Portfolio construction, asset allocation and rebalancing
What is tested
Allocation and portfolio construction: can you turn a client's objectives and constraints into a mandate, and do you understand what rebalancing and diversification actually do?
Core rules
- The investment policy statement records objectives (return target, risk tolerance), constraints (liquidity, time horizon, tax, legal and regulatory, unique client needs) and the permitted asset classes and limits.
- Strategic asset allocation is the long-term policy mix that drives most of the portfolio's risk and return; tactical asset allocation is a short-term tilt away from it. A tilt must stay inside the IPS limits, otherwise it is a breach, not a clever trade.
- Diversification reduces unsystematic, company-specific risk; it cannot remove systematic market risk, which is what beta measures.
- Rebalancing restores the policy weights after market moves. It enforces a sell-high, buy-low discipline and keeps portfolio risk at the level the client agreed to.
- Mandate and regulatory limits bind before conviction does: a single-issuer cap, a liquidity cap or a prohibited-instrument rule cannot be overridden by a good idea.
- Cash is a position with zero beta. It must be counted in the weights and it drags on return when markets rise.
Worked example
A client's policy is 60% equities and 40% bonds on a RM1,000,000 portfolio. Equities rise 20% and bonds are flat. New values: equities RM720,000, bonds RM400,000, total RM1,120,000. Target equity is 0.60 x 1,120,000 = RM672,000. So sell RM48,000 of equities and buy RM48,000 of bonds. Without the trade, equities would be 64.3% of the portfolio and the client would carry more risk than the policy allows.
Traps that cost marks
- Calling a tactical tilt strategic to make it sound permitted.
- Leaving cash out of the weight calculation.
- Believing more holdings always means more diversification - ten stocks in one sector is one bet.
- Ignoring that rebalancing frequency is itself a policy choice with transaction-cost and tracking-error consequences.