Chapter 3 - Asset Allocation and Investment Strategy - 8%

Question 1

What is an Asset Class?

Answer 1

An asset class is a specific category of assets or investments such as cash, stocks and bonds.

Question 2

What is Asset Allocation?

Answer 2

It is the general term used to describe the process of determining the appropriate proportions for different asset classes in an investor’s portfolio and maintaining those proportions over time.

Question 3

What are the 3 asset allocation strategies?

Answer 3

a) Strategic asset allocation (Passive/Policy/Benchmark): It becomes the benchmark against which the performance of the client’s portfolio can be measured.
b) Portfolio rebalancing (Dynamic Asset Allocation: refers to the systematic rebalancing, either temporarily or based on weights, needed to return the portfolio to the long-term benchmark asset class mix.
c) Tactical Asset Allocation: TAA strategy is a decision by the client and investment advisor to temporaily change the client’s SAA to take advantage of perceived opportunities created by short term fluctuations in the relative performance of asset classes.

Question 4

What are the benefits that client’s derive from using an asset allocation strategy?

Answer 4

1. Asset allocation accounts for most of the variation in a portfolio’s long-term returns;
2. The SAA is designed to be an optimal investment portfolio;
3. Asset allocation allows meaningful performance measurement;
4. Long-term investment objectives are kept in focus;
5. Tactical asset allocation allows for opportunities to realize enhanced returns through successful portfolio tilting.

Question 5

Describe the steps in the establishment of the SAA?

Answer 5

1. Establish client objectives and constraints;
2. Specify asset classes eligible for the portfolio;
3. Specify capital market expectations;
4. Derive the efficient portfolio frontier;
5. Find and set ehe optimal asset mix

Question 6

What is Mean-Variance Analysis (in SAA)?

Answer 6

Mean-Variance Analysis relies heavily on the precepts of modern portfolio theory. Own smaller amounts of less-than-perfectly correlated assets instead of large amounts of a single asset.

It can determine an SAA in one of 2 ways -

1. PURE MEAN-VARIANCE ANALYSIS: requires the IA to include info on capital market expectations and to estimate a numerical value for the client’s risk tolerance. Using this info, the pure optimizer, a quadratic formula that maximises investor utility, recommends a single strategic asset allocation that is both efficient and acceptable given the client’s risk tolerance.
2. Other optimizers require only a set of capital market expectations as input.

Question 7

What is Time Diversification Approach (in SAA)?

Answer 7

Time Diversification means that over the long term, the return/risk trade off for equities improves over that of all other asset classes, and therefore the longer the time horizon, the lower the risk of holding equities. A belief in TDA leads to a recommendation that younger clients hold a greater percentage of their portfolios in equities than older clients would because equities offer the greatest expected return.

Question 8

What is Age Approach (in SAA)?

Answer 8

It recommends a specific SAA based solely on the client’s age. It suggests an allocation to debt securities (includ. cash and cash equivalents) equal to the client’s age. With this rule, the allocation to equities equals 100 minus the client’s age.

Question 9

What are the basic assumptions of Dynamic Asset Allocation?

Answer 9

a) Capital market expectations remain constant.
b) Risk tolerance remains constant.
c) Investment objectives remain constant.

Question 10

What are the advantages of rebalancing a portfolio?

Answer 10

a) The integrity of the asset mix is enforced.
b) Value may be added to performance with counter-cyclical selling and buying.
c) Discipline is enforced.
d) Portfolio risk is controlled.

Question 11

What are the two most commonly employed rebalancing strategies for Dynamic rebalancing?

Answer 11

1. Temporal Rebalancing: involves rebalancing a portfolio back to target weights periodically.It does not involve continuous monitoring within the rebalancing period.One drawback, is that the strategy calls for rebalancing regardless of market conditions.
2. Weight-Based Rebalancing: involves setting rebalancing thresholds or trigger points that are a % of the portfolio’s value. Ex: if the target proportion for an asset class is 40% of portfolio value, 35% to 45% (which are the trigger points) is the corridor or tolerance band for the value of that asset class.

Question 12

What are the two Tactical Asset Allocation strategies?

Answer 12

1. Value-Based Tactical Asset Allocation: It means identifying times when an asset class is cheap or expensive by comparing the relative value of that class with the values of all other asset classes. They often uses an analysis of risk premiums - a) Stocks/T-bills risk premium: the expected return on equities minus the expected returns on T-bills; b) Bonds/T-bills risk premium: the expected return on bonds minus the expected returns on T-bills.; c) Stocks/bonds risk premium: The expected return on equities minus the expected return on bonds.
2. Cyclical Tactical Asset Allocation: involves monitoring economic activity for patterns that have historically led to stock market movements. IAs can use these movements as guides in tilting portfolios away from their strategic asset allocation.

