CAIA - 02 - Tactical AA, Mean-Variance Ext, Risk Budg, Risk Par and Factor Investing

Question 1

___ ___ ___ 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.

Answer 1

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.

Question 2

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 ___ ___ .

Answer 2

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.

Question 3

What is the equation for information ratio for a given information coefficient (IC) and breadth (BR).

Answer 3

Question 4

What is the equation for information ratio for a given Alpha and standard deviation of alpha?

Answer 4

Question 5

The fundamental law of active management (FLOAM) assumes portfolio managers are ___. In practice, managers face constraints imposed by S___ ___ ___, r___ and i___ costs.

Answer 5

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.

Question 6

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.

Answer 6

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.

Question 7

The ___ ___ reflects a manager’s ability to implement her recommendations.

Answer 7

The transfer coefficient reflects a manager’s ability to implement her recommendations.

Question 8

What is the equation for information ratio using information coefficient and transfer coefficient.

Answer 8

Question 9

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.

Answer 9

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.

Question 10

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.

1. The manager may not have ___ ___ to perform until the high watermark is reached.
2. The fund my no longer represent an ___ -___ fund, since it may be unable to retain best traders, risk management and compliance infrastructure.
3. Other investors may ___ their capital, which can result in the investor’s position becoming too ___ .
4. The investor may believe that the fund’s strategy is no longer ___

Answer 10

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.

1. The manager may not have sufficient incentive to perform until the high watermark is reached.
2. The fund my no longer represent an institutional-quality fund, since it may be unable to retain best traders, risk management and compliance infrastructure.
3. Other investors may withdraw their capital, which can result in the investor’s position becoming too large
4. The investor may believe that the fund’s strategy is no longer attractive

Question 11

What are the 4 lags associated with redeeming from 1 manager and investing in another?

1. The time needed to ___ ___and make a decision
2. The time between the ___ ___and ___
3. The time between ___ and ___ ___
4. The time between ___ ___ and ___.

Answer 11

What are the 4 lags associated with redeeming from 1 manager and investing in another?

1. The time needed to review results and make a decision
2. The time between the notification deadline and NAV
3. The time between NAV and receiving cash
4. The time between receiving cash and reinvesting.

Question 12

The four costs associated with liquidation and reinvestment of a manager:

1. Foregone ___ on dormant cash
2. Foregone ___ ___ on uncommitted cash
3. ___ and ___ ___ costs
4. ___ from market impact

Answer 12

The four costs associated with liquidation and reinvestment of a manager:

1. Foregone interest on dormant cash
2. Foregone excess returns on uncommitted cash
3. Administrative and due diligence costs
4. Slippage from market impact

Question 13

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.

Answer 13

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.

Question 14

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.

Answer 14

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.

Question 15

What is the equation for reducing the equity beta by taking short positions in equity futures contracts.

Answer 15

Question 16

___ 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.

Answer 16

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.

Question 17

Tactical asset allocation models should have strong ___ ___ using ___ -of-___ data.

Answer 17

Tactical asset allocation models should have strong historical performance using out-of-sample data.

Question 18

Tactical asset allocation models should include ___ meaningful signals and entail a ___ process that correctly identifies the signals.

Answer 18

Tactical asset allocation models should include economically meaningful signals and entail a research process that correctly identifies the signals.

Question 19

Development of sound forecasting models has three notable characteristics.

1. Use ___ ___ signals
2. No ___ ___
3. Avoidance of ___

Answer 19

Development of sound forecasting models has three notable characteristics.

1. Use economically meaningful signals
2. No data mining
3. Avoidance of overfitting

Question 20

___ ___ signals are signals that have rational, intuitive explanations for their expected predictive power.

Answer 20

Economically meaningful signals are signals that have rational, intuitive explanations for their expected predictive power.

Question 21

___ ___ refers to trying several models and variables to identify the models that perform best.

Answer 21

Data mining refers to trying several models and variables to identify the models that perform best.

Question 22

Models that ___ data generally have a large number of explanatory variables and can generate large r-squareds, particularly using small data sets.

Answer 22

Models that overfit data generally have a large number of explanatory variables and can generate large r-squareds, particularly using small data sets.

Question 23

Models that have (more/fewer) explanatory variables are more stable over time.

Answer 23

Models that have fewer explanatory variables are more stable over time.

Question 24

The most common approach to developing fundamental models is ___ ___ .

Answer 24

The most common approach to developing fundamental models is linear regression.

Question 25

\_\_\_ ___ models estimate expected returns as functions of values of a set of predictive variables.

