An asset owner must consider a number of constraints when modeling and choosing among asset allocation alternatives. Some of the most important are asset size, liquidity needs, taxes, and time horizon. Moreover, regulatory and other external considerations may influence the investment opportunity set or the optimal asset allocation decision.
Asset Size
The size of an asset owner’s portfolio has implications for asset allocation. It may limit the opportunity set—the asset classes accessible to the asset owner—by virtue of the scale needed to invest successfully in certain asset classes or by the availability of investment vehicles necessary to implement the asset allocation.
Smaller funds often lack the expertise and governance structure to invest in complex strategies, and therefore, often face a problem of how to achieve an adequate level of diversification. In addition, many capital markets impose local legislation, restricting investment in some assets to investors with a given level of capital or experience. Smaller funds may use commingled investment accounts (pooling money from a small group of investors) to achieve adequate size to diversify. To enable investment in assets where local legislation requires minimum investment levels, families may pool their assets to qualify.
Larger portfolios can generally access greater management expertise in the governance capacity, allowing them to consider complex strategies that smaller funds cannot. Their larger capital base also enables investment in accounts with relatively high minimum investment requirements. This allows large funds to achieve higher levels of diversification.
Large portfolios benefit from economies of scale via cost savings regarding internal management and greater negotiating power regarding management fees, allowing higher allocations to alternative investments. As the size of the fund increases, the per-participant cost of the internal governance infrastructure decreases, giving the fund a competitive advantage in private equity, hedge fund, and infrastructure investing.
Funds that are too large may not be able to take advantage of asset classes that lack the capacity to absorb large amounts of funds. A potential solution is to split the allocation among several managers, but identifying and monitoring suitable managers is an added burden and cost. The result is that large funds often take a passive approach in such situations.
Very large funds may find that there are not enough alternative investments available and may choose a fund-of-funds (FoF). But this carries a double fee structure for the FoF manager and the underlying fund managers. In addition, the strategies of one hedge fund manager may be offset by strategies of another manager.
Liquidity Needs
Two dimensions of liquidity must be considered when developing an asset appropriate allocation solution: the liquidity needs of the asset owner and the liquidity characteristics of the asset classes in the opportunity set. Integrating the two dimensions is an essential element of successful investment planning.
| Portfolio Owner | Typical Liquidity Needs |
|---|---|
| Banks | High liquidity needed to support day to day operations and stand ready to repay deposits |
| Sovereign Wealth Funds, Endowments, Pension Plans, Foundations | Longer time horizons and lower liquidity needs |
| Property and Casualty Insurance | Relatively high due to unpredictability of claims |
| Life and Auto Insurance | Relatively low due to predictability of claims |
| Individuals | Varies by individual circumstance |
Time Horizon
A portfolio’s time horizon is defined by a liability to be paid or a goal to be funded at a future date. Asset allocations must consider the horizons defined by each liability and goal, as well as adapting to the changing mix of assets and liabilities as time progresses. The value of human capital, for example, declines over time. As a result, the asset allocation will likely shift towards lower risk asset classes such as fixed income.
The changing nature of liabilities over time also requires changes in asset allocation. A pension fund catering for a young workforce, for example, would be heavily invested in long-term bonds. A more mature scheme would move towards intermediate and short-term bonds.
Portfolios with longer time horizons are often invested in assets with higher risk. There is evidence that risky asset returns mean revert over time, evening out below and above average levels of return. This concept is known as time diversification.
Example Subportfolios:
| Lifestyle Goals | Risk Preference | Asset Allocation | Sub-Portfolio as % of Total* |
|---|---|---|---|
| Required minimum | Conservative | 100% bonds and cash | 65% |
| Baseline | Moderate | 60% equities/40% bonds | 10% |
| Aspirational | Aggressive | 100% equities | 4% |
| College education | Conservative | 100% bonds and cash | 1% |
| Charitable gift (aspirational) | Aggressive | 100% equities | 5% |
| Special needs trust | Moderate | 60% equities/40% bonds | 15% |
| Aggregate portfolio | ≈ 25% equities/75% bonds and cash | 100% |
| Lifestyle Goals | Risk Preference | Asset Allocation | Sub-Portfolio as % of Total* |
|---|---|---|---|
| Required minimum | Conservative | 100% bonds and cash | 54% |
| Baseline | Moderate | 60% equities/40% bonds | 9% |
| Aspirational | Aggressive | 100% equities | 3% |
| Special needs trust | Moderate | 60% equities/40% bonds | 34% |
| Aggregate portfolio | ≈ 30% equities/70% bonds and cash | 100% |
Regulatory and Other External Constraints
Investment returns are a large contributor to the performance of an insurance company. The asset class with the largest allocation will be fixed income, reflecting the need for the insurer to match assets to the projected cash flows of the risks being insured. Local accounting laws often require fixed income investments to be stated at book value, so the insurer can focus primarily on the pattern of cash flow receipts rather than the volatility of market value.
The main risk considerations are the need to maintain enough capital to meet claims made by policyholders, along with factors that directly affect the company’s financial strength metrics. These include:
- Risk-based capital measures.
- Liquidity.
- Yield levels.
- Credit ratings.
- Potential to liquidate assets to meet claims.
As well as capping the allocation to certain asset classes, local legislation often places a wide range of tax, accounting, reporting, and funding constraints on pension funds. There may be tax incentives offered to invest in domestic assets. Accounting rules may allow deferred recognition of losses.
Endowments and foundations are both assumed to have an infinite time horizon and are subject to very few regulatory constraints compared to other entities. In some countries, there may be a minimum required annual distribution or socially responsible investment required to maintain a tax-exempt status.
Sovereign wealth funds are government-owned entities investing on behalf of the state, and are typically not looking to match assets and liabilities. They are, however, subject to scrutiny from the citizens of that state which may reduce the level of risk that their long time horizon would otherwise allow them to take on.
In addition, each fund self-governs by capping the allocation of funds to certain assets. The aim of these constraints may include:
- Minimum investment requirements in socially or ethically acceptable assets.
- Maximum investments in risky assets such as alternative investments.
- Limits on the investment allowed in certain currencies.