Introduction

The goal of strategic asset allocation (SAA) is to find an optimal allocation of funds across different asset classes subject to a relatively long investment horizon. The optimal allocation of funds should always reflect the risk–return preferences of an institution and the machinery underlying the strategic asset allocation decisions should be based on a transparent and accountable process with which such allocations can be determined and reviewed at regular intervals. Often ‘modern portfolio theory’ is presented following Markowitz (1959) and Sharpe (1964) in the context of the Capital Asset Pricing Model (CAPM) and mean-variance portfolio analysis as the basic theory for how equity markets behave in equilibrium and how investors should position themselves on the efficient frontier, depending on their risk aversion. This theory is central to the understanding of modern finance and thus important for students and market practitioners alike. However, when it comes to actual portfolio allocation decisions and the practical implementation of portfolio allocation decisions in public and private investment organizations the CAPM leaves, quite understandably, many questions unanswered. It is some of these missing answers that the present chapter aims at addressing. In doing so, the viewpoint of a strategic investor is taken; however, elements relevant for tactical asset allocation and portfolio managers are also touched upon. In particular, the focal point of the exposition is that of a central bank's reserves management. This perspective naturally narrows the investment universe considerably.