Understand the importance and intricacies of asset mix within an investment portfolio, including classifications such as cash, fixed-income securities, and equity securities as well as strategic and dynamic asset allocation approaches.
The main asset classes are cash, fixed-income securities, and equity securities. More sophisticated portfolios may also include alternative investments such as private equity capital funds, currency funds, or hedge funds.
Cash and cash equivalents include currency, money market securities, redeemable GICs, bonds with a maturity of one year or less, and all other cash equivalents. Cash is needed to pay for expenses, to capitalize on opportunities, and is primarily used as a source of liquid funds in case of emergencies.
In general terms, cash typically constitutes at least 5% of a diversified portfolio’s asset mix. Investors who are very risk-averse may hold as much as 10% in cash. The levels might temporarily rise greatly above these amounts during certain market periods or during portfolio rebalancing. However, normal long-term strategic asset allocations for cash range between 5% and 10%.
Fixed-income securities consist of bonds due in more than one year, strip bonds, mortgage-backed securities, fixed-income exchange-traded funds, bond mutual funds, and other debt instruments including preferred shares. Convertible securities may or may not be considered fixed-income products in the asset allocation process.
The primary purposes of including fixed-income products in a portfolio are to generate income and to provide some safety of principal. They also offer diversification and can generate capital gains. Preferred shares, although legally an equity security, are usually classified under fixed-income securities in a portfolio due to their price action and cash flow characteristics.
Several methods can be used to diversify the fixed-income component, such as:
Equities include common shares, equity exchange-traded funds, equity mutual funds, and both convertible bonds and convertible preferred shares. While a dividend stream may flow from the equity section of a portfolio, its principal aim is to generate capital gains through trading or long-term growth in value. Note that if the conversion privilege for a convertible security expires, it should be re-categorized as fixed income.
Although most retail clients’ portfolios consist of cash, fixed income, and equities, investors can diversify further by adding elements such as hedge funds, real estate, precious metals, collectibles, and commodities like gold, which is often considered a good inflation hedge.
Understanding the phases of the equity cycle—including expansion, peak, contraction, trough, and recovery—helps in setting the asset mix. Figure 16.2 illustrates the S&P/TSX Composite Index over several decades, highlighting various phases within the cycle.
gantt
title Equity Cycles
dateFormat YYYY-MM-DD
section Cycle Phases
Expansion :a1, 1995-01-01, 1999-06-30
Peak :a2, 1999-06-30, 1999-12-31
Contraction :a3, 2000-01-01, 2003-01-01
Trough :a4, 2003-01-01, 2003-12-31
Expansion :a5, 2003-01-01, 2007-09-30
Peak :a6, 2007-09-30, 2007-12-31
Contraction :a7, 2008-01-01, 2009-12-31
Trough :a8, 2010-01-01, 2010-12-31
Asset class timing involves strategically switching from stocks to T-bills, to bonds and back to stocks to improve returns. Understanding the role of interest rates and term-to-maturity is crucial in timing decisions.
The equity cycle typically precedes the economic cycle. Figure 16.3 illustrates how the sustained economic growth from 1982 and 1996 aligns closely with sustained rises in stock prices during that time. Notably, the start of the equity cycle precedes the beginning of the economic cycle, showing its role as a leading indicator.
Asset allocation is determining the optimal split of an investor’s portfolio among different asset classes based on the client’s risk tolerance and investment objectives. For instance, a portfolio might be divided as follows: 10% in cash, 30% in fixed-income securities, and 60% in equities.
Portfolio managers generate investment returns through:
In Table 16.4, the importance of asset mix is demonstrated by comparing hypothetical portfolios. Even if a portfolio manager outperforms another in each asset class, the total return can be lower if the asset allocation leans too heavily toward less favorable class mixes.
Balancing entails strategizing the appropriate mix between selected asset classes based on the client’s full circumstances. See the asset allocation examples provided in Table 16.5 for different types of investors.
Strategic asset allocation is a base policy mix setting the long-term asset allocation framework. It may be expressed in percentage holdings, allowing the portfolio manager to adhere to this mix through consistent monitoring and rebalancing (see Table 16.6 and Table 16.7).
Dynamic asset allocation systematically rebalances the portfolio back to its strategic mix in response to changes in market values. Examples illustrated in Table 16.8 show the rebalancing outcomes depending on specific market conditions.
Tactical asset allocation deviates from the strategic mix temporarily to capitalize on market opportunities. It’s a moderately active approach suitable for long-term investors.
Differentiate between security selection and asset allocation. This step involves choosing specific securities (stocks, bonds, managed products, etc.) for the portfolio based on previous analyses.
Portfolio management is an ongoing process involving monitoring three key areas: the investor’s goals, expectations for securities and capital markets, and shifting economic and industry trends.
Regularly update the client’s profile to reflect changes that could impact investment strategies. Amend the NAAF if significant changes occur.
Constantly observing capital market trends, including government and central bank policies, economic growth, and sector shifts, helps anticipate changes and adjust portfolios accordingly.
The success of portfolio management is assessed by comparing the total return with that of comparable portfolios using methods such as the Sharpe Ratio.
A simple method is to divide total earnings by the amount invested: $$\text{Total Return} = \frac{\text{Increase in Market Value}}{\text{Beginning Value}} \times 100 %$$
Sharpe Ratio formula: $$S = \frac{R_p - R_f}{\sigma_p}$$ where \(S\) is the Sharpe ratio, $R_p$ is the return of the portfolio, \(R_f\) is the risk-free rate, and \(\sigma_p\) is the standard deviation of the portfolio.
Rebalancing returns the portfolio composition to its intended asset class weights. This is often done by selling securities that have performed well and buying those that haven’t.
Familiarize yourself with the following terms from this chapter:
In this chapter, we explored key components of the portfolio management process, emphasizing the importance of asset allocation, setting the asset mix, monitoring the portfolio, and rebalancing to maintain strategic weightings in asset classes.