Asset allocation is one of the main concerns of portfolio management. Asset allocation answers several questions. What risk-return trade-off are we comfortable with? In other words, how much risk are we willing to take to achieve a certain level of active return? At each level of active return there is an equal amount of risk. Many portfolio managers are judged simply on the performance they have achieved without further analysis of the risk they took to produce that performance. This is why we have seen the arrival of new rogue traders like Kweku Odoboli. These traders want to take positions that will provide a certain amount of return to meet their strict benchmarks.

Asset allocation can be done using alpha or beta drivers. Alpha drivers measure the manager’s ability to generate a so-called active return. Active return is the difference between the benchmark index and the actual return. Alpha is more aggressive and aims to achieve returns above established benchmarks. Alpha Controllers are typically classified as Tactical Asset Allocation (TAA). TAA facilitates an investor’s long-term funding goals when seeking additional yield. It focuses on arbitrage in that it takes advantage of unbalanced market fundamentals. TAA requires more frequent trading than Strategic Asset Allocation (SAA) to produce additional returns.

Beta drivers are the more traditional investment techniques that aim to meet benchmarks. It involves the systematic capture of existing risk premiums. Beta drivers are used in the construction of SAA. This type of allocation crystallizes the investment policy of an institutional investor. This process highlights strategic benchmarks tied to broad asset classes that set policy/beta/market risk. This type of allocation is not designed to beat the market and must meet organizations’ long-term funding goals, such as defined benefit pension plans.

Extensive classes of Alpha controllers
1. Long or short investment
2. Absolute return strategies (hedge funds)
3. Market segmentation
4. Concentrated portfolios
5. Non-linear return processes (payment similar to an option)
6. Alternative cheap beta (anything outside of the normal stock/bond portfolio)

Typical Asset Allocation for an Institutional Portfolio

Equity 40%
Fixed Income 30%
Real Estate 15%
Inflation protection 15%

Breakdown of the portion of capital

Strategic equity allocation could be broken down into the following subclasses:
Beta drivers – 60%
• Passive equity
• 130-30
• Improved indexed equity

Alpha drivers – 40%
• Private capital
• Distressed debt

Convertible bonds have a hybrid structure that is a mix of equity and fixed income securities, so they can be included in either the equity or fixed income category.

Fixed income portfolio

This section of the portfolio can also be divided into alpha and beta drivers. The fixed income portfolio may be used in the following way:

Beta drivers – 60%
• US Treasury bonds.
• Investment grade corporate bonds
• Agency mortgage-backed securities

Alpha drivers – 40%
• Convertible bonds, high yield bonds and intermediate debt
• Collateralized debt obligation (CDO) and collateralized loan obligation (CLO)
• Hedge fund strategies based on fixed income, relative value of fixed income arbitrage, distressed debt

15% inflation hedge

This is an investment strategy that aims to provide a cushion against the risk of a currency losing value. Other investments may produce returns in excess of inflation, but inflation hedging is specifically designed to preserve the value of a currency. Here’s how you can split the inflation hedge portion of your portfolio:

TIPS (Treasury Inflation-Protected Securities) 20%
Infrastructure 20%
Commodities 20%
Natural resources 20%
Inflation-oriented stocks 20%

15% real asset allocation

Real estate is a form of investment with limited liquidity compared to other investments, it is also very capital intensive (although capital can be obtained through mortgage leverage) and is highly dependent on cash flow. Due to these realities, it is important that this section of the portfolio does not make up the majority of the portfolio. You could structure your real estate portfolio in the following way:

Real Estate Investment Trusts (REITs) 40%
Direct investment 30%
Private real estate capital 15%
Specialized 15%

However, it is very important to note that option-like securities are very risky and should be used with extreme caution. This is what brought down the UK’s oldest commercial bank and is what Warren Buffet describes as “financial weapons of mass destruction”. Portfolio management should be done as conservatively as possible. This means that the majority of the portfolio should be strategic and the minority tactical. It is also highly advisable to have caps on the search alpha positions an institution can pursue and to have a waterproof internal control system to curb dishonest trading.