Question 13

What are the risks of Tactical Asset Allocation?

Answer 13

1. Modest or no value added
2. Early calls
3. Shifts in normal valuations: A TAA strategy that focuses on valuation models may not incorporate changes in equilibrium in a timely way, thereby increasing portfolio risk.

Question 14

What is asset location?

Answer 14

Asset location refers to the decision to hold investment assets in taxable, tax-deferred and tax-exempt accounts to achieve the greatest after-tax return for a given risk tolerance.

• Debt securities which generate interest income, should always be held in a tax deferred account, such as RRSP or TFSA
• Equity securities which generate capital gains and dividends should be held in a taxable account.

Question 15

What are Equity Investment Strategies?

Answer 15

Strategy is a function of what the manager or advisor believes about investment finance. Strategies can be active or passive, can be bottom up or top down, can focus on value or growth or on small or large capitalization stocks or employ sector rotation.

Question 16

What is an Active Equity Strategy?

Answer 16

An active investment strategy uses expectations about individual securities and the overall investment environment to build a portfolio that will take advantage of those expectations. It is an attempt to outperform a benchmark portfolio on a risk-adjusted basis.

Question 17

What is a Passive Equity Strategy?

Answer 17

A passive investment strategy does not lead to portfolio changes when expectations change. It is consistent with a return objective equal to the expected return on the benchmark portfolio.

Question 18

What is Efficient Market Hypothesis? What are its three forms?

Answer 18

Efficient-market hypothesis states prices reflect available information in efficient markets. This theory has 3 forms, each of which assumes that a different amount if information is reflected in asset prices –

1. Weak Form: Current prices incorporate all info about past prices, volumes and returns. This implies that technical analysis cannot consistently beat the market.
2. Semi-strong Form: Current prices reflect all publicly available information. This implies that neither fundamental nor technical analysis can be used and will do nothing to help investors beat the market.
3. Strong Form: Prices reflect all information, including insider information. This implies that no type of further analysis is helpful in beating the market.

Question 19

What are the Passive Equity Strategies?

Answer 19

1. Indexing: is the most popular form of passive investing. An indexed portfolio is designed to track the performance of a specific market index. It is supported by the belief in the strong form efficient-market hypothesis.
   - Advantages: a) Low risk of under performing the benchmark; b) Fees that are usually lower than those associated with most active strategies; c) the fact that the strategy does not depend in the ability of the client or IA to select securities
   - Disadvantages: a) Potential underperformance relative to active strategies; b) the risk that the portfolio does not meet portfolio objectives or constraints; c) lack of assurance that the performance of the index will be matched
2. Buy-and-hold Strategy: The IA or client select a group of securities or managed products and the client holds them until he or she needs to sell them to meet investment goals.

Question 20

What are the Active Equity Strategies?

Answer 20

1. Bottom-up Approach: begin with a focus on individual stocks. Investors or portfolio managers look at the characteristics of individual stocks and build portfolios of the best stocks in terms of forecast risk-return characteristics.
2. Top-down Approach: begin with an analysis of macro factors. It begins with a study of broad macroeconomic factors before it narrows the analysis to individual stocks.

Question 21

What are the types of Bottom-up Approaches?

Answer 21

1. Style-based Approach: involve focusing on a particular set of stocks that have similar fundamental characteristics and performance patterns.
2. Non-style based Approach: do not focus on a particular group of stocks but involve a search for stocks with the best chance of meeting particular objectives.

Question 22

What is market capitalization?

Answer 22

This widely used equity style focuses on the size of the company as measured by equity market capitalization. The stocks with the smallest market capitalizations are called small-cap stocks and those with the largest market capitalizations are called large cap stocks.

Question 23

What bottom-up, non-style-based approach attempts to measure the intrinsic value of a stock by closely examining the company’s financials and operations?

a) Pure technical
b) Pure qualitative
c) Pure fundamental
d) Pure qualitative

Answer 23

The pure fundamental approach involves an analysis of the company’s historical and projected financial performance and valuation. This usually involves an in-depth look at the company’s financial statements, with a focus on earnings growth and cash flow, as well as the quality of the company’s management. The decision to buy or sell a stock is often made on the basis of an estimate of the stock’s true value compared to the stock’s market price.

