Portfolio Management and Asset Allocation
What this domain tests
The translation of client objectives into a portfolio: risk measurement, diversification, asset allocation, and evaluation of results against a benchmark. Expect Sharpe ratio arithmetic, beta interpretation, and questions on rebalancing and the investment policy statement.
Core rules
- Total risk = systematic + unsystematic. Diversification removes unsystematic risk only; market risk remains.
- Beta measures sensitivity to the market (beta 1.0 = market). Standard deviation measures total volatility.
- Strategic asset allocation sets long-term weights from the IPS; tactical asset allocation deviates within permitted ranges.
- Rebalancing restores target weights, enforcing a sell-high/buy-low discipline and controlling drift.
- Sharpe ratio = (portfolio return − risk-free rate) / standard deviation. Higher is better on a risk-adjusted basis.
- Time-weighted return removes the effect of cash flows and is the fair measure of manager skill; money-weighted return reflects the client's actual experience and is affected by deposit and withdrawal timing.
Worked example
Two portfolios over the same period; risk-free rate is 3%.
- Portfolio A: return 9%, standard deviation 12% → Sharpe = (9 − 3) / 12 = 0.50
- Portfolio B: return 11%, standard deviation 18% → Sharpe = (11 − 3) / 18 = 0.44 Portfolio B earned more but took proportionally more risk, so Portfolio A delivered the better risk-adjusted result. A raw return comparison would have chosen B; the exam wants the Sharpe comparison.
Traps
- Comparing returns without adjusting for risk or for the client's mandate.
- Using a benchmark that does not match the mandate (for example, comparing a Canadian dividend portfolio to the S&P 500).
- Using money-weighted return to judge a manager who had no control over client cash flows.
- Assuming maximum diversification eliminates all risk.
Key points
- Diversification eliminates unsystematic risk; systematic risk remains.