CFA CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA level 3 finquiz item set answers, study session 7, reading 17

A drawback of Markowitz’s MVO approach is that it is a single-period model which fails to consider the impact of rebalancing a portfolio over multiple periods with respect to rebalancing

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CFA Level III Item-set - Solution

Study Session 8 June 2017

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FinQuiz Level III 2017 – Item-sets Solution

Reading 17: Principles of Asset Allocation

1 Question ID: 134420

Correct Answer: B

B is correct The traditional MVO framework incorporates an investor’s risk aversion coefficient as

an input component for deriving an allocation’s expected utility and seeks to identify the allocation which maximizes utility for a given level of risk aversion Therefore, the risk tolerance of the investor

is incorporated in this approach

A is incorrect MVO tends to be highly concentrated in a subset of available asset classes and

therefore leads to poorly diversified asset allocations

C is incorrect A drawback of Markowitz’s MVO approach is that it is a single-period model which fails to consider the impact of rebalancing a portfolio over multiple periods with respect to

rebalancing costs and taxes

Correct Answer: A

A is correct A drawback of using investment vehicles when fulfilling the potential strategic asset allocation is that there are no low-cost passive investment vehicles to track the aggregate performance

of less liquid asset classes Therefore, the strategy is costly to implement

C is incorrect The risk and return characteristics of private equity funds is significantly different from the characteristics of the asset classes they are intending to represent which implies a low correlation between the investment vehicle and asset class

Correct Answer: C

C is correct A portfolio model requires multiple periods if rebalancing decisions are directly

incorporated into the model In this regard, an integrated asset-liability approach is appropriate given Gill’s requirement to consider rebalancing costs and taxes in the asset allocation framework On the other hand, both the surplus optimization and hedging/return-seeking portfolio approach rely on single-period models for deriving the strategic asset allocation

A is incorrect A surplus optimization approach is applicable to investors with any level of risk aversion and funding ratio However, as mentioned above, the approach is a single-period model which fails to consider the multi-period implications of rebalancing on an asset allocation

B is incorrect The hedging/return seeking portfolio approach is only appropriate for conservative investors and overfunded/fully funded investors that can fully hedge their liabilities Given the

underfunded nature of Paulus Manufacturing’s pension plan, the investor cannot create a fully

hedging portfolio unless there is a significantly large positive cash flow Since there are no current sponsor contributions, this approach is unsuitable

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B is correct Given the ongoing nature of the pension plan and the fact that it is open to new

participants, inflation will be a factor which influences the growing pension plan’s liabilities The asset allocation design is flawed because it lacks an allocation to asset categories that are positively correlated with the underlying risk factors Gill should consider the addition of inflation-linked bonds

as opposed to 25-year Treasuries which do not adequately hedge the plan’s liabilities

A is incorrect The asset allocation is adequately diversified as there is an allocation to a variety of asset class categories

C is incorrect An extremely high allocation to high growth asset classes such as private equity or even hedge funds is inappropriate given the risk tolerance and underfunded nature of the pension plan The focus of the plan sponsor should be to generate sufficient cash flow from portfolio

investments so that the plan shifts to a fully or slightly overfunded status and the sponsor is not required to make any future contributions to the plan Therefore, a moderate allocation to high growth

assets is more suitable

B is correct Gill is incorrect with respect to her comments A factor-based allocation can be

implemented with any of the three liability-relative approaches – surplus optimization,

hedging/return-seeking portfolio, and integrated asset-liability approach

Correct Answer:

The overall corridor width should be increased due to the following reasons:

An increase in the correlation between domestic equities and the rest of the portfolio will increase the tendency of the asset class to move in sync with the portfolio and will decrease the probability of further divergence from target weights The higher the correlation, the wider the optimal corridor

An increase in volatility will increase the frequency of divergence of an asset class from its target weight which should require a narrow corridor However, a narrow corridor implies more frequent rebalancing which will lead to higher rebalancing costs To keep rebalancing costs low, higher

volatility calls for a wider optimal corridor

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