
2017, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved.
Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the

products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are
trademarks owned by CFA Institute.

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1. Introduction
This reading is a part of a sequence of three readings that will cover asset allocation. The role of this
introductory reading is to provide us a ‘big picture’ of asset allocation. In the next reading ‘Principles of
Asset Allocation’ we will learn ‘how’ to develop an asset allocation and in the third reading ‘Asset
Allocation with Real-World Constraints’ we will learn about the real-world challenges in developing an
asset allocation.

2. Asset Allocation: Importance in Investment Management
Asset allocation is generally defined as the allocation of an investor’s portfolio across a number of asset
classes. Investment performance depends on asset allocation and its implementation, which implies
that the asset allocation is one of the most important decisions in the investment process. Exhibit 1
below shows that in portfolio management process, the investment opportunity set (on the right)
should match the investor’s objectives (on the left).
As reflected on the left hand-side of the Exhibit 1, we first need to identify and articulate the asset
owner’s objectives by understanding his economic balance sheet, investment constraints, and
preferences. Once the objectives are identified, these need to be properly documented in the IPS.

Besides investment objectives and constraints, IPS should identify rules and responsibilities, pre-defined
review process and rebalancing strategies, and other principles related to investment management
process. Simultaneously, as shown on the right hand side, we also need to develop capital market
expectations for the appropriate planning horizon of asset owner. Both of these activities help us in
creating a structure of a portfolio, which includes the following:
1) Strategic asset allocation (e.g. 60% allocation to equities, 30% allocation to bonds, and 10% to
commodities).
2) Active risk budgets, based on risk tolerance of an asset owner.
3) Manager selection
4) Security selection
5) Execution of portfolio, which involves the actual creation of the portfolio.
The lower section of left hand-side of Exhibit 1 reflects that with passage of time, we need to identify
changes in the economic balance sheet, objectives and constraints of asset because any changes in the
asset owner objectives and constraints would impact the IPS and which would subsequently affect the
portfolio structure. At the same time, we also need to monitor changes in asset prices and markets (if
any) because any changes in prices or market conditions would have an impact on market expectations
which would subsequently affect the asset allocation.
The lower part of Exhibit 1 shows that we need to evaluate progress towards achieving objectives and
compliance with IPS on a regular basis to ensure that the portfolio structure is align with the asset
owner objectives through time.
The entire asset allocation process rests on the foundation of strong investment governance, which
includes the assignment of investment decision making authority to qualified individuals as well as the
oversight of this entire process.

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IFT Notes

Source: CFA Curriculum.

3 THE INVESTMENT GOVERNANCE BACKGROUND TO ASSET ALLOCATION
Investment governance is the structure which helps ensure that assets are invested to achieve the asset
owner’s investment objectives within the asset owner’s risk tolerance and constraints. Investment
governance focuses on the organization of decision-making responsibilities and oversight activities and
compliance of investment actions with laws and regulations. Good investment governance practices
(such as clear articulation of roles and responsibilities) allow investment managers to better achieve the
asset owner’s stated goals by aligning his asset allocation and implementation processes.

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3.1 Governance Structures
Governance and management are separate but related functions. Governance involves specifying the
mission, creating a plan, and reviewing progress; whereas, management focuses on execution of the
plan to achieve agreed-on goals.

A common governance structure in an institutional investor context has the following three levels
within the governance hierarchy:
1. governing investment committee
2. investment staff
3. third-party resources
This section addresses LO.a:
LO.a: Describe elements of effective investment governance and investment governance
considerations in asset allocation;
Elements of effective investment governance: The effective investment governance models perform
the following tasks:
1) Articulate the long- and short-term objectives of the investment program.
2) Allocate decision rights and responsibilities among the functional units in the governance hierarchy
effectively depending on their knowledge, capacity, time, and position in the governance hierarchy.
3) Specify processes for developing and approving the investment policy statement that will govern the
day-to- day operations of the investment program.
4) Specify processes for developing and approving the program’s strategic asset allocation.
5) Establish a reporting framework to monitor the program’s progress toward the agreed-on goals and
objectives.
6) Undertake a governance audit on periodic basis.
Over the next few sections we will discuss each of these elements in detail.
Instructor’s tip: You can use the acronym ‘ODISRA’ to remember these steps.

3.2 Articulating Investment Objectives
Long-term and short-term objectives clarify what an investor is trying to achieve and give context to the
return requirement. In coming up with these investment objectives we need to:





Determine and communicate risk tolerance
Consider cash inflows and outflow characteristics
Consider liquidity needs
Find the best risk-return trade-off, given constraints and risk tolerance.

Examples of investment objectives linked with purposes/goals:
1. Defined benefit pension fund. The investment objective of the fund is to ensure that sufficient plan
assets are available to meet current and future pension liabilities.
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2. Endowment fund. The investment objective of the endowment is to earn a rate of return that
exceeds the spending rate plus the costs of managing the investment fund, expressed in real (or
inflation adjusted) terms.
3. Individual investor. The investment objective of an individual investor is to earn a rate of return that
will fund his retirement needs, family needs, bequests etc, taking into account his risk tolerance and
investment constraints.

