LOS j: Describe how taxes relate to mean–variance optimization and asset location.

Q1. On a graph where the risk is on the horizontal axis and the returns are on the vertical axis, the existence of taxes on investment returns would probably shift the mean-variance optimization portfolio:

A)   down and to the right.

B)   down and to the left.

C)   down only, and there would not be a shift left or right.

Q2. In applying efficient frontier analysis for an investor who uses both taxable and tax-advantaged accounts,

A)   no considerations need to be made because total taxes will be the same in the long run.

B)   the investor should set up two separate frontiers and optimize each in accordance with the separation theorem.

C)   constraints should be imposed to account for the limits that can be put in tax-exempt accounts.

Q3. In applying efficient frontier analysis for an investor who uses both taxable and tax-advantaged accounts, the mean-variance optimization:

A)   cannot simultaneously determine both the weights in the available assets and their location in the various accounts, but it can be done in a step-wise fashion. Usually the weights are determined first and then the locations.

B)   would simultaneously determine both the weights in the available assets and their location in the various accounts.

C)   cannot simultaneously determine both the weights in the available assets and their location in the various accounts, but it can be done in a step-wise fashion. Usually the locations are determined first and then the weights.

Q4. Which of the following most accurately describes the process for adjusting the returns when applying efficient frontier analysis for an investor who uses both taxable and tax-advantaged accounts?

A)   Accrual equivalent before-tax returns would be substituted for after-tax returns and after-tax risk would be substituted for before-tax risk.

B)   Accrual equivalent after-tax returns would be substituted for before-tax returns and after-tax risk would be substituted for before-tax risk.

C)   Accrual equivalent before-tax returns would be substituted for after-tax returns and before-tax risk would be substituted for after-tax risk.

LOS j: Describe how taxes relate to mean–variance optimization and asset location. fficeffice" />

Q1. On a graph where the risk is on the horizontal axis and the returns are on the vertical axis, the existence of taxes on investment returns would probably shift the mean-variance optimization portfolio:

A)   down and to the right.

B)   down and to the left.

C)   down only, and there would not be a shift left or right.

Correct answer is B)

Taxes lower returns, but they also shift some of the investment risk to the government.

Q2. In applying efficient frontier analysis for an investor who uses both taxable and tax-advantaged accounts,

A)   no considerations need to be made because total taxes will be the same in the long run.

B)   the investor should set up two separate frontiers and optimize each in accordance with the separation theorem.

C)   constraints should be imposed to account for the limits that can be put in tax-exempt accounts.

Correct answer is C)

A single frontier can be formed, and the optimization process would have to be constrained to account for limits on the amount of funds that can be placed in tax advantaged accounts and the type of assets that can be allocated to them.

Q3. In applying efficient frontier analysis for an investor who uses both taxable and tax-advantaged accounts, the mean-variance optimization:

A)   cannot simultaneously determine both the weights in the available assets and their location in the various accounts, but it can be done in a step-wise fashion. Usually the weights are determined first and then the locations.

B)   would simultaneously determine both the weights in the available assets and their location in the various accounts.

C)   cannot simultaneously determine both the weights in the available assets and their location in the various accounts, but it can be done in a step-wise fashion. Usually the locations are determined first and then the weights.

Correct answer is B)

The mean-variance optimization should optimally allocate assets and determine the optimal asset location for each asset. Substitution of adjusted returns would allow the process to be done in one step.

Q4. Which of the following most accurately describes the process for adjusting the returns when applying efficient frontier analysis for an investor who uses both taxable and tax-advantaged accounts?

A)   Accrual equivalent before-tax returns would be substituted for after-tax returns and after-tax risk would be substituted for before-tax risk.

B)   Accrual equivalent after-tax returns would be substituted for before-tax returns and after-tax risk would be substituted for before-tax risk.

C)   Accrual equivalent before-tax returns would be substituted for after-tax returns and before-tax risk would be substituted for after-tax risk.

Correct answer is B)

The mean-variance optimization should optimally allocate assets and determine the optimal asset location for each asset. Accrual equivalent after-tax returns would be substituted for before-tax returns and after-tax risk would be substituted for before-tax risk.