Discover the latest essential resource on asset allocation for students and investment professionals.
Part of the CFA Institute’s three-volume Portfolio Management in Practice series, Asset Allocation offers a deep, comprehensive treatment of the asset allocation process and the underlying theories and markets that support it. As the second volume in the series, Asset Allocation meets the needs of both graduate-level students focused on finance and industry professionals looking to become more dynamic investors.
Filled with the insights and industry knowledge of the CFA Institute’s subject matter experts, Asset Allocation effectively blends theory and practice while helping the reader expand their skillsets in key areas of interest.
This volume provides complete coverage on the following topics:
- Setting capital market expectations to support the asset allocation process
- Principles and processes in the asset allocation process, including handling ESG-integration and client-specific constraints
- Allocation beyond the traditional asset classes to include allocation to alternative investments
- The role of exchange-traded funds can play in implementing investment strategies
- An integrative case study in portfolio management involving a university endowment
To further enhance your understanding of tools and techniques explored in Asset Allocation, don’t forget to pick up the Portfolio Management in Practice, Volume 2: Asset Allocation Workbook. The workbook is the perfect companion resource containing learning outcomes, summary overview sections, and challenging practice questions that align chapter-by-chapter with the main text.
Table of Contents
Preface xiii
Acknowledgments xv
About the CFA Institute Investment Series xvii
Chapter 1 Basics of Portfolio Planning and Construction 1
1. Introduction 1
2. Portfolio Planning 2
2.1. The Investment Policy Statement 2
2.2. Major Components of an IPS 3
2.3. Gathering Client Information 17
3. Portfolio Construction 19
3.1. Capital Market Expectations 20
3.2. The Strategic Asset Allocation 20
3.3. Steps Toward an Actual Portfolio 28
3.4. ESG Considerations in Portfolio Planning and Construction 32
3.5. Alternative Portfolio Organizing Principles 33
4. Conclusion and Summary 34
References 35
Practice Problems 36
Chapter 2 Security Market Indexes 41
1. Introduction 41
2. Index Definition and Calculations of Value and Returns 42
2.1. Calculation of Single-Period Returns 43
2.2. Calculation of Index Values over Multiple Time Periods 45
3. Index Construction and Management 46
3.1. Target Market and Security Selection 46
3.2. Index Weighting 47
3.3. Index Management: Rebalancing and Reconstitution 56
4. Uses of Market Indexes 58
4.1. Gauges of Market Sentiment 58
4.2. Proxies for Measuring and Modeling Returns, Systematic Risk, and Risk-Adjusted Performance 58
4.3. Proxies for Asset Classes in Asset Allocation Models 58
4.4. Benchmarks for Actively Managed Portfolios 59
4.5. Model Portfolios for Investment Products 59
5. Equity Indexes 59
5.1. Broad Market Indexes 59
5.2. Multi-Market Indexes 60
5.3. Sector Indexes 61
5.4. Style Indexes 62
6. Fixed-Income Indexes 63
6.1. Construction 63
6.2. Types of Fixed-Income Indexes 63
7. Indexes for Alternative Investments 66
7.1. Commodity Indexes 66
7.2. Real Estate Investment Trust Indexes 66
7.3. Hedge Fund Indexes 67
8. Summary 70
Practice Problems 71
Chapter 3 Capital Market Expectations, Part 1: Framework and Macro Considerations 77
1. Introduction 78
2. Framework and Challenges 78
2.1. A Framework for Developing Capital Market Expectations 79
2.2. Challenges in Forecasting 82
3. Economic and Market Analysis 90
3.1. The Role of Economic Analysis 90
3.2. Analysis of Economic Growth 91
3.3. Approaches to Economic Forecasting 96
3.4. Business Cycle Analysis 100
3.5. Analysis of Monetary and Fiscal Policy 108
3.6. International Interactions 117
4. Summary 121
References 124
Practice Problems 125
