Once the IPS has been specified, the advisor can begin to construct the portfolio. The asset classes need to be defined and then a strategic asset allocation (SAA) formulated. The SAA is typically 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 the 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 between 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.
As 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 example splitting bonds into government and corporate bonds and then corporate bonds into investment and non-investment grade and government 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, for example 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:
- Homogenous within the asset class – the risk and return and correlation within the asset class should be high while providing diversification relative to other asset classes
- Mutually exclusive
- Representation of the investable universe
Typically, the SAA for risk-averse investors will have a large allocation to government bonds and cash whereas 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 constrained contained in the IPS.
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%
The correct answer is B.
Pension fund investors tend to have a large allocation to both government and corporate bonds. They also tend to have a lower allocation to more volatile asset classes like emerging market equities.
Reading 54 LOS 54f:
Explain the specification of asset classes in relation to asset allocation