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IFT Notes for Level I CFA® Program

LM04 Basics of Portfolio Planning and Construction.

Part 2


6. Portfolio Construction and Capital Market Expectations

We have defined the IPS with return and risk objectives, and five constraints. Now, using the points in the IPS as a guideline, we need to construct the portfolio.

Portfolio construction consists of three steps:

  • Strategic asset allocation
  • Tactical asset allocation
  • Security selection

6.1 Capital Market Expectations

Capital market expectations are the investor’s expectations about the return and risk of various asset classes. Capital market expectations include the return for each asset class an investor may invest in (e.g., stock market, bond market, alternative investments, real estate, etc.), the standard deviation of returns for each asset class (risk), and the correlation between the asset classes.

7. The Strategic Asset Allocation

The long-term capital market expectations and investor’s risk-return objectives are combined into a strategic asset allocation. This is accomplished through optimization and/or simulation on computer systems.

Strategic asset allocation is a strategy to allot a certain percentage of the portfolio, each to different IPS-permissible asset classes, in order to achieve the client’s long-term goals. Using this method, the portfolio manager decides how much of the client’s money should be invested in equities, bonds, or any other asset class to meet the client’s long-term goals. Strategic asset allocation is important because:

  • Most of a portfolio’s returns come from its systematic risk as nonsystematic risk is diversified away.
  • The returns of assets in an asset class reflect exposure to certain systematic factors. This information can be used to select asset classes that match an investor’s risk and return objectives.

How are asset classes defined?

The classification of asset classes is somewhat subjective. Furthermore, an asset class can be divided into sub-asset classes as illustrated below.

Criteria to define asset classes:

  • All assets in an asset class must be homogeneous, and not correlated to other asset classes.
  • Correlations of assets with an asset class should be high.
  • Risk and return expectations of assets within an asset class must be similar.
  • All the asset classes combined should account for the universe of all investable assets.

When defining the SAA, it is important to consider the asset class correlation matrix. When the correlation between asset classes is low, the diversification benefit will be high. This concept has been discussed in detail in earlier readings.


Given the matrix below, identify which asset class is most sharply distinguished from equities.

Historical correlation (May 31, 2005 to April 30, 2009)

  Equities Fixed Income Hedge Real Estate Private Equity Commodities Currencies
Equities 1.00
Fixed Income -0.35 1.00
Hedge 0.64 -0.35 1.00
Real Estate 0.88 -0.21 0.58 1.00
Private Equity 0.88 -0.30 0.65 0.92 1.00
Commodities 0.38 -0.37 0.60 0.29 0.45 1.00
Currencies 0.18 0.16 0.19 0.16 0.16 0.26 1.00

Source: FT Alphaville


The question asks us to identify the asset class with the lowest correlation with equities. As you can see from the table, fixed income has the lowest correlation with equities while real estate and private equity have the highest correlation with equities.

Once the asset allocation is done, it is possible for this asset allocation to drift from the target allocation with time. For example, let us assume the target asset allocation is 60 percent in stocks and 40 percent in bonds. If equities do well the following year, the asset allocation drifts to 90 percent in equities and 10 percent in bonds. This calls for rebalancing the portfolio as the drift is substantial. By rebalancing, we mean sell equities and buy bonds to bring the portfolio back to the target asset allocation. The amount of allowable drift and rebalancing policy should be defined in the IPS appendix. This material will be covered in detail at Level III.

8. Steps toward an Actual Portfolio and Alternative Portfolio Organizing Principles

Portfolio construction involves the following steps:

  1. Define IPS:
    1. a. Capture the investor’s requirements and constraints.
  2. Determine the strategic asset allocation:
    1. a. Define the investable asset classes for the portfolio and gather historical data on their risk, return, and correlation.
    2. b. Combine the IPS and the risk/return profile of various portfolios, derived from the above step, to decide on a strategic asset allocation for the portfolio. Until this step, investment decisions are entirely passive, i.e., returns are primarily generated by investing in asset class indexes.
    3. c. The SAA is a means of providing the investor with exposure to the systematic risks of asset classes in proportions that meet the risk and return objectives.  It drives a significant percentage of the overall return.
  3. Tactical asset allocation:
    1. a. This is the first step of active management where asset classes are selected.
    2. b. Determine whether there are any short-term opportunities that warrant a deviation from the strategic asset allocation.
    3. c.The weights of asset classes are altered from the strategic allocation weights.
    4. d. For example, a top-down analysis shows that given the economic cycle, commodities may outperform. Based on this premise, you alter the weight for the commodity asset class.
  4. Security selection:
    1. a. This is second step of active management, where particular securities are selected.
    2. b. Identify the relatively strong securities within the favored asset class.
    3. c. Increase the weights of these securities from the weights used in index construction, to outperform the benchmark.
    4. d. For example, in your analysis you decide to go overweight on the base metals securities.

Some additional terms you should know:

  • Risk budgeting: The process of deciding on the amount of risk to assume in a portfolio (the overall risk budget) and subdividing that risk over the sources of investment return (e.g., strategic asset allocation, tactical asset allocation, and security selection).
  • Passive versus active investing: Passive investing is a strategy in which investors invest based on a pre-defined benchmark. One example would be an investment in a fund that tracks the S&P 500.
  • Active investing is a strategy to identify (buy) underpriced and (sell) overpriced stocks. The objective is to earn a return higher than the benchmark.
  • Rebalancing policy: The process of restoring a portfolio’s original exposures to systematic risk factors is defined in the rebalancing policy.

8.1 New Developments in Portfolio Management

Two new developments in portfolio management are:

  • Increasing use of ETFs in combination with robo-advice by retail investors: ETFs provide a fast, inexpensive, and liquid exposure to asset classes. Robo-advice has also further reduced the costs for retail investors to create well-diversified portfolios.
  • Use of risk parity investing approach: Another new development with respect to portfolio planning and construction is the use of risk parity investing, whereby, asset classes are weighted according to risk contribution.

9. ESG Considerations in Portfolio Planning and Construction

ESG implementation approaches require a set of instructions for investment managers regarding selection of securities, the exercise of shareholder rights and the selection of investment strategies.

ESG implementation approaches affects both strategic asset allocation and the portfolio construction process. They may have a negative impact on expected risk and return of a portfolio as it may limit the manager’s investment universe and the manner in which investment management firms operate. Nonetheless, ESG investing continues to see strong adoptions. Responsible investing proponents argue that the potential improvements in governance and avoidance of material risks will enhance returns. Academic research on the impact of ESG factors on portfolio returns remains mixed.

CRASH COURSE For MAY 2024 CFA Program Exam
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