Asset Allocation System Using Liquid Proxies for Illiquid Assets

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Solution Overview

Problem

Traditional asset allocation methods struggle to effectively incorporate illiquid asset classes like private equity and real estate into investment portfolios, as they lack reliable historical data and accurate valuation methods, leading to difficulties in determining optimal asset allocations and managing risk and liquidity.

Innovation Solution

A comprehensive system and methodology that utilizes historical data from traditional asset classes to unsmooth and correct data for alternative asset classes, incorporating risk budgeting, tracking error, and Monte Carlo simulations to forecast returns and risks, allowing for the integration of illiquid assets into a unified portfolio framework.

Engineering Contradictions & Design Principles

VSEngineering Contradiction Analysis

1Adaptability or versatility

If traditional asset allocation methods are used, then liquid asset classes (stocks, bonds, cash) can be effectively managed, but illiquid asset classes (private equity, real estate) cannot be properly incorporated due to lack of reliable historical data and valuation methods

Engineering Contradiction:

Improveability to incorporate different asset classesVSAvoidaccuracy of allocation decisions

Core Design Contradiction:

Adaptability or versatilityVSReliability

Solution Approach 1:

The patent introduces liquid asset classes (stocks, bonds, cash) as intermediaries to proxy for illiquid asset classes (private equity, real estate). By using liquid assets with reliable historical data to represent illiquid assets, the system enables comprehensive portfolio optimization across all asset classes while maintaining measurement reliability. The liquid assets serve as measurable proxies that capture the risk-return characteristics of their illiquid counterparts.

Inventive Principle:

Principle #24Intermediary (Mediator)

Solution Approach 2:

The patent creates copies of illiquid asset class performance by using historical data from liquid asset classes. Instead of directly measuring illiquid assets which lack reliable historical data, the system copies their risk-return profiles using correlated liquid assets. This allows the optimization algorithm to work with complete historical data sets while still accounting for illiquid asset allocations.

Inventive Principle:

Principle #26Copying

2Productivity

If illiquid investments are added to portfolios to improve returns, then potential returns increase, but portfolio balance is disrupted due to inability to accurately measure and manage their different attributes

Engineering Contradiction:

Improveportfolio returnsVSAvoidportfolio management complexity

Core Design Contradiction:

ProductivityVSDevice complexity

Solution Approach 1:

The patent transforms the measurement parameters for illiquid assets by using liquid asset proxies. Instead of attempting to directly measure difficult-to-quantify parameters of illiquid assets, the system changes to using readily measurable parameters from liquid assets that have proven historical relationships with illiquid asset performance. This enables standard optimization techniques to be applied across all asset classes.

Inventive Principle:

Principle #35Parameter changes

Solution Approach 2:

The patent creates a universal measurement framework that uses liquid asset proxies to measure all asset classes uniformly. The same historical data and optimization methods that work for liquid assets are applied to illiquid assets through their liquid proxies, enabling a single unified approach to portfolio optimization across diverse asset classes with different characteristics.

Inventive Principle:

Principle #6Universality (Multi-functionality)

3Measurement precision

If historical data from traditional asset classes is used to proxy for alternative asset classes, then measurement reliability improves, but data accuracy may be compromised due to smoothing effects

Engineering Contradiction:

Improveability to measure risk and returnVSAvoidloss of raw historical performance data

Core Design Contradiction:

Measurement precisionVSLoss of information

Solution Approach 1:

The patent applies partial smoothing by using historical data from liquid assets to proxy for illiquid assets, but deliberately retains some roughness in the data to preserve information about actual performance variability. The smoothing is applied selectively to enable measurement while maintaining enough raw data characteristics to accurately represent risk and return properties of illiquid assets.

Inventive Principle:

Principle #16Partial or excessive action

Data Source

PatentUS7599872B2Method and system for asset allocation

Publication Date: 2009.10.06 CITIBANK N A

AI summary

A method and system of matching an investor's objectives for portfolio investment return and risk with an assessment of a range of expected returns and risks that are likely to be generated by investment portfolios consisting at least in part of alternative asset classes that involves, for example, selecting available historical data for a plurality of alternative asset classes, unsmoothing the historical data based at least in part on historical data for traditional asset classes related to the respective alternative asset classes, and correcting the historical data for the alternative asset classes for an impact of survivorship and selection biases. A forecast of an expected return and risk is computed for each of the alternative asset classes, based at least in part on the unsmoothed and corrected historical data for the alternative asset classes, and at least one of the alternative asset classes that has an expected return and risk that corresponds substantially to the investor's objectives for portfolio investment return and risk is identified for inclusion in the investment portfolio.