3.3 Allocation of Rights and Responsibilities
Effective investment governance rests on the proper allocation of rights and responsibilities across the
governance hierarchy. The decision of allocation of these rights and responsibilities is generally
determined at the highest level of investment governance, depending on the available knowledge and

expertise at each level of the hierarchy, the resource capacity of the decision makers, and the ability to
act on a timely basis. The resource availability has an impact on the scope and complexity of the
investment program.
The table below summarizes the allocation of duties and responsibilities from mission development to
investment governance audit.
Exhibit 2: Allocation of Rights and Responsibilities (reproduced from CFA Curriculum)
Investment Activity
Mission
Investment Policy Statement
Asset allocation Policy
Investment manager and
other service provider
selection
Portfolio construction
(individual asset selection)
Monitoring asset prices &
portfolio rebalancing

Investment Committee

Investment Staff

Craft and approve

n/a

n/a

Approve
Approve with input from

staff and consultant

Draft
Draft with input from
consultants
Research, evaluation, and
selection of investment
managers and service
providers

Consultants provide input

Delegate to outside
managers, or to staff if
sufficient internal resources

Execution if assets are
managed in-house

Execution by independent
investment manager

Delegate to staff within
confines of the investment
policy statement

Assure that the sum of all
sub-portfolios equals the
desired overall portfolio
positioning; approve and

execute rebalancing

Consultants and custodian
provide input

Approve principles and
conduct oversight

Create risk management
infrastructure and design
reporting

Investment manager
manages portfolio within
established risk guidelines;
consultants may provide
input and support

Oversight

Ongoing assessment of
managers

Consultants and custodian
provide input

Oversight

Evaluate manager’s
continued suitability for

assigned role; analyze
sources of portfolio return

Consultants and custodian
provide input

Delegate to investment staff;
approval authority retained
for certain service providers

Risk management

Investment manager
monitoring
Performance evaluation and
reporting

Third-party Resource

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Consultants provide input

Consultants provide input

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R16 Introduction to Asset Allocation
Governance audit
Commission and assess

Responds and corrects

IFT Notes
Investment Committee
contracts with an
independent third party for
the audit

3.4 Investment Policy Statement
The investment policy statement (IPS) is the foundation of an effective investment program. Typical
features of an IPS include the following:
1) Introduction –Describes the purpose and scope of the document itself and the asset owner. It may
also provide information about the following:
 business environment in which the asset owner operates and the sources and uses of
program assets;
 laws and regulations that govern the investment program;
2) Investment objective statement- Specifies an asset owner’s philosophy with respect to pursuing
investment returns subject to his investment constraints.
3) Investment constraints – Specifies the constraints that directly affect the asset allocation decision of
the asset owner, i.e. liquidity requirements, time horizon, tax concerns, legal and regulatory factors,
and unique circumstances. (LLTTU)
4) Allocation of decision rights and responsibilities among the investment committee, investment staff,
and any third-party service providers.
5) Investment guidelines that are needed to be followed in implementation (e.g., permissible use of
leverage and derivatives, exclusion of specific types of assets etc).
6) Frequency and nature of reporting to the investment committee and to the board of directors.

7) Risk management framework – specifying the overall level of risk that is acceptable and providing
guidance in the allocation of that risk budget among asset classes.

3.5 Asset Allocation and Rebalancing Policy
The IPS should contain the information relevant to rebalancing (i.e. rebalancing policy) as the
specification of rebalancing responsibilities reflects good governance. For example, in case of
institutional investors, the rebalancing policy may be the responsibility of the investment committee,
organizational staff, or the external consultant. Likewise, for individual investors, the rebalancing policy
may be delegated to an investment adviser.

3.6 Reporting Framework
A reporting framework is necessary to evaluate how well the investment program is progressing toward
the agreed-on goals and objectives. It should address performance evaluation, compliance with
investment guidelines, and progress toward achieving the stated goals and objectives.
Key elements of a reporting framework:
a) Benchmarking: Effective benchmarking facilitates the investment committee in performance
measurement, attribution, and evaluation of staff as well as external managers. There can be two
separate levels of benchmarks
i.
Benchmark that measures the performance of the investment managers relative to the
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purpose for which they were hired;
ii.
Benchmark that measures the gap between the policy portfolio and the portfolio as actually
implemented.
b) Management reporting: It provides information about performance of different segments of the
portfolio and adherence to investment guidelines. This reporting is generally prepared by the staff
with inputs from consultants and custodians.
c) Governance reporting: Governance reporting helps identifying the strengths and weaknesses of the
program execution. . It should be structured in a simpler manner so that any weaknesses that are
identified can be addressed relatively easily.

3.7 The Governance Audit
The governance audit is performed by an independent third party (called the governance auditor) to
examine the fund’s governing documents, assess the capacity of the organization to execute effectively
within the confines of those governing documents, and evaluate the efficiency of existing portfolio given
the governance constraints.
Besides ensuring accountability in investment management process, the good investment governance
provides the following benefits:




Good investment governance helps the investment committee to avoid “decision-reversal risk”,
which is the risk of reversing a selected course of action at the wrong time (or at the point of
maximum loss). This is done by providing new committee members with proper orientation sessions
so that they are able to easily perceive the design and intent of the investment program and
continue to execute it.
Good investment governance helps avoid the “key person risk”, which is the risk of overreliance on
any one staff member or long-term, illiquid investments dependent on a staff member.

See Example 1, which helps in identifying facts, consistent with effective investment governance,
needed in making investment decisions as well as the possible deficiencies in investment governance.
Refer to Example 1 from the curriculum.
Refer to Example 2 from the curriculum which discusses about governance practices in investment
management.

