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Reading 25: Asset Allocation-LOS i

SchweserOnline CFA: SchweserPro 2008 CFA Level 3
CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 7: Asset Allocation
Reading 25: Asset Allocation
LOS i: Evaluate the theoretical and practical effects of including additional asset classes in an asset allocation.

Adding an allocation to alternative asset classes such as private equity and hedge funds has what theoretical impact on the return and risk of an investment portfolio?

Impact on ReturnsImpact on Risk

A)
IncreaseDecrease
B)
DecreaseDecrease
C)
IncreaseIncrease
D)
DecreaseIncrease


Answer and Explanation

Each category of alternative investments, such as private equity, hedge funds, and real estate, on its own is fairly risky, but can have significant diversification effects for an investment portfolio. In a portfolio context, alternative investments can significantly increase returns and lower the risk of the portfolio due to their low correlation with traditional asset classes.

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Wahid Sedique, portfolio manager with Fort Meigs Investment Advisors is discussing the practical and theoretical benefits of adding additional asset classes to client portfolios with his colleague Elizabeth Alvarez. In their conversation Sedique states, From a practical standpoint, adding emerging markets to a portfolio consisting of developed U.S. and International equities provides valuable diversification in the event of a global crisis due to their low correlation with other asset classes. Alvarez replies, I think we should include U.S. TIPS in our client allocations because they are a liquid and virtually risk-free way to increase portfolio cash flows in the event of rising inflation.

With respect to their statements:

A)Sedique is correct; Alvarez is correct.
B)Sedique is incorrect; Alvarez is incorrect.
C)
Sedique is incorrect; Alvarez is correct.
D)Sedique is correct; Alvarez is incorrect.


Answer and Explanation

Sediques statement is incorrect. Although emerging markets have been shown to have a low correlation with other asset classes, and thus, diversification benefits, in a global crisis, the correlation between emerging markets and developed markets tends to be high. In other words, the diversification benefit of emerging markets is weak at exactly the time when the investor needs it the most. Alvarezs statement is correct. U.S. TIPS are highly liquid and virtually risk free because they are issued by the U.S. government. In addition, as inflation rises, the principal on which the TIPS coupon is based also rises, resulting in higher portfolio cash flows in an environment of rising inflation.

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Suzanne Melby, a newly hired analyst for Taylor Capital Advisors, is making a presentation to Taylors investment committee about the practical concerns when adding new asset classes to an investment portfolio. In her presentation, Melby makes two statements:

Statement 1: We have seen from the previous charts that adding international securities can increase the returns of a portfolio; however, from the investors standpoint, risk may be perceived as higher due to the inclusion of currency, political, and legal risk.

Statement 2: The investment committee has decided that some type of alternative investment such as hedge funds should be included in all client portfolios, but the large amounts of capital required and the difficulty of finding information may prevent us from investing in alternative investments in some client portfolios.

With regard to Melbys statements, the Taylor Capital Advisors investment committee should:

A)agree with Statement 1, but disagree with Statement 2.
B)disagree with Statement 1, but agree with Statement 2.
C)disagree with both Statement 1 and Statement 2.
D)
agree with both Statement 1 and Statement 2.


Answer and Explanation

The Taylor investment committee should agree with both of Melbys statements as she has correctly identified some of the practical concerns when investing in global securities and alternative investments such as hedge funds. The practical considerations of including global securities in a portfolio relate to risks that an investor does not face with a domestic-only portfolio such as currency, political, and legal risks. Even if there are diversification benefits from including global securities, a portfolio manager needs to consider that the investor would be exposed to risks that they would not otherwise be exposed to. Melbys second statement is also correct as a lack of information, large amount of required capital, and the need to carefully select out-performers are all drawbacks to alternative investments that potentially could prevent the investment manager from using them in client portfolios.

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a

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