11.7 Asset Mix, Monitoring, Performance Evaluation & Rebalancing

With objectives, constraints and the IPS in place, the manager builds and maintains the portfolio. This section covers Steps 3 to 7 of the portfolio management process: developing the asset mix, selecting securities, monitoring, evaluating performance on a risk-adjusted basis, and rebalancing.

1. Asset Allocation Strategies & Rebalancing

Academic studies show that asset allocation decisions account for more than 85% to 90% of the long-term variability in total portfolio returns, dwarfing the impact of market timing and individual security selection.

Asset Allocation Hierarchy:

                 [ Total Portfolio Capital ]
                             |
            +----------------+----------------+
            |                                 |
[ Strategic Asset Allocation (SAA) ]   [ Tactical Asset Allocation (TAA) ]
  - Long-term baseline target policy     - Short-term discretionary tilts
  - Driven by client IPS (e.g., 60/40)   - Exploits temporary mispricings
  - Dictates 90% of long-run return      - Kept within pre-authorized bands

1. Strategic Asset Allocation (SAA)

• The long-term baseline target asset mix designed to achieve the client's financial goals at their acceptable risk level.
• SAA is established based on long-term capital market forecasts and the client's IPS constraints. A typical balanced SAA might be: 5% Cash / 35% Fixed Income / 60% Equities.

2. Tactical Asset Allocation (TAA)

• Active, short-term discretionary deviations from SAA target weights to capitalize on temporary economic trends or asset class mispricings.
• TAA operates strictly within pre-authorized tolerance bandwidths specified in the IPS (e.g., if Equity target is 60%, authorized range may be 50% to 70%). Once the market mispricing corrects, weights are rebalanced back to SAA targets.

3. Dynamic Asset Allocation

• A rules-based, systematic strategy that automatically adjusts the asset mix in response to changing market conditions or portfolio performance (e.g., Portfolio Insurance models that systematically trim equity exposure as capital declines toward a floor value).

Rebalancing Methodologies

As asset classes grow at different rates, a portfolio's actual weights naturally drift away from target SAA weights. If left uncorrected, an equity bull market will cause the portfolio's equity weighting to expand, unintentionally elevating portfolio risk.

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Steps 4 and 5: Selecting Securities and Monitoring

Selecting securities. Within each asset class, the manager chooses specific securities or funds that fit the IPS. Choices include individual stocks and bonds, actively managed funds or low-cost index funds and ETFs, and top-down or bottom-up selection methods. Each choice must fit the client's constraints (for example, avoiding excluded industries or meeting liquidity needs).

Monitoring. The manager watches three things continuously:

• The client: changes in income, family situation, health, goals or risk profile can require a new IPS. KYC information must be updated after material changes.
• The market: price moves change the portfolio's actual weights and valuations.
• The economy: changes in growth, inflation, interest rates and exchange rates may justify tactical shifts within the IPS ranges.

2. Portfolio Performance Evaluation: Risk-Adjusted Metrics

Comparing raw returns alone is fundamentally flawed: a manager who generated a 15% return may have taken twice the risk of a manager who generated 12%. To determine true managerial skill, portfolio results must be measured on a risk-adjusted basis.

The Three Classic Risk-Adjusted Performance Measures:

1. Sharpe Ratio:   Excess return per unit of TOTAL RISK (Standard Deviation, σ).
   Formula: S = (R_p - R_f) / σ_p

2. Treynor Ratio:  Excess return per unit of SYSTEMATIC RISK (Beta, β).
   Formula: T = (R_p - R_f) / β_p

3. Jensen's Alpha: Excess return generated over the CAPM REQUIRED RETURN.
   Formula: α = R_p - [R_f + β_p * (R_m - R_f)]

1. The Sharpe Ratio

Developed by Nobel laureate William Sharpe, the Sharpe Ratio measures the excess return earned above the risk-free rate per unit of total risk (standard deviation, $\sigma_p$):

$\text{Sharpe Ratio} (S) = \frac{R_p - R_f}{\sigma_p}$

• Interpretation: The higher the Sharpe ratio, the greater the return generated per unit of total volatility.
• When to Use: Ideal for evaluating an entire client portfolio, an undiversified portfolio, or a standalone fund where the investor has concentrated holdings and is exposed to both systematic and unsystematic risk.

2. The Treynor Ratio

Developed by Jack Treynor, the Treynor Ratio measures the excess return earned above the risk-free rate per unit of systematic risk (Beta, $\beta_p$):

$\text{Treynor Ratio} (T) = \frac{R_p - R_f}{\beta_p}$

• Interpretation: The higher the Treynor ratio, the greater the excess return earned per unit of market sensitivity.
• When to Use: Ideal for evaluating a sub-portfolio or specialized investment fund that will be added to an already well-diversified existing portfolio, where unsystematic risk has already been eliminated.

3. Jensen's Alpha ($\alpha$)

Developed by Michael Jensen, Jensen's Alpha measures the absolute percentage return generated by an active manager over and above the return predicted by the Capital Asset Pricing Model (CAPM):

$\alpha_p = R_p - \{R_f + \beta_p [E(R_m) - R_f]\}$

• $\alpha > 0$ (Positive Alpha): The manager generated superior returns beyond what was expected for the systematic risk taken, demonstrating active skill in security selection or market timing.
• $\alpha = 0$ (Zero Alpha): The manager performed exactly in line with market risk expectations (typical of index funds after fees).
• $\alpha < 0$ (Negative Alpha): The manager underperformed the CAPM benchmark; returns were inadequate to justify the systematic risk assumed.

Comprehensive Worked Numeric Comparison

A Canadian institutional pension committee evaluates two active Canadian equity managers. Over the past 3 years, the risk-free rate was 3.0%, the S&P/TSX Composite market return was 10.0% (Market Risk Premium = $10.0\% - 3.0\% = 7.0\%$), and the market standard deviation was 14.0%.

1. Calculate Sharpe Ratios:

• Fund A: $S_A = \frac{14.0\% - 3.0\%}{18.0\%} = \frac{11.0\%}{18.0\%} = 0.611$
• Fund B: $S_B = \frac{11.5\% - 3.0\%}{10.0\%} = \frac{8.5\%}{10.0\%} = 0.850$
• Conclusion: Fund B has a significantly superior Sharpe ratio (0.850 vs. 0.611). Although Fund A achieved a higher raw return (14.0% vs. 11.5%), it took disproportionate total risk to achieve it.

2. Calculate Treynor Ratios:

• Fund A: $T_A = \frac{14.0\% - 3.0\%}{1.30} = \frac{11.0\%}{1.30} = 8.46\%$
• Fund B: $T_B = \frac{11.5\% - 3.0\%}{0.80} = \frac{8.5\%}{0.80} = 10.63\%$
• Conclusion: Fund B also dominates on systematic risk efficiency (10.63% vs. 8.46%).

3. Calculate Jensen's Alpha:

• Fund A Required Return: $3.0\% + 1.30 \times (10.0\% - 3.0\%) = 3.0\% + 9.10\% = 12.10\%$ $\alpha_A = 14.0\% - 12.10\% = +1.90\%$
• Fund B Required Return: $3.0\% + 0.80 \times (10.0\% - 3.0\%) = 3.0\% + 5.60\% = 8.60\%$ $\alpha_B = 11.5\% - 8.60\% = +2.90\%$
• Conclusion: Both managers generated positive alpha, but Manager B generated one full percentage point more net value add ($+2.90\%$ vs. $+1.90\%$) relative to the risk assumed.

Direct Comparison of Risk-Adjusted Ratios