Reading 54. Basics of portfolio planning and construction

In defining asset classes as part of the strategic asset allocation decision, pairwise correlations within asset classes should generally be: A equal to correlations among asset classes. B lower than correlations among asset classes. C higher than correlations among asset classes

C

In preparing an investment policy statement, which of the following is most difficult to quantify? A Time horizon. B Ability to accept risk. C Willingness to accept risk.

C

Returns on asset classes are best described as being a function of: A the failure of arbitrage. B exposure to the idiosyncratic risks of those asset classes. C exposure to sets of systematic factors relevant to those asset classes.

C

Risk assessment questionnaires for investment management clients are most useful in measuring: A value at risk. B ability to take risk. C willingness to take risk.

C

Which of the following is least likely to be placed in the appendices to an investment policy statement (IPS)? A Rebalancing Policy. B Strategic Asset Allocation. C Statement of Duties and Responsibilities

C

Which of the following is least important as a reason for a written investment policy statement (IPS)? A The IPS may be required by regulation. B Having a written IPS is part of best practice for a portfolio manager. C 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.

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: A long term. B short term. C medium term

A

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): A relative return objective. B absolute return objective. C arbitrage- based return objective.

A

ment (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: A low ability to take risk, but a high willingness to take risk. B high ability to take risk, but a low willingness to take risk. C high ability to take risk and a high willingness to take risk.

A

Which of the following best describes the underlying rationale for a written investment policy statement (IPS)? A A written IPS communicates a plan for trying to achieve investment success. B A written IPS provides investment managers with a ready defense against client lawsuits. C 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.

Consider the pairwise correlations of monthly returns of the following asset classes: Brazilian Equities East Asian Equities European Equities US Equities Brazili 1.00 0.70 0.85 0.76 East 0.70 1.00 0.91 0.88 Euro 0.85 0.91 1.00 0.90 US 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? A Brazilian equities. B European equities. C 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.

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: A is irrelevant to the IPS. B should be included in the IPS. C makes it illegal for the portfolio manager to work with this client.

B

A written investment policy statement (IPS) is most likely to succeed if: A it is created by a software program to assure consistent quality. B it is a collaborative effort of the client and the portfolio manager. C it reflects the investment philosophy of the portfolio manager.

B

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: A low ability to take risk, but a high willingness to take risk. B high ability to take risk, but a low willingness to take risk. C high ability to take risk and a high willingness to take risk.

B

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: A Investment Objectives. B Investment Guidelines. C Statement of Duties and Responsibilities.

B

Which of the following is best characterized as a relative risk objective? A Value at risk for the fund will not exceed US$3 million. B The fund will not underperform the DAX by more than 250 basis points. C The fund will not lose more than €2.5 million in the coming 12- month period.

B

Which of the following typical topics in an investment policy statement (IPS) is most closely linked to the client's "distinctive needs"? A Procedures. B Investment Guidelines. C Statement of Duties and Responsibilities.

B

Tactical asset allocation is best described as: A attempts to exploit arbitrage possibilities among asset classes. B the decision to deliberately deviate from the policy portfolio. C 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 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: A lower liquidity needs than life insurance companies. B greater liquidity needs than life insurance companies. C 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