question, because it directly tests the active management of the portfolio. It turns out that this is the most difficult question to answer, and the available results are highly dependent on the sample and the period they cover. Most studies find that asset allocation has little explanatory power in predicting whether a manager will outperform or underperform the asset allocation return. In fact, available studies covering samples of mutual funds and pension funds conclude that 65 % to 85 % of them underperform the long-run asset allocation described in their investment policy statements or their passive benchmarks (Ibbotson and Kaplan 2000)1.
Given the importance of asset allocation, the rest of this chapter focuses on the asset allocation process, the role of asset owners in determining the objectives and constraints of the process, and the difference between strategic and tactical asset allocation programs.
1.2 The Five Steps of the Asset Allocation Process
This section describes the typical steps that must be taken to implement a systematic asset allocation program.2 A systematic approach enables the asset allocator to design and implement an investment strategy for the sole benefit of the asset owners. Such an approach needs to focus on the objectives and the constraints that are relevant to the asset owner. We begin with a discussion of the first of the five steps in the asset allocation process: identifying the asset owners and their potential objectives and constraints. In most cases, assets are managed to fund potential liabilities. In some instances, these liabilities represent legal obligations of the asset owner, such as the assets of a defined benefit (DB) pension fund. In other cases, assets are not meant to fund legal obligations but to fund essential needs of the asset owners or their beneficiaries. For example, a foundation's assets are managed to fund its future philanthropic and grant-giving activities. The nature of these potential needs or liabilities is a major determinant of the objectives and constraints of each asset owner.
The second step involves developing an overall approach to asset allocation. A critical step is preparing the investment policy statement. The investment policy statement includes the asset allocator's understanding of the objectives and constraints of the asset owners, the menu of asset classes to be considered, whether active or passive approaches will be used, and how often and under what circumstances the allocation will be changed. Such changes arise because of fundamental changes in economic conditions or changes in the circumstances of the asset owner.
The third step is implementing the overall asset allocation policy described in the investment policy statement. This step will require applications of both quantitative and qualitative techniques to determine the weight of each asset class in the portfolio. Since allocations to alternative investments typically involve selection and allocation to managers (e.g., hedge fund and private equity managers), this step will need to have built-in flexibility, as extensive due diligence on managers must be completed, and thus planned allocations may turn out to be infeasible. For instance, the planned allocation may turn out to be less than the minimum investment level accepted by the manager who has emerged on top after the due diligence process.
The fourth step is allocating the capital according to the optimal weights determined in the previous step based on the due diligence and manager evaluation already conducted by the portfolio manager's team or outside consultants.
The final step is monitoring and evaluating the investments. Inevitably, the realized performance of the portfolio will turn out to be different than expected. This will happen because of unexpected changes in the market and because selected fund managers did not perform as expected. As previously stated, the investment policy statement should anticipate circumstances under which the allocation will be revised. This chapter focuses on the first four steps of the asset allocation process. The final step, which deals with benchmarking, due diligence, monitoring, and manager selection, was covered in CAIA Level I (benchmarking) and the rest of this book (due diligence, monitoring, and manager selection).
1.3 Asset Owners
A systematic asset allocation process starts with the asset owners. Chapters 3 through 6 of this book provide detailed descriptions of major types of asset owners and their investment strategies. This section briefly describes major classes of asset owners. Although the list of asset owners will not be exhaustive, it should be sufficient to highlight the differences that exist among major types of asset owners and how their characteristics influence their asset allocation policies. The following sections discuss four categories of asset owners:
1. Endowments and foundations
2. Pension funds
3. Sovereign wealth funds
4. Family offices
1.3.1 Endowments and Foundations
Endowments and foundations serve different purposes but, from an investment policy point of view, share many characteristics. Endowments are funds established by not-for-profit organizations to raise funds through charitable contributions of supporters and use the resources to support activities of the sponsoring organization. For example, a university endowment receives charitable contributions from its supporters (e.g., alumni) and uses the income generated by the fund to support the normal operations of the university. Endowments could be small or large, but since they have long investment horizons and are lightly regulated, the full menu of assets is available to them. In fact, among institutional investors, endowments are pioneers in allocating to alternative assets.
Foundations are similar to endowments in the sense that funds are raised through charitable contributions of supporters. These funds are then used to fund grants and support other charitable work that falls within the foundation's mandate. Most foundations are long-term investors and are lightly regulated in terms of their investment activities. However, in order to enjoy certain tax treatments, they are required to distribute a minimum percentage of their assets each year. Foundations are able to invest in the full menu of assets, including alternative asset classes.
1.3.2 Pension Funds
Pension funds are set up to provide retirement benefits to a group of beneficiaries who typically belong to an organization, such as for-profit or not-for-profit businesses and government entities. The organization that sets up the pension fund is called the plan sponsor. There are four types of pension funds (Ang 2014):
1. NATIONAL PENSION FUNDS. National pension funds are run by national governments and are meant to provide basic retirement income to the citizens of a country. The U.S. Social Security program, South Korea's National Pension Service, and the Central Provident Fund of Singapore are examples of such funds. These types of funds may not operate that differently from sovereign wealth funds, which are described later in this chapter and in Chapter 5 of this book. The investment allocation decisions of these large funds are controlled by national governments, which makes their management different from private pension funds. Given the size and long-term horizons of these funds, the menu of assets that are available for potential investments is large and includes various alternative assets.
2. PRIVATE DEFINED BENEFIT FUNDS. Private defined benefit funds are set up to provide prespecified pension benefits to employees of a private business. The plan sponsor promises the employees of the private entity a predefined retirement income, which is based on a set of predetermined factors. Typically, these factors include the number of years an employee has worked for the firm, as well as his or her age and salary. The plan may include provisions for changes in retirement income, such as a cost-of-living adjustment or a portion of the retirement income to be paid to the employee's surviving spouse or young children. The plan sponsor directs the management of the fund's assets. While these funds may not match the size or the length of time horizon of national funds, they are still large long-term investors, and therefore
Hundreds of studies have attempted to determine if active managers outperform passive strategies. S&P Dow Jones Indices publishes SPIVA® U.S. Scorecard on a regular basis. It reports on the relative performance of U.S. mutual funds.
More detailed discussions of asset allocation processes can be found in Maginn et al. (2007) and Ang (2014).
