LOS j: Formulate and implement the major steps in asset allocation.

Q1. Paul Kelley and Marie Dascenzo are portfolio managers for Myers and Schmolenberger Investment Advisors. Kelley and Dascenzo are discussing the asset allocation process that their firm should follow for its clients. Kelley states, “The asset allocation process should always start with determining the risk tolerance and return objective for each client.” Dascenzo replies, “While about half of the steps of the asset allocation process is the responsibility of the portfolio manager, the other half of the asset allocation process is the responsibility of the client.”
With regard to their statements about the asset allocation process:

A)   Kelley is incorrect; Dascenzo is incorrect.

B)   Kelley is correct; Dascenzo is incorrect.

C)   Kelley is correct; Dascenzo is correct.

Q2. Sarah Berndt recently hired Phil Ruyle as a new portfolio manager with her firm, Private Wealth Consultants. Ruyle spends his first day with the firm shadowing Berndt and learning about her process. During the day, Berndt makes two statements regarding the asset allocation process:

Statement 1:    “The downside to the strategic asset allocation process is that if the long-term capital market expectations that formed the basis of the strategic asset allocation change dramatically, the client’s long-term returns are likely to suffer significantly.”

Statement 2:    “Tactical asset allocation has no role in the formal asset allocation process.”

With regard to the statements made by Berndt:

A)   Statement 1 is incorrect; Statement 2 is incorrect.

B)   Statement 1 is correct; Statement 2 is correct.

C)   Statement 1 is correct; Statement 2 is incorrect.

Q3. Darlene Szuch is constructing an asset allocation for a client and just completed the step of formulating her expectations for the capital markets and making projections for the risk and return of various asset classes. Which of the following is her next step in the asset allocation process?

A)   Determine the mix of asset classes that best meets the objectives defined in the Investment Policy Statement.

B)   Determine the client’s risk objective and return requirement.

C)   Monitor the various asset classes and make adjustments to market and asset class expectations as necessary.

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Q1. Paul Kelley and Marie Dascenzo are portfolio managers for Myers and Schmolenberger Investment Advisors. Kelley and Dascenzo are discussing the asset allocation process that their firm should follow for its clients. Kelley states, “The asset allocation process should always start with determining the risk tolerance and return objective for each client.” Dascenzo replies, “While about half of the steps of the asset allocation process is the responsibility of the portfolio manager, the other half of the asset allocation process is the responsibility of the client.”
With regard to their statements about the asset allocation process:

A)   Kelley is incorrect; Dascenzo is incorrect.

B)   Kelley is correct; Dascenzo is incorrect.

C)   Kelley is correct; Dascenzo is correct.

Correct answer is B)

Kelley’s statement is correct. The asset allocation process starts with identifying the investor’s return requirement and risk tolerance. From there, the portfolio manager must identify capital market expectations, select the appropriate asset classes, and monitor and adjust the allocation as necessary. Dascenzo’s statement is incorrect – each of the steps in this process is the responsibility of the portfolio manager.

Q2. Sarah Berndt recently hired Phil Ruyle as a new portfolio manager with her firm, Private Wealth Consultants. Ruyle spends his first day with the firm shadowing Berndt and learning about her process. During the day, Berndt makes two statements regarding the asset allocation process:

Statement 1:    “The downside to the strategic asset allocation process is that if the long-term capital market expectations that formed the basis of the strategic asset allocation change dramatically, the client’s long-term returns are likely to suffer significantly.”

Statement 2:    “Tactical asset allocation has no role in the formal asset allocation process.”

With regard to the statements made by Berndt:

A)   Statement 1 is incorrect; Statement 2 is incorrect.

B)   Statement 1 is correct; Statement 2 is correct.

C)   Statement 1 is correct; Statement 2 is incorrect.

Correct answer is A)

Both of Berndt’s statements are incorrect. Once the strategic asset allocation has been implemented, it should be monitored regularly and include a “feedback loop” such that changes in long-term market factors are incorporated back into the process and an assessment can be made to determine whether adjustments to the strategic allocation are justified. The key point here is that asset allocation is a flowing, flexible process. Also, if identified market changes are only short-term in nature, the manager should consider implementing tactical asset allocation measures which have been approved in the IPS. Tactical asset allocation definitely has a role in the formal asset allocation process.

Q3. Darlene Szuch is constructing an asset allocation for a client and just completed the step of formulating her expectations for the capital markets and making projections for the risk and return of various asset classes. Which of the following is her next step in the asset allocation process?

A)   Determine the mix of asset classes that best meets the objectives defined in the Investment Policy Statement.

B)   Determine the client’s risk objective and return requirement.

C)   Monitor the various asset classes and make adjustments to market and asset class expectations as necessary.

Correct answer is A)

The asset allocation process starts with determining the investor’s risk tolerance and return objectives. Step 2 is to formulate capital market expectations and the potential effects on various asset classes. Step 3 is to determine the mix of assets that best meet the objectives defined in the IPS. Once the strategic asset allocation has been implemented it should be monitored regularly and adjustments should be made to the strategic allocation as needed. Also, if identified market changes are short-term only, the manager should determine if implementing tactical asset allocation measures is appropriate.