Chapter 4 Capital Market Expectations, Part 2: Forecasting Asset Class Returns 131
1. Introduction 132
2. Overview of Tools and Approaches 132
2.1. The Nature of the Problem 132
2.2. Approaches to Forecasting 133
3. Forecasting Fixed-Income Returns 134
3.1. Applying DCF to Fixed Income 134
3.2. The Building Block Approach to Fixed-Income Returns 136
3.3. Risks in Emerging Market Bonds 142
4. Forecasting Equity Returns 145
4.1. Historical Statistics Approach to Equity Returns 145
4.2. DCF Approach to Equity Returns 146
4.3. Risk Premium Approaches to Equity Returns 148
4.4. Risks in Emerging Market Equities 153
5. Forecasting Real Estate Returns 154
5.1. Historical Real Estate Returns 154
5.2. Real Estate Cycles 155
5.3. Capitalization Rates 156
5.4. The Risk Premium Perspective on Real Estate Expected Return 157
5.5. Real Estate in Equilibrium 158
5.6. Public vs. Private Real Estate 158
5.7. Long-Term Housing Returns 160
6. Forecasting Exchange Rates 161
6.1. Focus on Goods and Services, Trade, and the Current Account 162
6.2. Focus on Capital Flows 164
7. Forecasting Volatility 170
7.1. Estimating a Constant VCV Matrix with Sample Statistics 170
7.2. VCV Matrices from Multi-Factor Models 170
7.3. Shrinkage Estimation of VCV Matrices 172
7.4. Estimating Volatility from Smoothed Returns 173
7.5. Time-Varying Volatility: ARCH Models 174
8. Adjusting a Global Portfolio 175
8.1. Macro-Based Recommendations 175
8.2. Quantifying the Views 178
9. Summary 179
References 181
Practice Problems 183
Chapter 5 Overview of Asset Allocation 191
1. Introduction 191
2. Asset Allocation: Importance in Investment Management 193
3. The Investment Governance Background to Asset Allocation 194
3.1. Governance Structures 195
3.2. Articulating Investment Objectives 195
3.3. Allocation of Rights and Responsibilities 197
3.4. Investment Policy Statement 198
3.5. Asset Allocation and Rebalancing Policy 199
3.6. Reporting Framework 199
3.7. The Governance Audit 199
4. The Economic Balance Sheet and Asset Allocation 201
5. Approaches to Asset Allocation 205
5.1. Relevant Objectives 207
5.2. Relevant Risk Concepts 208
5.3. Modeling Asset Class Risk 209
6. Strategic Asset Allocation 215
6.1. Asset Only 217
6.2. Liability Relative 222
6.3. Goals Based 225
7. Implementation Choices 230
7.1. Passive/Active Management of Asset Class Weights 230
7.2. Passive/Active Management of Allocations to Asset Classes 231
7.3. Risk Budgeting Perspectives in Asset Allocation and Implementation 235
8. Rebalancing: Strategic Considerations 236
8.1. A Framework for Rebalancing 238
8.2. Strategic Considerations in Rebalancing 239
9. Summary 241
References 242
Practice Problems 244
Chapter 6 Principles of Asset Allocation 247
1. Introduction 248
2. Developing Asset-Only Asset Allocations 249
2.1. Mean-Variance Optimization: Overview 249
2.2. Monte Carlo Simulation 262
2.3. Criticisms of Mean-Variance Optimization 265
2.4. Addressing the Criticisms of Mean-Variance Optimization 267
2.5. Allocating to Less Liquid Asset Classes 279
2.6. Risk Budgeting 280
2.7. Factor-Based Asset Allocation 283
3. Developing Liability-Relative Asset Allocations 287
3.1. Characterizing the Liabilities 287
3.2. Approaches to Liability-Relative Asset Allocation 290
3.3. Examining the Robustness of Asset Allocation Alternatives 302
3.4. Factor Modeling in Liability-Relative Approaches 304
4. Developing Goals-Based Asset Allocations 304
4.1. The Goals-Based Asset Allocation Process 306
4.2. Describing Client Goals 308
4.3. Constructing Sub-Portfolios 310
4.4. The Overall Portfolio 314
4.5. Revisiting the Module Process in Detail 315
4.6. Periodically Revisiting the Overall Asset Allocation 319
4.7. Issues Related to Goals-Based Asset Allocation 320
5. Heuristics and Other Approaches to Asset Allocation 321
5.1. The “120 minus your age” rule 321
5.2. The 60/40 stock/bond heuristic 323
5.3. The endowment model 323
5.4. Risk parity 324
5.5. The 1/N rule 326
6. Portfolio Rebalancing in Practice 326
7. Conclusions 331
References 332
