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This section describes the typical steps that must be taken to implement a systematic asset allocation program.2 A systematic approach enables the asset allocator to design and implement an investment strategy for the sole benefit of the asset owners. Such an approach needs to focus on the objectives and the constraints that are relevant to the asset owner. We begin with a discussion of the first of the five steps in the asset allocation process: identifying the asset owners and their potential objectives and constraints. In most cases, assets are managed to fund potential liabilities. In some instances, these liabilities represent legal obligations of the asset owner, such as the assets of a defined benefit (DB) pension fund. In other cases, assets are not meant to fund legal obligations but to fund essential needs of the asset owners or their beneficiaries. For example, a foundation's assets are managed to fund its future philanthropic and grant-giving activities. The nature of these potential needs or liabilities is a major determinant of the objectives and constraints of each asset owner.

The second step involves developing an overall approach to asset allocation. A critical step is preparing the investment policy statement. The investment policy statement includes the asset allocator's understanding of the objectives and constraints of the asset owners, the menu of asset classes to be considered, whether active or passive approaches will be used, and how often and under what circumstances the allocation will be changed. Such changes arise because of fundamental changes in economic conditions or changes in the circumstances of the asset owner.

The third step is implementing the overall asset allocation policy described in the investment policy statement. This step will require applications of both quantitative and qualitative techniques to determine the weight of each asset class in the portfolio. Since allocations to alternative investments typically involve selection and allocation to managers (e.g., hedge fund and private equity managers), this step will need to have built-in flexibility, as extensive due diligence on managers must be completed, and thus planned allocations may turn out to be infeasible. For instance, the planned allocation may turn out to be less than the minimum investment level accepted by the manager who has emerged on top after the due diligence process.

The fourth step is allocating the capital according to the optimal weights determined in the previous step based on the due diligence and manager evaluation already conducted by the portfolio manager's team or outside consultants.

The final step is monitoring and evaluating the investments. Inevitably, the realized performance of the portfolio will turn out to be different than expected. This will happen because of unexpected changes in the market and because selected fund managers did not perform as expected. As previously stated, the investment policy statement should anticipate circumstances under which the allocation will be revised. This chapter focuses on the first four steps of the asset allocation process. The final step, which deals with benchmarking, due diligence, monitoring, and manager selection, was covered in CAIA Level I (benchmarking) and the rest of this book (due diligence, monitoring, and manager selection).