4 THE ECONOMIC BALANCE SHEET AND ASSET ALLOCATION
This section addresses LO.b:
LO.b: prepare an economic balance sheet for a client and interpret its implications for asset allocation;
In order to develop an appropriate asset allocation, it is necessary to consider both the financial
portfolio and extended portfolio asset and liabilities of asset owners.
Unlike conventional balance sheet which comprises financial asset and liabilities, an economic balance
sheet includes both the financial assets / liabilities and extended portfolio assets and liabilities that are

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relevant in making asset allocation decisions.
Components of economic balance sheet of individual investors:



Extended portfolio assets include human capital (the present value of future earnings), the
present value of pension income, and the present value of expected inheritances.
Extended portfolio liability includes present value of future consumption.

Components of economic balance sheet of institutional investors:



Extended portfolio assets would include items like underground mineral resources or the
present value of future intellectual property royalties.
Extended portfolio liabilities would include items like the present value of prospective payouts
for foundations.

Refer to Example 3 from the curriculum.

5 APPROACHES TO ASSET ALLOCATION
There are three broad approaches to asset allocation:
1. Asset-only (AO) approaches: AO approaches only focus on the asset side of the investor’s balance
sheet and do not take into account the liabilities. Most common example of AO approach is Mean–
variance optimization (MVO) which considers only the expected returns, risks, and correlations of
the asset classes in the investment opportunity set.
2. Liability-relative (LR) approaches: In LR approach, asset allocation considers both the risk
characteristics of the liabilities and assets. This approach focuses on funding the liabilities. This
approach is also known as liability-driven investing (LDI). An example of LR approach is surplus
optimization wherein the objective is to maximize growth of the surplus (value of the investor’s
assets - present value of the investor’s liabilities) for a given level of risk to the surplus (or deficit).
Another example is a liability-hedging portfolio which focuses on funding liabilities and, any
additional funds (also known as “return-seeking portfolio”) are invested in risky assets that can
generate a return above and beyond the liability benchmark.

3. Goals-based approaches: In goals-based approaches, asset allocations focus on addressing an
investor’s goals. For this purpose, sub-portfolios of an investor, reflecting various goals ranging from
supporting lifestyle needs to aspirational have their own specific asset allocation. This approach is
also known as Goals-based investing (GBI).
Distinctions between liabilities for an institutional investor and goals for an individual investor: Before
discussing the investment objectives of these three asset allocation approaches, it is important to
understand distinctions between liabilities for an institutional investor and goals for an individual
investor.
Institutional Investor Liabilities
Legal obligations or debts;

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Individual Investor Goals
Goals, such as meeting lifestyle or aspirational
objectives, are not obligations;

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Institutional liabilities, such as life insurer
obligations or pension benefit obligations, are
uniform in nature

An individual’s goals may be many and varied;

Liabilities of institutional investors of a given type
(e.g., the pension benefits owed to retirees) are
often numerous and so, through averaging, may
often be forecast with confidence

Individual goals are not subject to the law of large
numbers and averaging;

5.1 Relevant Objectives
This section addresses LO.c:
LO.c: Compare the investment objectives of asset-only, liability-relative, and goals-based asset allocation
approaches;
Exhibit 5: Asset Allocation Approaches: Investment Objective
Asset Allocation Approach
Asset only

Relation to Economic
Balance Sheet
Ignore liabilities or investor’s
goals

Typical Objective
Maximize Sharpe ratio for
acceptable level of risk

Liability-relative

Takes into account legal and

quasi-liabilities

Fund liabilities to meet
obligations and invest excess
assets for growth

Goals based

Takes into account investor’s
goals (or extended liabilities)

Achieve goals with specified
required probabilities of
success

Typical Uses and Asset
Owner Types
Use: focus on simplicity
Asset owner types:
 Some foundations,
endowments
 Sovereign wealth funds
 Individual investors
Use: focus on meeting
liability obligations as the
penalty for not meeting
them is high.
Asset owner types:
 Banks
 Defined benefit

pensions
 Insurers
Individual investors

5.2 Relevant Risk Concepts
This section addresses LO.d:
LO.d: Contrast concepts of risk relevant to asset-only, liability-relative, and goals-based asset allocation
approaches;

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Asset Allocation Approaches: Investment Risk
Asset Allocation Approach
Asset only

Relation to Economic Balance Sheet
Does not explicitly model liabilities or
goals







Liability-relative

Models legal and quasi-liabilities



Goals based

Models goals






Relevant Risk Concepts
Volatility (standard deviation) of portfolio return,
which depend on asset class volatilities and
correlation
risk relative to benchmarks, e.g. tracking risk or
tracking error;
downside risk, measures through semi-variance,
peak-to- trough maximum drawdown, value-atrisk (VAR);
Monte Carlo simulations, i.e. we can change
variables and analyze the impact on outcomes;
Shortfall risk to measure whether assets are

sufficient to pay obligations when due;

Risk of failing to achieve goals
Risk limits: Maximum acceptable probability of
not achieving a goal or minimum probabilities of
failure (risk of failing to achieve goals);
Overall portfolio risk is the weighted sum of the
risks associated with each goal;

5.3 Modeling Asset Class Risk
An asset class can be defined as a set of assets that have similar characteristics, attributes, and
risk−return relationships.
There are three broadly defined asset “super-classes”:
1) Capital assets: Capital assets provide a source of ongoing value (e.g. interest or dividends). As a
result, these may be valued based on the net present value of their expected returns. Equities and
fixed income are examples of capital assets.
2) Consumable/transformable assets: Consumable/transformable asset is one that can be consumed
or transformed into another asset as part of a production process. The value of a
consumable/transformable asset is based on its supply and demand. Commodities (such as grains,
metals and energy products) are examples of consumable/transformable assets.
3) Store of value assets: Store of value asset is one that does not generate cash flow and is not used as
an economic input. Their economic value can only be realized through sale or transfer. Art and
currencies are examples of store of value assets.
Note: While these three asset super-classes are by definition distinct, the lines between them are blur in
real life as many assets contain characteristics of two or even (as in the case of gold) all three
definitions.

