Asset allocation real world constraints

Asset size

  • Too small or too large

May limit the opportunity set:

  1. scale needed to invest successfully in certain asset classes
  2. available of investment vehicles necessary to implements (alt investments limit smaller investors)

Liquidity

Liquidity needs of the asset owner - vary by goals and time horizon

Liquidity characteristics of the asset classes in the opportunity set

Time horizon

As time passes, allocations must reflect shortening horizons (changing HC as time passes, changing character of liabilities)

Nature of liability or goal will affect the allocation (lower risk/return with shorter goal/liabiliies

Regulatory/other external constraints

  • may hold for regulatory purposes/tax purposes
  • credit-worthiness constraints
    -cultural/religious factors constraints

Tax considerations

Pre tax and after tax risk/return characteristics of each asset class can be materially different

After tax optimization = adjust each asset class E(r) and SD for expected tax

  • taxes reduces the expected return AND mutes the SD
  • correlations between asset classes remain the same

Rebalancing = frequent rebalancing exposes taxable asset owner to realized taxes that could have been deferred

Rebalancing ranges for a taxable portfolio can be wider than tax exempt (reduce the freq of trading)

Strategies to reduce tax impact

  • tax loss harvesting
  • tax location (place less tax efficient assets in accounts with favorable tax treatments
    - low tax assets > taxable accounts
    - high tax assets/high turnover -> tax exempt & tax deferred

Revising the SAA

Trigger by change in:

  • Goals - changes in business conditions/expected CFs
  • Constraints - Time, Liquidity, Asset size, Legal
  • Beliefs - changes in CMAs, change in committee/trustees
  • also naturally (glide paths) at specific milestones

Short term shifts in SAA

TAA = increase risk-adjusted return by taking advantage of short term market conditions

  • usually done at asset class level and asset-only approach

1. Discretionary TAA: manager skills in prediciting timing short term market moves

  1. Systematic TAA: based on technical analysis/market signals (look for asset class level return anomalies - value/momentum/valuation/trend-following)