Asset Allocation

From Theory to Practice and Beyond

William Kinlaw, Mark P. Kritzman, David Turkington

• Publisher: Wiley
• Year: 2021
• Print ISBN: 9781119817710
• eBook ISBN: 9781119817727
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Discover a masterful exploration of the fallacies and challenges of asset allocation

In Asset Allocation: From Theory to Practice and Beyond —the newly and substantially revised Second Edition of A Practitioner's Guide to Asset Allocation —accomplished finance professionals William Kinlaw, Mark P. Kritzman, and David Turkington deliver a robust and insightful exploration of the core tenets of asset allocation.

Drawing on their experience working with hundreds of the world's largest and most sophisticated investors, the authors review foundational concepts, debunk fallacies, and address cutting-edge themes like factor investing and scenario analysis. The new edition also includes references to related topics at the end of each chapter and a summary of key takeaways to help readers rapidly locate material of interest.

The book also incorporates discussions of:

• The characteristics that define an asset class, including stability, investability, and similarity
• The fundamentals of asset allocation, including definitions of expected return, portfolio risk, and diversification
• Advanced topics like factor investing, asymmetric diversification, fat tails, long-term investing, and enhanced scenario analysis as well as tools to address challenges such as liquidity, rebalancing, constraints, and within-horizon risk.

Perfect for client-facing practitioners as well as scholars who seek to understand practical techniques, Asset Allocation: From Theory to Practice and Beyond is a must-read resource from an author team of distinguished finance experts and a forward by Nobel prize winner Harry Markowitz.

CHAPTER 1
What Is an Asset Class?

Investors have access to a vast array of assets with which to form portfolios, ranging from individual securities to broadly diversified funds. The first order of business is to organize this massive opportunity set into a manageable set of choices. If investors stratify their opportunity set at too granular a level, they will struggle to process the mass of information required to make informed decisions. If, instead, they stratify their opportunity set at a level that is too coarse, they will be unable to diversify risk efficiently. Asset classes serve to balance this trade-off between unwieldy granularity and inefficient aggregation.

In light of this trade-off and other considerations, we propose the following definition of an asset class.

An asset class is a stable aggregation of investable units that is internally homogeneous and externally heterogeneous, that when added to a portfolio raises its expected utility without requiring selection skill, and which can be accessed cost-effectively in size.

This definition captures seven essential characteristics of an asset class. Let us consider each one in detail.

STABLE AGGREGATION

The composition of an asset class should be relatively stable. Otherwise, ascertaining its appropriate composition would require continual monitoring and analysis, and maintaining the appropriate composition would necessitate frequent rebalancing. Both efforts could be prohibitively expensive.

Asset classes whose constituents are weighted according to their relative capitalizations are stable, because when their prices change, their relative capitalizations change proportionately. By contrast, a proposed asset class whose constituents are weighted according to attributes that shift through time, such as momentum, value, or size, may not have a sufficiently stable composition to qualify as an asset class. Sufficiency, of course, is an empirical issue. Momentum is less stable than value, which is less stable than size. Therefore, a group of momentum stocks would likely fail to qualify as an asset class, while stocks within a certain capitalization range might warrant status as an asset class. Value stocks reside somewhere near the center of the stability spectrum and may or may not qualify as an asset class.

Investable

The underlying components of an asset class should be directly investable. If they are not directly investable, such as economic variables, then the investor would need to identify a set of replicating securities that tracks the economic variable. Replication poses two challenges. First, in addition to the uncertainty surrounding the out-of-sample behavior of the economic variable itself, the investor is exposed to the uncertainty of the mapping coefficients that define the association between the economic variable and the replicating securities. Second, because the optimal composition of the replicating securities changes through time, the investor is exposed to additional rebalancing costs.

