Portfolio Construction and Asset Allocation
Domain 4: Portfolio construction and asset allocation
This domain tests how portfolios are built from an investment policy statement, how strategic and tactical allocation differ, and how correlation and rebalancing affect risk. The exam expects candidates to apply portfolio mathematics rather than describe diversification generically.
Construction principles
- The investment policy statement sets objectives, constraints, time horizon, liquidity needs, tax position and risk tolerance. It governs the strategic asset allocation.
- Strategic allocation is the long-term mix driven by capital market assumptions and the client’s risk profile. Tactical allocation makes shorter-term deviations within agreed limits.
- Mean-variance optimisation seeks the efficient frontier: the highest expected return for a given risk, or the lowest risk for a given return.
- Rebalancing returns the portfolio to target weights; it controls drift but incurs costs and can create taxable disposals.
- Constraints include liquidity, concentration limits, regulatory restrictions, currency exposure and ESG preferences.
Risk budgeting
- Risk contribution depends on weight, volatility and correlation, not weight alone. A small allocation to a volatile, highly correlated asset can dominate portfolio risk.
- Diversification benefits are greatest when correlations are low and stable; correlations often rise in market stress.
- Over-diversification can dilute return and add costs without meaningfully reducing risk.
Worked example
A portfolio is 60% equities with volatility 15% and 40% bonds with volatility 5%. Correlation is 0.2. Portfolio variance = (0.60² × 15²) + (0.40² × 5²) + [2 × 0.60 × 0.40 × 0.2 × 15 × 5] = 81 + 4 + 7.2 = 92.2. Portfolio volatility = √92.2 = 9.60%. The weighted average volatility is (0.60 × 15%) + (0.40 × 5%) = 11%. The reduction from 11% to 9.60% is the diversification benefit; it disappears if correlation rises to 1, when portfolio volatility equals 11%.
Traps
- Confusing asset allocation with security selection; the exam may ask which decision drives most return variability.
- Assuming low correlations are permanent or ignoring correlation instability in crises.
- Rebalancing without considering costs, taxes and the client’s cash-flow needs.
- Treating a high-risk asset as a small risk contributor just because its weight is small.
- Building a portfolio that meets a model but breaches the client’s liquidity or concentration constraints.
Key points
- The IPS governs objectives, constraints and strategic allocation.
- Strategic allocation is long term; tactical allocation is within limits.
- Portfolio risk depends on weights, volatilities and correlations.
- Rebalancing controls drift but has cost and tax consequences.
- Risk contribution is not the same as portfolio weight.