Refresher Reading
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2024 Curriculum CFA Program Level III Portfolio Management and Wealth Planning
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Access the Full Reading in the Learning EcosystemDownload the full reading (PDF)Introduction
Asset owners are concerned with accumulating and maintaining the wealth needed tomeet their needs and aspirations. In that endeavor, investment portfolios—includingindividuals’ portfolios and institutional funds—play important roles. Asset allocationis a strategic—and often a first or early—decision in portfolio construction. Becauseit holds that position, it is widely accepted as important and meriting careful attention.Among the questions addressed in this reading are the following:
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What is a sound governance context for making asset allocation decisions?
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How broad a picture should an adviser have of an asset owner’s assets and liabilities in recommending an asset allocation?
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How can an asset owner’s objectives and sensitivities to risk be represented in asset allocation?
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What are the broad approaches available in developing an asset allocation recommendation, and when might one approach be more or less appropriate than another?
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What are the top-level decisions that need to be made in implementing a chosen asset allocation?
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How may asset allocations be rebalanced as asset prices change?
The strategic asset allocation decision determines return levelsin which allocations are invested, irrespective of the degree of active management.Because of its strategic importance, the investment committee, at the highest levelof the governance hierarchy, typically retains approval of the strategic asset allocationdecision. Often a proposal is developed only after a formal asset allocation studythat incorporates obligations, objectives, and constraints; simulates possible investmentoutcomes over an agreed-on investment horizon; and evaluates the risk and return characteristicsof the possible allocation strategies.
In providing an overview of asset allocation, this reading’s focus is the alignmentof asset allocation with the asset owner’s investment objectives, constraints, andoverall financial condition. This is the first reading in several sequences of readingsthat address, respectively, asset allocation and portfolio management of equities,fixed income, and alternative investments. Asset allocation is also linked to otherfacets of portfolio management, including risk management and behavioral finance.As coverage of asset allocation progresses in the sequence of readings, various connectionsto these topics, covered in detail in other areas of the curriculum, will be made.
In the asset allocation sequence, the role of this reading is the “big picture.” Italso offers definitions that will provide a coordinated treatment of many later topicsin portfolio management. The second reading provides the basic “how” of developingan asset allocation, and the third reading explores various common, real-world complexitiesin developing an asset allocation.
This reading is organized as follows: Section 2 explains the importance of asset allocationin investment management. Section 3 addresses the investment governance context inwhich asset allocation decisions are made. Section 4 considers asset allocation fromthe comprehensive perspective offered by the asset owner’s economic balance sheet.Section 5 distinguishes three broad approaches to asset allocation and explains howthey differ in investment objective and risk. In Section 6, these three approachesare discussed at a high level in relation to three cases. Section 7 provides a top-levelorientation to how a chosen asset allocation may be implemented, providing a set ofdefinitions that underlie subsequent readings. Section 8 discusses rebalancing considerations,and Section 9 provides a summary of the reading.
Learning Outcomes
The member should be able to:
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describe elements of effective investment governance and investment governance considerations in asset allocation;
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prepare an economic balance sheet for a client and interpret its implications for asset allocation;
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compare the investment objectives of asset-only, liability-relative, and goals-based asset allocation approaches;
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contrast concepts of risk relevant to asset-only, liability-relative, and goals-based asset allocation approaches;
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explain how asset classes are used to represent exposures to systematic risk and discuss criteria for asset class specification;
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explain the use of risk factors in asset allocation and their relation to traditional asset class–based approaches;
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select and justify an asset allocation based on an investor’s objectives and constraints;
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describe the use of the global market portfolio as a baseline portfolio in asset allocation;
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discuss strategic implementation choices in asset allocation, including passive/active choices and vehicles for implementing passive and active mandates;
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discuss strategic considerations in rebalancing asset allocations.
Summary
This reading has introduced the subject of asset allocation. Among the points made are the following:
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Effective investment governance ensures that decisions are made by individuals or groups with the necessary skills and capacity and involves articulating the long- and short-term objectives of the investment program; effectively allocating decision rights and responsibilities among the functional units in the governance hierarchy; taking account of their knowledge, capacity, time, and position on the governance hierarchy; specifying processes for developing and approving the investment policy statement, which will govern the day-to-day operation of the investment program; specifying processes for developing and approving the program’s strategic asset allocation; establishing a reporting framework to monitor the program’s progress toward the agreed-on goals and objectives; and periodically undertaking a governance audit.
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The economic balance sheet includes non-financial assets and liabilities that can be relevant for choosing the best asset allocation for an investor’s financial portfolio.
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The investment objectives of asset-only asset allocation approaches focus on the asset side of the economic balance sheet; approaches with a liability-relative orientation focus on funding liabilities; and goals-based approaches focus on achieving financial goals.
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The risk concepts relevant to asset-only asset allocation approaches focus on asset risk; those of liability-relative asset allocation focus on risk in relation to paying liabilities; and a goals-based approach focuses on the probabilities of not achieving financial goals.
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Asset classes are the traditional units of analysis in asset allocation and reflect systematic risks with varying degrees of overlap.
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Assets within an asset class should be relatively hom*ogeneous; asset classes should be mutually exclusive; asset classes should be diversifying; asset classes as a group should make up a preponderance of the world’s investable wealth; asset classes selected for investment should have the capacity to absorb a meaningful proportion of an investor’s portfolio.
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Risk factors are associated with non-diversifiable (i.e., systematic) risk and are associated with an expected return premium. The price of an asset and/or asset class may reflect more than one risk factor, and complicated spread positions may be necessary to identify and isolate particular risk factors. Their use as units of analysis in asset allocation is driven by considerations of controlling systematic risk exposures.
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The global market portfolio represents a highly diversified asset allocation that can serve as a baseline asset allocation in an asset-only approach.
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There are two dimensions of passive/active choices. One dimension relates to the management of the strategic asset allocation itself—for example, whether to deviate from it tactically or not. The second dimension relates to passive and active implementation choices in investing the allocation to a given asset class. Tactical and dynamic asset allocation relate to the first dimension; active and passive choices for implementing allocations to asset classes relate to the second dimension.
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Risk budgeting addresses the question of which types of risks to take and how much of each to take. Active risk budgeting addresses the question of how much benchmark-relative risk an investor is willing to take. At the level of the overall asset allocation, active risk can be defined relative to the strategic asset allocation benchmark. At the level of individual asset classes, active risk can be defined relative to the benchmark proxy.
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Rebalancing is the discipline of adjusting portfolio weights to more closely align with the strategic asset allocation. Rebalancing approaches include calendar-based and range-based rebalancing. Calendar-based rebalancing rebalances the portfolio to target weights on a periodic basis. Range-based rebalancing sets rebalancing thresholds or trigger points around target weights. The ranges may be fixed width, percentage based, or volatility based. Range-based rebalancing permits tighter control of the asset mix compared with calendar rebalancing.
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Strategic considerations in rebalancing include transaction costs, risk aversion, correlations among asset classes, volatility, and beliefs concerning momentum, taxation, and asset class liquidity.
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