Asset Allocation with Real-World Constraints

The following are the main points covered in the reading.

• The primary constraints on an asset allocation decision are asset size, liquidity, time horizon, and other external considerations, such as taxes and regulation.
• The size of an asset owner’s portfolio may limit the asset classes accessible to the asset owner. An asset owner’s portfolio may be too small—or too large—to capture the returns of certain asset classes or strategies efficiently.
• Complex asset classes and investment vehicles require sufficient governance capacity.
• Large-scale asset owners may achieve operating efficiencies, but they may find it difficult to deploy capital effectively in certain active investment strategies given liquidity conditions and trading costs.
• Smaller portfolios may also be constrained by size. They may be too small to adequately diversify across the range of asset classes and investment managers, or they may have staffing constraints that prevent them from monitoring a complex investment program.
• Investors with smaller portfolios may be constrained in their ability to access private equity, private real estate, hedge funds, and infrastructure investments because of the high required minimum investments and regulatory restrictions associated with those asset classes. Wealthy families may pool assets to meet the required minimums.
• The liquidity needs of the asset owner and the liquidity characteristics of the asset classes each influence the available opportunity set.
• Liquidity needs must also take into consideration the financial strength of the investor and resources beyond those held in the investment portfolio.
• When assessing the appropriateness of any given asset class for a given investor, it is important to evaluate potential liquidity needs in the context of an extreme market stress event.
• An investor’s time horizon must be considered in any asset allocation exercise. Changes in human capital and the changing character of liabilities are two important time-related constraints of asset allocation.
• External considerations—such as regulations, tax rules, funding, and financing needs—are also likely to influence the asset allocation decision.
• Taxes alter the distribution of returns by both reducing the expected mean return and muting the dispersion of returns. Asset values and asset risk and return inputs to asset allocation should be modified to reflect the tax status of the investor. Correlation assumptions do not need to be adjusted, but taxes do affect the return and the standard deviation assumptions for each asset class.
• Periodic portfolio rebalancing to return the portfolio to its target strategic asset allocation is an integral part of sound portfolio management. Taxable investors must consider the tax implications of rebalancing.
• Rebalancing thresholds may be wider for taxable portfolios because it takes larger asset class movements to materially alter the risk profile of the taxable portfolio.  
• Strategic asset location is the placement of less tax-efficient assets in accounts with more-favorable tax treatment.
• An asset owner’s strategic asset allocation should be re-examined periodically, even in the absence of a change in the asset owner’s circumstances.
• A special review of the asset allocation policy may be triggered by a change in goals, constraints, or beliefs.
• In some situations, a change to an asset allocation strategy may be implemented without a formal asset allocation study. Anticipating key milestones that would alter the asset owner’s risk appetite, and implementing pre-established changes to the asset allocation in response, is often referred to as a “glide path.”
• Tactical asset allocation (TAA) allows short-term deviations from the strategic asset allocation (SAA) targets and are expected to increase risk-adjusted return. Using either short-term views or signals, the investor actively re-weights broad asset classes, sectors, or risk-factor premiums. The sizes of these deviations from the SAA are often constrained by the Investment Policy Statement.
• The success of TAA decisions is measured against the performance of the SAA policy portfolio by comparing Sharpe ratios, evaluating the information ratio or the t-statistic of the average excess return of the TAA portfolio relative to the SAA portfolio, or plotting outcomes versus the efficient frontier.
• TAA incurs trading and tax costs. Tactical trades can also increase the concentration of risk.
• Discretionary TAA relies on a qualitative interpretation of political, economic, and financial market conditions and is predicated on a belief of persistent manager skill in predicting and timing short-term market moves.
• Systematic TAA relies on quantitative signals to capture documented return anomalies that may be inconsistent with market efficiency.
• The behavioral biases most relevant in asset allocation include loss aversion, the illusion of control, mental accounting, recency bias, framing, and availability bias.
• An effective investment program will address behavioral biases through a formal asset allocation process with its own objective framework, governance, and controls.
• In goals-based investing, loss-aversion bias can be mitigated by framing risk in terms of shortfall probability or by funding high-priority goals with low-risk assets.
• The cognitive bias, illusion of control, and hindsight bias can all be mitigated by using a formal asset allocation process that uses long-term return and risk forecasts, optimization constraints anchored around asset class weights in the global market portfolio, and strict policy ranges.
• Goals-based investing incorporates the mental accounting bias directly into the asset allocation solution by aligning each goal with a discrete sub-portfolio.
• A formal asset allocation policy with pre-specified allowable ranges may constrain recency bias.
• The framing bias effect can be mitigated by presenting the possible asset allocation choices with multiple perspectives on the risk/reward trade-off.
• Familiarity bias, a form of availability bias, most commonly results in an overweight in home country securities and may also cause investors to inappropriately compare their investment decisions (and performance) to other organizations. Familiarity bias can be mitigated by using the global market portfolio as the starting point in developing the asset allocation and by carefully evaluating any potential deviations from this baseline portfolio.
• A strong governance framework with the appropriate level of expertise and well-documented investment beliefs increases the likelihood that shifts in asset allocation are made objectively and in accordance with those beliefs. T his will help to mitigate the effect that behavioral biases may have on the long-term success of the investment program.