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Refer to Example 4 from the curriculum.
This section addresses LO.e:
LO.e: explain how asset classes are used to represent exposures to systematic risk and discuss criteria
for asset class specification;
Criteria for asset class specification: For the purpose of asset allocation, we can specify the asset classes
using the following five criteria:
1. Homogeneous: Assets within an asset class should be relatively homogeneous, which means they
should have similar attributes. Example: Common Stocks and Equities.
2. Mutually exclusive: Asset classes should be mutually exclusive, which means they should not be
overlapping. Example: if one asset class for a US investor is domestic common equities, then world
equities ex-US is more appropriate as another asset class rather than global equities, which include
US equities.
3. Diversifying: Asset classes should be diversifying, which means that the included asset class should
not have extremely high expected correlations with other asset classes or with a linear combination
of other asset classes. For this purpose, it is preferable to assess return series’ correlations during
times of financial market stress.
4. Investable Wealth: The asset classes as a group should make up a majority of world investable
wealth. In other words, the asset classes should be exhaustive (include everything).
5. Portfolio’s Liquidity: Asset classes selected for investment should have the capacity to absorb a
significant proportion of an investor’s portfolio without seriously affecting the portfolio’s liquidity.
Asset Classes in Practice: A typical list of asset classes includes the following.







Global public equity—composed of developed, emerging, and sometimes frontier markets and
large-, mid-, and small-cap asset classes; can be further divided by several sub-asset classes (e.g.,
domestic and non-domestic).
Global private equity—includes venture capital, growth capital, and leveraged buyouts (investment
in special situations and distressed securities).
Global fixed income—includes developed and emerging market debt and further divided into
sovereign, investment-grade, and high-yield sub-asset classes, cash and short-duration securities
and sometimes inflation-linked bonds (unless included in real assets as mentioned below).
Real assets—include assets that provide sensitivity to inflation, such as private real estate equity,
private infrastructure, commodities, and sometimes global inflation-linked bonds.

It is pertinent to note that hedge funds are not an asset class. Hedge funds encompass a wide variety of
investment strategies and through these different strategies, they invest in traditional asset classes,
such as equity, debt, property, commodities and cash. Therefore, hedge funds should be treated as a
category called “strategies” or “diversifying strategies.” Unlike strategies, asset classes generally provide
an inherent, non-skill-based ex ante expected return premium.
Refer to exhibit 6 below, reflecting examples of asset classes and sub-asset classes. Sub-asset class
choices become relevant when the investor moves from the strategic asset allocation phase to policy
implementation.

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Source: CFA Curriculum.
To achieve a diversified portfolio, it is preferred to use broadly defined asset classes with fewer risk
source overlaps, e.g. US and non-US equity asset classes would have fewer overlap in the sources of risk
as compared to US large-cap equity and US small-cap equity.
Refer to Example 5 from the curriculum.
This section addresses LO.f:
LO.f: explain the use of risk-factors in asset allocation and their relation to traditional asset class – based
approaches;
In mean–variance optimization, asset allocation is based on asset classes (e.g., global public equity,
global private equity, global fixed income, and real assets) taking into account their expected return,
return volatility, and return correlation estimates. The drawback of using asset classes as the unit of
analysis in asset allocation is that it may result in portfolio’s sensitivity to overlapping risk factors. For
example, in Exhibit 7 below, we can observe that even broadly defined asset classes (that is, US equity
and US Corporate Bonds) have some common risk factor exposures, such as both asset classes are
exposed to currency risk, inflation, etc. However, some factor exposures are not common between two
asset classes, such as, unlike US Corporate Bonds, US Equity is exposed to GDP growth. Due to common
factor exposures, the correlation between these two asset classes is not zero.

Source: CFA Curriculum.

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In contrast, in factor-based approaches, asset allocations are based on risk factors and the desired
exposure to each factor and thus, asset classes are described with respect to their sensitivities to each of
the risk factors.

Factor Representation: The following are a few examples of how risk factor exposures can be
achieved.






Inflation. The inflation component can be isolated by going long nominal Treasuries and short
inflation-linked bonds.
Real interest rates. Inflation-linked bonds provide a proxy for real interest rates.
US volatility. VIX (Chicago Board Options Exchange Volatility Index) futures provide a proxy for
implied volatility.
Credit spread. Credit exposure can be isolated by going long high-quality credit and short
Treasuries/government bonds.
Duration. Duration exposure can be isolated by going long 10+ year Treasuries and short 1–3 year
Treasuries.

Factor Models in Asset Allocation: The interest in using factors for asset allocation stems from:








The desire to shape the asset allocation based on goals and objectives that cannot be expressed by
asset classes. For example, if an investor’s goal is focused on inflation, then simply investing in
equities or bonds will not satisfy this goal. In this case, a portfolio needs to be created that is
focused on this particular risk factor.
An intense focus on portfolio risk in all of its various dimensions, helped along by availability of
commercial factor-based risk measurement and management tools. This implies that factor models
become important if an investment manager is not willing to take exposure to all the risk factors
associated with, say US Equities, and wants to focus on particular risk factor.
The acknowledgment that many highly correlated so-called asset classes are better defined as parts
of the same high-level asset class. In other words, some investors might define US Equities and Non
US Equities as different asset classes but considering the risk factors associated with these two asset
classes, it would be more appropriate to treat them as part of the same asset class, that is, global
equity.
The realization that equity risk can be the dominant risk exposure even in a seemingly welldiversified portfolio.

