Learning Material Sample

Investment principles, markets and environment

6. Portfolio construction and asset allocation

In this section, we introduce the portfolio management process.

The portfolio management process c...

Shortened demo course. See details at foot of page.

...cide the benchmark of the portfolio

Make active investment decisions about the benchmark.


In this section we discuss the optimisation models used to generate optimal portfolios on a risk/return basis that make up the “efficient frontier”.

Efficient frontier

With a multi asset portfolio, if alternative portfolios are plotted on a graph with expected returns measured against risk (standard deviation), the possible portfolios fall on and below a curve known as the “efficient frontier”. The efficient frontier is the...

Shortened demo course. See details at foot of page.

...e able to express risk in terms of standard deviation – something few would be able to grasp.

Further, transaction costs could create an imbalance to the model and constraints could be place in terms of turnover of assets held (churning).

Client constraints on the portfolio such as the desire to incorporate ethical investment could lead to the portfolio lying somewhere beneath the efficient frontier resulting in sub-optimal performance.


In this section we consider the benchmarks commonly used to assist in assembling a portfolio and evaluate its performance.


A benchmark is a mixture of assets assembled to reflect an investor’s long-term objectives and constraints. Its purpose is to:

Lay down the neutral long-term position of the portfolio. If the investment manager is totally neutral in his attitude on the asset classes in the benchmark, he will retain the benchmark weightings. If he takes a view on an asset which disagrees with the benchmark, he will overweight (positive) or underweight (negative) his exposure relative to the benchmark

It will also be used to evaluate investment performance of the portfolio.

Benchmarks could be the following:

A recognised stock or bond index or the London Inter bank Offered Rate (LIBOR)

A peer group average. In the UK this would favour the home market and might lead to UK equities covering over 50% of the portfolio.

Asset allocation can also be carried out based on the exposure to an industry or a particular sector. More and more investment managers consider asset allocation on a global industry basis.


As a result of an initiative by he Association of Priva...

Shortened demo course. See details at foot of page.

...ere in the form of income

Property lacks any correlation with other assets such as equities so is effective in diversifying a portfolio

As an asset it has shown a moderate level of risk in respect of standard deviation of returns

It has provided tax efficient gearing for individuals since interest costs can be offset against rental income.


Lack of liquidity especially when markets decline

High management, vacancy and transaction costs

High specific risk if the property portfolio is not diversified

High minimum investment size

Property can not be divided into easy segments

Difficult to analyse and make accurate valuations

In the long term the property market could be vulnerable in a down turn in the economy as will equities, so the benefits of using property to diversify the portfolio will become diluted.

Pension funds

At the end of 2006, according to a recent report on pension markets by International Financial Services, London, a typical UK pension fund had the following asset allocation:




UK equities


International equities


UK bonds


International bonds









Shortened demo course. See details at foot of page.

In this section we discuss the different forms of passive investment management, the arguments in favour of and against this technique, passive fund selection and finally discuss a popular form of passive investment management – exchange traded funds. Our audiovisual presentation helps explain this topic.

Introduction and passive management techniques

Investment portfolio management is classified under two main strategies – active management incorporating analysis in a bid to achieve higher than average returns and passive investment management which does not need constant intervention as no attempt is made to beat the performance of the relevant market.

Passive management can be achieved in two ways:

- Buy and Hold

- Indexation

Buy and hold

The simplest strategy is to buy investments and then retain them over the given timescale of the investment. This may not however, mean that the client’s objectives have been fulfilled.


There are four main types of indexation.

The two most commonly used approaches are replication and stratified sampling . The former will involve the building of a portfolio to match an index and could therefore be expensive with the constant need to rebalance it in accordance with entrants and leavers to the index. Stratified sampling using a sample of securities from the index to provide a representation of how it will move can reduce overall transaction costs in relation to purchase of and sale of securities (as t...

Shortened demo course. See details at foot of page.

...narrow or broader index

Cost structure. Fees will have the most effect on the long term performance of a tracker fund against its benchmark index

Tax implications of the fund structure on investors and the effect of their domicile/residency status

Whether alternatives may be more attractive such as the structured products discussed in Module 5.

Exchange traded funds

These are funds usually designed to track a particular share index such as the FTSE 100.

An investor will buy shares in the ETF which is quoted on the stock exchange like an investment trust.

Unlike an investment trust, ETFs are open-ended funds in that they increase in size as more people invest in them and reduce as people withdraw funds.

An ETF’s share price reflects its underlying asset value.

Investor returns will be in the form of taxable dividends paid by the ETF and the possibility of a taxable capital gain or loss on disposal of the fund’s shares.

ETFs are traded on the London Stock Exchange in the UK. Shares are bought and sold via stockbrokers and are likely to have the following charges:

The spread between the investor’s buying and selling price is very small, usually 0.1 or 0.2 per cent for an ETF tracking the FTSE 100, for example

An annual management charge typically 0.5% which is deducted from the fund

Investors pay stockbrokers commission when they buy and sell, however, there is no stamp duty to pay on purchases.

ETFs can be placed within an ISA wrapper.


In this section we discuss the different forms of active investment management, the arguments in favour of and against this technique, and finally fund selection in line with the investor’s income /growth strategy.


Active Management will involve the portfolio manager using skill to select the appropriate investments to meet the client’s objectives. A strategy of this type will usually involve the manager trying to achieve returns over and above those achieved by a benchmark index for instance.

There are two main approaches to active management:

Top down management where initially, various classes of asset are selected for instance, equities bonds, cash etc. From there the manager will consider appropriate sectors within those asset classes and then finally decide on which is the most appropriate security.

Bottom up management where securities are selected on their own merits and their class or sector is not relevant. These strategies tend to apply where the investment objectives of a fund make asset selection irrelevant e.g. unit trusts investing in American Smaller Companies...

Shortened demo course. See details at foot of page.

...r “star” status will provide high returns

Fund’s history – An understanding of the fund’s history is important in determining its suitability. Its investment objectives of a few years ago for example, may be unrecognisable to what they are now following restructuring

Fund’s size – The relevance of fund size will depend upon the sector being considered. There is no guarantee that a larger fund will find it any easier to pick winning stocks than a smaller one. A smaller fund that has enjoyed success, may now find that resultant large sums being invested into it, actually make it more difficult to pick winners relative to its resources

Volatility – Most fund performance measures now include a measure of volatility usually expressed as the standard deviation of 36 month returns. There will be no guarantee that future volatility will follow this course

External rankings – A number of independent groups publish performance and rank fund managers. These rankings may assist in selecting appropriate funds in line with other research criteria.


In this section we briefly discuss the effects of churning and switching on a managed portfolio.

A switch of investments takes place when a new investment is effected as a result of a full or partial encashment ...

Shortened demo course. See details at foot of page.

... e.g. CGT. Advisers should consider mitigating these penalties with careful planning e.g. passing assets over to a spouse prior to disposal to use up their allowances or offsetting gains against other losses.


About Demo Courses

This is a shortened version of our online course, built so that you can get a good idea of what is provided. The full version shows all the current text and is fully formatted. Use the top right drop down menu to view the chapters. If you have already purchased this course, please log in to access the full version

Our online courses page lists details of all our courses. For more details on the above course see;

Chapter Links