CFA 44: Basics of Portfolio Planning
Which of the following best describes the underlying rationale for a written investment policy statement (IPS)? A written IPS communicates a plan for trying to achieve investment success. A written IPS provides investment managers with a ready defense against client lawsuits. A written IPS allows investment managers to instruct clients about the proper use and purpose of investments.
A is correct. A written IPS is best seen as a communication instrument allowing clients and portfolio managers to mutually establish investment objectives and constraints.
An investment policy statement that includes a return objective of outperforming the FTSE 100 by 120 basis points is best characterized as having a(n): relative return objective. absolute return objective. arbitrage-based return objective.
A is correct. Because the return objective specifies a target return relative to the FTSE 100 Index, the objective is best described as a relative return objective.
A client who is a 34-year old widow with two healthy young children (aged 5 and 7) has asked you to help her form an investment policy statement. She has been employed as an administrative assistant in a bureau of her national government for the previous 12 years. She has two primary financial goals—her retirement and providing for the college education of her children. This client's time horizon is best described as being: long term. short term. medium term.
A is correct. The client's financial objectives are long term. Her stable employment indicates that her immediate liquidity needs are modest. The children will not go to college until 10 or more years later. Her time horizon is best described as being long term.
Investing the majority of the portfolio on a passive or low active risk basis while a minority of the assets is managed aggressively in smaller portfolios is best described as: the core-satellite approach. a top-down investment policy. a delta-neutral hedge approach.
A is correct. The core-satellite approach to constructing portfolios is defined as "investing the majority of the portfolio on a passive or low active risk basis while a minority of the assets is managed aggressively in smaller portfolios."
Consider the pairwise correlations of monthly returns of the following asset classes: Brazilian Equities East Asian Equities European Equities US Equities Brazilian equities 1.00 0.70 0.85 0.76 East Asian equities 0.70 1.00 0.91 0.88 European equities 0.85 0.91 1.00 0.90 US equities 0.76 0.88 0.90 1.00 Based solely on the information in the above table, which equity asset class is most sharply distinguished from US equities? Brazilian equities. European equities. East Asian equities.
A is correct. The correlation between US equities and Brazilian equities is 0.76. The correlations between US equities and East Asian equities and the correlation between US equities and European equities both exceed 0.76. Lower correlations indicate a greater degree of separation between asset classes. Therefore, using solely the data given in the table, returns on Brazilian equities are most sharply distinguished from returns on US equities.
After interviewing a client in order to prepare a written investment policy statement (IPS), you have established the following: The client has earnings that vary dramatically between £30,000 and £70,000 (pre-tax) depending on weather patterns in Britain. In three of the previous five years, the after-tax income of the client has been less than £20,000. The client's mother is dependent on her son (the client) for approximately £9,000 per year support. The client's own subsistence needs are approximately £12,000 per year. The client has more than 10 years' experience trading investments including commodity futures, stock options, and selling stock short. The client's responses to a standard risk assessment questionnaire suggest he has above average risk tolerance. The client is best described as having a: low ability to take risk, but a high willingness to take risk. high ability to take risk, but a low willingness to take risk. high ability to take risk and a high willingness to take risk.
A is correct. The volatility of the client's income and the significant support needs for his mother and himself suggest that the client has a low ability to take risk. The client's trading experience and his responses to the risk assessment questionnaire indicate that the client has an above average willingness to take risk.
A client who is a director of a publicly listed corporation is required by law to refrain from trading that company's stock at certain points of the year when disclosure of financial results are pending. In preparing a written investment policy statement (IPS) for this client, this restriction on trading: is irrelevant to the IPS. should be included in the IPS. makes it illegal for the portfolio manager to work with this client.
B is correct. When a client has a restriction in trading, such as this obligation to refrain from trading, the IPS "should note this constraint so that the portfolio manager does not inadvertently trade the stock on the client's behalf."
A written investment policy statement (IPS) is most likely to succeed if: it is created by a software program to assure consistent quality. it is a collaborative effort of the client and the portfolio manager. it reflects the investment philosophy of the portfolio manager.
B is correct. A written IPS, to be successful, must incorporate a full understanding of the client's situation and requirements. As stated in the reading, "The IPS will be developed following a fact finding discussion with the client."
Which of the following typical topics in an investment policy statement (IPS) is most closely linked to the client's "distinctive needs"? Procedures. Investment Guidelines. Statement of Duties and Responsibilities.
B is correct. According to the reading, "The sections of an IPS that are most closely linked to the client's distinctive needs are those dealing with investment objectives and constraints." Investment Guidelines "[provide] information about how policy may be executed, including investment constraints." Procedures "[detail] the steps to be taken to keep the IPS current and the procedures to follow to respond to various contingencies." Statement of Duties and Responsibilities "detail[s] the duties and responsibilities of the client, the custodian of the client's assets, the investment managers, and so forth."
