Practical analysis for investment professionals
10 March 2015

Three Key Decisions in Formulating an Asset Allocation Strategy

Managing a multi-asset strategy portfolio is much more complicated than putting together a puzzle. There are three important stages in the process: asset allocation strategy, portfolio construction, and performance evaluation. In addition to the primer on multi-asset strategies, I’ll share some practitioners’ insights with you about each of these stages in a separate post. This is the first installment where I’ll focus on the formulation of an asset allocation strategy.

So what are the most important considerations in this stage? At an AsianInvestor conference in Beijing last year, I asked a panel of experts from some of the world’s largest institutional investors (including Korea’s sovereign wealth fund Korea Investment Corporation (KIC)Second Swedish National Pension Fund – AP2, and Russell Investments) for their opinions. They shared three key decisions they all had to make in formulating an asset allocation strategy.

1. The first question is what pieces should go in the puzzle — in other words, what asset classes should you include?

KIC started with a mostly global equity and fixed income portfolio in 2005. Since 2008, their mandate gradually expanded to include alternative investments, such as hedge funds, infrastructure, private equities, and real estate, explained former CIO Dong Ik Lee.

Tomas Franzén, chief investment strategist at AP2, told us that the fund started up over 10 years ago. Its policy portfolio now includes emerging market debt and equities as well as alternative investments (private equity, real estate, timber and agriculture, alternative risk premium, and alternative credit).

My Take: The textbook answer to this question is that everybody should have the same pieces, with size (total assets or total net worth) being the only difference. In reality, however, investors have different levels of risk tolerance and home country bias. They tend to start from the low end of the risk spectrum and stick closer to home, and then move towards a global portfolio. People generally begin with domestic stocks and bonds, then transition towards international, first with developed markets and then emerging markets. Many institutional investors have also gradually added alternatives exposures in recent decades.

2. How active should the portfolio be?

There is no single right answer to this question. Investors will have to look at their own circumstances.

Whether active management can add value has been a perennial debate. As Franzén put it, “Pure alpha is divine. And it’s quite expensive as well.” As a result, AP2 has been increasingly relying upon enhanced index strategies to get market exposures and some other well established drivers of return, especially in more efficient markets.

But many have not given up the fight entirely. KIC initially adopted a quantitative approach with low tracking error but has more recently started trying to add extra return by hiring research staff and becoming “more creative,” in Lee’s words. AP2 also realizes the value of active managers in particular asset classes. For example, they believe that Qualified Foreign Institutional Investor (QFII) is strategically better than investing in H-shares, and that they need good external managers based in the region. These managers enjoy more freedom to deviate from the benchmark.

My Take: Unless you have proven skills investing directly or in identifying external managers who do, (enhanced) indexing seems to be the natural solution.

3. Should you manage the money yourself or use external managers?

“When expanding outside of Sweden, we hired external managers, which turned out less successful than we hoped. We have since developed tilted indices and took assets in-house using a quantitative process. The exception is alternatives, all [are] managed externally,” said AP2’s Franzén. Similarly, KIC outsources about a third of its publicly traded securities and all alternatives.

Scott Anderson, head of equity research for Japan at Russell Investments, discussed their manager search process. “We try to understand qualitatively [ . . . ] their approach on top of conducting quantitative analysis of performance data and see if they are consistent. In particular, we screen for poor performance and see whether that can be explained by the philosophy.” Anderson believes that it is important to distinguish between luck and skill. “Being contrarian and delivering solid performance is a good indication of skill,” Anderson added.

My Take: Unless you have proven skills investing directly, hiring external managers seems to be a natural solution. And unless you have tremendous skills in trading operations and/or running extremely large sums of money, you should not even be doing your own index investing since the top vendors in the business would have a tremendous cost advantage.

Answering these three questions correctly should be sufficient in getting you started in managing your multi-asset strategy portfolio, be it an institutional fund or your retirement money. For more advanced discussions, stay tuned for the next two installments in this series.

For another great source of practitioner insights on our website, you can search all CFA Institute publications or use the advanced search option and limit your search to Conference Proceedings and Research Foundation publications in which we document the wisdom of some of the best and brightest in the industry.

For more in-depth coverage of these topics, Multi-Asset Strategies: The Future of Investment Management is available to CFA Institute members.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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About the Author(s)
Larry Cao, CFA

Larry Cao, CFA, senior director of industry research, CFA Institute, conducts original research with a focus on the investment industry trends and investment expertise. His current research interests include multi-asset strategies and FinTech (including AI, big data, and blockchain). He has led the development of such popular publications as FinTech 2017: China, Asia and Beyond, FinTech 2018: The Asia Pacific Edition, Multi-Asset Strategies: The Future of Investment Management and AI Pioneers in Investment management. He is also a frequent speaker at industry conferences on these topics. During his time in Boston pursuing graduate studies at Harvard and as a visiting scholar at MIT, he also co-authored a research paper with Nobel laureate Franco Modigliani that was published in the Journal of Economic Literature by American Economic Association. Larry has more than 20 years of experience in the investment industry. Prior to joining CFA Institute, Larry worked at HSBC as senior manager for the Asia Pacific region. He started his career at the People’s Bank of China as a USD fixed-income portfolio manager. He also worked for US asset managers Munder Capital Management, managing US and international equity portfolios, and Morningstar/Ibbotson Associates, managing multi-asset investment programs for a global financial institution clientele. Larry has been interviewed by a wide range of business media, such as Bloomberg, CNN, the Financial Times, South China Morning Post and the Wall Street Journal.

