CAIA - 02 - Tactical AA, Mean-Variance Ext, Risk Budg, Risk Par and Factor Investing Flashcards
___ ___ ___ is an active approach to allocating capital to assets expected to have desirable short-to medium-term risk-return profiles. Thus, ___ essentially shifts a portfolio’s strategic asset allocation based on short- to medium-term changes.
Tactical asset allocation is an active approach to allocating capital to assets expected to have desirable short-to medium-term risk-return profiles. Thus, TAA essentially shifts a portfolio’s strategic asset allocation based on short- to medium-term changes.
According to the ___ ___ of ___ ___ , an active portfolio manager’s risk-adjusted added value is a function of his/her skill at forecasting returns and the number of positions taken. The value added by active management may be expressed as the manager’s ___ ___ .
According to the Fundamental Law of Active Management, an active portfolio manager’s risk-adjusted added value is a function of his/her skill at forecasting returns and the number of positions taken. The value added by active management may be expressed as the manager’s information ratio.
What is the equation for information ratio for a given information coefficient (IC) and breadth (BR).
What is the equation for information ratio for a given Alpha and standard deviation of alpha?
The fundamental law of active management (FLOAM) assumes portfolio managers are ___. In practice, managers face constraints imposed by S___ ___ ___, r___ and i___ costs.
The fundamental law of active management (FLOAM) assumes portfolio managers are unconstratined. In practice, managers face constraints imposed by Strategic Asset Allocation, regulations and implementation costs.
The fundamental law of active management (FLOAM) can be extended to include a third term, called ___ ___ , which relaxes the assumption that manager face no constraints and incorporates implementation costs.
The fundamental law of active management (FLOAM) can be extended to include a third term, called transfer coefficient, which relaxes the assumption that manager face no constraints and incorporates implementation costs.
The ___ ___ reflects a manager’s ability to implement her recommendations.
The transfer coefficient reflects a manager’s ability to implement her recommendations.
What is the equation for information ratio using information coefficient and transfer coefficient.
The ___ ___ ___ ___ is borne by every investor in funds with asymmetric fee structures, and arises when investors lose the fee benefits of owning a fund below its high watermark.
The foregone loss carry forward is borne by every investor in funds with asymmetric fee structures, and arises when investors lose the fee benefits of owning a fund below its high watermark.
Despite the cost associated with forgoing loss carry forward, there are four reasons investors may still choose to replace a manager with a carry forward loss.
- The manager may not have ___ ___ to perform until the high watermark is reached.
- The fund my no longer represent an ___ -___ fund, since it may be unable to retain best traders, risk management and compliance infrastructure.
- Other investors may ___ their capital, which can result in the investor’s position becoming too ___ .
- The investor may believe that the fund’s strategy is no longer ___
Despite the cost associated with forgoing loss carry forward, there are four reasons investors may still choose to replace a manager with a carry forward loss.
- The manager may not have sufficient incentive to perform until the high watermark is reached.
- The fund my no longer represent an institutional-quality fund, since it may be unable to retain best traders, risk management and compliance infrastructure.
- Other investors may withdraw their capital, which can result in the investor’s position becoming too large
- The investor may believe that the fund’s strategy is no longer attractive
What are the 4 lags associated with redeeming from 1 manager and investing in another?
- The time needed to ___ ___and make a decision
- The time between the ___ ___and ___
- The time between ___ and ___ ___
- The time between ___ ___ and ___.
What are the 4 lags associated with redeeming from 1 manager and investing in another?
- The time needed to review results and make a decision
- The time between the notification deadline and NAV
- The time between NAV and receiving cash
- The time between receiving cash and reinvesting.
The four costs associated with liquidation and reinvestment of a manager:
- Foregone ___ on dormant cash
- Foregone ___ ___ on uncommitted cash
- ___ and ___ ___ costs
- ___ from market impact
The four costs associated with liquidation and reinvestment of a manager:
- Foregone interest on dormant cash
- Foregone excess returns on uncommitted cash
- Administrative and due diligence costs
- Slippage from market impact
Despite FLOAM presenting information coefficient (IC) and breadth (BR) as ___ factors, in practice, they tend to be more ___ on one another. In fact, IC and BR have a ___ relationship: the ___ markets to which managers apply their skills, the ___ accurate their forecasts.
Despite FLOAM presenting information coefficient (IC) and breadth (BR) as independent factors, in practice, they tend to be more dependent on one another. In fact, IC and BR have a negative relationship: the more markets to which managers apply their skills, the less accurate their forecasts.
The information coefficient applied to asset classes is (larger/smaller) than that applied to individual securities, since asset class expected returns are (more/less) predictable and thus (easier/harder) to forecast than returns on individual securities that contain (less/considerable) noise.
