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Asset owners typically use a two-stage process to construct their investment portfolio. The first step is the creation of a “policy portfolio.” This portfolio makes the tradeoff between expected returns and risk, and involves forecasting expected returns, volatilities and correlations for the various asset classes under consideration. The policy portfolio provides the baseline set of factor risks desired by the investor and serves as the anchor to the final portfolio. After the components of the policy portfolio are determined, the second step involves manager selection, whereby specific managers are hired under the assumption that, in aggregate, the managers’ portfolios reflect the factor risks of the policy portfolio. While this process makes portfolio construction tractable, it may lead to unintended risk exposures at the overall portfolio level. To the extent managers’ portfolios imbed structural tilts to certain risk factors, asset allocators may be systematically exposing themselves to risks beyond those expected from their policy portfolio.
Quantitative Research Analyst, Asset Allocation Research
Client Solutions & Analytics
This Research paper is a joint effort between PIMCO and GIC, Singapore’s sovereign wealth fund. GIC authors Grace Qiu Tiantian Ph.D., Ding Li, and Zhihui Yap collaborated with PIMCO’s Josh Davis, German Ramirez, and Helen Guo to produce this report.
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This paper contains hypothetical analysis based on a set of assumptions that may or may not develop over time. Results shown may not be attained and should not be construed as the only possibilities that exist. Different weightings in the asset allocation illustration will produce different results. Actual results will vary and are subject to change with market conditions. There is no guarantee that results will be achieved. The analysis reflected in this information is based upon data at time of analysis. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.
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The correlation of various indexes or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility.
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