The Implementation of Asset Allocation Approaches: Theory and Evidence

What is it about?

This study develops three capital allocation approaches and a directional weight increment algorithm to identify the efficient frontier of all possible multi-asset portfolios precisely and rapidly. Subsequently, this study proposes an asset selection criterion, based on the coefficient of variance and volatility risk measures, to perform the asset allocation for two types of investors who are willing or not willing to bear the risk. Finally, this study uses a multivariate generalized autoregressive conditional heteroskedasticity (GARCH) model to estimate the conditional variance and covariance of several multi-asset portfolios constituted of seven assets dispersed in the oil, stock, and currency markets of the US. The empirical results show that, via applying the proposed asset selection criterion, the most suitable multi-asset portfolios are the SP500-Nasdaq and the GasNyh-DJ, which belong to the relatively most efficient portfolios. Moreover, two capital allocation approaches using the entire sample weight forecasts have the best forecast performance. Additionally, for all multi-asset portfolios the weight combination set of portfolios on the efficient frontier that resulted from the proposed algorithm is consistent with that obtained from the traditional approach.

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Why is it important?

I propose the following important policy implications for investors and fund managers. First, the UDI is a good hedge asset, especially for assets in the oil market, since the portfolios including the UDI have the smallest and even negative value of correlation coefficients, and the above portfolios thus have a lower risk according to portfolio theory. Second, regarding two types of investors who are willing and not willing to bear risk, the fund managers should use the proposed asset selection criterion to select the suitable assets in the financial market to construct an effective portfolio. The asset selection criterion uses the values of volatility and CV on the MVPs of all possible component-based portfolios to choose the assets because the MVP is the start point of the efficient frontier of component-based portfolios. Moreover, the asset selection criterion is a compromise method in the portfolio picking process because it can solve the contradictory results appearing in the portfolios selection process under two different risk measures, the volatility and CV. Third, to identify the efficient frontier efficiently, investors should use the capital allocation approaches using the entire sample weight forecasts, the MDWI and CWI, to find the weight combination of MVP quickly and precisely, and then they can utilize a directional weight increment algorithm to find the weight range of component assets of all portfolios on the efficient frontier rapidly

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