Approaches to Asset Allocation

Portfolio managers rely on one of three frameworks for analyzing and managing their portfolios. The three approaches below have advantages and disadvantages, which the analysts and managers must know to make prudent investment decisions.

Asset-only Approach

This approach considers only the asset side of the investor’s balance sheet. Liabilities are not taken into consideration. The most common form of asset-only management is mean-variance optimization. This analytical framework follows the modern portfolio theory to create a mathematically superior portfolio for a given investor’s needs. Increasing the Sharpe ratio of the portfolio within the IPS constraints is the ultimate goal.

Liability-relative Investing

It begins by examining the liabilities of the portfolio and seeks to satisfy those outflows with designated assets. Once the liabilities have been satisfied, the portfolio may shift focus to maximizing the return of the remaining portion not dedicated to paying down specific liabilities, as is the case in portfolio surplus optimization. This manner of investing generally comes down to the importance of having obligations paid on time and often belies a legal requirement to do so.

Goals-based Investing

The goals-based approach is similar to a liability-relative approach in that investors’ future goals are examined (outflows), prioritized, and then satisfied with specific assets within the portfolio. The difference between the two approaches is that goals are not actual legal liabilities but desires.

Also, the lack of an accounting paradigm tends to lend itself to more informal and individual investor-friendly settings. Goals-based investing can lend itself well to portfolio layering. Although it is less than optimal from a modern portfolio theory perspective, it can help build portfolios that clients can understand and stick to.

Relevant Concepts of Risk

$$ \begin{array}{c|c|c|c} \textbf{Approach} & { \textbf{Accounting} \\ \textbf{Orientation} } & {\textbf{Typical} \\ \textbf{Objective}} & {\textbf{Typical} \\ \textbf{Investors} }\\ \hline \text{Asset only} & \text{Models assets} & { \text{Maximize Sharpe} \\ \text{ratio}} & { \text{Foundations,} \\ \text{endowments,} \\ \text{sovereign wealth} \\ \text{funds, individual} \\ \text{investors}} \\ \hline { \text{Liability} \\ \text{driven}} & { \text{Models} \\ \text{liabilities}} & { \text{Pay liabilities, then} \\ \text{maximize surplus} } & { \text{Banks, defined} \\ \text{benefit pension} \\ \text{plans, insurers} } \\ \hline { \text{Goals} \\ \text{based}} & {\text{Models goals}} & {\text{Achieve goals with} \\ \text{minimum specified} \\ \text{probabilities of} \\ \text{success} } & { \text{Individual} \\ \text{investors} } \end{array} $$

Question

Liability-driven investing is often appropriate for investors who may face stringent penalties or consequences for not meeting promised payouts. Which of the following investor types is most likely to use liability-driven investing?

1. A sovereign wealth fund.
2. A foundation.
3. A pension fund.

Solution

The correct answer is C:

Provided that the fund is defined- as a benefit and not a defined contribution, a pension fund is most likely to use LDI. This is because a pension fund is legally obligated to support the retirement of previous firm employees who have met the contractual obligations to earn the pension, a pension they were promised in return for their services.

B is incorrect. A foundation is a charitable organization funded not through ongoing donations but by a portfolio set up to generate income. While foundations may have minimum payout requirements to maintain preferred tax status, the obligations are not legally required as in a pension fund.

A is incorrect. A sovereign wealth fund is a state-owned investment portfolio, generally set up to benefit the country’s citizens. It is not required to make distributions and generally falls under the purview of asset-only investing.

Asset Allocation: Learning Module 3: Overview of Asset Allocation; Los 3(d) Contrast concepts of risk relevant to asset-only, liability-relative, and goals based asset allocation approaches.