Answer 25

**Conditional expectation** models estimate expected returns as functions of values of a set of predictive variables.

Question 26

When ____ expected returns are used as inputs in the asset allocation process, TAA can be considered SAA.

Answer 26

When **conditional** expected returns are used as inputs in the asset allocation process, TAA can be considered SAA.

Question 27

There are two types of liquidity risk: ___ liquidity and \_\_\_liquidity.

Answer 27

There are two types of liquidity risk: **market** liquidity and **funding** liquidity.

Question 28

\_\_\_ liquidity risk refers to the risk of being forced to sell a fairly illiquid asset in a market with few active market participants.

Answer 28

**Market** liquidity risk refers to the risk of being forced to sell a fairly illiquid asset in a market with few active market participants.

Question 29

Two factors increase illiquidity of some assets during financially stressed periods: 1. Lack of \_\_\_ 2. ___ \_\_\_ between buyers and sellers

Answer 29

Two factors increase illiquidity of some assets during financially stressed periods: 1. Lack of **transparency** 2. **Asymmetric information** between buyers and sellers

Question 30

\_\_\_ 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.

Answer 30

**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.

Question 31

\_\_\_ liquidity risk in private equity refers to investors being unable to meet capital calls.

Answer 31

**Funding** liquidity risk in private equity refers to investors being unable to meet capital calls.

Question 32

What is the mean-variance equation that adjusts for liquidity preference?

Answer 32

Question 33

Inputs to the portfolio allocation process are typically exposed to ___ risk and thus can be challenging to estimate accurately.

Answer 33

Inputs to the portfolio allocation process are typically exposed to **estimation** risk and thus can be challenging to estimate accurately.

Question 34

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.

Answer 34

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.

Question 35

What is the equation for estimation error

Answer 35

Question 36

\_\_\_ ___ 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.

Answer 36

**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.

Question 37

What is the equation for variance?

Answer 37

Question 38

What is the equation for marginal contribution of asset i to the total risk of a portfolio P

Answer 38

Question 39

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.

Answer 39

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.

Question 40

What are the steps to implement a risk parity approach? 1. Identifying a definition for the ___ \_\_\_ of the portfolio. 2. Determine the ___ \_\_\_ contribution of each asset class to the portfolio's total risk 3. Determine the ___ \_\_\_ for all available assets

Answer 40

What are the steps to implement a risk parity approach? 1. Identifying a definition for the **total risk** of the portfolio. 2. Determine the **marginal risk** contribution of each asset class to the portfolio's total risk 3. Determine the **portfolio weights** for all available assets

Question 41

What is the equation for Beta?

Answer 41

Question 42

What is the portfolio's total risk factor in terms of risk factor contributions

Answer 42

Question 43

What is the standard deviation of a 2 asset portfolio?

Answer 43

Question 44

What is the equation for volatility weighted weight?

Answer 44

Question 45

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.

Answer 45

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.

Question 46

The ___ \_\_\_ theory maintains that many investors cannot or are unwilling to lever up low-volatility portfolios to produce attractive returns.

Answer 46

The **leverage aversion** theory maintains that many investors cannot or are unwilling to lever up low-volatility portfolios to produce attractive returns.

Question 47

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.

Answer 47

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.

Question 48

Evidence indicates that the volatility anomaly has (increased/waned) since its discovery.

Answer 48

Evidence indicates that the volatility anomaly has **waned** since its discovery.

Question 49

The ___ \_\_\_ ___ anomaly maintains that portfolios of low-beta stocks have historically outperformed the market.

Answer 49

The **betting against beta** anomaly maintains that portfolios of low-beta stocks have historically outperformed the market.

Question 50

Four rationales for the risk-parity approach are: 1. Strong ___ \_\_\_ 2. Well-\_\_\_portfolios 3. Well-\_\_\_ in terms of \_\_\_ 4. ___ \_\_\_in alternative markets

Answer 50

Four rationales for the risk-parity approach are: 1. Strong **historical performance** 2. Well-**balanced** portfolios 3. Well-**diversified** in terms of **risk** 4. **Exploit anomalies** in alternative markets

Question 51

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.

Answer 51

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.

Question 52

In addition to risk-parity, there are 3 other approaches for constructing low-volatility portfolios: 1. \_\_\_-weighted 2. \_\_\_-variance 3. \_\_\_-weighted

Answer 52

In addition to risk-parity, there are 3 other approaches for constructing low-volatility portfolios: 1. **Equally**-weighted 2. **Minimum**-variance 3. **Volatility**-weighted

Question 53

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.