The information coefficient applied to asset classes is larger than that applied to individual securities, since asset class expected returns are more predictable and thus easier to forecast than returns on individual securities that contain considerable noise.
What is the equation for reducing the equity beta by taking short positions in equity futures contracts.
___ forecasting models should be used to maximize the value added by TAA, since according to the FLOAM, the value of TAA is enhanced when models’ error terms are ___ of one another.
Several forecasting models should be used to maximize the value added by TAA, since according to the FLOAM, the value of TAA is enhanced when models’ error terms are independent of one another.
Tactical asset allocation models should have strong ___ ___ using ___ -of-___ data.
Tactical asset allocation models should have strong historical performance using out-of-sample data.
Tactical asset allocation models should include ___ meaningful signals and entail a ___ process that correctly identifies the signals.
Tactical asset allocation models should include economically meaningful signals and entail a research process that correctly identifies the signals.
Development of sound forecasting models has three notable characteristics.
- Use ___ ___ signals
- No ___ ___
- Avoidance of ___
Development of sound forecasting models has three notable characteristics.
- Use economically meaningful signals
- No data mining
- Avoidance of overfitting
___ ___ signals are signals that have rational, intuitive explanations for their expected predictive power.
Economically meaningful signals are signals that have rational, intuitive explanations for their expected predictive power.
___ ___ refers to trying several models and variables to identify the models that perform best.
Data mining refers to trying several models and variables to identify the models that perform best.
Models that ___ data generally have a large number of explanatory variables and can generate large r-squareds, particularly using small data sets.
Models that overfit data generally have a large number of explanatory variables and can generate large r-squareds, particularly using small data sets.
Models that have (more/fewer) explanatory variables are more stable over time.
Models that have fewer explanatory variables are more stable over time.
The most common approach to developing fundamental models is ___ ___ .
The most common approach to developing fundamental models is linear regression.
___ ___ models estimate expected returns as functions of values of a set of predictive variables.
Conditional expectation models estimate expected returns as functions of values of a set of predictive variables.
When ____ expected returns are used as inputs in the asset allocation process, TAA can be considered SAA.
When conditional expected returns are used as inputs in the asset allocation process, TAA can be considered SAA.
There are two types of liquidity risk: ___ liquidity and ___liquidity.
There are two types of liquidity risk: market liquidity and funding liquidity.
___ liquidity risk refers to the risk of being forced to sell a fairly illiquid asset in a market with few active market participants.
Market liquidity risk refers to the risk of being forced to sell a fairly illiquid asset in a market with few active market participants.
Two factors increase illiquidity of some assets during financially stressed periods:
- Lack of ___
- ___ ___ between buyers and sellers
Two factors increase illiquidity of some assets during financially stressed periods:
- Lack of transparency
- Asymmetric information between buyers and sellers
___ liquidity risk refers to the risk of investors being unable to obtain financing, roll over currently available debt, or meet capital commitments due to lack of liquidity.
Funding liquidity risk refers to the risk of investors being unable to obtain financing, roll over currently available debt, or meet capital commitments due to lack of liquidity.
___ liquidity risk in private equity refers to investors being unable to meet capital calls.
Funding liquidity risk in private equity refers to investors being unable to meet capital calls.
What is the mean-variance equation that adjusts for liquidity preference?
Inputs to the portfolio allocation process are typically exposed to ___ risk and thus can be challenging to estimate accurately.
Inputs to the portfolio allocation process are typically exposed to estimation risk and thus can be challenging to estimate accurately.
One approach to adjust for estimation risk is ___ ___ that incorporates estimation risk by selecting optimal weights using estimated expected returns reduced by an estimation error ε.
One approach to adjust for estimation risk is robust optimization that incorporates estimation risk by selecting optimal weights using estimated expected returns reduced by an estimation error ε.
What is the equation for estimation error
___ ___ refers to a general framework of portfolio construction and maintenance based on selecting a level of risk and allocating it to different categories of risk.
Risk budgeting refers to a general framework of portfolio construction and maintenance based on selecting a level of risk and allocating it to different categories of risk.
What is the equation for variance?
What is the equation for marginal contribution of asset i to the total risk of a portfolio P
The ___ ___ approach to asset allocation uses the results from risk budgeting to construct portfolios that equally weight the risk contributions of each asset or asset class.
The risk parity approach to asset allocation uses the results from risk budgeting to construct portfolios that equally weight the risk contributions of each asset or asset class.
What are the steps to implement a risk parity approach?
- Identifying a definition for the ___ ___ of the portfolio.
- Determine the ___ ___ contribution of each asset class to the portfolio’s total risk
- Determine the ___ ___ for all available assets
What are the steps to implement a risk parity approach?
- Identifying a definition for the total risk of the portfolio.
