Asset Allocation: SAA and TAA Part II

Introduction

• Speaker: Fernando Forcada, CFA
• Date: February 2025

Asset Classes: Definition and Classification

• Importance: Correctly defining asset classes is crucial for diversification.
• Approach 1: Based on investment attributes:
  • Similar economic/investment factors
  • Similar risk and return characteristics
  • Common legal/regulatory structure
• Approach 2: Criteria for an asset class:
  1. Independence from other classes
  2. Raises portfolio utility
  3. Homogeneous investments
  4. Sufficient capitalization capacity
• Evaluation: Sharpe ratio comparison for inclusion in portfolios.

Traditional Asset Classes

• Equity:
  • Domestic vs. International
  • Developed Market (DM) vs. Emerging Market (EM)
  • Large-cap, mid-cap, small-cap
• Fixed Income:
  • Domestic vs. International
  • Government, Credit, Investment Grade vs. High Yield
  • Inflation-protected vs. nominal bonds
• Cash and Equivalents
• Alternative Investments: Real estate, private equity, hedge funds, commodities

Strategic Asset Allocation (SAA) and Tactical Asset Allocation (TAA)

• SAA: Long-term allocation targets with bands for different asset classes.
• TAA: Short-term adjustments within strategic bands.

Economic Balance Sheet

• Conventional assets: Financial assets and liabilities.
• Extended portfolio assets: Includes human capital and future consumption.

Constraints in Asset Allocation

• Asset Size: Affects investment opportunities and efficiencies.
• Time Horizon: Aligns risk assets with long-term goals.
• Liquidity Needs: Must consider both investor needs and asset characteristics.
• Regulatory and External Constraints: Includes regulations, tax rules, and ESG considerations.

Exercises: Liquidity and External Constraints

• Liquidity: Property and casualty insurers need more liquidity than life insurance companies.
• External Constraints: Multinational corporations must consider different regulatory environments for pensions.

Rebalancing Policy

• Purpose: Maintain portfolio risk levels by adjusting asset weights.
• Methods:
  • Constant Mix: Countercyclical, contrarian approach.
  • Constant Proportion: Maintains exposure relative to a floor value.

Approaches to Asset Allocation

• Asset-Only: Focus on creating an efficient asset mix without liabilities.
• Liability-Relative: Aligns assets with liabilities, higher fixed-income allocation.
• Goals-Based: Tailors allocation to individual goals with time horizon considerations.

Optimization Techniques

• Mean-Variance Optimization (MVO): Common but sensitive to input changes.
• Risk Factor Optimization: Uses investment factors rather than asset classes.

Liability-Relative Asset Allocation

• Surplus Optimization: Balances asset and liability interaction.
• Hedging/Return-Seeking Portfolios: Separates assets based on purpose.

Executive Summary

• Definitions and characteristics of SAA and TAA.
• Different approaches and constraints in asset allocation.
• Importance of rebalancing and optimization techniques.

References

• Extensive list of academic and professional sources on asset allocation.