Investment Management
What the exam tests
This domain tests portfolio construction and management: asset allocation, diversification, risk and return, fixed income, equities, funds, rebalancing and performance evaluation. The exam expects quantitative reasoning and an understanding of why a portfolio behaves differently from the sum of its parts.
Core rules and concepts
- Strategic and tactical allocation: strategic allocation follows the IPS and long-term risk; tactical tilts must stay within mandate and be documented.
- Diversification: correlations matter. Portfolio volatility is not a simple weighted average of asset volatilities; low or negative correlation reduces risk.
- Fixed income: bond prices move inversely to yields. Duration approximates the percentage price change for a 1% yield change; credit spread, default, liquidity and convexity also matter.
- Equities and funds: valuation, earnings, dividends, style and benchmark choice drive active/passive decisions. Derivatives may hedge or create leverage and counterparty risk.
- Rebalancing: calendar-based or threshold-based; balance risk control against transaction costs and tax.
- Performance: time-weighted return removes the effect of client cash flows and is used to judge manager skill; money-weighted return reflects the investor's experience. Sharpe ratio = (portfolio return − risk-free rate) / volatility.
Worked example
A portfolio is 60% equities with expected return 7% and volatility 15%, and 40% bonds with expected return 3% and volatility 5%. Correlation is 0.2. Expected return = 0.6×7% + 0.4×3% = 5.4%. Variance = 0.6²×15%² + 0.4²×5%² + 2×0.6×0.4×0.2×15%×5% = 0.0081 + 0.0004 + 0.00072 = 0.00922. Volatility = √0.00922 = 9.6%. Diversification lowers risk below the weighted average of 11%, which is why correlation is central.
Traps that cost marks
Comparing returns without risk; using money-weighted return to judge manager skill; confusing duration with maturity; ignoring fees and taxes; over-diversifying into expensive funds; letting style drift; using an inappropriate benchmark; treating derivatives as income without considering leverage.