- Determine the marginal risk contribution of each asset class to the portfolio’s total risk
- Determine the portfolio weights for all available assets
What is the equation for Beta?
What is the portfolio’s total risk factor in terms of risk factor contributions
What is the standard deviation of a 2 asset portfolio?
What is the equation for volatility weighted weight?
The primary economic rationale for low-volatility portfolios is that, due to market imperfections, many investors have an aversion to ___ that could be used to enhance their investment returns.
The primary economic rationale for low-volatility portfolios is that, due to market imperfections, many investors have an aversion to leverage that could be used to enhance their investment returns.
The ___ ___ theory maintains that many investors cannot or are unwilling to lever up low-volatility portfolios to produce attractive returns.
The leverage aversion theory maintains that many investors cannot or are unwilling to lever up low-volatility portfolios to produce attractive returns.
The notion that low-risk stocks are underpriced and, thus, offer higher expected risk-adjusted returns is explained by the ___ ___ , which maintains that portfolios of low-volatility stocks have historically outperformed the market.
The notion that low-risk stocks are underpriced and, thus, offer higher expected risk-adjusted returns is explained by the volatility anomaly, which maintains that portfolios of low-volatility stocks have historically outperformed the market.
Evidence indicates that the volatility anomaly has (increased/waned) since its discovery.
Evidence indicates that the volatility anomaly has waned since its discovery.
The ___ ___ ___ anomaly maintains that portfolios of low-beta stocks have historically outperformed the market.
The betting against beta anomaly maintains that portfolios of low-beta stocks have historically outperformed the market.
Four rationales for the risk-parity approach are:
- Strong ___ ___
- Well-___portfolios
- Well-___ in terms of ___
- ___ ___in alternative markets
Four rationales for the risk-parity approach are:
- Strong historical performance
- Well-balanced portfolios
- Well-diversified in terms of risk
- Exploit anomalies in alternative markets
Since some alternative investments have (high/low) volatility and (high/low)correlations with other asset classes, the risk parity and volatility-weighted approaches make relatively (large/small) allocations to alternative investments compared to market weights and typical institutional portfolios.
Since some alternative investments have low volatility and low correlations with other asset classes, the risk parity and volatility-weighted approaches make relatively large allocations to alternative investments compared to market weights and typical institutional portfolios.
In addition to risk-parity, there are 3 other approaches for constructing low-volatility portfolios:
- ___-weighted
- ___-variance
- ___-weighted
In addition to risk-parity, there are 3 other approaches for constructing low-volatility portfolios:
- Equally-weighted
- Minimum-variance
- Volatility-weighted
The ___ ___ approach inherently constructs a well-diversified portfolio, which likely has relatively high allocations to less-risky assets. This is because equity is typically the largest and riskiest asset class. Therefore, ___ ___ the assets tends to underweight equities.
The equally weighted approach inherently constructs a well-diversified portfolio, which likely has relatively high allocations to less-risky assets. This is because equity is typically the largest and riskiest asset class. Therefore, equally weighting the assets tends to underweight equities.
The ___ ___ approach uses an optimization technique to identify weights that minimize a portfolio’s return volatility.
The minimum variance approach uses an optimization technique to identify weights that minimize a portfolio’s return volatility.
The ___ ___ approach constructs a low-volatility portfolio by establishing the weight of each asset class as proportional to the inverse of its volatility.
The volatility weighted approach constructs a low-volatility portfolio by establishing the weight of each asset class as proportional to the inverse of its volatility.
The difference between the volatility weighted approach and the risk parity approach is that the volatility approach makes allocations based only on each asset’s ___-___ ___, whereas the RP approach takes into account each asset’s ___ ___.
The difference between the volatility weighted approach and the risk parity approach is that the volatility approach makes allocations based only on each asset’s stand-alone risk, whereas the RP approach takes into account each asset’s diversification benefit.
The volatility weighted approach is the same as the RP approach when the portfolio has only ___ ___ , or when ___ between asset returns are the same.
The volatility weighted approach is the same as the RP approach when the portfolio has only two assets, or when correlations between asset returns are the same.
The ___ ___ ___ ___ , which may be considered the first theory of risk factors, states that a risky asset’s expected excess return equals the beta of the asset times the market portfolio’s risk premium.
The capital asset pricing model, which may be considered the first theory of risk factors, states that a risky asset’s expected excess return equals the beta of the asset times the market portfolio’s risk premium.
For normally distributed returns, the CAPM identifies the market portfolio ___ as the only risk factor and the asset’s exposure to the factor as its ___.
For normally distributed returns, the CAPM identifies the market portfolio return as the only risk factor and the asset’s exposure to the factor as its beta.
The CAPM (can/cannot) be extended to include multiple factors.
