Which method can be used to include less liquid asset classes in asset allocation?

Including less liquid asset classes in asset allocation can be effectively accomplished by using modeling inputs that account for their specific risk characteristics. This approach allows an investor to evaluate the risk-return profile of less liquid assets, factoring in aspects such as volatility, illiquidity premium, and correlation with other asset classes. By understanding and modeling these characteristics, investors can make informed decisions about how to incorporate these assets into their overall portfolio strategy.

This method facilitates a more comprehensive risk assessment, thereby enabling asset allocation that reflects a better understanding of potential returns and risks related to less liquid investments. It is a critical consideration, as simply excluding illiquid assets could lead to a suboptimal portfolio that misses out on diversification and potential returns associated with those asset classes.

In contrast, focusing only on historical returns may not provide a complete picture of future performance and risks, especially for less liquid assets, since past performance does not guarantee future results. Excluding less liquid asset classes or only including highly liquid ones would limit the diversification benefits derived from asset allocation, which is a fundamental principle in portfolio management.