CISI IAD Portfolio Construction and Management — Questions and Answers
Question 1: What is 'asset allocation' and why is it considered the most important investment decision?
- Choosing specific securities within each asset class; it is important because security selection drives returns
- The decision of how to divide a portfolio among different asset classes (equities, bonds, property, cash, alternatives); research shows it explains the majority of long-term portfolio return variation (Correct answer)
- The process of selecting a fund manager for each asset class; it determines total costs
- The process of rebalancing a portfolio quarterly; it maintains target risk levels
Correct answer: The decision of how to divide a portfolio among different asset classes (equities, bonds, property, cash, alternatives); research shows it explains the majority of long-term portfolio return variation
Asset allocation is the strategic decision about how to divide a portfolio among different asset classes. Research (including Brinson, Hood, and Beebower) showed that asset allocation decisions explain approximately 90% of the variation in portfolio returns over time, more than security selection or market timing.
Question 2: What is the difference between 'strategic asset allocation' and 'tactical asset allocation'?
- Strategic allocation is for equity funds; tactical allocation is for bond funds
- Strategic allocation is the long-term target allocation based on risk tolerance and objectives; tactical allocation involves short-term deviations from the strategic allocation to exploit perceived market opportunities (Correct answer)
- Strategic allocation changes daily; tactical allocation is fixed for five years
- There is no meaningful difference between the two
Correct answer: Strategic allocation is the long-term target allocation based on risk tolerance and objectives; tactical allocation involves short-term deviations from the strategic allocation to exploit perceived market opportunities
Strategic asset allocation (SAA) sets the long-term target weights for each asset class based on the investor's objectives, risk tolerance, and time horizon. Tactical asset allocation (TAA) involves short-term deviations from the SAA based on near-term market views, aiming to add returns.
Question 3: What is 'portfolio rebalancing' and why is it necessary?
- Changing the fund manager when performance falls below the benchmark
- The process of periodically restoring a portfolio to its target asset allocation after market movements have caused drift, maintaining the intended risk profile (Correct answer)
- The process of switching between active and passive strategies annually
- Selling all underperforming assets and replacing them with top performers
Correct answer: The process of periodically restoring a portfolio to its target asset allocation after market movements have caused drift, maintaining the intended risk profile
Rebalancing involves selling assets that have grown above their target weight and buying those that have fallen below, restoring the portfolio to its intended strategic allocation. Without rebalancing, portfolios drift towards higher risk as equities outperform bonds over time.
Question 4: What is 'dollar cost averaging' (or pound cost averaging) as an investment strategy?
- Converting all investments into US dollars to benefit from currency movements
- Investing a fixed amount at regular intervals regardless of market price, automatically buying more units when prices are low and fewer when prices are high (Correct answer)
- Investing only when the market has fallen more than 10% from its peak
- Spreading investments equally across 10 different asset classes
Correct answer: Investing a fixed amount at regular intervals regardless of market price, automatically buying more units when prices are low and fewer when prices are high
Pound cost averaging involves investing a fixed regular amount (e.g., monthly), so more units are purchased when prices are low and fewer when prices are high. Over time, this can result in a lower average cost per unit than investing a lump sum at market peak.
Question 5: What is a 'model portfolio' in the context of investment advice?
- A theoretical portfolio used only for academic research
- A pre-constructed portfolio of assets or funds built to a specified risk profile and investment objective, used by advisers as a basis for client recommendations (Correct answer)
- A portfolio that exactly replicates the FTSE All-Share index
- A portfolio constructed by an AI system without human oversight
Correct answer: A pre-constructed portfolio of assets or funds built to a specified risk profile and investment objective, used by advisers as a basis for client recommendations
A model portfolio is a standardised, pre-built portfolio aligned to a specific risk level (e.g., cautious, balanced, adventurous). Advisers use model portfolios to efficiently serve clients with similar risk profiles, providing consistency and simplifying ongoing management.
Question 6: What is 'factor investing' (also called 'smart beta')?
- Investing based on macroeconomic factors such as GDP growth and inflation only
- An investment approach that systematically targets specific factors (such as value, momentum, quality, low volatility, or size) that research shows have historically driven excess returns (Correct answer)
- An approach that replicates active strategies at the cost of passive strategies
- A method of investing exclusively in government bonds to eliminate credit risk
Correct answer: An investment approach that systematically targets specific factors (such as value, momentum, quality, low volatility, or size) that research shows have historically driven excess returns
Factor investing targets systematic risk factors — such as value (cheap stocks), momentum (recent winners), quality (high-quality businesses), and size (smaller companies) — that academic research suggests generate risk-adjusted excess returns over time. Smart beta funds implement factor strategies at lower cost than traditional active management.
CISI IAD Portfolio Construction and Management
What is 'asset allocation' and why is it considered the most important investment decision?