Abstract
Asset allocation represents a fundamental strategic decision for every institutional investor. Although many asset allocation approaches have been recommended and implemented in various forms, each has its own strengths and weaknesses. A careful review of current asset allocation frameworks motivated the authors to design a hybrid approach that addresses many of these perceived individual shortcomings. The authors’ guiding principle was to use several familiar elements to create a flexible process that incorporates lessquantifiable investment ideas around a rigorous foundation. The result, which they call flexible indeterminate factor-based asset allocation (FIFAA), is an adaptive four-step asset allocation synthesis that remains quantitatively and theoretically well grounded. To achieve this goal, FIFAA overlays informed judgment about investment opportunities onto an objectively derived set of core factor exposures.
Highlights
Asset allocation is arguably the most fundamental strategic investment decision an institution can make—it is arguably the most challenging
Our guiding principle was to use elements of various asset allocation approaches to create a flexible process around a rigorous foundation, resulting in a comprehensive process that we term Flexible Indeterminate Factor-based Asset Allocation (FIFAA)
We believe that FIFAA borrows strength from several attractive asset allocation approaches and perspectives, while at the same time limiting some of their perceived practical weaknesses
Summary
Asset allocation is arguably the most fundamental strategic investment decision an institution can make—it is arguably the most challenging. The implied exposures in the second row, which are derived from a hypothetical portfolio that we feel is reasonably representative of institutional investors, form the basis for a constrained optimization, whose output is in the third row.22 This analysis suggests that a better systematic risk-return profile than the implied could be achieved by increasing exposure to the high yield factor, increasing the diversification benefits of U.S Treasuries, reducing inflation protection, and hedging foreign currency risk. The main challenge in selecting appropriate strategic asset class weights and ranges—and the main opportunity for incorporating best ideas—is that, in general, there is an infinite number of portfolio solutions that satisfy the institution’s desired factor exposures This “indeterminacy” is the key element of FIFAA, and results from the simple fact that there are many more collections of investments or asset classes than there are primary factors. Portfolio, this is challenging in practice due to data availability, high idiosyncratic risk, and required resources
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