Investment management and asset allocation
Domain 2: Investment management and asset allocation
This domain tests portfolio construction and appraisal: strategic versus tactical allocation, diversification arithmetic, risk-adjusted performance measurement, and the wrapper and tax context in which the portfolio sits. Expect quantitative items - you should be able to compute a portfolio return, a standard deviation and a Sharpe ratio from supplied figures.
Allocation and risk measurement
- Strategic asset allocation follows from objectives, horizon and capacity for loss; tactical tilts are short-term deviations with a stated rationale and a review trigger.
- Diversification comes from low correlation, not from the number of holdings: adding a highly correlated fund adds cost, not risk reduction.
- Core measures: volatility (standard deviation), beta, duration and credit spread for bonds, maximum drawdown, shortfall probability, Sharpe (excess return per unit of total risk), Sortino (downside risk), information ratio (active return per unit of tracking error).
- Costs, turnover and tax drag belong in the expected return, not in a footnote.
Worked example: a 60/40 portfolio
Equities: 60%, expected return 7%, volatility 15%. Bonds: 40%, expected return 3%, volatility 5%. Correlation 0.1; risk-free rate 3%. Portfolio return = 0.6 x 7 + 0.4 x 3 = 5.4%. Variance = (0.36 x 225) + (0.16 x 25) + (2 x 0.6 x 0.4 x 0.1 x 15 x 5) = 81 + 4 + 3.6 = 88.6, so standard deviation = 9.4%. Sharpe = (5.4 - 3) / 9.4 = 0.26. The naive weighted-average volatility would be 11.0%, so the correlation benefit is 1.6 percentage points. Note that a 100% equity portfolio has a Sharpe of (7 - 3) / 15 = 0.27 - essentially the same risk-adjusted return, but with far higher absolute risk, which matters if the client has a short horizon or a fixed liability.
Marks-losing traps
- Mixing arithmetic and geometric returns when compounding over long horizons.
- Comparing managers' information ratios without checking they use the same benchmark.
- Rebalancing on a fixed calendar only, ignoring drift and transaction costs.
- Equating volatility with risk of permanent loss (shortfall risk is the client's real concern).
- Quoting gross performance when the wrapper is taxable.