How is the policy portfolio (SAA) constructed from the IPS?

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AcadiFi · Accepted Answer

The strategic asset allocation (SAA) is the long-run policy mix that embodies the IPS. Construction follows five steps:

1. Translate return and risk objectives into feasible targets. Required return and risk tolerance become the portfolio's point on the efficient frontier.

2. Define asset classes. Broad (equity, bond, cash, alternatives) or granular (US large cap, EM, IG credit, HY, TIPS, REITs, commodities, private equity). Granularity matches client complexity.

3. Gather capital market assumptions (CMAs). Expected returns, volatilities, and correlations for each asset class, typically from the firm's research team over a 10-year horizon.

4. Optimize. Mean-variance optimization subject to constraints (minimums, maximums, liquidity requirements, tax sleeves, unique circumstances). More advanced: Black-Litterman with views, resampled efficient frontier.

5. Stress-test and review. Test the portfolio across historical regimes (2008, 2020) and hypothetical scenarios. Confirm it meets the return target in base case with acceptable tail risk.

Constraints from the IPS translate directly:

- Liquidity requirement = minimum cash + short-bond allocation.
- Time horizon binds near-term sleeves (LDI for liabilities).
- Tax position influences after-tax CMAs (municipals, equity-favored).
- Unique circumstances (ESG, concentration) filter the universe.

A concrete example: Cornelius Radburn's IPS requires 7% nominal pre-tax, moderate risk (target stdev 11%), liquidity buffer $150K, horizon 25 years, tax-sensitive taxable account, ESG fossil-fuel-free.

Proposed SAA:
- 50% global equity (ESG-screened)
- 25% core bond + 5% TIPS
- 10% alternatives (private credit, infrastructure)
- 5% REITs (excluding thermal-coal-linked)
- 5% cash/short-duration (liquidity)

CMA expected return: 6.9% nominal, stdev 10.7%. Within 10 bps of target, stdev 30 bps under. Stress test in 2008-equivalent drawdown: -29%, acceptable given 25-year horizon.

CFA exam: policy portfolio must trace directly to IPS line items. Demonstrate the linkage explicitly in exam answers.

How is the policy portfolio (SAA) constructed from the IPS?

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