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.

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The Author

Ravi K. Mattu

Global Head of Analytics

Mukundan Devarajan

Quantitative Research Analyst, Asset Allocation Research

Steven Sapra

Quantitative Research Analyst, Client Analytics

Dzmitry Nikalaichyk

Quantitative Research Analyst



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