Three Frameworks, Three Different Investors
The CFA Level III curriculum presents three distinct approaches to asset allocation, each designed for a different type of investor. Choosing the wrong framework is like using the wrong map — you might arrive somewhere, but probably not where you intended.
Understanding when each approach is appropriate, how to implement it, and what its limitations are is central to the asset allocation readings. This guide walks through each framework with practical examples and exam-focused insights.
Asset-Only: Maximizing Risk-Adjusted Returns
When to Use It
The asset-only approach is appropriate when the investor has no explicit, quantifiable liabilities to fund. The classic examples are endowments, sovereign wealth funds, and foundations with perpetual time horizons and spending policies based on portfolio value rather than specific future obligations.
How It Works
The investor defines a set of eligible asset classes, develops capital market expectations (expected returns, volatilities, and correlations), and runs an optimization — typically mean-variance optimization (MVO) — to find the portfolio that maximizes expected return for a given level of risk.
The key metric is the Sharpe ratio: excess return per unit of total risk. The efficient frontier plots all optimal combinations of risk and return, and the investor selects their preferred point based on risk tolerance.
Practical Considerations
Pure MVO is rarely used in practice due to its well-documented sensitivity to input assumptions. Practitioners address this through Black-Litterman reverse optimization, resampled MVO, shrinkage estimators, and explicit weight constraints. These refinements produce more diversified and stable allocations.
Liability-Relative: Funding Obligations First
When to Use It
The liability-relative approach is designed for investors with quantifiable future obligations: defined benefit pension plans, insurance companies, and banks with deposit liabilities. The investment objective shifts from maximizing returns to ensuring that obligations are funded with high confidence.
How It Works
Instead of optimizing asset returns, the investor optimizes the surplus — the difference between assets and liabilities. Surplus return depends not only on asset performance but critically on the correlation between asset returns and liability changes.
This creates a powerful insight: assets that are highly correlated with liabilities reduce surplus volatility even if they have modest standalone returns. For a pension fund whose liabilities are driven by long-term interest rates, long-duration government bonds are the natural hedge, because when rates fall and liabilities increase, these bonds also increase in value.
The Liability Glide Path
Many pension funds implement a glide path that gradually increases the allocation to liability-hedging assets (long bonds) as the funded ratio improves. An underfunded plan needs the growth potential of equities to close the gap; a fully funded plan prioritizes protecting the surplus through duration matching.
Surplus Optimization
Surplus optimization applies the MVO framework to surplus returns. The mathematical structure is identical to asset-only MVO, but the inputs are transformed to reflect the liability dimension. The surplus return for any asset class depends on its standalone return minus the liability-weighted liability return.
Goals-Based: Personal Finance Done Right
When to Use It
The goals-based approach is designed for individual investors and families with multiple financial objectives that have different time horizons, importance levels, and risk tolerances. It is the dominant framework in wealth management.
How It Works
The investor's goals are classified by priority: essential needs (retirement income, healthcare), important desires (home purchase, education funding), and aspirational wishes (philanthropy, luxury purchases). Each goal is assigned a required success probability reflecting its importance — perhaps 90% or greater for essential needs and 50% or lower for aspirational goals.
Each goal then receives its own sub-portfolio, selected from a menu of pre-built modules ranging from conservative to aggressive. The module for each goal is chosen such that, given the capital allocated and the time horizon, it achieves the required success probability.
The overall portfolio is simply the aggregation of all sub-portfolios. Its composition emerges naturally from the goal-level decisions rather than being set top-down.
Why Goals-Based Works for Individuals
The framework's strength is transparency. An investor can see exactly what would happen if they increase the probability of funding their essential needs: the capital available for aspirational goals decreases. Trade-offs are explicit and understandable, even for clients without financial expertise.
Goals-based allocation also constructively harnesses mental accounting — the behavioral tendency to treat different pools of money differently. Rather than fighting this bias, the framework channels it into a disciplined structure.
Choosing the Right Approach: A Decision Framework
For the CFA Level III exam, the choice of approach is usually signaled clearly in the vignette. If the investor is an institution with no liabilities (endowment, SWF), use asset-only. If there are explicit dated obligations (pension, insurance), use liability-relative. If it is an individual with multiple goals, use goals-based.
Some investors require a combination: a pension fund employee might have liability-relative allocation for the pension and goals-based allocation for personal savings. The exam tests whether you can identify which framework applies to each component of the overall problem.
Rebalancing Across All Approaches
Regardless of which framework is used, every strategic allocation requires a rebalancing policy. Calendar rebalancing trades on a fixed schedule; percent-range rebalancing sets corridors around target weights and trades when drift exceeds the corridor.
Corridor width depends on transaction costs (higher costs mean wider corridors), volatility (higher volatility may warrant narrower corridors to control risk), correlation with the portfolio (higher correlation allows wider corridors), and tax sensitivity (taxes favor wider corridors for taxable investors).
Master these three approaches and you will be well-prepared for the asset allocation portion of the CFA Level III exam. Practice with our question bank to solidify your understanding of when and how to apply each framework.