Asset-Only vs Liability-Relative vs Goals-Based: when do you use each approach?

Question

AcadiFi · Accepted Answer

This is a core distinction in the Level III curriculum. Here's a decision framework:

**1. Asset-Only Approach**
- **What it is:** Optimize the portfolio's risk-return trade-off without reference to any specific liabilities or goals. Classic mean-variance optimization falls here.
- **Best for:** Endowments, sovereign wealth funds, individuals without specific dated liabilities.
- **Example:** A university endowment that aims to maximize long-term real returns to support operations indefinitely. There's no specific liability to 'match' — they want the best risk-adjusted return.
- **Key metric:** Sharpe ratio, expected return, portfolio volatility.

**2. Liability-Relative Approach**
- **What it is:** Optimize the portfolio relative to a specific set of liabilities. The goal is funding those liabilities with high confidence.
- **Best for:** Defined benefit pension plans, insurance companies, banks — any entity with quantifiable future obligations.
- **Example:** A corporate pension fund with $500M in PV of pension obligations. The allocation must ensure these obligations are met. The key metric is *surplus* (assets − liabilities) and surplus risk.
- **Techniques:** Surplus optimization, liability-driven investing (LDI), liability glide paths.
- **Key metric:** Surplus return, funded ratio, shortfall probability.

**3. Goals-Based Approach**
- **What it is:** Divide the investor's wealth into sub-portfolios, each aligned with a specific goal that has its own time horizon, required probability of success, and risk tolerance.
- **Best for:** High-net-worth individuals and families with multiple financial objectives.
- **Example:** A wealthy retiree with three goals:
  - *Essential needs* ($2M, 95% confidence): Conservative allocation — short-term bonds, TIPS.
  - *Lifestyle desires* ($1M, 75% confidence): Balanced allocation — 60/40 stocks/bonds.
  - *Aspirational legacy* ($500K, 50% confidence): Aggressive — 80% equities, alternatives.
- **Key insight:** Each sub-portfolio has a different efficient frontier because each has a different minimum required return and acceptable failure probability.

**Quick Decision Rule:**

| Investor Type | Approach |
|---|---|
| Endowment, SWF, foundation | Asset-Only |
| DB pension, insurer | Liability-Relative |
| HNW individual, family office | Goals-Based |
| Individual with DB pension + personal wealth | Combination (LR for pension, Goals for personal) |

**Exam Tip:** The vignette will usually describe the investor's situation in enough detail that the correct approach becomes clear. If there are explicit dated liabilities, it's liability-relative. If it's a wealthy individual with multiple objectives, it's goals-based.

Dive deeper into each approach with our CFA Level III practice materials.

Asset-Only vs Liability-Relative vs Goals-Based: when do you use each approach?

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