hinsafdar

Dynamic asset allocation is most suitable for investors who:

A) undertake the asset-liability approach to strategic asset allocation.

B) have insignificant liabilities.

C) have a long time horizon.

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Dynamic asset allocation is most suitable for investors who have significant liabilities and utilize the asset-liability approach to strategic asset allocation.

hinsafdar

What is the major difference between dynamic asset allocation and static asset allocation? Dynamic asset allocation:

A) considers more than one asset class while static asset allocation only considers one asset class at a time.

B) considers asset and liability management simultaneously while static asset allocation does not.

C) takes a multi-period view of the investment horizon while static asset allocation does not.

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

prashantsahni

Kimbo Slice has several different places where he has assets in which he manages as separate accounts such as his checking account which he uses for short term cash and emergency needs, his 401(k) account for retirement, and his children’s college fund. In his 401(k) he owns a small cap stock in a company which makes catheters to be used in experimental cancer treatment in which the catheter is used to deliver cancer killing drugs to hard to reach tumors in the body. The stock has recently taken a downturn in price due to the FDA not approving their most recent catheter. As a result of the downturn in price, Slice purchases more of the stock in hopes of recouping his losses at some future time. Slice’s management of his portfolio is indicative of:

A) money illusion and fear of regret.

B) mental accounting and loss aversion.

C) asset allocation and pyramiding.

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Slice is exhibiting mental accounting by having separate accounts for his assets which he manages each account separately for a specific purpose and does not manage his assets as a complete portfolio for asset allocation purposes. He is also exhibiting loss aversion by not accepting the loss on the stock which is also leading to risk seeking behavior by buying more of the losing stock. Loss aversion is similar to fear of regret which also results in holding onto loser too long because you regret selling at a loss, but fear of regret does not lead to risk seeking behavior as loss aversion can. Also fear of regret tends to lead to safer investments and undiversified portfolios as can be seen in mental accounting, too. Pyramiding is similar to mental accounting, but pyramiding is where a person layers their investments in the shape of a pyramid in which their most pressing and important needs are on the bottom layer in the most conservative investments. As one moves up the pyramid, investments move more towards equities and riskier investments until you get to the top which reflects investment for wish list type items. Money illusion deals with inflation and thinking that you have more money if your investments (or income) went up by the same amount as inflation.

prashantsahni

Sam and Ellen Smithson have recently retired after numerous years of working as a heart surgeon and pediatrician, respectively. The Smithsons were unable to have children, so they devoted their lives to helping others through their professional and charitable activities. Sam is involved in the local “Pantry Pass,” an organization that gathers food items for distribution to the needy. Ellen is involved in her local “Housing for the Homeless,” chapter. Over the years they have served the two organizations as active volunteers and as board members.
The Smithson’s professional activities generated high incomes, well in excess of expenses. Prior to retirement, their lifestyle could be described as comfortably frugal. Over the years, a retirement savings account in the amount of $4,000,000 was accumulated.
Marcus Medley, CFA is an investment consultant who serves high net worth individuals. During his discussions with the Smithsons, Sam and Ellen mentioned the following:

• We consider our retirement portfolio to be large both in absolute terms and relative to our lifestyle needs.
• Our living expenses are estimated to be no greater than $150,000 per year, but we do want to maintain our purchasing power without eroding the principal of our account.
• We are both in good health and have at least another 20 to 25 years of life expectancy. We do not expect any major medical expenses, either chronic or acute, over the foreseeable future.
• We have no debts and are not interested in anything that would require us to borrow.
• After we die, we would like to leave the remainder of our portfolio equally to the charities with which we have been involved all these years. One of our objectives is to maximize the funds transferred.
• Although we hope to leave a substantial estate to the charities, we wish to ensure that at least a floor value amount will be transferred.
• Neither one of us has a high tolerance for risk. For the most part, our retirement savings have been in low-risk investment vehicles. Our investment portfolio decisions have been made in congruence with our desire to leave a legacy for future generations and to help our fellow man.
• We know we could establish a charitable remainder trust but we’re not ready to do that yet; we want to stay in control of all our assets as long as we’re able. Besides, our estate probably isn’t large enough right now to be subject to death taxes.
• We agree with your firm’s capital market expectations and the projection that inflation will average 3.25% over the long-term.
• We do not want to use any type of derivative security like options or futures – and we would never consider short selling.

During the course of their meeting, Medley asks the Smithsons whether their approach to investing has been passive or active. Ellen Smithson says “Oh, I’m definitely the passive type – I don’t believe in getting too involved, so I let Sam make most of the decisions on our portfolio. He’s done a wonderful job up to now, but I guess it’s time we had someone else take an active role in helping us.”
Sam comments, saying “Yes, it’s pretty much been up to me. My investment philosophy has been to invest 70% of our assets in a total return bond fund and 30% in an S&P 500 index fund, thus ensuring that we track their performance fairly closely while holding down costs. Then I’ve tried to get a little more juice by investing selectively in individual companies that produce surgical instruments or products for the cardiovascular field. That way I can leverage my expertise and judiciously use my limited time for investing.”
Later, Medley reviews the Smithsons’ personal statements and the latest economic activity forecasts. He then begins to formulate an Investment Policy Statement (IPS) and some general asset allocation recommendations.
Which of the choices below most closely matches the investment strategies of Ellen and Sam?

A) Ellen has a passive approach; Sam has a semi-active approach.

