Portfolio Construction & Asset Allocation

• Topic 01

  Portfolio Construction & Asset Allocation

  85 questions

A few questions from this unit, with the answer and a full explanation. The complete bank is available when you start practising.

1. What is the hybrid rebalancing approach and in what circumstances does it initiate a rebalance?

   • A
     A combination of calendar and threshold-based rebalancing; it reviews the portfolio on a fixed schedule (e.g., quarterly) but only rebalances if an asset class has also breached a tolerance band
     Correct answer
   • B
     An approach that alternates between calendar rebalancing in bull markets and threshold rebalancing in bear markets
   • C
     A method that rebalances whenever a single holding rises by more than 10% in a calendar month
   • D
     A strategy that rebalances automatically on every trading day using algorithm-based monitoring of asset class weights
   Explanation

   The hybrid rebalancing approach combines calendar rebalancing (set review dates) with threshold rebalancing (tolerance bands around target weights). On each scheduled review date, the manager checks whether any asset class weight has drifted beyond its permitted band. If no band has been breached, no trades are made; if a band has been breached, rebalancing is triggered. This avoids unnecessary trading costs when drift is minor while still responding promptly to significant drift.

2. A discretionary manager runs a client portfolio with a SAA of 60% global equities, 30% bonds, 10% cash. After a strong equity bull market, the portfolio has drifted to 73% equities, 21% bonds, 6% cash. The manager is considering two rebalancing options: (1) immediate full rebalance or (2) threshold-band rebalancing only when drift exceeds 5%. The client is a moderate-risk investor. Which approach is more appropriate and why?

   • A
     The portfolio has already breached the threshold (equities at 73% vs 60% target = 13% drift) so rebalancing is warranted; threshold-band rebalancing is generally more cost-effective than calendar rebalancing, but the current 13% drift significantly increases the portfolio's risk beyond the client's moderate risk profile, making rebalancing necessary now
     Correct answer
   • B
     The choice between rebalancing approaches is irrelevant because both produce identical long-term outcomes for the client
   • C
     Option 2 (threshold-band) is typically superior; the manager should wait until a further 5% drift occurs before acting
   • D
     The manager should implement option 2 but set the threshold at 15% to reduce transaction costs, even though this increases risk
   Explanation

   The portfolio has drifted significantly: equities are 13 percentage points above target (73% vs 60%). This represents a meaningful increase in the portfolio's risk level — a moderate-risk client now has a portfolio weighted like a higher-risk client. From a Consumer Duty perspective, the firm must ensure the portfolio remains suitable. Threshold-band rebalancing is generally preferred over calendar rebalancing because it is more responsive and cost-efficient (only rebalances when necessary). Since the drift (13%) substantially exceeds any reasonable threshold (typically 3–5%), rebalancing is appropriate now. The psychological challenge (selling equities that have done well) should not prevent the manager from maintaining the client's agreed risk profile.

3. What is the core-satellite approach to portfolio construction?

   • A
     The core-satellite approach means the core manager makes all investment decisions and the satellite managers are restricted to administrative functions
   • B
     The core-satellite approach divides the portfolio into a large passive/low-cost core (usually 50-80%) providing diversified market exposure and smaller satellite positions seeking alpha or specialist exposure
     Correct answer
   • C
     The core-satellite approach involves using exchange-traded funds as the core and individual stocks as satellites
   • D
     The core-satellite approach is where the core holds only cash and gilts while satellites take equity risk
   Explanation

   The core-satellite approach to portfolio construction separates the portfolio into two distinct components: (1) Core: Typically 50–80% of the portfolio, usually managed passively or as a low-cost diversified fund. The core aims to efficiently capture market returns (beta) at minimal cost. Common vehicles include index funds, ETFs, or multi-asset funds; (2) Satellites: Smaller positions (the remaining 20–50%) in specialist funds, thematic investments, actively managed strategies, or alternative investments seeking to generate alpha or provide specific exposure. Benefits: balances cost efficiency with potential for outperformance; clearly separates passive beta from active alpha; limits the damage if any single satellite underperforms significantly.