16.5.1 Asset Mix

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.

16.5.1 Asset Mix

The Asset Mix

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

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

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:

  • Utilizing both government and corporate bonds across a range of credit qualities, from Aaa to lower grades.
  • Adding foreign bonds to domestic holdings.
  • Employing a variety of terms-to-maturity (e.g., laddering).
  • Choosing both deep discount or strip bonds and high-coupon bonds.

Equity Securities

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.

Other Asset Classes

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.

Setting the Asset Mix

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

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

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.

Importance of Asset Allocation

Portfolio managers generate investment returns through:

  • Choice of asset mix
  • Market timing decisions
  • Securities selection
  • Chance

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 the Asset Classes

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

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

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

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.

Step 4: Select the Securities

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.

Step 5: Monitor the Client, the Market, and the Economy

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.

Monitoring the Client

Regularly update the client’s profile to reflect changes that could impact investment strategies. Amend the NAAF if significant changes occur.

Monitoring the Markets and Economy

Constantly observing capital market trends, including government and central bank policies, economic growth, and sector shifts, helps anticipate changes and adjust portfolios accordingly.

Step 6: Evaluate Portfolio Performance

The success of portfolio management is assessed by comparing the total return with that of comparable portfolios using methods such as the Sharpe Ratio.

Measuring Portfolio Returns

$$$$

A simple method is to divide total earnings by the amount invested: $$\text{Total Return} = \frac{\text{Increase in Market Value}}{\text{Beginning Value}} \times 100 %$$

Calculating Risk-Adjusted Rate of Return

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.

Step 7: Rebalance 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.

Key Terms & Definitions

Familiarize yourself with the following terms from this chapter:

  • Asset Mix: The distribution of investments among different asset classes.
  • Fixed-Income Securities: Investments that provide regular interest income, such as bonds.
  • Equities: Shares of ownership in a corporation, providing entitlement to part of its profits.
  • Asset Allocation: The process of dividing an investment portfolio among different asset categories.
  • Dynamic Asset Allocation: A strategy that involves adjusting the asset mix based on market conditions.
  • Tactical Asset Allocation: Short-term deviations from the strategic asset allocation to capitalize on market conditions.

Summary

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.


CSC® Exams Practice Questions

📚✨ CSC Exam Questions ✨📚

Welcome to the Knowledge Checkpoint! You'll find 10 carefully curated CSC exam practice questions designed to reinforce the key concepts covered. These questions will help you gauge your grasp of the material, identify areas that need further review, and ensure you're on the right track towards mastering the content for the Canadian Securities certification exams. Take your time, think critically, and use these quizzes as a tool to enhance your learning journey. 📘✨

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## Which of the following assets is classified as a cash equivalent? - [ ] Convertible bonds - [x] Money market securities - [ ] Corporate bonds - [ ] Preferred shares > **Explanation:** Cash equivalents include highly liquid assets such as money market securities, which are easily convertible to known amounts of cash. ## How much percentage of cash is usually held in a diversified portfolio for long-term strategic asset allocations? - [ ] 2%-5% - [ ] 15%-20% - [x] 5%-10% - [ ] 10%-15% > **Explanation:** Cash in a diversified portfolio typically comprises about 5%-10% for normal long-term strategic asset allocations. ## What are preferred shares considered as in asset allocation? - [ ] Equity security only - [ ] Primer investment - [x] Fixed-income security - [ ] High-risk investment > **Explanation:** Despite being legally categorized as equity securities, preferred shares are treated as fixed-income securities in portfolios due to their stated level of income and other fixed-income characteristics. ## What is the primary purpose of including fixed-income products in a portfolio? - [x] To produce income and provide safety of principal - [ ] To generate high capital gains only - [ ] To achieve high growth potential - [ ] To avoid market fluctuations > **Explanation:** Fixed-income products are primarily included to produce a steady income stream and offer safety of principal. ## For what reason may investors opt to temporarily hold a higher percentage of cash in their portfolios? - [ ] Always prefer maintaining more cash - [ ] As a mark of high-risk investment strategy - [x] During certain market periods or rebalancing - [ ] To reduce fluctuations in their portfolio value > **Explanation:** Investors may temporarily hold higher cash levels during specific market periods or while rebalancing their portfolios. ## Which class of investments falls outside the main asset classes for further diversification? - [x] Real estate - [ ] Equity mutual funds - [ ] Convertible preferred shares - [ ] Money market securities > **Explanation:** Real estate is an example of an additional asset type that falls outside the primary asset categories of cash, fixed-income, and equities for further diversification. ## What is the suggested approach called when investors switch between stocks, T-bills, bonds, and back to stocks to improve returns? - [ ] Long-term strategy - [x] Asset class timing - [ ] Buy and hold strategy - [ ] Minimum risk approach > **Explanation:** This strategy is referred to as asset class timing, aiming to enhance returns by switching between asset classes based on market conditions. ## What aspect must be understood to apply stock market strategies effectively? - [x] The link between equity cycles and economic cycles - [ ] The method of high-risk investment - [ ] The criteria for investment in speculative stocks - [ ] The principles of day trading > **Explanation:** To apply stock market strategies effectively, understanding the relationship between equity cycles and economic cycles is crucial. ## What is the primary process described in step 4 of selecting specific securities for a portfolio? - [ ] Analyzing market conditions - [ ] Determining the proportion in cash and fixed income - [ ] Identifying client's investment constraints - [x] Choosing specific securities for inclusion in a client’s portfolio > **Explanation:** Step 4 involves the selection of specific securities such as stocks, bonds, or managed products to be included in a client’s portfolio. ## When does portfolio rebalancing typically become necessary according to dynamic asset allocation? - [x] When an asset category moves more than the specified percentage above or below the long-term target mix - [ ] On a weekly basis irrespective of market conditions - [ ] Only when the client requests a review - [ ] Annually without considering the portfolio's performance > **Explanation:** Rebalancing, guided by dynamic asset allocation, is typically required when an asset category deviates more than a certain percentage from its long-term target mix.

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