Asset-only approaches to asset allocation focus solely on the asset side of the investor’s balance sheet. Liabilities are not explicitly modeled. Mean–variance optimization (MVO) is the most familiar and deeply studied asset-only approach.
Liability-relative approaches to asset allocation choose an asset allocation in relation to the objective of funding liabilities. The phrase “funding of liabilities” means to provide for the money to pay liabilities when they come due. An example is surplus optimization: mean–variance optimization applied to surplus (defined as the value of the investor’s assets minus the present value of the investor’s liabilities).
Goals-based approaches are geared toward asset allocations for subportfolios, which help individuals or families achieve lifestyle and aspirational financial objectives.
Asset Allocation Approaches: Investment Objective
| Asset Allocation Approach | Relation to Economic Balance Sheet | Typical Objective | Typical Uses and Asset Owner Types |
|---|---|---|---|
| Asset only | Does not explicitly model liabilities or goals | Maximize Sharpe ratio for acceptable level of volatility | Liabilities or goals not defined and/or simplicity is important Some foundations, endowments Sovereign wealth funds Individual investors |
| Liability relative | Models legal and quasi-liabilities | Fund liabilities and invest excess assets for growth | Penalty for not meeting liabilities high Banks Defined benefit pensions Insurers |
| Goals based | Models goals | Achieve goals with specified required probabilities of success | Individual investors |
Asset-only approaches focus on asset class risk and effective combinations of asset classes.
The baseline asset-only approach, mean–variance optimization, uses volatility of portfolio return as a primary measure of risk. A mean–variance asset allocation can also incorporate other risk sensitivities, including risk relative to benchmarks and downside risk.
Mean–variance results are regularly augmented by Monte Carlo simulation. Insights from simulation can then be incorporated as refinements to the asset allocation.
Liability-relative approaches focus on the risk of having insufficient assets to pay obligations when due, which is a kind of shortfall risk. Other risk concerns include the volatility of contributions needed to fund liabilities. Risk in a liability-relative context is generally underpinned by the differences between asset and liability characteristics.
Goals-based approaches are concerned with the risk of failing to achieve goals. The risk limits can be quantified as the maximum acceptable probability of not achieving a goal.
For the purposes of asset allocation, it is necessary to define asset classes. With this information, investors and managers can better distinguish among asset classes when developing an investment strategy.
The following criteria can be used to specify asset classes:
- Assets in an asset class should have similar attributes from both a descriptive and statistical perspective.
- Assets cannot be classified into more than one asset class.
- Asset classes should not be highly correlated in order to provide desired diversification.
- Asset classes should cover all possible investable assets.
- Asset classes should contain a sufficiently large percentage of liquid assets.
