CHAPTER 19Asset Allocation

Asset allocation studies are intended to formulate diversified portfolios of asset classes that will maximize long‐term return within acceptable levels of risk. With the expected returns, risks, and correlations in Exhibit 18.2 as inputs, portfolios of maximum return can be calculated for varying levels of risk using optimization software. Collectively these optimized portfolios form what is called an efficient frontier.

Ideally, investors that are fiduciaries select a portfolio‐risk level that is prudent, which means a risk level that peers might select facing similar circumstances. This prescription for decision‐making has turned circular in recent years as returns for otherwise prudent portfolios are insufficient to meet enterprise required returns, such as actuarial interest rates. This moves fiduciaries to select higher‐risk, higher‐return asset mixes, now deemed prudent because others are doing the same. The concern is that return, not risk, is now driving asset allocation studies.

Along the way fiduciaries have looked to alternative investments as a potential solution for improving returns without excessive risk. Commercial equity real estate was the earliest alternative to stocks and bonds in the 1980s but lost its bloom during real estate busts of the early 1990s and again in 2008–2009. Allocators have systematically increased risk forecasts for real estate over time without commensurate increases in return. As a result, asset allocation ...

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