Bridging the Gap between Strategic Allocation and Investment Risk

Journal of Portfolio Management, Forthcoming

32 Pages Posted: 1 Oct 2019 Last revised: 23 Dec 2019

See all articles by Redouane Elkamhi

Redouane Elkamhi

University of Toronto - Rotman School of Management

Jacky S.H. Lee

Healthcare of Ontario Pension Plan

Sheikh Sadik

University of Toronto - Rotman School of Management

Date Written: September 16, 2019

Abstract

For many institutional investors, there is a potential inconsistency between models used for long term strategic asset allocation and investment risk management. Investment risk models, often calibrated with a shorter history spanning five to fifteen years, could provide misleading results when used for portfolio construction decisions, which usually take into account longer term asset characteristics spanning multiple business cycles. In this article, we propose a methodology inspired by change of measure and importance sampling to address this challenge. We show that it is possible to reflect long term asset characteristics in the simulated scenarios generated by a risk system, creating a better alignment between the risk and long term asset allocation models. Our methodology allows institutional investors to better utilize their existing simulation from risk models for portfolio allocation, sensitivity analysis, stress testing and other portfolio applications.

Keywords: Financial Markets, Financial Economics, Investment Risk, Asset Allocation, Risk Analysis, Market Simulation, Bayesian Analysis, Change of Measure, Importance Sampling, Institutional Investors, Pension Fund, Sovereign Wealth Funds

JEL Classification: G11, G12, G17, G23, C53

Suggested Citation

Elkamhi, Redouane and Lee, Jacky and Sadik, Sheikh, Bridging the Gap between Strategic Allocation and Investment Risk (September 16, 2019). Journal of Portfolio Management, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3454958 or http://dx.doi.org/10.2139/ssrn.3454958

Redouane Elkamhi

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

Jacky Lee (Contact Author)

Healthcare of Ontario Pension Plan ( email )

1 York Street
Toronto, Ontario M5J0B6
Canada

Sheikh Sadik

University of Toronto - Rotman School of Management ( email )

Toronto, Ontario M5S 3G8
Canada

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