CAIA - 01 - Asset Allocation Processes and the Mean-Variance Model

Question 1

Whether asset allocation or security selection has the greatest impact on portfolio performance depends on what two factors?

Answer 1

Diversified vs concentrated

Definition of performance

Question 2

There are 3 key questions regarding the importance of asset allocation for the performance of diversified portfolios:

1. How much return variability is explained by ___ ___ ?
2. How much of the difference in average returns between diversified funds is explained by differences in ___ ___ ?
3. What part of a fund’s ___ return is explained by its ___ ___ policy?

Answer 2

There are 3 key questions regarding the importance of asset allocation for the performance of diversified portfolios:

1. How much return variability is explained by asset allocation?
2. How much of the difference in average returns between diversified funds is explained by differences in investment policies?
3. What part of a fund’s average return is explained by its asset allocation policy?

Question 3

Most studies find that ___ - ___% of variation in diversified traditional portfolios is explained by overall asset allocation decisions.

Answer 3

Most studies find that 85-90% of variation in diversified traditional portfolios is explained by overall asset allocation decisions.

Question 4

Most studies find that less than 50% of the difference in average returns can be explained by differences in asset allocation. The remaining differences are explained by factors such as asset-class ___, s___, s___ s___, and f___.

Answer 4

Most studies find that less than 50% of the difference in average returns can be explained by differences in asset allocation. The remaining differences are explained by factors such as asset-class timing, style, security selection, and fees.

Question 5

The five steps for implementing a systemic asset allocation program are:

1. Identify asset owners’ ___ and ___
2. Develop an ___ ___ ___
3. Implement ___ ___ policy described in IPS
4. ___ ___ according to optimal weights
5. ___ and ___ the investments

Answer 5

The five steps for implementing a systemic asset allocation program are:

1. Identify asset owners’ objectives and constraints
2. Develop an investment policy statement
3. Implement asset allocation policy described in IPS
4. Allocate capital according to optimal weights
5. Monitor and evaluate the investments

Question 6

___ funds are funds established by not-for-profit entities that invest supporters’ charitable contributions and use the invested capital to support the activities of an organization.

Answer 6

Endowment funds are fund established by not-for-profit entities that invest supporters’ charitable contributions and use the invested capital to support the activities of an organization.

Question 7

___ raise funds through charitable contributions and use the capital to fund grants and support charities.

Answer 7

Foundations raise funds through charitable contributions and use the capital to fund grants and support charities.

Question 8

___ funds have long investment horizons and are not heavily regulated in terms of investment activities, so they can use a broad universe of assets (including alternative assets).

Answer 8

Endowment funds have long investment horizons and are not heavily regulated in terms of investment activities, so they can use a broad universe of assets (including alternative assets).

Question 9

Like ___ funds, ___ can use a broad universe of assets due to their long investment horizons and light regulation. However, to take advantage of beneficial tax treatments, ___ must distribute a minimum percentage of their assets each year.

Answer 9

Like endowment funds, foundations can use a broad universe of assets due to their long investment horizons and light regulation. However, to take advantage of beneficial tax treatments, foundations must distribute a minimum percentage of their assets each year.

Question 10

What are the 4 types of pension funds?

Answer 10

National

Private DB

Private DC

Individually Managed Accounts

Question 11

___ pension funds are established to provide retirement income to a country’s citizens.

Answer 11

National pension funds are established to provide retirement income to a country’s citizens.

Question 12

For national pension funds, investment decisions are made by ___ ___.

Answer 12

For national pension funds, investment decisions are made by national governments.

Question 13

___ ___ ___ plans are established to provide pension benefits to private companies’ employees. The employees are promised a specific retirement income based on a number of factors.

Answer 13

Private defined benefit plans are established to provide pension benefits to private companies’ employees. The employees are promised a specific retirement income based on a number of factors.

Question 14

The ___ ___ directs the management of a private defined benefit plans assets.

Answer 14

The plan sponsor directs the management of a private defined benefit plans assets.

Question 15

___ ___ ___ funds receive contributions for employees from the plan sponsors, as specified by the plan. Each beneficiary’s assets are managed by the plan sponsor and the employee. The sponsor decides on the list of available asset classes and the employee selects the asset allocation. When the employee retires, they are given the value of their account.

Answer 15

Private defined contribution funds receive contributions for employees from the plan sponsors, as specified by the plan. Each beneficiary’s assets are managed by the plan sponsor and the employee. The sponsor decides on the list of avaialbel asset classes and the employee selects the asset allocation. When the employee retires, they are given the value of their account.

Question 16

The Broad categories of asset owners are:

Answer 16

1. Endowments and Foundations
2. Pension Funds
3. Sovereign Wealth Funds
4. Family Offices

Question 17

___ ___ ___ funds are established and managed by national governments and invest a country’s income to benefit its citizens

Answer 17

Sovereign wealth funds are established and managed by national governments and invest a country’s income to benefit its citizens

Question 18

The growth of sovereign wealth funds is linked to increases in prices of ___ ___

Answer 18

The growth of sovereign wealth funds is linked to increases in prices of natural resources

Question 19

Family offices (are/are not) typically large enough to have access to a full menu of assets.

