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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.



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.

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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.



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.

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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)
IncreaseIncrease
B)
DecreaseDecrease
C)
IncreaseDecrease



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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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.



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.

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



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.

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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.



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.

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The first step in the portfolio construction process is called:
A)
strategic asset allocation.
B)
tactical asset allocation.
C)
capital market expectation.


The steps in the asset allocation process are:
  • Determine the investor's risk, return, and constraints.
  • Formulate long-term capital market expectations.
  • Determine the mix of assets (allocation) that best meets the objectives of the IPS.
  • Monitor the portfolio.
  • Adjust the portfolio as necessary for strategic or tactical asset allocation.

Strategic asset allocation is the first step in the portfolio construction process which is step 3 above. Tactical asset allocation is the subsequent deviation from the strategic asset allocation based on short-term capital market expectations. Capital market expectations are used for the generation of the efficient frontier used in step 2 above which occurs before the portfolio construction takes place.

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Any mean-variance efficient portfolio has the:
A)
lowest standard deviation and the highest expected return.
B)
lowest standard deviation for a given level of expected return.
C)
highest return among all other portfolios.



A mean-variance efficient portfolio has the lowest standard deviation for a given level of expected return. Note that the lowest standard deviation portfolio and the highest return portfolio are just two of the infinite number of efficient portfolios.

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Which of the following does NOT accurately reflect a statement describing the resampled efficient frontier?
A)
A single portfolio with specific asset class weights at each level of return.
B)
At each level of return the most efficient of the simulated efficient portfolios is at the center of a distribution.
C)
A portfolio may be considered statistically equivalent if the manager’s portfolio is within a 90% confidence interval of the most efficient portfolio.



A single portfolio with specific asset class weights at each level of return describes traditional mean variance optimization. The other answer choices describe the resampled efficient frontier where Monte Carlo simulation is used to create an efficient frontier at each return level and run thousands of times resulting in an efficient frontier that is the result of an averaging process. The efficient frontier becomes a blur rather than a single sharp curve. At each level of return, the most efficient of the simulated efficient portfolios is at the center of the distribution.

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Constrained optimization usually involves an additional constraint that:
A)
each asset class weight should be positive.
B)
short sales are not allowed.
C)
the weights of all asset classes add up to 1.



The weight of all asset classes adding up to one is part of un-constrained optimization. Constrained optimization has an additional constraint that the weights of all the asset classes should be non-negative or that there be no short sales. The weight of asset classes can be zero or positive.

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