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FTIP: Portfolio Management and Asset Allocation

FTIP · Work through your exam, one topic at a time.

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Portfolio Management and Asset Allocation

Portfolio Management and Asset Allocation tests whether you can build a portfolio consistent with an investment policy statement (IPS), quantify risk and return, and explain diversification. Expect modern portfolio theory, the efficient frontier, CAPM and beta, the Sharpe ratio, strategic versus tactical allocation, rebalancing, and performance attribution.

Core rules and concepts

  • IPS: specify objectives (return and risk), constraints (liquidity, time horizon, tax, legal/regulatory, unique circumstances), and the benchmark. Suitability comes before optimization.
  • Portfolio expected return: weighted average of asset expected returns. Portfolio variance depends on weights, individual variances, and covariances; correlation below +1 creates diversification benefit.
  • Efficient frontier: portfolios offering the highest expected return for a given risk. Adding a risk-free asset produces the capital market line; the tangency portfolio maximizes the Sharpe ratio.
  • CAPM: E(R_i) = R_f + beta_i x [E(R_m) - R_f]. Beta measures systematic risk, not total risk. Unsystematic risk is diversifiable and should not earn a premium.
  • Sharpe ratio: (R_p - R_f)/sigma_p. Use it to compare portfolios on a risk-adjusted basis, not to average component Sharpe ratios.
  • Rebalancing controls drift and risk; it can be calendar-based or threshold-based. Attribution separates allocation, selection, and interaction effects.

Worked example

A portfolio has 60% equities with expected return 8% and standard deviation 15%, and 40% bonds with expected return 4% and standard deviation 5%. Correlation is 0.2. Expected return = 0.6 x 8% + 0.4 x 4% = 6.4%. Variance = (0.6^2 x 0.15^2) + (0.4^2 x 0.05^2) + (2 x 0.6 x 0.4 x 0.2 x 0.15 x 0.05) = 0.0081 + 0.0004 + 0.00072 = 0.00922. Standard deviation = square root of 0.00922 = 9.60%. The weighted-average standalone standard deviation would be 11.0%, so diversification reduced risk by 1.4 percentage points. With a 2% risk-free rate, Sharpe = (6.4% - 2%)/9.60% = 0.458.

Traps that cost marks

Do not add standard deviations; combine variances and covariances. Do not assume low-correlation assets eliminate all risk. Do not use beta as a measure of total risk. Do not optimize before confirming the client's constraints. Do not compare Sharpe ratios computed over different periods or frequencies without adjustment.