A Strategic Asset Allocation (SAA) for an Endowment has been created and consists of 40% allocation to the domestic bond market and 60% allocation to the domestic equity market.

Based on historical 20 year data, the average volatility and return for the two asset classes and the SAA are as follows (all figures have been annualized and in real terms):

Bonds Equities SAA

Returns 1.5% 8.3% 5.58%

Volatility 2.2% 13.7% 9.5%

The Endowment has a required real return of 5.5% per annum, which includes 4% for an annual spend (on operations), 0.5% for management fee and 1% increase in the real value of the fund. The risk objective requires the volatility below 10% per annum.

Based on the above table, it seems that the SAA is suitable to achieve the investment objectives.

1. Back-Testing or Out-of-Sample Testing a SAA using real returns for the portfolio, a Notional Dollar starting portfolio value and taking into account an annual spend and fees can provide additional information regarding the suitability of the SAA to achieve investment objectives.
2.  Explain
3. why analysts should test the portfolio/SAA using Real Returns, Notional Dollars and Spend instead of only considering portfolio's historical average return to evaluate the suitability of the portfolio/SAA? Further explain what specific information is obtained regarding (i)the ability to achieve investment return objective; and (ii) the ability to bear investment risk objective.