Modern Asset Allocation for Wealth Management

CHAPTER 3Asset Selection

Step 2 of the four in our journey toward a modern yet practical asset allocation framework answers the following simple question: what assets should I consider for inclusion in a client portfolio? We begin by reviewing a tool that helps identify assets that are accretive to client utility, where we consider utility impacts beyond just the first two moments. We then introduce the second key tool of the chapter that helps ensure our assets have minimal redundancy, a critical requirement to limiting estimation error sensitivity during optimization. By deploying these two methods in the context of risk premia we will be able to quickly establish a well-motivated asset class taxonomy that is simultaneously beneficial to our clients, cognizant of higher moments, and minimal.

Key Takeaways:

1. Systematic asset selection helps ensure that assets are both accretive to utility and generate minimal estimation error sensitivity during optimization, with the knock-on benefit of minimizing the number of asset classes to manage.
2. Cross-asset portfolio moment contributions are a powerful and transparent way of assessing how accretive an asset is to client utility.
3. Mimicking portfolios are deployed to ensure our assets are not redundant, thereby minimizing portfolio sensitivity to estimation error.
4. Application of our two asset selection tools across traditional and alternative risk premia provides for a streamlined taxonomy of asset classes that greatly simplifies the ...