Asset Allocation and Institutional Investors
What to know
Institutional allocators frame alternatives with risk rather than capital weights: risk budgeting and marginal contribution to risk, factor-based allocation, and the practical limits of mean–variance (estimation error, resampling, and Black–Litterman, which blends CAPM equilibrium returns Π = λΣw with subjective views). Pensions need liability-driven investing and surplus optimization, where the discount rate reflects liability risk, not the expected asset return. Endowments follow the endowment model: spending + inflation + fees defines the required return, and illiquidity is budgeted explicitly through commitment pacing and liquidity tiers. Watch the measurement layer: appraisal-based real estate and smoothed hedge fund returns are serially correlated, understating volatility and inflating Sharpe ratios. Use downside measures (Sortino, maximum drawdown, CVaR) and de-smoothed returns. Rebalancing is constrained because illiquid holdings cannot be sold on demand, so drift is managed with new contributions and distributions rather than trades.
Traps
- Claiming the liability discount rate should equal the expected return on assets.
- Comparing a smoothed private-asset Sharpe ratio with a public equity Sharpe ratio.
- Treating risk parity as equal capital weights (it equalizes risk contributions).
- Forgetting that Black–Litterman equilibrium returns derive from the market portfolio, not the manager's forecasts.
Rule of thumb
Endowment required return = spending (5%) + inflation (2.5%) + fees (0.5%) = 8%. If expected return is 7%, the policy is infeasible and spending must fall or a higher failure probability accepted. For a duration-12 pension, a 1% decline in the discount rate raises liabilities roughly 12%.