Investment Course III – November 2007
Topic Two:
Asset Allocation: Decisions & Strategies
The Asset Allocation Decision

A basic decision that every investor must make is how to distribute his or
her investable funds amongst the various asset classes available in the
marketplace:







Stocks (e.g., Domestic, Global, Large Cap, Small Cap, Value, Growth)
Fixed-Income (e.g., Government, Investment Grade, High Yield)
Cash Equivalents (e.g., T-bills, CDs, Commercial Paper)
Alternative Assets (e.g., Private Equity, Hedge Funds)
Real Estate (e.g., Residential, Commercial)
Collectibles (e.g., Art, Antiques)
The Strategic (or Benchmark) allocation is the proportion of wealth the
investor decides to place in each of these asset classes. It is sometimes
also referred to as the investor’s long-term normal allocation because it is
presumed to be the “baseline” allocation that will remain in place until the
investor’s life circumstances change appreciably (e.g., retirement)
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Examples of Strategic Asset Allocations

University Endowments (Average):
2-2
Examples of Strategic Asset Allocations (cont.)

University Endowments (Large (Q4) vs. Small (Q1) AUM):
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Examples of Strategic Asset Allocations (cont.)

Public Retirement Fund:
2-4
Examples of Strategic Asset Allocations (cont.)
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The Importance of the Asset Allocation Decision

In an influential article published in Financial Analysts
Journal in July/August 1986, Gary Brinson, Randolph
Hood, and Gilbert Beebower examined the issue of how
important the initial strategic allocation decision was to
an investor

They looked at quarterly return data for 91 pension funds
over a ten-year period and decomposed the average
returns as follows:




Actual Overall Return (IV)
Return due to Strategic Allocation (I)
Return due to Strategic Allocation and Market Timing (II)
Return due to Strategic Allocation and Security Selection (III)
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The Importance of the Asset Allocation Decision (cont.)

Graphically:

In terms of return performance,
they found that:
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The Importance of the Asset Allocation Decision (cont.)

In terms of return variation:

Ibbotson and Kaplan support this conclusion, but argue that the
importance of the strategic allocation decision does depend on
how you look at return variation (i.e., 40%, 90%, or 100%).
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Components of University Endowment Returns

Notice that over time,
university endowment
returns (R) exceed their
benchmark (RB) by 165
basis points.

Of this 165 basis points of
outperformance, 148 is due
to security selection (RS)
and 17 is due to market
timing (RT)
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Components of University Endowment Returns (cont.)

To see how much of the overall
endowment return is explained by
the various components, consider
several versions of the following
regression: R = a + bRk + e, where
k = B, T, or S

When this regression is run for a
single fund over several years, the
vast majority (74.2%) of the
variation in total returns is
explained by the strategic asset
allocation decision. This is
comparable to the Brinson et al
result for pension funds

However, when the evaluating the
cross-sectional performance of a
group of funds during a single
year, the security selection
decision is almost five time more
important that the asset allocation
decision (72.8% vs. 15.3%).
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Asset Allocation and Building an Investment Portfolio
I. Global Market Analysis
- Asset Class Allocation
- Country Allocation Within Asset Classes
II. Industry/Sector Analysis
- Sector Analysis Within Asset Classes
III. Security Analysis
- Security Analysis Within Asset Classes
and Sectors
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Asset Allocation Strategies

Strategic Asset Allocation: The investor’s “baseline” asset
allocation, taking into account his or her return requirements, risk
tolerance, and investment constraints.

Tactical Asset Allocation: Adjustments to the investor’s strategic
allocation caused by perceived relative mis-valuations amongst the
available asset classes. Ordinarily, tactical strategies overweight the
undervalued asset class. Also known as market timing strategies.

Insured Asset Allocation: Adjustments to the investor’s strategic
allocation caused by perceived changes in the investor’s risk
tolerance. Usually, the asset class that experiences the largest
relative decline is underweighted. Portfolio insurance is a wellknown application of this approach.
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Sharpe’s Integrated Asset Allocation Model
C1
Capital Market
Conditions
I1
Investor Assets, Liabilities
and Net Worth
C2
Prediction
Procedure
I2
Investor's Risk Tolerance
Function
C3
Expected Returns, Risk
and Correlations
I3
Investor's Risk Tolerance
M1
Optimizer
M2
Investor's Asset Mix
M3
Returns
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Sharpe’s Integrated Asset Allocation Model (cont.)