Question 24

Which statement(s) is/are true regarding tactical asset allocation?
I. Tactical asset allocation assumes constant risk tolerance.
II. Changes in risk tolerance lead to changes in tactical asset allocation
III. Tactical asset allocation is either value-based or momentum-based

Answer 24

I only. TAA is an active management strategy employed to add value by temporarily departing from the long-term policy asset mix. It operates independently from risk tolerance - a change in risk tolerance could give rise to a change in strategic asset allocation, but TAA assumes constant risk tolerance. TAA strategies are either value-based or cyclical.

Question 25

What approach to active investing gives priority to the identification of individual stocks as opposed to broad macro factors? a) Break-even approach b) Top-down approach c) Cost-benefit approach d) Bottom-up approach

Answer 25

The bottom-up approach begins with a focus on individual stocks. Investors or portfolio managers look at the characteristics of individual stocks and build portfolios of the best stocks in terms of forecasted risk-return characteristics.

Question 26

Which statements about active and passive investment strategies are true? I. Active strategies try to outperform passive strategies by at least the incremental costs. II. Passive approaches try to outperform active approaches by saving time and resources from analyzing market information. III. Passive approaches may involve creating a portfolio that invests in the same proportion as a market index.

Answer 26

I, II and III. For an active strategy to be successful, it must earn a return greater than which can be earned with a passive strategy. The excess return must at least compensate the incremental costs and risks of pursuing this approach. If not, active investors are paying a portion of their investment in fees to a manager who isn't necessary. Active managers try to outperform a passive benchmark on a risk-adjusted basis. A passive strategy is based on the EMH, which implies that active managers who spend time and resources in acquiring and analyzing information will under perform those who spend no time analyzing market information.

Question 27

Which statement regarding equity investment strategies is true? A. The two most popular active strategies are laddering and market timing. B. The top-down approach to equity analysis may be either a macroeconomic or style-based approach. C. Active equity strategies are separated into interest rate anticipation and sector rotation analysis. D. The bottom-up approach to equity analysis may be either a microeconomic or style-based approach.

Answer 27

B. The top-down approach may be either a macroeconomic approach or a style-based approach.

Question 28

What two methods can be used to determine when a portfolio's asset allocation is rebalanced back to its strategic asset allocation? A. Rebalancing by weights and temporal re-balancing. B. Rebalancing by asset type and variable re-balancing. C. Rebalancing by weights and variable re-balancing. D. Rebalancing by asset type and temporal re-balancing.

Answer 28

A. Rebalancing a portfolio back to the strategic asset allocation may be done in one of two ways: temporally or by weights.

Question 29

Alphonso has a strategic asset allocation of 5% cash and cash equivalents, 35% debt securities, and 60% equities. Over the last year, his portfolio grew in value from $200,000 to $225,000, of which $13,000 is in cash and cash equivalents, $90,000 is in debt securities, and $122,000 is in equities. Which of the following sets of transactions will re-balance Alphonso's portfolio back to its strategic asset allocation? A. Sell $1,750 of cash and cash equivalents, sell $11,250 of debt securities, and buy $13,000 of equities. B. Buy $1,750 of cash and cash equivalents, buy $11,250 of debt securities, and sell $13,000 of equities. C. Sell $3,000 of cash and cash equivalents, sell $20,000 of debt securities, and sell $2,000 of equities. D. Buy $22,000 of cash and cash equivalents, sell $20,000 of debt securities, and sell $2,000 of equities.

Answer 29

A. Based on his strategic asset allocation and the current dollar value of his portfolio, Alphonso needs to have $11,250 in cash and cash equivalents, $78,750 in debt securities, and $135,000 in equities. Given the current values in each of these asset classes, Alphonso needs to sell $1,750 of cash and cash equivalents, sell $11,250 of debt securities, and buy $13,000 of equities.

Question 30

Which statements are true regarding style-based investing? I. Value stocks tend to have low P/E ratios and high dividend yields. II. Growth stocks tend to have low P/E ratios and high dividend yields. III. Value stocks tend to have high P/E ratios and low dividend yields. IV. Growth stocks tend to have high P/E ratios and low dividend yields.

Answer 30

I and IV. The company’s price-to-book (P/B) ratio is the most commonly used factor to define value versus growth. In addition to P/B ratios, growth and value stocks are sometimes distinguished by their price-earnings (P/E) ratios and dividend yields. Value stocks tend to have low P/E and P/B ratios and high dividend yields, while growth stocks have high P/Es and P/Bs and low dividend yields.

