2019 CFA level 3 qbank reading 18 introduction to asset allocation answers

C Strategic asset allocation, similar to tactical asset allocation, employs a short-run capital market projection.. Explanation Strategic asset allocation employs a long-term capital mar

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Question #1 of 33

Which of the following statements regarding the strategic asset allocation process

is least accurate?

A) The strategic asset allocation review is typically performed once per year.

B) The strategic asset allocation must be rebalanced periodically for changes in the

valuation of the various asset classes in the portfolio

C) Strategic asset allocation, similar to tactical asset allocation, employs a short-run

capital market projection

Explanation

Strategic asset allocation employs a long-term capital market projection

(Study Session 9, Module 18.4, LOS 18.f)

A) The R-squared of the model is high.

B) The intercept term is signi cantly di erent from zero.

C) The error term is high.

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Tactical asset allocation is a deviation from the strategic asset allocation for the purpose of:

A) aligning with investor’s risk preferences.

B) exceeding investor’s return objectives.

C) taking advantage of short-term capital market expectations.

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James Mason is the Chief Operating O cer of the Homeless Mission Foundation (HMF), afoundation with the purpose of providing food, clothing, and shelter for homeless individuals.Mason is currently in the process of preparing a report to HMF's board recommending an assetallocation for the foundation This year, Mason estimates that HMF's operating budget will be

$2.75 million In order to assist with preparation of his report, Mason has compiled the

following data

The market value of the foundation is currently $50,000,000

The cost for providing services to homeless individuals is expected to rise at a rate of3.0% per year

The board would like to maintain a cash cushion equal to half of the estimated operatingbudget in order to meet any unexpected expenses

Management fees for the foundation are estimated to be 0.40%

The board is willing to accept market risk in order to meet its long-term objectives, butthe board wants to accept shortfall risk (de ned as expected return minus two standarddeviations) of no more than 15%

Mason must recommend one of three di erent portfolios to the board Mason's choice ofportfolios is shown below:

Asset Class Portfolio A Portfolio B Portfolio C

International – Developed market

International – Emerging market

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In his report, Mason is going to recommend a portfolio based on 3 criteria: liquidity needs,return requirements, and shortfall risk Which of the portfolios should Mason recommend?

Shortfall risk – The shortfall risk for each portfolio is as follows:

Portfolio A: 7.85% - (2 ×11.15%) = -14.45%

Portfolio B: 9.20% - (2 ×12.10%) = -15.00%

Portfolio C: 8.80% - (2 ×12.20%) = - 15.60%

Therefore, only Portfolios A and B meet the shortfall risk requirement

Since Portfolio B is the only one to meet all three requirements, Portfolio B is thebest choice

(Study Session 9, Module 18.2, LOS 18.c)

Related Material

SchweserNotes - Book 3

Which of the following is least likely a characteristic of strategic asset allocation?

A) Short-term capital market expectations.

B) Investor constraints.

C) Investor risk and return objectives.

Explanation

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Strategic asset allocation takes into account long-term capital market expectations and theinvestor's investment policy statement (risk/return objectives and constraints).

Strategic asset allocation re ects what systematic risk exposure?

A) Asset class systematic risk.

B) Investor’s desired systematic risk exposure.

C) Long-term systematic risk exposure.

Explanation

Strategic asset allocation re ects the investor's desired systematic risk exposure

A) Asset classes have di erent systematic risk exposures.

B) Liability funding is more accurately controlled.

C) Liabilities and assets are highly correlated.

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su ciently liquid, and they cover the majority of all investable assets.

(Study Session 9, Module 18.3, LOS 18.d)

Tactical asset allocation analysis:

A) is often based on deviant beliefs.

B) assumes lack of ine ciencies in the market.

C) assumes that investor's risk tolerance decreases with wealth.

