The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

DYNAMIC ALLOCATION DECISIONS TO THE PERFORMANCE-SEEKING AND LIABILITY-HEDGING PORTFOLIOS

Assuming that reasonable proxies for performance-seeking and liability-hedging portfolios have been designed using some of the afore-mentioned methodologies, we must still determine the optimal allocation strategy to those two building blocks. A series of novel paradigms, which we describe next, are reshaping our approaches to long-term investment decisions for long-term investors facing liability commitments and short-term performance constraints.

Accounting for the Presence of Investors’ Liability Commitments: The Liability-Driven Investment Paradigm

As explained earlier in this chapter, investors endowed with consumption/ liability objectives need to invest in two distinct portfolios, in addition to cash: one performance-seeking portfolio and one liability-hedging portfolio, construction methods that have been discussed in previous sections.

Formally, under the assumption of a constant opportunity set,¹⁴¹ we obtain the following expression of the fund separation theorem in the intertemporal context when trading is possible between current date and investment horizon:

This expression is similar to that in equation (7.2), extended to the asset-liability management setting. As appears from this equation, the allocation to the “risky” building block is a decreasing function of the PSP ...