6 STRATEGIC ASSET ALLOCATION
Strategic asset allocation or policy allocation: Asset allocation that is expected to be effective in
achieving investment objectives given investment constraints and risk tolerance.
Optimal asset allocation maximizes utility of ending wealth subject to constraints.
Steps of selecting a strategic asset allocation: Selecting a strategic asset allocation involves the
following steps:

1. Formulate the investor’s objectives (in quantitative terms)

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2.
3.
4.
5.
6.
7.
8.

Formulate the investors risk tolerance (in quantitative terms).
Determine the investment horizon(s).
Determine constraints that may impact asset allocation choices.
Determine most suitable approach to asset allocation (i.e. AO, LR, GB) 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 further consideration.
Evaluate the potential results in relation to investment objectives and risk tolerance over
appropriate planning horizon(s) for the different asset allocations developed in Step 7 as well as the
sensitivity of the outcomes to changes in capital market expectations.

9. Iterate back to Step 7 until an appropriate and agreed-on asset allocation is constructed.
This section addresses LO.g:
LO.g: select and justify an asset allocation based on an investor’s objectives and constraints;

6.1 Asset Only
Asset-only allocation is based on mean-variance optimization which focuses on maximizing expected
(mean) return at a given level of risk (variance). 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.
Example: GPFC, A Sovereign Wealth Fund
The emerging country of Cafastan has established a sovereign wealth fund (name: Government
Petroleum Fund of Cafastan (GPFC)) to earn revenue from its abundant petroleum reserves. The details
are as under:
 Tax status: Non-taxable.
 Refer to exhibit 8 below, reflecting Economic Balance Sheet of GPFC.

Source: CFA Curriculum.
Before selecting an appropriate asset allocation for GPFC, it is important to consider the following:

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








IFT Notes

Promote a fair sharing of the benefits between current and future generations;
The amount and timing of funds needed for future distributions to Cafastan citizens are, as yet, not
clear.
Diversification across global asset classes;
Correlations with the petroleum sources of income to GPFC;
The potential positive correlation of future spending with inflation and population growth in
Cafastan;
Long investment horizon and no liquidity needs;
return outcomes in severe financial market downturns

Risk tolerance: GPFC is willing to bear volatility of up to 17% and 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.
Evaluate the following current strategic asset allocation of GPFC and the three alternatives to determine
which asset mix can provide an incremental improvement on the current asset allocation.

Source: CFA Curriculum.

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Alternative

Mix A









Mix B





Mix C











Pros
10% allocation to diversifying strategies does not
pose liquidity risk owing to GPFC’s long investment
horizon and absence of liquidity needs.
Lower allocation to private real estate (10% v/s 20%
current) would improve overall liquidity profile of the
fund.
lower volatility (14.2%) than the current allocation
(15.57%).
Lower tail risk (VaR −15%) against VaR of -17% for
the current asset mix.
Higher Sharpe ratio compared with current asset
mix.
Higher allocation to equities and lower allocation to
bonds and diversifying strategies in relation to Mix A
may result in higher expected return.
VaR (-18.5%) is > in relation with current mix and mix
A but within GPFC’s tolerance of 22%.

Higher allocation to equities (55%) – potential for
higher expected return and providing exposure to
such a factor as a GDP growth factor.
More diversified mix, reflected by 25% allocation in
non-domestic equities.
Fixed-income allocation has been diversified with an
exposure to both nominal and inflation-linked bonds
– providing hedge against inflation risk inherent in

future distributions.
Reduced weight in real estate (illiquid in nature).
Lowest volatility and the lowest VaR among the asset
mixes.
Sharpe ratio is slightly or insignificantly higher than
Mix A’s.

IFT Notes

Cons
Since real estate is
illiquid, it could be
difficult to reallocate
from real estate to
diversifying strategies
in short time.

Decision
Should be considered as it
provides an incremental
improvement on the
current asset allocation.

Lower Sharpe ratio
(0.353) in comparison
with current mix and
mix A – indicating
that this mix makes
inefficient use of its
additional risk.

Should not be considered as
it does not provide
incremental improvement.

Should be considered as it
has edge over other asset
mixes.

Refer to Example 6 from the curriculum.
Global Market Portfolio
This section addresses LO.h:
LO.h: describe the use of the global market portfolio as a baseline portfolio in asset allocation;
The global market portfolio (GMP) represents the global market for investable asset classes broken
down by their share of the global market. The global market-value weighted portfolio can be considered
as a baseline asset allocation. According to the two-fund separation theorem, all investors optimally
hold a combination of a risk-free asset and an optimal portfolio of all risky assets. This optimal portfolio
is the global market value portfolio.
Investing in the global market portfolio is done in two steps, i.e.
i.
Step 1: The assets are allocated in the portfolio in proportion to the global portfolio of stocks,

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IFT Notes

bonds, and real assets.
Step 2: Each of these broad asset classes are broken down into regional, country, and security
weights using capitalization weights.