Practice Problems 335
Chapter 7 Asset Allocation with Real-World Constraints 345
1. Introduction 345
2. Constraints in Asset Allocation 346
2.1. Asset Size 346
2.2. Liquidity 352
2.3. Time Horizon 355
2.4. Regulatory and Other External Constraints 359
3. Asset Allocation for the Taxable Investor 364
3.1. After-Tax Portfolio Optimization 365
3.2. Taxes and Portfolio Rebalancing 369
3.3. Strategies to Reduce Tax Impact 370
4. Revising the Strategic Asset Allocation 374
5. Short-Term Shifts in Asset Allocation 381
5.1. Discretionary TAA 382
5.2. Systematic TAA 383
6. Dealing with Behavioral Biases in Asset Allocation 386
6.1. Loss Aversion 387
6.2. Illusion of Control 387
6.3. Mental Accounting 388
6.4. Representativeness Bias 389
6.5. Framing Bias 390
6.6. Availability Bias 391
7. Summary 394
References 396
Practice Problems 397
Chapter 8 Asset Allocation to Alternative Investments 407
1. Introduction 407
2. The Role of Alternative Investments in a Multi-Asset Portfolio 408
2.1. The Role of Private Equity in a Multi-Asset Portfolio 411
2.2. The Role of Hedge Funds in a Multi-Asset Portfolio 412
2.3. The Role of Real Assets in a Multi-Asset Portfolio 412
2.4. The Role of Commercial Real Estate in a Multi-Asset Portfolio 413
2.5. The Role of Private Credit in a Multi-Asset Portfolio 414
3. Diversifying Equity Risk 414
3.1. Volatility Reduction over the Short Time Horizon 414
3.2. Risk of Not Meeting the Investment Goals over the Long Time Horizon 418
4. Perspectives on the Investment Opportunity Set 420
4.1. Traditional Approaches to Asset Classification 421
4.2. Risk-Based Approaches to Asset Classification 424
4.3. Comparing Risk-Based and Traditional Approaches 429
5. Investment Considerations Relevant to the Decision to Invest in Alternatives 431
5.1. Risk Considerations 431
5.2. Return Expectations 432
5.3. Investment Vehicle 432
5.4. Liquidity 434
5.5. Fees and Expenses 438
5.6. Tax Considerations 438
5.7. Other Considerations 439
6. Suitability Considerations 442
6.1. Investment Horizon 442
6.2. Expertise 442
6.3. Governance 442
6.4. Transparency 443
7. Asset Allocation Approaches 445
7.1. Statistical Properties and Challenges of Asset Returns 446
7.2. Monte Carlo Simulation 451
7.3. Portfolio Optimization 458
7.4. Risk Factor-Based Optimization 465
8. Liquidity Planning 469
8.1. Achieving and Maintaining the Strategic Asset Allocation 470
8.2. Managing the Capital Calls 476
8.3. Preparing for the Unexpected 476
9. Monitoring the Investment Program 480
9.1. Overall Investment Program Monitoring 480
9.2. Performance Evaluation 481
9.3. Monitoring the Firm and the Investment Process 483
10. Summary 485
References 487
Practice Problems 488
Chapter 9 Exchange-Traded Funds: Mechanics and Applications 497
1. Introduction 497
2. ETF Mechanics 498
2.1. The Creation/Redemption Process 499
2.2. Trading and Settlement 503
3. Understanding ETFs 504
3.1. Expense Ratios 504
3.2. Index Tracking/Tracking Error 505
3.3. Tax Issues 511
3.4. ETF Trading Costs 512
3.5. Total Costs of ETF Ownership 518
3.6. Risks 521
4. ETFs IN PORTFOLIO MANAGEMENT 526
4.1. ETF Strategies 526
4.2. Efficient Portfolio Management 526
4.3. Asset Class Exposure Management 528
4.4. Active and Factor Investing 530
5. Summary 533
Practice Problems 536
Chapter 10 Case Study in Portfolio Management: Institutional 541
1. Introduction 541
2. Background: Liquidity Management 542
2.1. Liquidity Profiling and Time-to-Cash 543
2.2. Rebalancing, Commitments 545
2.3. Stress Testing 546
2.4. Derivatives 547
2.5. Earning an Illiquidity Premium 547
3. QUINCO Case 548
3.1. Quadrivium University Investment Company (QUINCO) 550
3.2. Investment Strategy: Background and Evolution 551
3.3. Strategic Asset Allocation 553
3.4. Liquidity Management 558
3.5. Asset Manager Selection 563
3.6. Tactical Asset Allocation 565
3.7. Asset Allocation Rebalancing 570
4. Summary 574
References 575
Practice Problems 576
Glossary 581
About the Authors 587
About the CFA Program 589
Index 591
