Asset Allocation: From Theory to Practice and Beyond (Wiley Finance)

369 Pages·2021·7.907 MB·English

by  Mark P. Kritzman, William Kinlaw, David Turkington

Praise for the first edition:
“A Practitioner’s Guide to Asset Allocation”
“Asset allocation is the most important yet challenging decision faced by every
investor. By masterfully bridging theory and practice, Kinlaw, Kritzman, and
Turkington have produced a modern guide to the topic that will be useful to
practitioners and scholars alike.”
— Robin Greenwood, George Gund Professor
of Finance and Banking, Harvard Business School
“A Practitioner’s Guide to Asset Allocation is an exceptionally comprehensive
treatise on the subject, as can be seen from just a sampling of the chapter headings—
Fallacies (of which there are many), Time Diversification (not as easy as it may
seem), Factors (points out some issues with this current hot trend), Illiquidity (what
does it really cost), Risks (not just at- horizon, but also within- and beyond- horizon),
and perhaps most important of all, Regime Shifts. This book has a lot to say, and a
page- by- page read may be a bit much for the typical ‘Practitioner,’ but the authors
provide a very readable chapter of Takeaways that should perhaps be the first point
of entry. But even these more compact Takeaways are full of fresh insights into this
truly important topic that is all too often given too short a shrift.”
— Martin L. Leibowitz, PhD,
Vice Chairman – Research, Morgan Stanley
“Kinlaw, Kritzman, and Turkington have a long history of discovering and very
clearly describing surprising and useful investment results. This book continues
that tradition by correcting several common myths about asset allocation and pre-
senting the latest thinking about this fundamental issue. All investors who practice
asset allocation for a living will benefit from reading this.”
— Ronald N. Kahn, Global Head
of Scientific Equity Research, BlackRock
“One of the best books ever written on applied research for asset allocation. This
outstanding effort provides the missing link between academic research and practice.
With remarkable clarity, the authors explain how to put risk at the center of portfolio
construction. Speaking from experience advising some of the largest pools of assets
in the world, they bring the practice and science of risk-b ased investing to a whole
new level, and challenge conventional wisdom along the way. Everyone involved in
asset allocation should read this book, including CIOs, quants, non-q uants, academ-
ics, consultants, portfolio managers, advisors, individual investors, and plan sponsors.
It will become a reference for the next wave of innovation in our industry. Bravo!”
— Sébastien Page, CFA, Head of Asset Allocation, T. Rowe Price; author, Beyond
Diversification: What Every Investor Needs to Know About Asset Allocation
“Everything you ever wanted and need to know about asset allocation but were
afraid to ask, written by three accomplished practitioners who put their money
where their mouths are.”
— Andrew W. Lo, Charles E. and
Susan T. Harris Professor, MIT Sloan School of Management

Asset Allocation
From Theory to Practice and Beyond
WILLIAM KINLAW
MARK KRITZMAN
DAVID TURKINGTON
Copyright © 2021 by William Kinlaw, Mark Kritzman, and David Turkington. All rights
reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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Library of Congress Cataloging-i n- Publication Data is Available:
9781119817710 (hardback)
9781119817734 (epdf)
9781119817727 (epub)
Cover design: Wiley
Cover Image: © Kentoh/Getty Images
Contents
Foreword to the First Edition xiii
Preface xv
Key Takeaways xix

CHAPTER 1
What Is an Asset Class? 1
Stable Aggregation 1
Internally Homogeneous 2
Externally Heterogeneous 3
Expected Utility 3
Selection Skill 4
Cost- Effective Access 4
Potential Asset Classes 5
References 6
Notes 6

CHAPTER 2
Fundamentals of Asset Allocation 7
The Foundation: Portfolio Theory 7
Practical Implementation 10
The Sharpe Algorithm 17
References 22
Notes 22

CHAPTER 3
The Importance of Asset Allocation 24
Fallacy: Asset Allocation Determines More Than 90%
of Performance 24
The Determinants of Portfolio Performance 24
The Behavioral Bias of Positive Economics 27
The Samuelson Dictum 31
v
vi Contents
The Bottom Line 31
Related Topics 31
References 32
Notes 32

CHAPTER 4
Time Diversification 33
Fallacy: Time Diversifies Risk 33
Samuelson’s Bet 33
Time, Volatility, and Probability of Loss 33
Time and Expected Utility 34
Within- Horizon Risk 37
A Preference- Free Contradiction to Time Diversification 38
The Bottom Line 38
Related Topics 39
References 39
Notes 39

CHAPTER 5
Divergence 40
Fallacy: Volatility Scales with the Square Root of Time,
and Correlation Is Constant Across Return Intervals 40
Excess Dispersion 41
The Evidence 42
The Intuition 45
The Math 46
Implications 49
The Bottom Line 55
Related Topics 55
References 56
Notes 56

CHAPTER 6
Correlation Asymmetry 58
Fallacy: Diversification Is Symmetric 58
Correlation Mathematics 59
Correlation Asymmetry Between Asset Classes 65
Implications for Portfolio Construction 66
The Bottom Line 69
Related Topics 70
References 70
Notes 70
Contents vii

CHAPTER 7
Error Maximization 72
Fallacy: Optimized Portfolios Are Hypersensitive
to Input Errors 72
The Intuitive Argument 72
The Empirical Argument 73
The Analytical Argument 77
The Bottom Line 82
Related Topics 82
References 82
Notes 83

CHAPTER 8
Factors 84
Fallacy: Factors Offer Superior Diversification
and Noise Reduction 84
What Is a Factor? 84
Equivalence of Asset Class and Factor Diversification 85
Noise Reduction 87
The Bottom Line 89
Related Topics 89
References 90
Notes 90

CHAPTER 9
1/N 91
Fallacy: Equally Weighted Portfolios Are Superior to
Optimized Portfolios 91
The Case for 1/N 91
Setting the Record Straight 92
Empirical Evidence in Defense of Optimization 92
Practical Problems with 1/N 93
Broken Clock 94
The Bottom Line 95
Related Topics 95
References 95
Note 95

CHAPTER 10
Policy Portfolios 96
Fallacy: Policy Portfolios Matter 96
Risk Instability 96
viii Contents
What Investors Want 97
Responding to Risk Regimes 97
The Bottom Line 99
Related Topics 99
Reference 99

CHAPTER 11
The Private Equity Leverage Myth 100
Fallacy: Private Equity Volatility Scales with Its Leverage 100
The Private Equity Leverage Puzzle 101
Leverage and Volatility in the Public Equity Market 102
The Bottom Line 106
Related Topics 107
References 108
Notes 108

CHAPTER 12
Necessary Conditions for Mean- Variance Analysis 110
The Challenge 110
Departures from Elliptical Distributions 111
Departures from Quadratic Utility 114
Full- Scale Optimization 117
The Curse of Dimensionality 118
Applying Full- Scale Optimization 120
The Bottom Line 121
Related Topics 122
References 122
Notes 122

CHAPTER 13
Forecasting 124
The Challenge 124
Conventional Linear Regression 124
Regression Revisited 126
Partial Sample Regression 130
The Bottom Line 133
Related Topics 134
References 134
Note 134

CHAPTER 14
The Stock–Bond Correlation 135
The Challenge 135