Asset Allocation

Multiple studies show that asset allocation is the most critical driver of portfolio risk and return. As such, we believe that setting a long-term, strategic asset allocation is a critical component to the investment policy. Since each plan has different objectives and goals, we believe no one optimal portfolio will suit all clients and plan types. The plan’s portfolio guidelines and overall structure should reflect consideration of each investor’s risk/return objectives and constraints, such as time horizon, liquidity, and legal/regulatory requirements.

Asset Allocation Studies

Asset allocation studies are the foundation of the asset allocation process. Studies are based on mean variance optimization (MVO), which produces a set of optimal portfolios that provide the highest level of expected return for a given level of risk. Although no asset allocation process or client portfolio is perfect, we employ a rigorous methodology that leverages quantitative tools to inform human judgment. We believe the resulting discussions with clients is healthy, enlightening, and sharpens the alignment between plan objectives and portfolio structure.

To fully appreciate the rigor of these studies, there are several elements that are worthy of discussion:

  • Capital Markets Assumptions:
    The critical inputs of an asset allocation study are the expected risk, return, and correlations of different asset classes. Each year, RVK completes an extensive asset allocation assumption setting process, requiring participation from virtually all investment professionals of the firm. Teams are assigned to review the historical performance, current dynamics, and future economic expectations of each asset class to set expected risk, return, and correlations. Given the long time horizon of analysis (10+ years), annual adjustments are typically small on a relative basis, yet they still have an impact on the asset allocation process.
  • Adjustments for "Non-Normality" of Asset Class Returns:
    A common criticism of MVO is that by predicting portfolio returns and risk based on standard deviations, it assumes that future asset class returns fit a "normal distribution." However, history has proven that returns do not fit this pattern—in fact, significant outlier events (often referred to as "fat tail" events) happen much more frequently than expected. Realizing this weakness, RVK has employed advanced statistical techniques to verify that our return distributions properly reflect these "fat tail" events and provide our clients with more realistic expectations of portfolio volatility over short and long time periods.
  • Qualitative Analysis Informed by Quantitative Results:
    MVO is a powerful tool, but it is not a suitable replacement for human judgment. For example, perhaps the most significant drawback of MVO is that it defines “risk” solely in terms of standard deviation of returns despite the fact that there are many other risks with which Trustees must be concerned. One such risk that is considered is liquidity (i.e., will the portfolio be able to meet spending requirements), and there are many others. To verify that risk is viewed holistically, RVK supplements the MVO analysis with a qualitative review to shape optimal portfolios that consider objectives and risks beyond simple metrics of risk and return.