Answer 19

Family offices are typically large enough to have access to a full menu of assets.

Question 20

A(n) ___ is a preference that differentiates between optimal and suboptimal solutions.

Answer 20

An objective is a preference that differentiates between optimal and suboptimal solutions.

Question 21

A ___ is a condition that must be satisfied by any solution.

Answer 21

A constraint is a condition that must be satisfied by any solution.

Question 22

___ constraints are set by the asset owner and depend on factors such as the owner’s time horizon, liquidity needs, and desire to avoid certain sectors.

Answer 22

Internal constraints are set by the asset owner and depend on factors such as the owner’s time horizon, liquidity needs, and desire to avoid certain sectors.

Question 23

____ IPS constraints come from market conditions and regulations.

Answer 23

External IPS constraints come from market conditions and regulations.

Question 24

Asset owners should clearly state their investment objectives in terms of ___ and ___ that are consistent with their risk tolerance levels and current ___ ___ . In addition, objectives need to be consistent with the fact that higher ___ are associated with higher levels of ___ .

Answer 24

Asset owners should clearly state their investment objectives in terms of risks and returns that are consistent with their risk tolerance levels and current market conditions. In addition, objectives need to be consistent with the fact that higher returns are associated with higher levels of risk.

Question 25

The probability weighted expected return may be expressed as

Answer 25

Question 26

The probability weighted standard deviation may be expressed as

Answer 26

Question 27

\_\_\_ is a measure of satisfaction gained from investment wealth or return

Answer 27

**Utility** is a measure of satisfaction gained from investment wealth or return

Question 28

\_\_\_ ___ is the probability-weighted average utility over all possible outcomes

Answer 28

**Expected utility** is the probability-weighted average utility over all possible outcomes

Question 29

A ___ \_\_\_ U(\*) describes the relationship that converts an investment's wealth or return into the investor's level of utility

Answer 29

A **utility Function** U(\*) describes the relationship that converts an investment's wealth or return into the investor's level of utility

Question 30

An investor's utility may be expressed as a function of ___ W as U(W).

Answer 30

An investor's utility may be expressed as a function of **wealth** W as U(W).

Question 31

If utility functions are concave, then owners are said to be ___ \_\_\_.

Answer 31

If utility functions are concave, then owners are said to be **risk averse**.

Question 32

An investment's expected utility may be expressed in terms of its expected return and its variance of returns as:

Answer 32

Question 33

Larger λ means that the variance has a (greater/less) effect on the expected utility

Answer 33

Larger λ means that the variance has a **greater** effect on the expected utility

Question 34

If the λ is 0 then the investor is said to be risk \_\_\_

Answer 34

If the λ is 0 then the investor is said to be risk **neutral**

Question 35

If the λ is negative then the investor is said to be risk \_\_\_

Answer 35

If the λ is negative then the investor is said to be risk **seeking**

Question 36

For investments with non-normal returns, the higher-order moments of ___ and ___ should be incorporated in expected utility.

Answer 36

For investments with non-normal returns, the higher-order moments of **skewness** and **kurtosis** should be incorporated in expected utility.

Question 37

What is the utility function in terms of higher-order moments?

Answer 37

Question 38

What is the utility function in terms of Value at Risk?

Answer 38

Question 39

What is the utility function used to manage the risk of a defined benefit pension fund

Answer 39

Question 40

What is the equation for the degree of risk aversion, λ?

Answer 40

Question 41

What is the utility function of a DB Plan with liability Growth? (Equation)

Answer 41

Question 42

What are the 3 typical internal constraints for an investment policy statement? 1. \_\_\_ 2. ___ \_\_\_ 3. \_\_\_and \_\_\_limits

Answer 42

What are the 3 typical internal constraints for an investment policy statement? 1. **Liquidity** 2. **Time Horizon** 3. **Sector** and **country** limits

Question 43

Does time horizon impact the allocation to commodities?

Answer 43

Yes - since investors will not be able to benefit from commodities' long-run mean reversion.

Question 44

What are the 2 main sources of external constraints for an IPS? 1. \_\_\_ 2. ___ \_\_\_

Answer 44

What are the 2 main sources of external constraints for an IPS? 1. **Regulation** 2. **Tax Status**

Question 45

The ___ \_\_\_ ___ \_\_\_ ___ regulates management of private pension funds in the U.S. and the ___ \_\_\_ ___ establishes regulations for pension funds in the UK

Answer 45

The **Employee Retirement Income Security** **Act (ERISA)** regulates management of private pension funds in the U.S. and the **Financial** **Conduct** **Authority (FCA)** establishes regulations for pension funds in the UK

Question 46

A typical IPS has seven common elements: 1. B\_\_\_ 2. O\_\_\_ 3. A\_\_\_ \_\_\_ 4. G\_\_\_ 5. M\_\_\_ \_\_\_ 6. R\_\_\_ and \_\_\_ 7. S\_\_\_ ___ \_\_\_

Answer 46

A typical IPS has seven common elements: ## Footnote **1. Background** **2. Objective** **3. Asset Classes** **4. Governance** **5. Manager Selection** **6. Reporting and Monitoring** **7. Strategic Asset Allocation**

Question 47

What are the 3 components of an asset class return?