14 thoughts on “Three Key Decisions in Formulating an Asset Allocation Strategy”

  1. Savio Cardozo says:

    Hello Larry
    The discussion you have started is a timely one as the plethora of products we have in the market create both an opportunity to assemble the pieces of the puzzle as you eloquently describe in the first point but also make it difficult for the layman to do so effectively, as you also suggest in the next two points.
    Perhaps I am jumping ahead in your discussion but would like to add two things that I have found to be useful in deciding what asset classes to include – the covariance matrix between assets and liquidity of the assets.
    Thank you again for taking the time to put this together – I look forward to reading your next post on this subject.
    Best wishes

    1. Brad Case, PhD, CFA, CAIA says:

      I totally agree on the importance of the covariance matrix, but it’s absolutely crucial to note that we’re talking about the TRUE covariance, not the MEASURED covariance matrix. I think that the biggest reason for the very unfortunate growth of investing in illiquid assets (especially private equity) is that their illiquidity “forces” (permits) the use of valuation measures that disguise their true volatility and their true covariances with other assets, thereby making them appear to provide greater portfolio diversification benefits than they really do. That doesn’t help the beneficiaries at all–but unfortunately it often does help the people who should be exercising better fiduciary responsibility on behalf of the beneficiaries!
      Great post, especially your discussion of #2. Thank God for Franzen!

      1. Larry Cao, CFA says:


        Good point about the true vs. measured covariance matrices. As balanced funds evolved into multi-asset strategies, stability of covariance matrices became a bigger problem. In the next post, we’ll discuss a way out.

        Warm regards,

      2. Savio Cardozo says:

        Hello Brad, that is an excellent distinction – thank you. Regards Savio

    2. Larry Cao, CFA says:


      Thank you for your kind words. You are right in pointing out that there are various “criteria” investors could use to determine what asset classes should go into the puzzle. What Lee and Franzen discussed in the first point were in a way what have passed the screening process.

      The explosion of new “asset classes” complicates this picture. Note liquidity becomes a more important criteria in the selection process as the number of asset classes multiply and co-variance matrices become less effective. We’ll get into more details in the next post. Stay tuned.

      Warm regards,

  2. The one point is that institutional investors are increasing over weighing illiquid assets in their asset allocation strategies owing to their long term horizon position. Agains fund managers peformance and skills have come under spotlight post 2008 financial crisis. Research has shown a very justifiable reason that most managers performances are more of idiosyncratic returns which in most cases has nothing to do with diversification and market timing. Nice thought Cao. Hopefully looking forward to the next two discussion.

    1. Brad Case, PhD, CFA, CAIA says:

      I may be misunderstanding your point, but I certainly don’t think it’s true that institutional investors are increasing their holdings of illiquid assets because of their long-term horizon.
      For example, the measured volatility of illiquid assets is less than for otherwise-similar liquid assets when measured over short investment horizons such as a month, quarter, or even year, but not when measured over the longer investment horizons that many institutional investors SHOULD be using.
      Similarly, the measured correlation of illiquid assets with liquid is relatively low when measured over short investment horizons, but not when measured over longer investment horizons.
      These patterns are called a “downward-sloping term structure of volatilities” and a “downward-sloping term structure of correlations.” They arise in part because returns of illiquid assets are measured incorrectly over short horizons, but those return measurement errors tend to be corrected over longer horizons.
      For an example of the downward-sloping term structure of volatilities, please check out,

  3. Jeremy Smilg says:

    Excellent point by Brad but even more troubling is the misuse of return data. Asset allocators continue to use – for example- hedge fund indices which suffer massively from survivorship and back-fill bias. See Ang’s book on Asset Management, for example. Remarkably, sometimes the data deficiencies are noted in the disclaimers but then ignored. The result is an unjustifiable exposure to hedge funds which suits consultants and sometimes trustees as it enables long term unrealistic return forecasts to be justified.

    1. Brad Case, Ph.D., CFA, CAIA says:

      I totally agree, Jeremy. Another big problem is that investment managers love to report gross returns, not returns net of fees and expenses. That’s not a big problem if the fees and expenses are relatively low, such as for index funds and even actively managed funds of many listed assets–but for hedge funds, private equity, and private equity real estate, it feels a lot like outright fraud. (I should note that the HFRI is an index of net returns.)

      In CEM Benchmarking’s study of actual investment results for more than 300 U.S. pension funds over the 14-year period 1988-2011 (available at, the highest investment costs were for private equity (238.3 basis points per year), hedge funds (125.1), and private real estate (112.6). In fact, for hedge funds investment costs burned up more than one-fifth of gross total return. No wonder they want to focus on gross returns, rather than what the investors actually receive.

  4. Larry Cao, CFA says:

    I just wanted to alert readers interested in further exploring the correlation issue etc. to check out the next article in this series. Hope it helps answer some of the questions.

    Thanks all for visiting our blog!


  5. To msowanick says:


    Thanks for whittling away the bark to expose the root of so many analytical problems. Or lack of proper analytics.


    1. Brad Case, PhD, CFA, CAIA says:

      I’m glad my comments are helpful, Tom. Thanks.

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