Explanation

Tactical asset analysis often operates on the assumption that the market overreacts toinformation

Tactical asset analysis is typically performed routinely as part of a continuing asset

management, attempts to take advantage of perceived ine ciencies in the relative prices ofsecurities in di erent asset classes, and assumes that investor's risk tolerance is una ected

by changes in wealth

(Study Session 9, Module 18.5, LOS 18.i)

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Carl Allen and Cli Hanes are analysts for Tacticon Advisory (Tacticon) Allen and Hanes havebeen assigned the task of documenting some of Tacticon's asset allocation techniques Afterreceiving accolades in a recent trade magazine article featuring investment rms with

innovative trading strategies, their supervisor, Amos Ridley, decides it is time the rm beganformally documenting the rm's proprietary asset allocation process

Ridley wants Allen and Hanes to record the speci cs of Tacticon's investment process forinternal use He also wants them to compile a document explaining a variety of allocationtechniques to be used by the marketing sta and portfolio managers when working withprospects and clients

At their rst meeting after receiving the assignment, a discussion of strategic and tacticalallocation commences Allen and Hanes feel con dent about the distinction between the two,but are less certain about the di erences between asset-liability management (ALM) versusasset-only approaches to asset allocation

Hanes states "ALM and asset-only approaches are used for strategic asset allocation With ALM

an investor's optimal asset allocation is directly related to explicit liability modeling On theother hand, with asset-only strategies, liabilities only indirectly impact the return objective."Allen replies, "I'm not so sure I thought that tactical, asset-only approaches like immunizationand cash ow matching are more precise than ALM for controlling risk."

Strategic asset allocation:

A) sets a portfolio’s asset class exposures to unsystematic risk.

B) establishes a portfolio’s long-term asset class exposures by integrating each

element of investment policy with capital market expectations

C) involves short-term variations from an investor’s normal asset mix.

Explanation

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Strategic asset allocation establishes a portfolio's long-term asset class exposures by

integrating each element of investment policy with capital market expectations It a ords aninvestor the ability to control systematic risk exposures by aligning their risk and returnobjectives with the actual portfolio of investments. Tactical asset allocation involves

adjustments away from the strategic mix to take advantage of short-term projections ofrelative asset class performance

A) both are correct.

B) only one is correct.

C) both are incorrect.

Deviation from the policy portfolio due to short-term capital market expectations is called:

A) tactical asset allocation.

B) targeted asset allocation.

C) strategic asset allocation.

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B) Correlations between broad asset classes are likely to be high.

C) Increasing granularity in asset classes is important to the strategic asset allocation

process

Explanation

Sub-asset classes are divisions within a class such as value versus growth within the equityclass They will not be as di erent from each other as the di erences between broad assetclasses (such as equity versus xed income) In other words sub-assets within a broad classare relatively more highly correlated than broad asset classes are to each other Broad assetclasses are most important in SAA, not creating lots of sub-asset classes which is whatincreasing granularity means More sub-asset classes can be useful in TAA or strategyimplementation

(Study Session 9, Module 18.3, LOS 18.d)

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B) Strategic asset allocation employs a long-run view of capital market conditions.

C) Tactical asset allocation employs a long-run view of capital market conditions.

Explanation

Tactical asset allocation is an attempt to take advantage of temporary capital market

ine ciencies and takes a short-run view of market conditions Both of the other statementsare true

B) considers more than one asset class while static asset allocation only considers one

asset class at a time

C) considers asset and liability management simultaneously while static asset

allocation does not

Explanation

Dynamic asset allocation takes a multi-period view of the investment horizon while staticasset allocation does not Dynamic asset allocation and static asset allocation both can beused for asset only or asset-liability approaches to strategic asset allocation Both dynamicand static asset allocation approaches consider more than one asset class

(Study Session 9, Module 18.5, LOS 18.h)

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Regarding the use of risk factors when making asset allocation decisions, which of the followingstatements is most correct?

A) Risk factors are as easy to invest in as an asset class.

B) Risk factors cannot be used as units of analysis in asset allocation.

C) Multifactor models can be used to isolate systematic risk exposures.

