Asset Allocation

Once the IPS has been specified, the advisor can construct the portfolio. The asset classes need to be defined, and a strategic asset allocation (SAA) formulated. The SAA is the first step and is the set of exposures to permissible asset classes that are expected to achieve the investment objectives subject to the investment constraints.

Capital Market Expectations

The investor expectations on the risk and return prospects of various asset classes are known as capital market expectations. Traditionally, these are quantified in terms of expected returns, the standard deviations of those returns, and the correlation between pairs of asset classes. The expected return consists of a risk-free rate and one or more risk premiums associated with the asset class. Expected returns can be derived in a variety of ways by using historical estimates, economic analysis, or valuation models.

Strategic Asset Allocation

Traditionally, investors have distinguished cash, equities, bonds, and real estate as the major asset classes. This list has recently been expanded to include private equity, hedge funds, commodities, and sometimes, assets such as art and intellectual property rights. These “newer” asset classes sometimes get grouped together as alternative investments.

Since the SAA is built up by asset class, defining the asset classes is an important first step. An investor may choose to have a very granular approach. For instance, they may split bonds into government and corporate bonds. Besides, they may cluster corporate bonds into investment and non-investment grade bonds. Finally, they may split government bonds into domestic and foreign bonds. This creates four different bond categories for which return-risk expectations and correlations with other assets can be expressed. A similar exercise could be conducted on equities. This could, for example, entail differentiating between foreign and domestic, small-cap and large-cap, or developed and emerging market equities.

When defining an asset class, a number of criteria apply:

• Homogeneity within the asset class: the risk, return, and correlation within the asset class should be high while providing diversification relative to other asset classes.
• Mutual exclusivity.
• Representation of the investable universe.

The SAA for risk-averse investors will have a large allocation to government bonds and cash. In contrast, those investors with more ability and willingness to take on risk will have a greater allocation to equities and alternative assets. The SAA is a result of the capital market expectations of the defined asset classes and the investor objectives and constraints contained in the IPS.

Question

Which option most likely represents the SAA for a pension fund investor?

A. Developed market equities = 15%; emerging market equities = 35%; commodities = 25%; real estate = 10%; government bonds = 5%; corporate bonds = 5%; cash = 5%

B. Developed market equities = 35%; emerging market equities = 5%; commodities = 5%; real estate = 10%; government bonds = 25%; corporate bonds = 15%; cash = 5%

C. Developed market equities = 25%; emerging market equities = 25%; commodities = 20%; real estate = 15%; government bonds = 5%; corporate bonds = 5%; cash = 5%

Solution

The correct answer is B.

Pension fund investors tend to have a large allocation of government and corporate bonds. They also tend to have a lower allocation of more volatile asset classes, such as emerging market equities.