After interviewing a client in order to prepare a written investment policy statement (IPS), you have established the following: The client has earnings that have exceeded €120,000 (pre-tax) each year for the past five years. She has no dependents. The client's subsistence needs are approximately €45,000 per year. The client states that she feels uncomfortable with her lack of understanding of securities markets. All of the client's current savings are invested in short-term securities guaranteed by an agency of her national government. The client's responses to a standard risk assessment questionnaire suggest she has low risk tolerance. The client is best described as having a: low ability to take risk, but a high willingness to take risk. high ability to take risk, but a low willingness to take risk. high ability to take risk and a high willingness to take risk.
B is correct. On the one hand, the client has a stable, high income and no dependents. On the other hand, she exhibits above average risk aversion. Her ability to take risk is high, but her willingness to take risk is low.
Tactical asset allocation is best described as: attempts to exploit arbitrage possibilities among asset classes. the decision to deliberately deviate from the policy portfolio. selecting asset classes with the desired exposures to sources of systematic risk in an investment portfolio.
B is correct. Tactical asset allocation allows actual asset allocation to deviate from that of the strategic asset allocation (policy portfolio) of the IPS. Tactical asset allocation attempts to take advantage of temporary dislocations from the market conditions and assumptions that drove the policy portfolio decision.
The section of the investment policy statement (IPS) that provides information about how policy may be executed, including investment constraints, is best described as the: Investment Objectives. Investment Guidelines. Statement of Duties and Responsibilities.
B is correct. The major components of an IPS are listed in Section 2.2 of the reading. Investment Guidelines are described as the section that provides information about how policy may be executed, including investment constraints. Statement of Duties and Responsibilities "detail[s] the duties and responsibilities of the client, the custodian of the client's assets, the investment managers, and so forth." Investment Objectives is "a section explaining the client's objectives in investing."
Which of the following is best characterized as a relative risk objective? Value at risk for the fund will not exceed US$3 million. The fund will not underperform the DAX by more than 250 basis points. The fund will not lose more than €2.5 million in the coming 12-month period.
B is correct. The reference to the DAX marks this response as a relative risk objective. Value at risk establishes a minimum value of loss expected during a specified time period at a given level of probability. A statement of maximum allowed absolute loss (€2.5 million) is an absolute risk objective.
The timing of payouts for property and casualty insurers is unpredictable ("lumpy") in comparison with the timing of payouts for life insurance companies. Therefore, in general, property and casualty insurers have: lower liquidity needs than life insurance companies. greater liquidity needs than life insurance companies. a higher return objective than life insurance companies.
B is correct. The unpredictable nature of property and casualty (P&C) claims forces P&C insurers to allocate a substantial proportion of their investments into liquid, short maturity assets. This need for liquidity also forces P&C companies to accept investments with relatively low expected returns. Liquidity is of less concern to life insurance companies given the greater predictability of life insurance payouts.
Which of the following is least likely to be placed in the appendices to an investment policy statement (IPS)? Rebalancing Policy. Strategic Asset Allocation. Statement of Duties and Responsibilities.
C is correct. The major components of an IPS are listed in Section 2.2 of the reading. Strategic Asset Allocation (also known as the policy portfolio) and Rebalancing Policy are often included as appendices to the IPS. The Statement of Duties and Responsibilities, however, is an integral part of the IPS and is unlikely to be placed in an appendix.
In defining asset classes as part of the strategic asset allocation decision, pairwise correlations within asset classes should generally be: equal to correlations among asset classes. lower than correlations among asset classes. higher than correlations among asset classes.
C is correct. As the reading states, "an asset class should contain homogeneous assets... paired correlations of securities would be high within an asset class, but should be lower versus securities in other asset classes."
Which of the following is least important as a reason for a written investment policy statement (IPS)? The IPS may be required by regulation. Having a written IPS is part of best practice for a portfolio manager. Having a written IPS ensures the client's risk and return objectives can be achieved.
C is correct. Depending on circumstances, a written IPS or its equivalent may be required by law or regulation and a written IPS is certainly consistent with best practices. The mere fact that a written IPS is prepared for a client, however, does not ensure that risk and return objectives will in fact be achieved.
In preparing an investment policy statement, which of the following is most difficult to quantify? Time horizon. Ability to accept risk. Willingness to accept risk.
C is correct. Measuring willingness to take risk (risk tolerance, risk aversion) is an exercise in applied psychology. Instruments attempting to measure risk attitudes exist, but they are clearly less objective than measurements of ability to take risk. Ability to take risk is based on relatively objective traits such as expected income, time horizon, and existing wealth relative to liabilities.
Risk assessment questionnaires for investment management clients are most useful in measuring: value at risk. ability to take risk. willingness to take risk.
C is correct. Risk attitude is a subjective factor and measuring risk attitude is difficult. Oftentimes, investment managers use psychometric questionnaires, such as those developed by Grable and Joo (2004), to assess a client's willingness to take risk.
Returns on asset classes are best described as being a function of: the failure of arbitrage. exposure to the idiosyncratic risks of those asset classes. exposure to sets of systematic factors relevant to those asset classes.
C is correct. Strategic asset allocation depends on several principles. As stated in the reading, "One principle is that a portfolio's systematic risk accounts for most of its change in value over the long run." A second principle is that, "the returns to groups of like assets... predictably reflect exposures to certain sets of systematic factors." This latter principle establishes that returns on asset classes primarily reflect the systematic risks of the classes.