Notice that the feedback loops after the performance assessment
box (M3) make the portfolio management process dynamic in
nature.

The strategic asset allocation process can be viewed as going
through the model once and then removing boxes (C2) and (I2),
thus removing any temporary adjustments to the baseline allocation.

Tactical asset allocation effectively removes box (I2), but allows for
allocation adjustments due to perceived changes in capital market
conditions (C2).

Insured asset allocation effectively removes box (C2), but allows for
allocation adjustments due to perceived changes in investor risk
tolerance conditions (I2).
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Measuring Gains from Tactical Asset Allocation

Example: Consider the following return and allocation characteristics for a
portfolio consisting of stocks and bonds only.
Allocation:
Strategic
Actual
Stock
60%
50
Returns:
Benchmark
Actual
10%
9

Bond
40%
50
7%
8
The returns to active management (i.e., tactical and security selection) are:
Policy Performance:
Actual Performance:
(.6)(.10) + (.4)(.07)
(.5)(.09) + (.5)(.08)
Active Return =
= 8.80%
= 8.50%
- 30 bp
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Measuring Gains from Tactical Asset Allocation (cont.)
Also:
(Policy & Timing):
(.5)(.10) + (.5)(.07)
= 8.50%
(Policy & Selection): (.6)(.09) + (.4)(.08)
= 8.60%
so:
8.50 – 8.80
= -0.30%
Selection Effect: 8.60 – 8.80
= -0.20%
Other: 8.50 – 8.60 – 8.50 + 8.80
= +0.20%
Timing Effect:
Total Active
= -0.30%
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Example of Tactical Asset Allocation: Fidelity Investments
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Example of Performance & Tactical Asset Allocation:
Texas Teacher Retirement System
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Texas TRS Peer Group Ranking: March 2007
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Texas TRS Attribution Analysis: 7/1/06 – 6/30/07
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Performance and Attribution Analysis Example:
UTIMCO Endowment Funds
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Example of Tactical Asset Allocation: UTIMCO
Recommended
2005 Asset Allocation Policy
Percent of Portfolio (%)
Asset Category
Policy Targets Policy Ranges
US Equities
Global ex US Equities
Non-US Developed Equity
Emerging Markets Equity
Directional Hedge Funds
10.0
Absolute Return Hedge Funds
15.0
Inflation Linked
REITS
Commodities
TIPS
Fixed Income
Cash
Expected Return>
1 Year Downside Risk>
Standard Deviation>
95% 1 Year VaR>
Illiquidity>
10 to 30
17.0
10 to 30
25.0
15 to 30
15.0
5 to 20
13.0
0 to 20
10.0
0.0
5 to 15
-10 to 10
10.0
7.0
Hedge Funds
Private Capital
Venture Capital
Private Equity
20.0
Benchmark
Russell 3000 Index
Policy target-weighted composite of the sub-indices
in this category
MSCI EAFE Index with net dividends
MSCI Emerging Markets Index with net dividends
Policy target-weighted composite of the sub-indices
in this category
Combination index: 50% S&P Event-Driven Hedge
Fund Index plus 50% S&P Directional/Tactical
Hedge Fund Index
Combination index: 66.7% S&P Event-Driven
Hedge Fund Index plus 33.3% S&P Arbitrage
Hedge Fund Index
Venture Economics' Periodic IRR Index
4.0
11.0
5.0
3.0
5.0
8.34%
7.6%
10.8%
-13.8%
32.4%
Policy target-weighted composite of the sub-indices
in this category
Wilshire Associates Real Estate Securities Index
GSCI Index minus 1%
Lehman Brothers US TIPS Index
Lehman Brothers Aggregate Index
91 Day T-Bills
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Attribution Analysis Example: UTIMCO Tactical Allocations
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UTIMCO Attribution Analysis: 3/1/06 – 2/28/07 (cont.)
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UTIMCO Cumulative Alpha: 9/1/02 – 1/31/06
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The MBA Investment Fund Attribution Analysis: 3/1/05 – 2/28/06

Over this period, both the Growth (+814 bp) and Value (+548) Portfolios outperformed their
respective benchmarks by a significant amount

Notice that this Attribution Analysis is calculated in a slightly different way; it isolates the Allocation
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Effect more precisely by including a third term (i.e., Interaction Effect)
The MBA Investment Fund Attribution Analysis: 3/1/06 – 2/28/07

Over this period, both the Growth (-219 bp) and Value (-442 bp) Portfolios
underperformed their respective benchmarks by a significant amount
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