Answer 53

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.

Question 54

The ___ \_\_\_ approach uses an optimization technique to identify weights that minimize a portfolio's return volatility.

Answer 54

The **minimum variance** approach uses an optimization technique to identify weights that minimize a portfolio's return volatility.

Question 55

The ___ \_\_\_ approach constructs a low-volatility portfolio by establishing the weight of each asset class as proportional to the inverse of its volatility.

Answer 55

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.

Question 56

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 ___ \_\_\_.

Answer 56

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**.

Question 57

The volatility weighted approach is the same as the RP approach when the portfolio has only ___ \_\_\_ , or when ___ between asset returns are the same.

Answer 57

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.

Question 58

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.

Answer 58

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.

Question 59

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 \_\_\_.

Answer 59

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**.

Question 60

The CAPM (can/cannot) be extended to include multiple factors.

Answer 60

The CAPM **can** be extended to include multiple factors.

Question 61

Ang (2014) presents three important observations related to factor investing. 1. ___ matter (not ___ ) 2. ___ are bundles of \_\_\_ 3. Different investors should use different ___ \_\_\_

Answer 61

Ang (2014) presents three important observations related to factor investing. 1. **Factors** matter (not **assets**) 2. **Assets** are bundles of **factors** 3. Different investors should use different **risk factors**

Question 62

A ___ \_\_\_is a unique source of risk and risk premium such that the observed risk and risk premium cannot be fully explained by other ___ \_\_\_.

Answer 62

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**.

Question 63

Risk factors (are/are not) highly correlated with each other.

Answer 63

Risk factors **are not** highly correlated with each other.

Question 64

Risk factors should be based on a sound ___ foundation and ___ and ___ research, and show that their ___ \_\_\_ are persistent over the long-term.

Answer 64

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.

Question 65

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.

Answer 65

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.

Question 66

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.

Answer 66

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.

Question 67

The ___ premium is based on the return earned by stocks with high book values relative to their market values.

Answer 67

The **value** premium is based on the return earned by stocks with high book values relative to their market values.

Question 68

The ___ premium is based on the return earned by small-cap stocks.

Answer 68

The **size** premium is based on the return earned by small-cap stocks.

Question 69

The ___ premium is based on past performance of stocks.

Answer 69

The **momentum** premium is based on past performance of stocks.

Question 70

The ___ premium is based on the premium associated with illiquid assets.

Answer 70

The **liquidity** premium is based on the premium associated with illiquid assets.

Question 71

The ___ \_\_\_ premium is based on the credit quality of bonds.

Answer 71

The **credit risk** premium is based on the credit quality of bonds.

Question 72

The ___ premium is based on the riskiness of long-term bonds

Answer 72

The **term** premium is based on the riskiness of long-term bonds

Question 73

The ___ \_\_\_ premium is based on the risk premium earned by the volatility factor, and the strategy involves being ___ the ___ \_\_\_ of options.

Answer 73

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.

Question 74

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.

Answer 74

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.

Question 75

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 ___ .

Answer 75

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**.

Question 76

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.

Answer 76

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.

Question 77

Factors that generate attractive returns in good and bad times are not risk factors, but ____ opportunities.

Answer 77

Factors that generate attractive returns in good and bad times are not risk factors, but **arbitrage** opportunities.

Question 78

The value factor tends to generate (attractive/poor) risk-adjusted returns during normal market conditions, but (attractive/poor)risk-adjusted returns during economic downturn.

Answer 78

The value factor tends to generate **attractive** risk-adjusted returns during normal market conditions, but **poor** risk-adjusted returns during economic downturn.

Question 79

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.

Answer 79

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.

Question 80

The value factor is strongest for \_\_\_-cap companies.

Answer 80

The value factor is strongest for **small**-cap companies.

Question 81

There are two issues related to factor investing 1. No ___ for passive factor investing 2. No ___ \_\_\_ factor portfolios

Answer 81

There are two issues related to factor investing 1. No **benchmark** for passive factor investing 2. No **passively** **managed** factor portfolios

Question 82

The ___ \_\_\_ strategy exploits a risk factor related to the risk of a merger being completed.

Answer 82

The **merger arbitrage** strategy exploits a risk factor related to the risk of a merger being completed.

Question 83

The ___ arbitrage strategy exploits a form of the implied volatility factor.

Answer 83

The **convertible** arbitrage strategy exploits a form of the implied volatility factor.

Question 84

Many global macro strategies use the ___ \_\_\_ factor.

Answer 84

Many global macro strategies use the **carry** **trade** factor.