Bridging the Gap between Strategic Allocation and Investment Risk

Abstract

For many institutional investors, there is a potential inconsistency between models used for long-term strategic asset allocation and investment risk management. Investment risk models, often calibrated with a shorter history spanning 5 to 15 years, could provide misleading results when used for strategic portfolio construction decisions, which usually consider longer-term asset characteristics spanning multiple business cycles. In this article, the authors propose a methodology to address this challenge. They show that it is possible to reflect long-term asset characteristics in simulated scenarios generated by a risk system calibrated with short-term history, creating a better alignment between risk and strategic asset allocation models. Their methodology allows institutional investors to better use existing simulations from their risk models for portfolio allocation, sensitivity analysis, stress testing, and other portfolio applications.

TOPICS: Portfolio construction, simulations, risk management, performance measurement

Key Findings

• ▪ The authors propose a methodology to address the common inconsistency that exists between models used for long-term strategic asset allocation and investment risk management.

• ▪ The authors show that it is possible to reflect long-term asset characteristics in simulated scenarios generated by a risk system calibrated with short-term history, creating a better alignment between risk and strategic asset allocation models.

• ▪ The methodology allows institutional investors to better use existing simulations from their risk models for portfolio allocation, sensitivity analysis, stress testing, and other portfolio applications.