Most commonly used proxy for a global market portfolio is an exchange-traded fund (ETF). Investors can
deviate from global portfolio by e.g. overweighting the home-country market, value, size (small cap),
and emerging markets.
Implementation hurdles in investing in a global market portfolio:
1) Size of each asset class on a global basis cannot be precisely determined due to uneven availability
of information on non-publicly traded assets.
2) It is practically difficult to invest proportionately in residential real estate.
3) Private commercial real estate and global private equity assets cannot be easily carved into portions
that is accessible to most investors.

6.2 Liability Relative
Let us examine the following example of defined benefit (DB) pension plan of (hypothetical) GPLE
Corporation for understanding liability-relative approach.






GPLE Corporation Pension: GPLE is a machine tool manufacturer with a market value of $2 billion.
GPLE is the sponsor of a $1.25 billion legacy DB plan, which is now frozen (i.e., no new plan

participants and no new benefits accruing for existing plan participants). GPLE Pension has a funded
ratio of 1.15. Thus, the plan is slightly overfunded. Responsibility for the plan’s management rests
with the firm’s treasury department.
Tax status: Non-taxable.
Capital market assumptions indicate that equities have a significantly higher expected return and
volatility than fixed income.
Exhibit 10 below shows the economic balance sheet of GPLE.

Source: CFA Curriculum.
 Factor to consider for choosing asset allocation: Pensioners want to receive the stream of promised
benefits with as little risk, or chance of interruption, as possible;
GPLE, the plan sponsor, receives two asset allocation recommendations, as explained below.

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Recommendation
Recommendation A

Description
does not explicitly
consider GPLE’s
pension’s
liabilities; based on
an asset-only

approach;

Asset allocation
65% allocation to
global equities and a
35% allocation to
global fixed income;





Recommendation B

explicitly consider
liabilities by
incorporating a
liability-hedging
portfolio;





$1.125 billion or
90% allocation to a
fixed-income
portfolio, i.e. equal
to present value of
plan liabilities

(liability hedging
portfolio);
a $0.125 or 10%
allocation to
equities (the
return-seeking
portfolio).



Pros
This asset
allocation is
mean–variance
efficient and has
the highest
Sharpe ratio
may increase the
size of the buffer
between pension
assets and
liabilities.
However, it is
important to
know that any
increase in buffer
would not benefit
the sponsors if
the current buffer
is adequate.

No substantial
contribution risk
because the risk
characteristics of
the $1.125 billion
fixed-income
portfolio are
closely matched
with those of the
$1.087 billion of
pension liabilities
with a buffer;

IFT Notes
Cons
Subject to
contribution risk
for the plan,
because
with a 0.65 × $1.25
billion = $0.8125
allocation to equities
and a current buffer
of assets of $1.25
billion – $1.087 billion
= $0.163 billion, a
decline of that
amount or more in
equity values (a 20%
decline) would make

the plan status into
underfunded;




lies below the
asset-only
efficient frontier
with a
considerably
lower expected
return vis-à- vis
Recommendation
A;

Conclusion: Since interest rates are a major financial market driver of both liability and bond values, the
LR approaches put more weight to fixed income in asset allocation, for frozen DB in particular). In case
of underfunded plans, the potential upside of equities may have greater value for the plan sponsor than
in the fully funded case that we examined.
Liability Glide Paths: A liability glide path is a technique which is used for underfunded plans. In this
technique, the plan sponsor specifies in advance the desired proportion of liability-hedging assets and
return-seeking assets and the duration of the liability hedge as funded status changes and contributions
are made. This technique helps in increasing the funded status by reducing surplus risk over time.

6.3 Goals Based
As goals-based asset allocation has advanced, various classification systems for goals have been
proposed. Two of those classification systems are as follows.

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Brunel (2012):
 Personal goals—to meet current lifestyle requirements and unanticipated financial needs
 Dynastic goals—to meet descendants’ needs
 Philanthropic goals
Chhabra (2005):
 Personal risk bucket—to provide protection from a dramatic decrease in lifestyle. It is allocated in
safe-haven investments.
 Market risk bucket—to ensure maintenance of current lifestyle. It is allocated in average riskadjusted market returns investments.
 Aspirational risk bucket—to increase wealth substantially. It is allocated in high risk assets.
Let us discuss the following example of hypothetical Lee family to understand some thematic elements
of a goals-based approach.
Narrative: Ivy is a 54-year-old life sciences entrepreneur. Charles is 55 years old and employed as an
orthopedic surgeon. They have two unmarried children aged 25 (Deborah) and 18 (David). Deborah has
a daughter with physical limitations.
The Lees’ lifestyle goal is split into three components:
1) “lifestyle—minimum”: It provides protection for the Lees’ lifestyle in a disaster scenario.
2) “lifestyle—baseline”: It involves meeting needs outside of worst cases.
3) “lifestyle—aspirational”: It aims for a markedly higher lifestyle.
Refer to exhibit 11 and 12 below, reflecting Lee’s economic balance sheet and required probability of
meeting goals and their time horizons, respectively. Note that for the Lees, the value of assets is greater

than the value of liabilities, resulting in a positive economic net worth.

Source: CFA Curriculum.

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From Exhibit 11, we can observe that Lee family has $18 million of economic net worth, most of this
comes from the $16 million extended asset of human capital.
From Exhibit 11, we can identify the following four goals totaling $24 million in present value terms:
1)
2)
3)
4)

Lifestyle goal ($20 million in present value terms);
Education goal ($0.25 million);
Charitable goal ($0.75 million);
Special needs trust ($3 million).

The PV of expected future earnings (human capital) at $16 million < lifestyle PV of $20 million, which
means that some part of the investment portfolio is required to fund the Lees’ standard of living.