INTERNALLY HOMOGENEOUS

The components within an asset class should be similar to each other. If they are not, the investor imposes an implicit constraint that two or more distinct groupings within the proposed asset class must be held according to their weights within the asset class. There is nothing to ensure that the weights of distinct groupings within a larger group are efficient. If the proposed asset class is disaggregated into distinct groupings, the investor is free to weight them for maximum efficiency.

Consider, for example, global equities. Domestic equities may behave very differently from foreign equities, and developed market foreign equities may behave differently from emerging market equities. Investors may be able to form a more efficient portfolio by disentangling these equity markets and weighting them based on their respective contributions to a portfolio's expected utility, as opposed to fixing their weights as they appear in a broad global index. Not only might the optimal weights of these components shift relative to each other, but the optimal allocation to equities as a whole might shift up or down relative to the allocation that would occur if they were treated as a unified asset class.

EXTERNALLY HETEROGENEOUS

Each asset class should be sufficiently dissimilar from the other asset classes in a portfolio as well as linear combinations of other asset classes. If the asset classes are too similar to each other, their redundancy will force the investor to expend unnecessary resources analyzing their expected return and risk properties and searching for the most effective way to invest in them.

In Chapter 2, we build portfolios from seven asset classes: US equities, foreign developed market equities, emerging market equities, Treasury bonds, corporate bonds, commodities, and cash equivalents. We considered including intermediate-term bonds as well. However, the lowest possible tracking error of a portfolio composed of these asset classes with intermediate-term bonds is only 1.1%. Intermediate-term bonds are, therefore, redundant. The lowest possible tracking error with commodities, by contrast, is 19.5%; hence, we include commodities in our menu of asset classes. Although there is no generically correct tracking error threshold to determine sufficient independence, within the context of a particular group of potential asset classes the answer is usually apparent.

EXPECTED UTILITY

The addition of an asset class to a portfolio should raise the portfolio's expected utility. This could occur in two ways. First, inclusion of the asset class could increase the portfolio's expected return. Second, its inclusion could lower the portfolio's risk, either because its own risk is low or because it has low correlations with other asset classes in the portfolio.

The expected return and risk properties of an asset class should not be judged only according to their average values across a range of market regimes. A particular asset class such as commodities, for example, might have a relatively low expected return and high risk on average across shifting market regimes, but during periods of high financial turbulence could provide exceptional diversification against financial assets. Given a utility function that exhibits extreme aversion to large losses, which typically occur during periods of financial turbulence, commodities could indeed raise a portfolio's expected utility despite having unexceptional expected return and risk properties on average.

It might occur to you that in order to raise a portfolio's expected utility, an asset class mu...

Table of contents

• Cover
• Table of Contents
• Title Page
• Copyright
• Foreword to the First Edition
• Preface
• Key Takeaways
• CHAPTER 1: What Is an Asset Class?
• CHAPTER 2: Fundamentals of Asset Allocation
• CHAPTER 3: The Importance of Asset Allocation
• CHAPTER 4: Time Diversification
• CHAPTER 5: Divergence
• CHAPTER 6: Correlation Asymmetry
• CHAPTER 7: Error Maximization
• CHAPTER 8: Factors
• CHAPTER 9: 1/N
• CHAPTER 10: Policy Portfolios
• CHAPTER 11: The Private Equity Leverage Myth
• CHAPTER 12: Necessary Conditions for Mean‐Variance Analysis
• CHAPTER 13: Forecasting
• CHAPTER 14: The Stock–Bond Correlation
• CHAPTER 15: Constraints
• CHAPTER 16: Asset Allocation Versus Factor Investing
• CHAPTER 17: Illiquidity
• CHAPTER 18: Currency Risk
• CHAPTER 19: Estimation Error
• CHAPTER 20: Leverage Versus Concentration
• CHAPTER 21: Rebalancing
• CHAPTER 22: Regime Shifts
• CHAPTER 23: Scenario Analysis
• CHAPTER 24: Stress Testing
• CHAPTER 25: Statistical and Theoretical Concepts
• Glossary of Terms
• Index
• End User License Agreement