Choose the objective before the asset mix

Learning goals

• Distinguish asset-only, liability-relative and goals-based policies.
• Use an economic balance sheet and governance process.

Draft · approximately 60 minutes, excluding further revision.

Decision case · fictional facts

A fictional charity holds liquid investments 80, an operating building 30 and expected committed donor receipts with estimated PV 20. Spending commitments have PV 90, of which 8 is due within one year. The board compares a return-maximizing policy with a policy protecting spending. Its building is illiquid and closely linked to the charity’s local economy.

Economic exposures extend beyond the trading account

An economic balance sheet includes relevant financial and nonfinancial assets, human or sponsor capital and liabilities, with uncertainty and liquidity identified. Counting the building and donor PV as wealth does not make them spendable cash. Correlation with operating income can make local equity exposure more concentrated than the investment account alone suggests.

Asset-only policy emphasizes portfolio return and risk without a direct liability benchmark. Liability-relative policy focuses on funding surplus or tracking liabilities; goals-based policy organizes distinct priorities and shortfall tolerances. Total volatility, surplus volatility and probability of missing a goal are different risk definitions. Choose the definition that corresponds to the institution’s purpose.

Make governance and implementation explicit

Document decision rights, strategic weights, risk budgets, delegated authority, reporting and rebalancing triggers. Asset classes should be investable, meaningfully distinct and internally coherent; labels can hide shared factors such as equity beta, illiquidity and inflation. Compare a broad market baseline with liability or factor exposures before active deviations.

Passive implementation limits some costs and active risks but retains market and index-design risk. Active mandates require an evidence-based expected benefit net of fees, turnover and oversight. Rebalancing can be calendar- or threshold-based; consider flows, taxes, transaction costs and illiquidity rather than mechanically restoring weights every day.

Select risk definitions and a feasible economic allocation

An asset-only portfolio may minimize volatility for a target mean, whereas a liability-relative portfolio controls surplus or liability tracking error. Goals-based policy prioritizes shortfall against essential and discretionary commitments. A household with a stable nominal pension and floating living costs has different risks from an endowment with real spending. Define the objective before comparing efficient portfolios.

Choose asset classes that represent investable, sufficiently homogeneous exposures without excessive overlap. Listed property and equity can share beta; private debt and public credit share default sensitivity. A factor map exposes this overlap. For a charity with80 liquid assets and8 due next year, first reserve suitable liquidity, then assess the remaining72 against liability duration and operating-building concentration rather than maximizing its isolated mean.

Global baselines, implementation and rebalancing governance

The global market portfolio supplies a broad capitalization-weighted starting point, not a mandatory final policy. Home-currency liabilities, restricted assets and tax status can justify documented deviations. Passive funds, futures and separately managed portfolios differ in tracking, leverage, collateral and ownership rights; active management requires expected value after all incremental costs and oversight.

State who chooses policy, who can trade and what triggers escalation. Calendar rebalancing is simple, tolerance bands react to drift, and incoming cash can reduce selling. Greater asset volatility or covariance shifts can favor tighter control, while high taxes and illiquidity can favor wider bands. Evaluate cost and risk jointly; restore weights only when feasible under the mandate.

Formula and assumptions

Economic net wealth=financial and relevant nonfinancial assets−liabilities; funding ratio=eligible assets/liability PV

Errors to catch

• Treating nonfinancial assets as immediately liquid.
• Comparing policies using different risk definitions without noticing.

Write, compare, then self-assess

Your writing stays in this page’s memory and is lost on reload. Export includes self-assessment totals only.

Original knowledge check

Answer every question before checking. Review explanations after submitting; retry starts a new attempt.

Sources and coverage status

These original lessons are drafts. Public outlines are used to check scope; the official learning-outcome text and proprietary question banks are not reproduced here. Follow the source for exam-year requirements and updates.

• Reference · www.cfainstitute.org