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

Steve Sapra

Client Solutions & Analytics

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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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Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio.

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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