Asset Allocation and Top-Down Portfolio Construction
In this presentation given to Financial Accounting Standards Board (FASB) in October 2021, as part of their ‘Think Like an Investor’ series, I draw upon my experience to highlight some important issues in top-down portfolio construction. I discuss some key considerations in constructing a multi-asset portfolio like the time horizon, risk profile and investment goals; and highlight how empirical research has shown that greater than 90% of the variation in total returns of a multi-asset portfolio can be attributed to asset allocation. Asset allocation has grown more complex over the last few decades as asset classes increased in number and became more granular, private markets increased in size and financial markets geographically became more integrated. I discuss asset allocation over different time horizons – strategic, dynamic, and tactical. While tactical asset allocation depends on short-term market dislocations, strategic and dynamic asset allocation decisions depend on capital market assumptions (the forecasts of return, volatility, and correlation of the different asset classes) as the foundational block. I discuss two alternate methodologies for designing capital market assumptions – macroeconomic model and the risk-premia framework.
I also talk about the increasingly important topic of climate change by presenting a few highlights of my peer-reviewed research paper ‘Incorporating Climate Change in Asset Allocation and Portfolio Construction’, accepted for publication in the forthcoming book titled ‘Climate Change: Managing the Financial Risk and Funding the Transition and Adaptation’, to be published by Risk.net in early 2022.