In goals-based approach, Lees’ lifestyle goals are addressed with three sub-portfolios with following
characteristics, in line with associated time horizons and required probabilities of not attaining these
goals. For example, the sub-portfolio associated with the longest horizon goal can have less liquid and
high risk investments. Similarly, to meet short-term lifestyle and education goals, the portfolio allocation
should comprise of liquid and stable investments, e.g. cash, fixed income bonds.
Refer to Example 7 from the curriculum.

7 IMPLEMENTATION CHOICES
This section addresses LO.i:
LO.i: discuss strategic implementation choices in asset allocation, including passive/active choices and
vehicles for implementing passive and active mandates;
There are two dimensions of passive/active choices:
1) Managing the strategic asset allocation, that is, whether to deviate from it tactically or not. This
includes tactical and dynamic asset allocation.
2) Passive and active implementation choices in investing the allocation to a given asset class.

7.1 Passive/Active Management of Asset Class Weights
Strategic asset allocation: Strategic asset allocation involves a target asset mix based on an investor's
expected rate of return and risk tolerance, and the long-term performance of different asset classes.
Investment portfolios are periodically rebalanced to restore the target or long-term asset mix.
Rebalancing is not done to respond to market conditions.
Dynamic asset allocation: Dynamic asset allocation may involve several portfolio adjustments in
response to longer-term valuation signals or economic views. There is no target asset mix because
portfolio managers can change allocations based on their assessments of current and future market
trends.
Tactical asset allocation: Tactical asset allocation (TAA) involves making short-term deviations from the
strategic asset allocation based on short-term expected relative performance among asset classes with
the objective of increasing return and/or reducing risk. Hence, TAA is active management at the asset

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class level. Generally, the deviations in TAA are kept within a certain range or risk budget. This implies
that if risk tolerance is higher or risk budget is higher, then the deviations from strategic weights can be
relatively wide. Key drivers of TAA include price momentum, perceived asset class valuation, or the
particular stage of the business cycle. TAA can follow two types of approaches, i.e.


Stock-bond-cash allocation: Deviations from strategic weights are done based on views on the
market.



Comprehensive multi-asset approach: It involves adding or subtracting asset classes depending on
overall view on capital market expectations. For example, if we think commodities are undervalued
then we might consider adding commodities to overall asset mix.

Tactical asset allocation is a source of both active risk (i.e. tracking error) and active return, hence,
tactical asset allocation strategy involves the trade-off of any potential outperformance against this
tracking error.
There are some key barriers in implementing TAA. These include
 higher monitoring and trading costs;

 higher taxes associated with short-term capital gains;
Market timing vs TAA: Both market timing and tactical asset allocation involve moving in and out of an
asset class. There is, however, a difference, that is, TAA usually involves smaller allocation deviations as
compared to an invested-or- not- invested market timing strategy.

7.2 Passive/Active Management of Allocations to Asset Classes
Once the asset allocation policy is set, then the focus can turn to implementation, that is, whether the
individual allocations within asset classes are made using active management techniques or passive
management techniques or both active and passive management.
Passive management approach: Passive management approach does not attempt to “beat the market”
and does not react to changes in the investor’s capital market expectations or to information on or
insights into individual investments. Instead, in passive management, a market benchmark like the S&P
500 is selected and then investment manager tries to track the index very closely without incurring high
expenses. It is also referred to as indexing, which involves replicating a benchmark.
Indexing/Passive investing involves less transaction costs, particularly for market-cap-weighted index
because indexing to such indices is self-rebalancing. Nonetheless, indexing to other weighting schemes
(i.e. equal weighting) requires ongoing transactions to maintain the portfolio weights in line with index
weights. Portfolios tracking fixed-income indices also incur ongoing transaction costs as holdings
mature, default, or are called away by their issuers.
Active management approach: Active management approach, the portfolio manager responds to
changing capital market expectations or to investment insights resulting in changes to portfolio
composition with an objective to earn, after expenses, positive excess risk-adjusted returns relative to a
passive benchmark. Active investing can be performed in various ways, for example,


Indexing an equity allocation to a broad-based value equity style index is a strategy in which active

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



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decision is involved in tilting an allocation toward value but the passive management is involved in
implementation because it involves indexing.
Investing the equity allocation with managers with a value investing approach whereby managers
attempt to outperform through security selection. In this approach, managers have positive tracking
risk relative to the value index in general.
In unconstrained active investment, as the name implies, managers can invest anywhere and
portfolio is not managed with consideration of any traditional asset class benchmark (i.e.,
“benchmark agnostic”).

Example: Investment in developed market equities can be implemented through a pure passive
approach; whereas investment in emerging market bonds can be done using an unconstrained, indexagnostic approach.
The degree of active management can be measured using two measures, i.e. tracking risk and active
share. Refer to exhibit 13 below which reflects that both tracking risk and active share tend to increase
as managers move from left (passive approach) to right (active approach) on the spectrum; however,
they do not increase (or decrease) in lockstep with each other, in general.

Source: CFA Curriculum.
Asset class allocations may be managed with different approaches on the spectrum. This decision

depends on following factors:
a) Available investments, that is, availability of an investable and representative index.
b) Scalability of active strategies being considered. This implies how large a position can be taken in
case of active management.
c) The feasibility of investing passively while incorporating client-specific constraints. E.g. it is difficult
to find a benchmark for indexing that aligns with ESG investing criteria of investor.
d) Beliefs concerning market informational efficiency. If markets are considered to be efficient, active
management would not generate excess returns relative to benchmark.
e) The trade-off of expected incremental benefits relative to incremental costs and risks of active
choices. Active management is costly as it involves investment management costs, trading costs,
and turnover-induced taxes, Therefore, decision for choosing active management requires costbenefit analysis (i.e. costs versus excess risk-adjusted returns).
f) Tax status. Due to turn-over induces taxes, active management is not attractive for taxable
investors.

