the level of expected return that is needed to meet certain liabilities.
3. ASSET CLASSES. This segment will include a list of asset classes that the portfolio manager is allowed to consider for allocation. It may provide additional information about how each asset class will be accessed. For instance, the asset owner may decide to use a passive approach to allocations to traditional asset classes and then use active managers for alternative asset classes.
4. GOVERNANCE. The organizational structure of the fund is described here. The responsibilities of various parties who are involved in the investment process (e.g., the portfolio manager, investment committee, administrator, and custodian) are carefully explained.
5. MANAGER SELECTION. This section describes the basic framework that the asset owner will follow in selecting outside managers. For example, it may state that all hedge fund managers will need to have three years of experience with at least $100 million in assets under management.
6. REPORTING AND MONITORING. The IPS describes the reporting requirements for the portfolio manager (e.g., frequency, type of reports, and disclosures).
7. STRATEGIC ASSET ALLOCATION. The IPS may include the long-run allocation of the fund during normal periods. The statement may include upper and lower limits for each asset class as well. Further details about strategic asset allocation are discussed in the next section.
1.7.2 Strategic Asset Allocation: Risk and Return
The central focus of strategic asset allocation (SAA) is to create a portfolio allocation that will provide the asset owner with the optimal balance between risk and return over a long-term investment horizon. The SAA not only represents the long-run normal allocation of the investors' assets but also serves as the basis for creating a benchmark that will be used to measure the actual performance of the portfolio. The SAA also serves as the starting point of the tactical asset allocation process, which will adjust the SAA based on short-term market forecasts.4 (Tactical asset allocation will be discussed in the next chapter.)
SAA is based on long-term risk-return relationships that have been observed in the past and that, based on economic and financial reasoning, are expected to persist under normal economic conditions into the future. While historical risk-return relationships are used as the starting point of generating the inputs needed to create the optimal long-run allocation, these historical relationships should be adjusted to reflect fundamental and potentially long-lasting economic changes that are currently taking place. For example, although long-term historical returns to investment-grade corporate bonds were once high, the prevailing yields on those instruments would indicate that the long-run return from this asset class should be adjusted down.
In developing long-term risk-return relationships for major asset classes, it is important to begin with fundamental factors affecting the economy. Macroeconomic performance of the global economy is the driving force behind the performance of various asset classes. The expected return on all asset classes can be expressed as the sum of three components:
(1.11)
The real short-term riskless rate of interest is believed to be relatively stable and lower than the real growth rate in the economy.5 Typically, there is a lower bound of zero for this rate. Therefore, if the global economy is expected to grow at 3 % per year going forward, the short-term real riskless rate is expected to be somewhere between zero and 1 %. In turn, population growth and increases in productivity are known to be the major drivers of economic growth. Long-term expected inflation is far less stable, as it depends on central banks' policies as well as long-term economic growth. Historically, it was believed that long-term expected inflation would depend on the growth rate in the supply of money relative to the real growth rate in the economy. For instance, it was believed that long-term inflation would be around 5 % if the money supply were to grow at 8 % in an economy that is growing at 3 %. However, this long-term relationship has been challenged by empirical observations following the 2008–9 financial crisis.
Once long-term estimates of the short-term real riskless rate and expected inflation have been obtained, the next step involves the estimation of the long-term risk premium of each asset class. At this stage, one may assume that historical risk premiums would prevail going forward. This would be particularly appropriate if we believe that historical estimates of volatilities, correlations, and risk exposures of various asset classes are likely to persist into the future. For instance, if the long-term historical risk premium on small-cap equities has been 5 %, then, assuming 2 % expected inflation and a 1 % short-term real riskless rate, one could assume an 8 % expected long-term return from this asset class.
For several reasons, long-term returns from alternative asset classes could be more difficult to estimate. First, while alternative assets such as real estate and commodities have a long history, some of the more modern alternative asset classes (e.g., hedge funds or private equity) do not have a long-enough history to obtain accurate estimates of their risk exposures and risk premiums. Second, to the degree that alpha was a major source of return for alternative asset classes in the past, the same level of alpha may not be available going forward if there is increased allocation to this asset class by investors. That is, the supply of alpha is limited, and increased competition is bound to reduce it. Third, the alternative investment industry has shown to be quite innovative and adaptive in response to changing economic conditions. Therefore, we should expect to see new classes of alternative assets going forward, with their potential place in investors' strategic asset allocations unknowable at this point.
EXHIBIT 1.4 Hypothetical Strategic Asset Allocation for an Endowment
1.7.3 Developing a Strategic Asset Allocation
Given the risk-return preference of an asset owner and estimates of expected long-term returns from various asset classes, the portfolio manager and the asset owner can develop an SAA. Exhibit 1.4 displays a hypothetical SAA for a U.S. endowment.
A typical IPS contains a strategic asset allocation and describes the circumstances under which the strategic asset allocation could change; for example, due to fundamental changes in the global economy or changes in the circumstances of the asset owner, the SAA could be revised.
1.7.4 A Tactical Asset Allocation Strategy
Related to SAA is tactical asset allocation (TAA), which is a dynamic asset allocation strategy that actively adjusts a portfolio's SAA based on short- to medium-term market forecasts. TAA's objective is to systematically exploit temporary market inefficiencies and divergences in market values of assets from their fundamental values. Long-term performance of a broadly diversified portfolio is driven mostly by its SAA over time. TAA can add value if designed based on rigorous economic analysis of financial data so it can overcome the headwinds created by the costs associated with portfolio turnover and the fact that global financial markets are generally efficient. The next chapter will provide further details about TAA and the more recent developments based on factor allocation and economic regime-driven investment strategies.
1.8 Implementation
After the completion of the IPS, the next step is its implementation. A variety of quantitative and qualitative portfolio construction approaches are available for this stage. We will focus our attention on the mean-variance approach, as it is the best-known approach, and most of the subsequent developments in this area have attempted to improve on its shortcomings. Some of these approaches are discussed in the next chapter.
Earlier, this chapter discussed how the general expected utility
For a detailed discussion of strategic asset allocation, see Eychenne, Martinetti, and Roncalli (2011) and Eychenne and Roncalli (2011).
In a simple equilibrium model, the short-term real riskless rate is shown to equal the real growth in the economy minus a premium that depends on the volatility of the economy's real growth rate and the degree of risk aversion. See Cox, Ingersoll, and Ross (1985).
