Asset allocation has long been one of the favourite tools for investors that want a diversified portfolio. With this technique, investors can divide their investments into various asset classes. These asset classes have different markets and characteristics. It limits investors’ losses when one of the markets in which they own assets goes into a downfall.
Asset allocation can be significantly helpful for investors. However, the traditional approach to this technique may not be as effective for every investor. There are several other variations of asset allocation that allow investors to customize their portfolios accordingly. One such approach that is relatively uncommon is liability-relative asset allocation.
What is Liability-Relative Asset Allocation?
With the traditional asset allocation approach, investors divide their portfolios into various asset classes. Usually, they have an objective based on which they allocate their investments into a specific portfolio mix. However, some investors may want to focus their asset allocation approach based on their liabilities. This approach is most common among pension funds or insurance agencies.
With liability-relative asset allocation, investors can manage their assets to reduce any risks associated with failure to repay liabilities. Usually, pension fund managers use it to choose assets that meet the objectives set to meet their liabilities. Another name used for liability-relative asset allocation is asset-liability management. It goes against the traditional asset-only strategic allocation techniques.
With Liability-relative asset allocation, investors can consider both their assets and liabilities. Usually, they net both of these to calculate whether they have a surplus or deficit of assets. With this approach, investors aim to manage their surplus or deficit to ensure they have enough assets to pay off future obligations. Therefore, they usually incorporate liabilities as a separate asset class when considering the portfolio mix.
How does Liability-Relative Asset Allocation work?
As mentioned, liability-relative asset allocation is prevalent among pension funds. These funds have liabilities that they need to pay off in the future. Liability-relative asset allocation works by defining the liabilities first. These liabilities dictate the asset allocation ratio used by these funds. It, in turn, influences the risks needed to support these liabilities.
Pension fund managers also need to consider the time value of money when estimating their liabilities. Therefore, they use the present value of all their obligations. Once they determine those, managers can establish a funding ratio. Based on this ratio, they can divide their assets into various asset classes. On top of this, the surplus or deficit calculated by the manager will also impact the asset allocation used.
Overall, with the liability-relative asset allocation approach, managers can hedge the risks associated with their funds. Therefore, it involves building a portfolio that recognizes those risks and reacting to them accordingly. Managers use their identified risks to decide on the assets they want to include in their portfolios. As mentioned, these assets need to correlate with the fund’s liabilities for liability-relative asset allocation to be effective.
Conclusion
Liability-relative asset allocation is a variation of the traditional asset allocation technique to investing. It is most prevalent among pension funds and insurance companies. Using this approach, fund managers must first identify their liabilities. Once they do so, they identify assets that can help the fund in meeting its obligations. Overall, it allows managers to hedge the risks associated with their funds.
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