issues in Strategic Asset Allocation 105 lyzed in the context of an asset/liability study (Chapter 10 has a longer discussion

of the impact of liabilities on asset allocation). Further risk reductions can be easily achieved through international diversification of the equity and fixed income portions of the portfolio. Each of these decisions has the impact of reducing total portfolio volatility and correspondingly increasing the total portfolio Sharpe ratio fto a point). A portfolio's Sharpe ratio is simply its excess return divided by its volatility. While international diversification has the benefit of reducing portfolio volatility, it also exposes the portfolio to currency fluctuations. These fluctuations in turn mean that the portfolio has another risk exposure. Consequently, investors need to formulate a long-term currency hedging policy. This policy should clearly balance the level of currency risk in the portfolio with the risk exposure from other asset classes. Note that since this policy is the strategic currency hedging policy, it should not reflect any short-term views on currency movements. These views are best expressed as part of an active management process. Exposure to active management represents a fourth policy decision. In our view, active risk represents exposure to both another source of risk and, correspondingly, another source of potential performance. Investors can improve their Sharpe ratios by including allocations to active risk. The basic issues are to balance the allocation to active risk against other portfolio exposures, and to structure an active portfolio so that active risk is being taken where it is most likely to be rewarded. The final strategic issue that investors must consider is the allocation to alternative asset classes such as hedge funds, private equity, real estate, and natural resources. Exposures to these asset classes can provide important sources of portfolio performance. Thorough portfolio analysis, however, is made more difficult due to the generally poor quality of data. Each of these decisions deserves careful consideration. In addition to a thorough analysis of each component, investors would be well advised to consider how each decision interacts with all other decisions. To our minds, the best analytical structure to consider these decisions is an equilibrium approach. This approach, as best we can tell, is the only one that lets investors consider all trade-offs in a theoretically consistent manner. It is relatively easy to implement, identifies the key trade-offs, is portable across clientele types, and is free of the limitations of standard approaches to asset allocation. ISSUES WITH STANDARD FRAMEWORK AS USUALLY APPLIED Asset allocation analysis has played an important role in the management of institutional assets for at least the past 20 years. As computer costs dropped, it became increasingly easy for institutional investors to implement the textbook approaches to asset allocation. Figure 9.1 gives a paradigm for finding a strategic asset allocation based on applications of standard tools. The approach outlined in Figure 9.1 begins with an assessment of the available asset classes. Moving clockwise, in the next step an investor assesses the volatility and correlation of excess returns for each of the asset classes. The following step is to define expected returns over the investment horizon for each of the asset classes.

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