Quick Answer
Client circumstances move strategic targets; market conditions trigger tactical, temporary shifts back to those targets. Rebalancing sells winners and buys losers to restore strategic weights, and skipping it lets a portfolio's risk profile drift away from the client's original objectives.
Asset allocation is a foundational portfolio management decision. Strategic asset allocation sets the long-term, client-driven baseline mix a portfolio returns to over time. The exam tests two allocation approaches: strategic and tactical.
What Is Strategic Asset Allocation?
Definition: A long-term, baseline allocation of a portfolio across asset classes (stocks, bonds, cash, alternatives), based on the client's investment objectives, risk tolerance, and time horizon.
- Represents the "policy portfolio" - the default target mix the adviser returns to over time
- Example: 60% equities / 30% bonds / 10% cash for a moderate-growth investor
- Changes only when the client's fundamental circumstances change (e.g., nearing retirement, major life event)
- Rebalancing brings the portfolio back to strategic targets after market movements cause drift
Think of it this way: Strategic asset allocation is like setting the thermostat in your house. You choose a target temperature (your allocation) and the system periodically kicks in to bring things back to that level. You are not constantly adjusting; you set a plan and maintain it.
Exam Tip: Gotchas
- Strategic allocation is long-term and client-driven. If a question describes changing allocations because the client's goals or risk tolerance changed, that is a strategic allocation adjustment, NOT tactical.
How Does Rebalancing Work?
Rebalancing restores the portfolio to its strategic asset allocation targets after market movements cause drift.
What Triggers a Rebalance?
| Trigger | How It Works | Advantage |
|---|---|---|
| Calendar-based | Rebalance at fixed intervals (quarterly, semi-annually, annually) | Simple, predictable |
| Threshold-based | Rebalance when any asset class drifts beyond a set percentage (e.g., +/- 5% from target) | More responsive to market moves |
What Happens When You Rebalance?
- Sell overweight positions (winners that have grown beyond target)
- Buy underweight positions (losers that have fallen below target)
- Enforces a buy low, sell high discipline: selling outperformers, buying underperformers
- Tax implications: Selling appreciated assets triggers capital gains (consider tax-loss harvesting or rebalancing within tax-advantaged accounts)
- Transaction costs: Frequent rebalancing increases trading costs
- Failure to rebalance causes style drift - the portfolio's risk profile diverges from the client's original objectives
Think of it this way: Without rebalancing, a 60/40 stock/bond portfolio can drift to 75/25 after a strong equity run. The portfolio now carries significantly more risk than the client agreed to.
Exam Tip: Gotchas
- Style drift occurs when a portfolio deviates from its stated investment style over time (e.g., a value fund gradually buying growth stocks, or a mid-cap fund holding large-cap positions). On the exam, style drift is presented as a reason to monitor managers and rebalance.
What Is Tactical Asset Allocation?
Definition: Short-term deviations from the strategic allocation to exploit perceived market opportunities. Sometimes called market timing at the asset-class level.
- The adviser temporarily overweights or underweights an asset class based on market outlook
- Requires active judgment about market conditions
- The portfolio returns to strategic targets once the perceived opportunity passes
- Higher turnover and transaction costs than strategic allocation
How Does a Tactical Shift Play Out?
A client's strategic target is 60% equity / 40% bonds. The adviser believes stocks are undervalued and temporarily shifts to 70% equity / 30% bonds. When prices normalize, the adviser returns to the 60/40 target.
Exam Tip: Gotchas
- If a question says an adviser "temporarily overweights equities to take advantage of a short-term opportunity," that is tactical allocation. If it says "the allocation changed because the client is 5 years from retirement," that is strategic.
How Do Strategic and Tactical Allocation Compare?
| Feature | Strategic Allocation | Tactical Allocation |
|---|---|---|
| Time horizon | Long-term | Short-term |
| Trigger | Client circumstances change | Market conditions change |
| Approach | Set and maintain targets | Deviate from targets temporarily |
| Goal | Match risk/return to client profile | Capture excess returns |
| Turnover | Low (rebalancing only) | Higher (active shifts) |
What Should You Check on Exam Day?
- Allocation changes triggered by the client's goals, risk tolerance, or timeline are strategic; a temporary shift to chase a market view is tactical.
- Tactical allocation always returns to the strategic targets once the perceived opportunity passes.
- Rebalancing sells overweight winners and buys underweight losers to restore strategic targets, a buy-low, sell-high discipline.
- Threshold-based rebalancing triggers when an asset class drifts beyond a set band (e.g., +/- 5% from target); calendar-based rebalancing triggers at fixed intervals.
- Rebalancing can trigger capital gains on appreciated positions; tax-loss harvesting or rebalancing inside tax-advantaged accounts can offset that.
- Failing to rebalance causes style drift, where the portfolio's risk profile diverges from the client's original objectives.