Explanation

Multifactor models can be used for asset allocation by creating factor portfolios, whichisolate systematic risk exposures (i.e., non-diversi able risks) Risk factors can be used asunits of analysis in asset allocation But one problem is that it is not always easy to determinehow to invest in those identi ed risk factors Some may be investable and others may not.Asset classes are by de nition assets that are owned and investable, though the cost andease of investing varies

(Study Session 9, Module 18.3, LOS 18.e)

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Stokes Day Nursery is a nonpro t organization to provide day care for children from income homes The endowment that funds the nursery has a value of $8 million, and it isestimated that the nursery will need $360,000 in the current year to fund its operations Thenursery's expenses are expected to grow by 3% annually, in line with in ation William Rose hasbeen hired as a consultant to review Stokes Day Nursery's portfolio The asset allocation for thecurrent portfolio is shown below.

low-Asset Class Allocation (%) Expected Return

Intermediate-term Treasury bonds 35% 4.5%

High quality corporate bonds 33% 5.0%

Int'l equities (developed markets) 5% 10.0%

Int'l equities (emerging markets) 0% 12.0%

Rose makes four suggestions regarding the current portfolio:

Suggestion 1: The allocation to cash should be higher.

Suggestion 2: The allocation to intermediate-term Treasury bonds

should be lower.

Suggestion 3: The allocation to U.S equities should be lower.

Suggestion 4: The allocation to emerging market international equities is appropriate.

Which of the suggestions should the board of directors for Stokes Day Nursery agree with?

A) Suggestions 1 and 2 only.

B) Suggestions 2 and 4 only.

C) Suggestions 1 and 3 only.

Explanation

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The board should agree with Suggestion 1 – $360,000 is needed to fund the current year'sexpenses, representing 4.5% of the portfolio The cash allocation should be higher to makesure the current year's expenses can be paid The board should also agree with Suggestion 2– an endowment needs more growth to meet future needs as well as keep up with in ation.With a spending rate of 4.5% and an in ation rate of 3.0%, the endowment requires a return

of at least 7.5% The current allocation to bonds is too high Given the growth needs of theendowment and the return projections of the asset classes, the allocation should be higherfor U.S equities and both emerging and developing market equities, therefore, the boardshould not agree with Suggestions 3 and 4

(Study Session 9, Module 18.1, LOS 18.a)

In terms of vehicles for implementing passive and active mandates within asset classes, which

of the following investments would be the most passive approach?

A) Tilting the asset allocation toward a certain investment style index.

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B) Not managing the portfolio with regard to any benchmark.

C) Investing in the global market portfolio.

Explanation

The most passive approach would include buying and holding a self-rebalancing, broad index

of risky assets, such as the global market portfolio Tilting allocation toward a certain

investment style index is slightly more active given that it involves an active decision, but stilluses the passive implementation of indexing The most active approach would include

unconstrained mandates where the portfolio is not restricted in degree of deviation from itsbenchmark Not managing the portfolio with regard to any benchmark sounds like no IPS orSAA has ever been created and a likely ethics violation

(Study Session 9, Module 18.5, LOS 18.h)

B) The residual from the regression model of returns should be heteroskedastic.

C) It should be easy to construct a bogey portfolio for each class.

Explanation

The asset classes used should explain a large part of portfolio return variability, and it should

be easy to construct a bogey portfolio for each class Heteroskedasticity refers to a constant variance of the error terms in a regression, which makes the regression modelunreliable

non-(Study Session 9, Module 18.3, LOS 18.d)

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Which of the following would indicate that the asset classes used for describing the returns of aportfolio are desirable?

A) High R-squared and easily measured manager asset proportions.

B) Low R-squared and easily measured manager asset proportions.

C) High R-squared and large con dence intervals.

Explanation

Desirable asset classes would explain a high proportion of portfolio returns and thus have ahigh R-squared The asset mix proportions for each manager should be easily measured.(Study Session 9, Module 18.3, LOS 18.d)

A) The standard deviation of the overall portfolio.

B) The standard deviation of the funding ratio.

C) The standard deviation of the surplus.

Explanation

For an asset-only approach, the relevant risk measure is the standard deviation of portfolioreturns, which incorporates asset class volatilities and asset class return correlations Thiscase speci cally says an asset only approach is being used and that is not uncommon for DBplans Arguably a liability relative style is more appropriate, but the asset only approach canimplicitly deal with the liabilities by targeting a rate of return su cient to meet the liabilitypayouts

(Study Session 9, Module 18.2, LOS 18.c)

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