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Refer to Example 8 & 9 from the curriculum.

7.3 Risk Budgeting Perspectives in Asset Allocation and Implementation
Risk budgets refer to which types of risks to take and how much of each to take. Risk budgets can be
stated in absolute or in relative terms and in money or percent terms.

Example of Absolute risk budget stated in percent terms: An overall risk budget for a portfolio stated in
terms of volatility of returns, i.e. 20% for portfolio return volatility.
Asset allocation can be done based on a risk budgeting approach.
Active Risk Budgeting: Refers to how much benchmark-relative risk an investor is willing to take in
seeking to outperform a benchmark.
Like two dimensions of the passive/active decision discussed above, active risk budgeting also has
following two levels:
i.
Overall asset allocation: Active risk is defined relative to the strategic asset allocation benchmark.
Active risk budgeting at the level of overall asset allocation is relevant to tactical asset allocation.
ii.
Individual asset classes: Active risk is defined relative to the asset class benchmark.

8 REBALANCING: STRATEGIC CONSIDERATIONS
Rebalancing means selling and/or buying investments in an attempt to adjust changes in portfolio
weights driven by normal changes in asset prices to keep them aligned with the strategic asset allocation
or target weights.
Rebalancing is an essential element of the monitoring and feedback step of the portfolio construction,
monitoring, and revision process. The primary goal of a rebalancing strategy is to minimize risk relative
to a target asset allocation, rather than to maximize returns because rebalancing helps in avoiding
concentrated and high risk portfolios. The IPS should specify the investor’s rebalancing policy as well as
the personnel responsible for rebalancing.

8.1 A Framework for Rebalancing
There are various approaches to rebalancing.
a) Calendar rebalancing: In this approach, the portfolio is rebalanced at a predetermined time
interval—daily, monthly, quarterly, annually, and so on. The choice of rebalancing frequency is
sometimes linked to the schedule of portfolio reviews. As the strategy’s name implies, the only
variable taken into consideration is time, regardless of how much or how little the portfolio’s asset
allocation has drifted from its target.

 Example: If an investor’s policy portfolio has three asset classes with target proportions of
35/25/40, and his investment policy specifies rebalancing at the beginning of each month, at
each rebalancing date asset proportions would be brought back to 35/25/40.
b) Percent-range rebalancing: Percent-range rebalancing allows to maintain a tighter control of the
asset mix compared with calendar rebalancing. In this approach, portfolio is rebalanced only when
the portfolio’s asset allocation has drifted from the target asset allocation by a predetermined

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minimum rebalancing threshold such as 1%, 5%, or 10%, regardless of the frequency. The
rebalancing events could be as frequent as daily or as infrequent as every five years, depending on
the portfolio’s performance relative to its target asset allocation. The rebalancing range represents a
no-trade region. The portfolio is rebalanced when an asset class’s weight first passes through one of
its trigger points.
 Example: If the target proportion for an asset class is 40 percent of portfolio value, trigger points
could be at 35 percent and 45 percent of portfolio value. We would say that 35 percent to 45
percent (or 40 percent ±5 percent) is the corridor or tolerance band for the value of that asset
class.
In percent-range rebalancing, the investment committee should consider the following:
 Who is responsible for rebalancing;
 Frequency of monitoring portfolio values for breaches of a trigger point; the more frequent the

monitoring, the greater the precision in implementation.
 The deviation size that would trigger rebalancing; trigger points would depend on traditional
practice, transaction costs, asset class volatility, volatility of the balance of the portfolio, correlation
of the asset class with the balance of the portfolio, and risk tolerance.
 Fixed ranges can be applied irrespective of size or volatility of the allocation target, e.g. both a
45% domestic equity allocation and a 20% corporate bond allocation might have ±5%
rebalancing ranges.
 Tolerance bands may depend on the size of the target weight, e.g., a 60% target asset class
might have a ±6% band, whereas a 5% allocation would have a ±0.5% band. Proportional bands
may also depend on the relative volatility of the asset classes.
 The rebalancing trade size and the timeline for implementing the rebalancing. Here the following
approaches are used:
i.
Rebalance back to target weights;
ii.
Rebalance to range edge
iii.
Rebalance halfway between the range-edge trigger point and the target weight.

8.2 Strategic Considerations in Rebalancing
This section addresses LO.h:
LO.j: discuss strategic considerations in rebalancing asset allocations.
Following are the strategic considerations in rebalancing asset allocations: All things equal
a) it is better to set wider corridors for illiquid investments with high transaction costs, such as real
estate or private equity.
b) if the portfolio is in a taxable account, it is preferred to set wider bands than in a tax-deferred
account. In most jurisdictions the sale of appreciated assets triggers a tax liability for taxable
investors and is a cost of rebalancing for such investors.
 Rebalancing ranges in taxable accounts may also be asymmetric. For example, a 30% target
asset class might have an allowable range of 28%–34%, which is –2% to +4%.

c) the higher an asset class’ volatility, the narrower should be the corridors. For example, commodities
will typically have a tighter band than high-quality fixed income.
d) the higher an asset class’ correlation with the rest of the portfolio, the wider is the optimal corridor.

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