Answer 47

Short-term risk-free rate Expected Inflation Risk Premium

Question 48

\_\_\_ asset allocation can add value if it is based on thorough analysis so that it incorporates the fact that financial markets are mostly efficient and it is not adversely affected by portfolio turnover costs.

Answer 48

**Tactical** asset allocation can add value if it is based on thorough analysis so that it incorporates the fact that financial markets are mostly efficient and it is not adversely affected by portfolio turnover costs.

Question 49

What is the equation for the optimal weight of a risky asset in a portfolio that contains only one risky asset and one riskless asset?

Answer 49

Question 50

What is the equation for finding optimal portfolios using MVO and liability values?

Answer 50

Question 51

When the covariance between assets and liabilities, δ, is positive, the fund will hold (more/less) of the risky asset.

Answer 51

When the covariance between assets and liabilities, δ, is positive, the fund will hold **more** of the risky asset.

Question 52

The graph of optimal portfolio's expected returns and standard deviations is referred to as the ___ \_\_\_.

Answer 52

The graph of optimal portfolio's expected returns and standard deviations is referred to as the **efficient frontier**.

Question 53

In general, MVO does not generate realistic weights. The issue can be resolved by imposing \_\_\_.

Answer 53

In general, MVO does not generate realistic weights. The issue can be resolved by imposing **constraints**.

Question 54

What is the equation for a new asset's hurdle rate?

Answer 54

Question 55

Return parameters estimated using historical data (are/are not) reliable.

Answer 55

Return parameters estimated using historical data **are not** reliable.

Question 56

Given portfolio optimizers' tendency to generate extreme portfolio weights, the optimizers tend to exaggerate estimation errors and are referred to as "\_\_\_ ___ ."

Answer 56

Given portfolio optimizers' tendency to generate extreme portfolio weights, the optimizers tend to exaggerate estimation errors and are referred to as "**error maximizers**."

Question 57

Accuracy of estimated variance-covariance matrices is improved by using \_\_\_-\_\_\_ data.

Answer 57

Accuracy of estimated variance-covariance matrices is improved by using **higher-frequency** data.

Question 58

Accuracy of estimated means is improved by using a ___ \_\_\_ of data.

Answer 58

Accuracy of estimated means is improved by using a **longer history** of data.

Question 59

\_\_\_\_-based returns result in smoothed returns, and assets with smoothed returns have ___ return variances and covariances, which result in MVO generating portfolios that \_\_\_-allocate to these assets.

Answer 59

**Appraisal**-based returns result in smoothed returns, and assets with smoothed returns have **understated** return variances and covariances, which result in MVO generating portfolios that **over**-allocate to these assets.

Question 60

The number of required covariance estimates can be reduced using ___ \_\_\_.

Answer 60

The number of required covariance estimates can be reduced using **factor models.**

Question 61

When using factor models for covariance estimates, covariance is estimated as the relationship between each asset and a number of factors, using the ___ of a factor model.

Answer 61

When using factor models for covariance estimates, covariance is estimated as the relationship between each asset and a number of factors, using the **beta** of a factor model.

Question 62

One issue with MVO is that is only considers the first two moments of a return distribution (\_\_\_ and ___ ) and ignores higher-order moments (\_\_\_ and ___ ).

Answer 62

One issue with MVO is that is only considers the first two moments of a return distribution (**mean** and **variance**) and ignores higher-order moments (**skewness** and **kurtosis**).

Question 63

All else equal, an asset with negative skew has a (higher/lower) expected return than one with positive skew.

Answer 63

All else equal, an asset with negative skew has a **higher** expected return than one with positive skew.

Question 64

MVO tends to (overweight/underweight) assets with negative skews.

Answer 64

MVO tends to **overweight** assets with negative skews.

Question 65

\_\_\_ and ___ asset allocation model addresses the issue of extreme portfolio weights generated by MVO and enables historical returns to be adjusted to reflect portfolio manager's views about future returns.

Answer 65

**Black** and **Litterman** asset allocation model addresses the issue of extreme portfolio weights generated by MVO and enables historical returns to be adjusted to reflect portfolio manager's views about future returns.

Question 66

The ___ and ___ model starts with the market equilibrium expected returns and is tilted away from the market portfolio in the direction of the manager's views.

Answer 66

The **Black** and **Litterman** model starts with the market equilibrium expected returns and is tilted away from the market portfolio in the direction of the manager's views.

Question 67

In practice, investors add (too many/not enough) constraints to the MVO process.

Answer 67

In practice, investors add **too** **many** constraints to the MVO process.

Question 68

Correlation Coefficient (Equation)

Answer 68