Chapter 18

Question 1

A procedure devised by the American economist Harry Markowitz to identify the efficient frontier from a set of asset class returns, standard deviations, and correlations.

Answer 1

mean-variance optimization

(Mean-Variance Optimization is a strategy used to build an investment portfolio. It aims to maximize returns for a given level of risk, or equivalently, minimize risk for a given level of expected return, by carefully choosing the proportions of various assets.

To remember this, think of it as balancing a scale (the mean or return) with a thermometer (the variance or risk). The goal is to get the best temperature (returns) with the least fluctuations (risk).)

Question 2

An approach to TAA that involves monitoring economic and business cycles and looking for patterns that have historically led to rises and falls in the stock and bond markets.

Answer 2

cyclical-based approach

Question 3

A strategy of defining the optimal distribution of investments among the different asset classes for a particular portfolio.

Answer 3

strategic asset allocation

Question 4

Also known as temporal rebalancing. It involves rebalancing the portfolio at regular intervals, either monthly, quarterly, semi-annually, or annually.

Answer 4

calendar rebalancing

Question 5

With this method, the advisor might adjust the portfolio whenever an asset class deviates from its target by a certain percentage point.

Answer 5

weight-based rebalancing

Question 6

Also called the build-up method. It uses risk premiums from historical data to develop capital market expectations.

Answer 6

Ibbotson method

Question 7

A strategy used to take advantage of opportunities created by anticipated short-term fluctuations in the performance of different asset classes.

Answer 7

tactical asset allocation

Question 8

Under this principle, above-average returns tend to offset below-average returns over time, so that the annualized standard deviation of an investment diminishes

Answer 8

time diversification

Question 9

An approach to TAA that entails identifying an inexpensive or expensive asset class by comparing the current and prospective value of an asset class relative to other asset classes.

Answer 9

valuation-based approach

Question 10

With this technique, returns are explained in terms of the relative contributions of asset allocation and security selection.

Answer 10

performance attribution

Question 11

When determining the distribution of assets in a client’s portfolio, you must consider the following aspects of asset
allocation:

Answer 11

• Classification of assets
• Selection of asset classes
• Location of assets
• Costs of rebalancing and trading

Question 12

The debt securities asset class can be segmented into categories based on the following characteristics, either alone or combined:

Answer 12

• Term to maturity (short, intermediate, or long)
• Credit quality (investment grade or high yield)
• Structure (convertible, preferred, or other)
• Geography (Canadian, U.S., or international)

Question 13

Equity securities are classified according to structure or risk-return profile. They can be further classified into the following sub-categories:

Answer 13

• Capitalization (small, medium, or large)
• Geography (Canadian, U.S., or international)
• Style (value or growth)

Question 14

Traditionally, investors focused on diversifying their portfolios across three asset classes:

Answer 14

cash, debt securities, and equity securities

Question 15

Once a portfolio contains ____ to ____ asset classes, further diversification provides little gain in expected return per unit of risk.

Answer 15

Four to Six

Question 16

Capital market expectations are based on two factors:

Answer 16

past performance and professional judgment.

Question 17

starts from a reference benchmark mix and takes out explicit assumptions

Answer 17

Reverse optimization

Question 18

Advisors typically use one of three methods to design a client’s SAA:

Answer 18

• Mean-variance optimization
• Rules of thumb (based on time diversification)
• The ad hoc approach

Question 19

What is the key to mean-variance optimization?

Answer 19

It is the quality and integrity of the inputs.

Question 20

Most rules of thumb are based on the principle of

Answer 20

time diversification

Question 21

Two common rules of thumb deserve special mention

Answer 21

The life-cycle approach and the age approach

Question 22

RULES OF THUMB
Explain the life cycle approach:

Answer 22

The life-cycle approach to SAA categorizes investors by different life cycles based on their age and the characteristics associated with their stage of life.

The focus in the early earning years and the early part of the mid-earning years should be growth.
The allocation between equities and debt securities should therefore gradually shift in favour of debt securities

Question 23

RULES OF THUMB
Explain the age approach:

Answer 23

The age approach to SAA is more specific than the life-cycle approach because the SAA is based on the client’s
specific age, rather than on an age range.

Using this rule, the allocation to equities equals 100 minus
the client’s age.

Question 24

With this approach, the SAA is based simply on the advisor’s opinion or instinct:

Answer 24

Ad-Hoc Approach

Question 25

The trading band within which the market value of each asset class can fluctuate without having to be rebalanced is called the:

Answer 25

Corridor Width

Question 26

What is the difference between automatic and discretionary rebalancing?

Answer 26

Automatic rebalancing, sometimes called mechanical
rebalancing, means that it is carried out when deemed appropriate without discussion.

With discretionary rebalancing, the client and advisor discuss their options when the time comes to rebalance.

Question 27

that a decision not to rebalance is, in effect, a

Answer 27

tactical strategy