Overview of Asset Allocation

The strategic asset allocation is the investor's most important decision, and it is only as good as the governance behind it and the view of the investor's full balance sheet that informs it. This module explains effective investment governance, builds the economic balance sheet, contrasts asset-only, liability-relative and goals-based approaches and the concept of risk behind each, shows how asset classes and risk factors describe systematic exposures, and closes with implementation choices and the strategic case for rebalancing.

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What you will learn

1. Describe the elements of effective investment governance and explain how governance shapes asset allocation decisions.

Six elements: objectives, decision rights, IPS process, SAA process, reporting, periodic governance audit.
The governing body sets mission, IPS and strategic allocation; staff or managers implement within approved ranges.
Place each decision where the competence and accountability sit; the shortest-horizon decisions go to the most expert parties.
Common pitfalls: second-guessing implementation, performance chasing, dominant individuals, unclear accountability.
Rules set in advance (ranges, rebalancing) protect the allocation from emotional decisions in a crisis.

2. Construct an economic balance sheet and explain its implications for an investor's asset allocation.

Economic balance sheet = financial assets and liabilities plus extended assets (human capital, pensions) and extended liabilities (PV of consumption, education, bequests).
Economic net worth = total economic assets - total economic liabilities.
Bond-like human capital supports more equity in the financial portfolio; equity-like human capital calls for less.
Avoid holding financial assets correlated with one's own human capital, such as employer stock.
Human capital declines with age as it turns into financial capital, so allocations typically become more conservative.

3. Contrast asset-only, liability-relative and goals-based approaches to asset allocation and the concept of risk behind each.

Asset-only: risk is volatility or tracking risk against a policy portfolio.
Liability-relative: risk is surplus volatility and the chance of a funding shortfall; liability-hedging bonds are the low-risk asset.
Goals-based: risk is the probability of failing to meet each goal; each goal gets its own sub-portfolio.
Surplus = assets - liabilities; funded ratio = assets / liabilities.
The same asset can be low risk in one framework and high risk in another.

4. Explain how asset classes are specified and how risk factors can be used to represent the systematic exposures in a portfolio.

Asset classes should be homogeneous, mutually exclusive, diversifying, comprehensive and have capacity.
Different asset classes often share the same factors: growth, rates, inflation, credit, liquidity, volatility, currency.
Portfolio factor exposure = weighted sum of each holding's factor sensitivity.
Factor analysis often reveals a portfolio dominated by equity risk despite many asset class labels.
Pure factor exposures need long-short or leveraged positions, so many investors allocate by asset class and monitor factors.

5. Discuss implementation choices, including passive versus active management and the choice of vehicle, and explain the strategic case for rebalancing.

Passive is efficient where markets are efficient; active is justified only where expected alpha exceeds fees, risk and governance costs.
Vehicles range from direct holdings and separate accounts to pooled funds, ETFs, partnerships and derivatives overlays.
Rebalancing keeps risk at its chosen level and imposes a buy-low, sell-high discipline.
Rebalancing tends to add value in oscillating markets and to lag in strongly trending markets.
Calendar and percentage-range methods are the main approaches; costs and taxes argue for corridors and partial rebalancing.

Module at a glance

Effective governance sets objectives and the strategic allocation at the top and delegates implementation within documented ranges.
The economic balance sheet adds human capital, pensions and the PV of future spending; manage the financial portfolio as their complement.
Bond-like human capital supports more equity; equity-like or employer-linked human capital calls for less.
Asset-only risk is volatility or tracking risk; liability-relative risk is surplus volatility; goals-based risk is the chance of missing a goal.
Specify asset classes that are homogeneous, mutually exclusive and diversifying, and check the factor exposures they share.
Use passive management where markets are efficient and active only where the edge justifies the cost.
Rebalancing keeps risk where the investor chose it; it adds value in oscillating markets and lags in trends.

This free module has 5 lessons, 18 practice questions with full explanations and 1 essay case with a model answer.

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