Funding-First Asset Allocation
Match investments to funding duration, return needs, and capital constraints
- Difficulty
- Advanced
- Time to result
- ~months to results
- Steps
- 6
- Confidence
- 98%
Funding-First Asset Allocation begins with the investor's obligations rather than a menu of attractive assets. First, identify whether funding can be withdrawn overnight, redeemed in months, or committed for years. Next, establish the return required to meet pensions, spending needs, or other obligations. The portfolio is then constructed so asset duration, liquidity, and expected return correspond to those constraints. Regulatory capital requirements are included when relevant because structure can alter the capital cost of an investment. The mechanism reduces the danger of being forced to sell long-term assets to satisfy short-term calls. It also reframes portfolio design: the objective is not maximum theoretical return, but the required return with enough liquidity and resilience to meet obligations throughout the holding period.
Origin
Extracted from Masters in Business during Julian Salisbury's explanation of how Goldman Sachs aligns client portfolios with funding sources and liabilities.
Core principles
- 01Funding terms determine how much investment risk is sustainable
- 02Asset duration should reflect liability duration
- 03Required returns should be pursued with the least necessary risk
- 04Liquidity needs must be funded before capital is locked up
- 05Regulatory capital rules can change an investment's suitability
How to run it
- 1
Identify the Funding Source
Document where the invested capital comes from and whether it belongs permanently to the investor or must eventually be returned.
Pro tip Separate stable capital from funding that can be withdrawn on demand.
Watch out Do not treat nominally available capital as permanent capital.
- 2
Measure Funding Duration
Determine when depositors, clients, pensioners, or other claimants can require payment. Express each material obligation on a clear timeline.
Pro tip Use the earliest plausible withdrawal date when terms permit rapid redemption.
Watch out A long-term investment financed by short-term funding creates forced-sale risk.
- 3
Set the Return Requirement
Calculate the average return needed to meet future obligations rather than selecting an arbitrary performance target.
Pro tip Distinguish the required return from an aspirational upside target.
Watch out Pursuing returns beyond what is required can introduce unnecessary risk.
- 4
Reserve Near-Term Liquidity
Keep sufficient liquid assets available for living costs, redemptions, margin calls, and other foreseeable cash needs.
Pro tip Model liquidity needs under both ordinary and stressed conditions.
Watch out An investor can be solvent on paper and still fail because cash is unavailable.
- 5
Match Assets to Obligations
Choose asset classes and lockup periods that fit the duration and return requirements of the funding source.
Pro tip Use longer-duration assets only where the funding structure can patiently support them.
Watch out Do not rely on selling illiquid assets quickly at fair value.
- 6
Apply Structural Constraints
Include regulatory, tax, and capital-treatment effects when deciding how an investment should be held or structured.
Pro tip Compare economically similar structures for differences in capital efficiency.
Watch out Ignoring capital rules can make an otherwise attractive investment unsuitable.
In the wild
A pension fund estimates that it must earn an average seven percent to meet payments to retirees. It maps the timing of those payments, reserves liquid assets for the next several years, and allocates the remaining long-duration capital across assets capable of generating the required return without excessive risk.
→ The portfolio targets its obligations while reducing the chance of forced liquidation.
A hedge fund offers investors monthly or quarterly withdrawals. Rather than placing most capital into assets that may take years to sell, it limits illiquid positions and maintains enough realizable investments to satisfy plausible redemption requests.
→ Investor withdrawals can be met without dumping long-term holdings at distressed prices.
Common mistakes
Starting With the Product
Choosing an appealing fund before understanding the investor's obligations reverses the correct sequence and can create a structural mismatch.
Ignoring Withdrawal Timing
Assuming funding will remain available because it has historically been stable leaves the portfolio exposed to sudden redemptions or calls.
Chasing Unnecessary Returns
Targeting maximum return instead of the return actually required may add volatility, leverage, and illiquidity without improving the investor's ability to meet obligations.
Is it for you?
Best for
It is best for institutions, funds, and individuals building portfolios around defined future obligations.
Not ideal for
It is not ideal for investors who lack reliable information about their liabilities, cash needs, or funding terms.
From the transcript
“first understand the duration of your funding source.”
“the second is understand the return requirement of that funding source.”
“It's really understanding funding source duration, funding source, return requirement, and then for certain types of financial institutions, understanding the capital rules.”
From the episode
Julian C. Salisbury on Managing Global Assets
Julian C. Salisbury