Question 31

``` Your client believes that neither technical nor fundamental analysis can be used to beat the market. Identify the form of the efficient market hypothesis your client believes in. A. Weak form. B. Moderate form. C. Strong form. D. Semi-strong form. ```

Answer 31

D. The efficient-market hypothesis states that asset prices reflect available information in efficient markets. This theory has three forms: Weak form: Current prices incorporate all information about past prices, volumes, and returns. This implies that technical analysis cannot consistently beat the market. Semi-strong form: Current prices reflect all publicly available information. This implies that fundamental analysis is unnecessary and will do nothing to help investors beat the market. Strong form: Prices reflect all information, including insider information. This implies that no type of further analysis is helpful in beating the market.

Question 32

Which statement regarding active or passive investment strategies is true? A. Active strategies are based on the belief that markets are efficient. B. Passive strategies have lower investment management fees than active strategies. C. Active strategies mimic the composition of an index. D. Passive strategies are based on the belief that markets are inefficient.

Answer 32

B. Investors who believe that the market is not efficient use an active management strategy in an attempt to outperform the market. Fees tend to be higher for active management due to additional research, monitoring and investment selection.

Question 33

``` Which statement is true regarding the tolerance bands with respect to weights-based rebalancing? A. The higher the correlation between an asset class and the remainder of the portfolio, the wider the tolerance band. B. The higher the investor’s risk tolerance, the narrower the tolerance band. C. The higher the liquidity of an asset class, the wider the tolerance band. D. The higher the asset class volatility, the wider the tolerance band. ```

Answer 33

A. Weight-based rebalancing involves setting rebalancing thresholds or trigger points that are a percentage of the portfolio’s value. The higher the investor’s risk tolerance, the wider corridors can be. The lower the liquidity of an asset class, the wider its corridor should be. Higher asset-class volatility should lead to a narrower corridor. A high correlation between a particular asset class and the remainder of the portfolio should also lead to wider tolerance bands.

Question 34

Toni has a strategic asset allocation of 5% cash, 25% debt securities, and 70% equities. Toni's investment policy allows her portfolio's cash balance to range from 0% to 25%, while the debt securities balance can range from 15% to 40%, and the equities can range from 60% to 80%. Currently, her asset allocation is 6% cash, 30% debt securities, and 64% equities. You feel that the economy is headed toward a recession, and as a result, you expect interest rates and corporate profits to decline significantly over the next six months. Which of the following tactical asset allocation (TAA) recommendations would be most appropriate? A. Reduce cash to 0%, maintain 30% in debt securities and increase equities to 70%. B. Reduce cash to 0%, reduce equities to 60%, and increase debt securities to 40%. C. Reduce cash to 5%, reduce debt securities to 15%, and increase equities to 80%. D. Reduce debt securities to 15%, reduce equities to 60%, and increase cash to 25%.

Answer 34

B. Tactical asset allocation (TAA) involves a decision to allow asset class weights to deviate from the initial strategic asset allocation. A cyclical-based approach to TAA can be used to justify a shift in allocations from equities into bonds when, for example, the investor expects that the economy is heading into a recessionary period. The basis for this decision is the belief that in recessionary periods, bonds will outperform stocks, as has historically been the case. Therefore, you would probably recommend that Toni allocate the maximum possible to debt securities, which in this case is 40%. This would require Toni to do the following: reduce her cash balance to zero; increase her debt securities exposure to 40% and increase her equity exposure to 60%.

Question 35

Which of the following correctly identifies a goal of the strategic asset allocation decision? A. To eliminate systematic and unsystematic risk. B. To eliminate systematic risk and lower unsystematic risk. C. To lower systematic risk and eliminate unsystematic risk. D. To increase systematic risk and eliminate unsystematic risk.

Answer 35

C. Portfolios are subject to two kinds of risk: systematic (market) and unsystematic (related to the individual securities). The goal of strategic asset allocation is to lower systematic risk and eliminate unsystematic risk.

Question 36

What two factors determine an appropriate strategic asset allocation? A. Capital market expectations and investment objectives and constraints. B. Investment strategies and investment objectives and constraints. C. Capital market expectations and the degree of market efficiency. D. Investment strategies and the degree of market efficiency.

Answer 36

A. The appropriate strategic asset allocation for a particular client integrates two key factors: the client's investment objectives and constraints; and capital market expectations.

Question 37

``` Janet feels that no excess returns can be earned by using trading strategies based on historical share price data. What form of the Efficient Market Hypothesis (EMH) does Janet believe in? A. The weak form B. The semi-strong form. C. The moderate form. D. The strong form. ```

Answer 37

A. With the weak form, current prices incorporate all information about past prices, volumes and returns. This implies that technical analysis cannot consistently beat the market.