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Reading 1CFA L3 AAFull chapter

Strategic asset allocation — mean-variance and beyond

In this chapter: Mean-variance optimisation (MVO) and limitations · Black-Litterman approach · Risk-parity · Liability-driven investing (ALM) · Re-sampled efficient frontier

~3 min readLayer 4 · Professional CertificationsFree

SAA defines the long-run mix of asset classes. Different methodologies suit different investor types and constraints. CFA L3 essays test selecting and defending an approach.

Foundation

**Mean-variance optimisation (MVO)**: - Inputs: expected returns (μ), covariances (Σ), risk aversion (λ). - Solve: max U = μ'w – (λ/2) w'Σw subject to constraints. - Output: weights minimising variance for target return (or maximising return for target risk). MVO weaknesses: - "Error maximisation": small changes in inputs → big shifts in weights. - Highly sensitive to expected return inputs. - Concentrates in 2-3 assets often (corner solutions). - Single-period framework. **Black-Litterman**: - Combines market-implied equilibrium returns with investor views. - Reduces estimation error by anchoring at market consensus. - Allows partial views (e.g., "Indian equity will outperform US by 2%"). **Risk parity**: - Equal risk contribution from each asset class. - Typically: lever fixed income to match equity risk. - 60/40 in dollars ≠ 60/40 in risk (equity dominates). **ALM (Liability-Driven Investing)**: - For pension/insurance: assets must match liability profile. - Surplus optimisation: maximise return subject to surplus volatility.

Deep Dive

Constraints in SAA: - Long-only (most common). - Position limits (max 30% any class). - Liquidity reserve. - ESG exclusions. Resampling: - Run MVO across many input scenarios. - Average resulting frontier weights. - Reduces input-sensitivity. Used by Ibbotson, Morningstar. Factor-based approach: - Allocate to factors (value, momentum, low-vol) rather than asset classes. - Cleaner risk attribution; matches what drives returns. Rebalancing rules: - Calendar (e.g., quarterly). - Tolerance bands (rebalance when weight drifts >5% from target). - Tax-aware: minimise realised gains.

Advanced

CFA L3 essay: "Recommend an SAA framework for [investor type]." Score points by: - Identifying objectives + constraints (return, risk, liquidity, time horizon, taxes, legal, unique). - Choosing methodology consistent with investor type. - Listing weaknesses and remedies. - Specifying rebalancing policy. For pensions: ALM (surplus optimisation). For endowments: spending-policy-driven optimisation (Yale model). For private wealth: goals-based or after-tax MVO. For sovereign wealth: long-horizon equilibrium with intergenerational equity.

Regulatory references
  • CFA Institute Asset Allocation curriculum
  • Custom IPS templates
Common mistakes & pitfalls
  • Letting MVO do all the work — input quality matters more.
  • Ignoring tax in personal-wealth SAA.
  • Fixed-percentage rebalancing without tolerance bands → over-trading.
  • Not aligning SAA with liability profile for institutions.

Frequently asked

What's the right rebalance frequency?
Annual + tolerance bands works well for most. Monthly: too much trading. Bi-annual + bands: better.
Should I use risk parity for personal wealth?
Possible but requires leverage. Most retail investors prefer simpler 60/40 or goals-based.

Practice questions

Click each question to reveal the answer and explanation.

Q 1
MVO is highly sensitive to:
  1. (a)Holdings period
  2. (b)Expected return inputs
  3. (c)Asset names
  4. (d)Currency
Correct: (b) Expected return inputs
Small changes in expected returns → large shifts in optimal weights. "Error maximisation."
Q 2
Black-Litterman starts with:
  1. (a)Investor views only
  2. (b)Market-implied equilibrium returns
  3. (c)Equal weights
  4. (d)Random
Correct: (b) Market-implied equilibrium returns
BL combines market equilibrium (anchor) with investor views (adjustment).
Q 3
Risk parity equalises:
  1. (a)Dollar weights
  2. (b)Risk contributions across assets
  3. (c)Returns
  4. (d)Volatility of each holding
Correct: (b) Risk contributions across assets
Each asset contributes equal risk to portfolio. Typically requires leverage.
Q 4
ALM is most relevant for:
  1. (a)Young retail investors
  2. (b)Pension and insurance with explicit liabilities
  3. (c)Day traders
  4. (d)Charities only
Correct: (b) Pension and insurance with explicit liabilities
ALM matches assets to liability profile — pensions, insurance.
Q 5
Rebalancing tolerance bands reduce:
  1. (a)Diversification
  2. (b)Trading costs while keeping risk in line
  3. (c)Long-run return
  4. (d)Tax burden always
Correct: (b) Trading costs while keeping risk in line
Tolerance bands trade only when drift material — fewer trades, lower costs.
Educational purposes only. The numbers, returns, and examples used in this lesson are illustrative. Past performance does not guarantee future results. Mutual fund and securities investments are subject to market risks. This lesson is not investment advice; for advice tailored to your circumstances, consult a SEBI-registered Investment Adviser. Read our full disclaimer.