B) Ellen has no investment approach; Sam has a semi-active approach.

C) Ellen has no investment approach; Sam has a passive approach.

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Ellen is describing a passive personality type, rather than a passive approach to investing. Sam’s investment methodology is closest to that of semi-active (risk-controlled, enhanced index) managers. He seeks to track an underlying index while trying to provide extra value by more heavily weighting the medical technology and services sector. (Study Session 9, LOS 23.b)

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While writing the risk objective statement, Medley ponders the Smithson’s ability and willingness to accept risk. The Smithson’s appear to have the ability:

A) to take below-average risk; willingness to take above-average risk.

B) to take above-average risk; willingness to take below-average risk.

C) and willingness to take below-average risk.

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Given the data regarding the Smithsons’ situation, it appears that they are able to take above-average risks (large absolute and relative sized portfolio), but are only willing to accept below average risks (“neither of us has a high tolerance for risk”). (Study Session 8, LOS 21.g)

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One of the first concepts Medley wants to explain to the Smithson’s at their next meeting is the idea of holding an “optimal” portfolio. Which of the following will dictate the selection of an investor’s optimal portfolio?

A) The global minimum variance portfolio.

B) The tangential intersection between an investor's risk and return and the efficient frontier.

C) Any portfolio lying above the efficient frontier.

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An optimal portfolio is any set of assets yielding the highest returns for given risk levels (dictated by the efficient frontier). Assuming the risk free asset is available to invest in then a straight line, the capital allocation line (CAL), would be drawn from the risk free rate to the efficient frontier touching the efficient frontier at the point of tangency representing the global market portfolio. The CAL then becomes the efficient frontier. Any point on this line would represent the optimal portfolio combination of the risk free asset with the global market portfolio resulting in the highest Sharpe ratio (highest return for a given level of risk). (Study Session 8, LOS 21.n)

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According to the Smithson’s risk profile, a general asset allocation that would fit well with their objectives is:

A) a conservative, total return asset allocation to meet their current income and wealth transfer goals.

B) an asset allocation heavily-weighted toward risk-free securities to meet their current income needs and minimize the possibility of losing any of the original $4 million.

C) an asset allocation heavily-weighted toward fixed-income to meet their current income needs and provide for modest growth.

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An asset allocation that focuses on total return would appear to best meet the Smithson’s objectives given the apparent disconnect between ability and willingness to take risk. The Smithson’s need to earn a 3.75% return ($150,000/$4,000,000) to meet their current income needs in today’s dollars. To protect their purchasing power, they must also generate an additional 3.25%. A conservative total return approach provides an appropriate balance between meeting their retirement needs and their goal of maximizing the amount of their charitable estate. The risk-free and modest growth portfolios would not meet all their objectives. (Study Session 8, LOS 21.g)

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Which of the following dynamic asset allocation strategies would be most appropriate for meeting the Smithson’s charitable objectives?

A) Buy and hold.

B) Constant mix strategy.

C) Constant proportion portfolio insurance strategy.

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A constant mix strategy would have a zero floor value, hence would not be an appropriate strategy for meeting Smithson’s objectives. A buy and hold strategy is not a dynamic asset allocation strategy but is the "do nothing" strategy where once your initial asset allocation is chosen you do not reallocate but instead just let the allocation fluctuate according to any changes in the market. (Study Session 16, LOS 40.j)

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A constant mix asset allocation strategy assumes that an investor’s risk tolerance:

A) is constant, regardless of wealth levels.

B) increases as the portfolio value rises and falls as the portfolio value falls.

C) falls as the portfolio value approaches the floor value.

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With a constant mix strategy, an investor’s risk tolerance is constant, regardless of wealth levels. CPPI assumes that risk tolerance increases as stocks rise and falls as stocks fall. (Study Session 16, LOS 40.j)

prashantsahni

Which of the following statements regarding the characteristics of asset classes is most correct? Asset classes should:

A) have an index.

B) be negatively correlated.

C) not be highly correlated.

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Asset classes should not be highly correlated with each other is a desired characteristic. Furthermore, asset classes should be mutually exclusive and collectively mutually exhaustive.

prashantsahni

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

A) High R-squared and large confidence intervals.

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

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

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Desirable asset classes would explain a high proportion of portfolio returns and thus have a high R-squared. The asset mix proportions for each manager should be easily measured.

prashantsahni

Which of the following is NOT a desirable characteristic of an asset class used for describing the returns on a portfolio?

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

B) The asset classes used should explain a large part of the variability of portfolio returns.

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

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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 non-constant variance of the error terms in a regression, which makes the regression model unreliable.

prashantsahni

Which of the following would indicate that an asset class is useful for describing the returns of a portfolio?

A) The error term is high.

B) The intercept term is significantly different from zero.

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

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A high R-squared would indicate that the model explains a good proportion of portfolio returns.

prashantsahni

Which of the following characteristics of asset classes is most desirable? Asset classes should:

A) be mutually exhaustive.

B) have an index.

C) be negatively correlated.

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One of the desired characteristics of asset classes is that they should be mutually exhaustive- or cover most of the investable assets. They also should not be highly (positively or negatively) correlated with each other.

prashantsahni

Which of the following characteristics of asset classes is most desirable? Asset classes should:

A) be mutually exclusive.

B) have an index.

C) be negatively correlated.

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One of the desired characteristics of asset classes is that they should be mutually exclusive. They also should not be highly (positively or negatively) correlated with each other.