Asset classes and the strategic asset allocation

In short

• An asset class groups assets with similar characteristics and risk-return relationships. Good asset classes are homogeneous (high correlation within, lower correlation with other classes), mutually exclusive, and together approximate the investable universe.
• The SAA focuses on asset classes because systematic risk explains most long-run portfolio value changes, and asset class returns reliably reflect exposure to systematic factors.
• Capital market expectations: expected returns (risk-free rate + risk premiums), standard deviations and correlations of asset classes.
• IPS + capital market expectations → optimisation and/or simulation → SAA. The SAA is kept separate from the IPS because it rests on different information and is reviewed on a different cycle.
• In mean-variance terms, the SAA is where the client's highest indifference curve touches the efficient frontier, using utility $U_p = E(R_p) - \lambda\sigma_p^2$. In practice the IPS gives thresholds, and multi-period problems use simulation.