prashantsahni

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 client’s risk objective and return requirement.

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

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

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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.

prashantsahni

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 Returns

Impact on Risk

A) Increase Increase

B) Decrease Decrease

C) Increase Decrease

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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.

prashantsahni

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.

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Sedique’s 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. Alvarez’s 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.

prashantsahni

Suzanne Melby, a newly hired analyst for Taylor Capital Advisors, is making a presentation to Taylor’s 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 investor’s 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 Melby’s 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) agree with both Statement 1 and Statement 2.

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The Taylor investment committee should agree with both of Melby’s 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. Melby’s 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.

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.

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 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 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 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 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.