The CAPM can be extended to include multiple factors.
Ang (2014) presents three important observations related to factor investing.
- ___ matter (not ___ )
- ___ are bundles of ___
- Different investors should use different ___ ___
Ang (2014) presents three important observations related to factor investing.
- Factors matter (not assets)
- Assets are bundles of factors
- Different investors should use different risk factors
A ___ ___is a unique source of risk and risk premium such that the observed risk and risk premium cannot be fully explained by other ___ ___.
A risk factor is a unique source of risk and risk premium such that the observed risk and risk premium cannot be fully explained by other risk factors.
Risk factors (are/are not) highly correlated with each other.
Risk factors are not highly correlated with each other.
Risk factors should be based on a sound ___ foundation and ___ and ___ research, and show that their ___ ___ are persistent over the long-term.
Risk factors should be based on a sound economic foundation and academic and industry research, and show that their risk premiums are persistent over the long-term.
The ___ factor is constructed by building two equally weighted portfolios, one with stocks that performed well, and one of stocks that performed poorly, and going long the winners and short the losers.
The momentum factor is constructed by building two equally weighted portfolios, one with stocks that performed well, and one of stocks that performed poorly, and going long the winners and short the losers.
The ___ factor is constructed by building two portfolios, one with low book-to-market stocks and one with high book-to-market stocks, and going long the high book-to-market stocks and short the low book-to-market stocks.
The value factor is constructed by building two portfolios, one with low book-to-market stocks and one with high book-to-market stocks, and going long the high book-to-market stocks and short the low book-to-market stocks.
The ___ premium is based on the return earned by stocks with high book values relative to their market values.
The value premium is based on the return earned by stocks with high book values relative to their market values.
The ___ premium is based on the return earned by small-cap stocks.
The size premium is based on the return earned by small-cap stocks.
The ___ premium is based on past performance of stocks.
The momentum premium is based on past performance of stocks.
The ___ premium is based on the premium associated with illiquid assets.
The liquidity premium is based on the premium associated with illiquid assets.
The ___ ___ premium is based on the credit quality of bonds.
The credit risk premium is based on the credit quality of bonds.
The ___ premium is based on the riskiness of long-term bonds
The term premium is based on the riskiness of long-term bonds
The ___ ___ premium is based on the risk premium earned by the volatility factor, and the strategy involves being ___ the ___ ___ of options.
The implied volatility premium is based on the risk premium earned by the volatility factor, and the strategy involves being short the implied volatility of options.
The ___ ___ is based on the return on investing in high-interest rate currencies, and the strategy involves buying bonds denominated in currencies with high interest rates and selling bonds denominated in currencies with low interest rates.
The carry trade is based on the return on investing in high-interest rate currencies, and the strategy involves buying bonds denominated in currencies with high interest rates and selling bonds denominated in currencies with low interest rates.
The ___ premium is based on the return earned on backwardated commodities, and the strategy involves buying commodities that are in ___ and selling commodities that are in ___ .
The roll premium is based on the return earned on backwardated commodities, and the strategy involves buying commodities that are in backwardation and selling commodities that are in contango.
A better approach than ___ allocating to risk factors is to apply ___ asset allocation to risk factors, assigning ___ weights to factors that offer better risk premiums.
A better approach than passively allocating to risk factors is to apply tactical asset allocation to risk factors, assigning higher weights to factors that offer better risk premiums.
Factors that generate attractive returns in good and bad times are not risk factors, but ____ opportunities.
Factors that generate attractive returns in good and bad times are not risk factors, but arbitrage opportunities.
The value factor tends to generate (attractive/poor) risk-adjusted returns during normal market conditions, but (attractive/poor)risk-adjusted returns during economic downturn.
The value factor tends to generate attractive risk-adjusted returns during normal market conditions, but poor risk-adjusted returns during economic downturn.
The ___ factor tends to generate positive returns most of the time but, when a market correction occurs, displays large negative returns for a short time.
The momentum factor tends to generate positive returns most of the time but, when a market correction occurs, displays large negative returns for a short time.
The value factor is strongest for ___-cap companies.
The value factor is strongest for small-cap companies.
There are two issues related to factor investing
- No ___ for passive factor investing
- No ___ ___ factor portfolios
There are two issues related to factor investing
- No benchmark for passive factor investing
- No passively managed factor portfolios
The ___ ___ strategy exploits a risk factor related to the risk of a merger being completed.
The merger arbitrage strategy exploits a risk factor related to the risk of a merger being completed.
The ___ arbitrage strategy exploits a form of the implied volatility factor.
The convertible arbitrage strategy exploits a form of the implied volatility factor.
Many global macro strategies use the ___ ___ factor.
Many global macro strategies use the carry trade factor.
