Chapter 8 - Portfolio Performace and Review Flashcards
Which of the following factors is NOT typically considered in portfolio performance review?
A) Risk-adjusted returns
B) Tracking error
C) Inflation correlation
D) Investor’s personal tax situation
Answer: C) Inflation correlation
Explanation: While inflation impact is important in long-term investing, portfolio performance reviews focus on risk-adjusted returns, tracking error, and tax efficiency rather than direct correlation with inflation.
What is the primary purpose of benchmarking in portfolio management?
A) To maximise absolute returns
B) To compare portfolio performance against an index or peer group
C) To eliminate systematic risk
D) To ensure 100% capital preservation
Answer: B) To compare portfolio performance against an index or peer group
Explanation: Benchmarking allows investors and fund managers to evaluate how a portfolio performs relative to a chosen standard, which may be a market index or peer group.
What is the main difference between time-weighted return (TWR) and money-weighted return (MWR)?
A) TWR accounts for timing of cash flows, MWR does not
B) MWR is more commonly used in performance benchmarking
C) TWR removes the impact of external cash flows, MWR does not
D) MWR is better for comparing fund managers
Answer: C) TWR removes the impact of external cash flows, MWR does not
Explanation: Time-weighted return (TWR) neutralises the effect of cash inflows and outflows, making it suitable for comparing fund managers, whereas money-weighted return (MWR) is influenced by cash flow timing.
Under GIPS, which of the following is required for firms claiming compliance?
A) Reporting all historical performance data for at least 20 years
B) Applying benchmarks selectively based on client objectives
C) Including all fee structures in reported returns
D) Adhering to a verified set of global standards for performance reporting
Answer: D) Adhering to a verified set of global standards for performance reporting
Explanation: GIPS requires firms to follow standardised performance reporting principles, but they must report at least 5 years of historical performance, not 20.
The CAPS and WM benchmarks are primarily used to evaluate the performance of:
A) Hedge funds
B) Private equity investments
C) UK pension and wealth management portfolios
D) High-frequency trading strategies
Answer: C) UK pension and wealth management portfolios
Explanation: CAPS (Combined Actuarial Performance Services) and WM (Wealth Management Association) benchmarks help measure pension and wealth management performance in the UK.
What distinguishes MSCI PIMFA benchmarks from broader market indices?
A) They are designed specifically for wealth management portfolios
B) They exclude emerging markets
C) They have lower volatility than FTSE 100
D) They focus only on ethical investments
Answer: A) They are designed specifically for wealth management portfolios
Explanation: MSCI PIMFA benchmarks cater specifically to discretionary wealth management portfolios and include different risk-return profiles.
Which of the following indices is considered a price-weighted index?
A) FTSE 100
B) MSCI World
C) S&P 500
D) Nikkei 225
Answer: D) Nikkei 225
Explanation: Unlike market-cap-weighted indices like the S&P 500, the Nikkei 225 is price-weighted, meaning higher-priced stocks have more influence on the index.
The FTSE Actuaries UK Gilts Index Series is primarily used to measure:
A) Corporate bond performance
B) UK government bond (gilt) performance
C) High-yield bond movements
D) UK equity market performance
Answer: B) UK government bond (gilt) performance
Explanation: This index series measures the performance of UK government bonds across different maturities.
Which of the following is NOT a common ethical investment exclusion criterion?
A) Weapons manufacturing
B) Fossil fuel industries
C) High-frequency trading firms
D) Tobacco companies
Answer: C) High-frequency trading firms
Explanation: Ethical investment indices commonly exclude sectors like weapons, tobacco, and fossil fuels, but high-frequency trading firms are not typically excluded.
Which metric measures a portfolio’s performance relative to a benchmark, adjusted for risk?
A) Sharpe ratio
B) Information ratio
C) Alpha
D) Sortino ratio
Answer: B) Information ratio
Explanation: The information ratio compares the excess return of a portfolio over a benchmark, adjusted for tracking error.
Which of the following is an absolute return measure?
A) Alpha
B) Benchmark-adjusted return
C) Annualised return
D) Tracking error
Answer: C) Annualised return
Explanation: Absolute return refers to the raw return generated by a portfolio over a period, whereas relative return compares performance to a benchmark.
Asset allocation is responsible for approximately what percentage of a portfolio’s returns, according to academic studies?
A) 20%
B) 40%
C) 60%
D) 90%
Answer: D) 90%
Explanation: Studies (e.g., Brinson, Hood, Beebower) suggest that asset allocation accounts for around 90% of a portfolio’s long-term return variability.
What impact does a depreciating domestic currency have on foreign investments?
A) Increases the value of foreign holdings
B) Decreases the value of foreign holdings
C) No impact if the investor is unhedged
D) Reduces portfolio diversification
Answer: A) Increases the value of foreign holdings
Explanation: A weaker domestic currency makes foreign investments more valuable in local currency terms.
A risk/reward ratio of 1:3 implies:
A) 1 unit of risk generates 3 units of return
B) 3 units of risk generate 1 unit of return
C) The investment has a Sharpe ratio of 3
D) The investment has negative alpha
Answer: A) 1 unit of risk generates 3 units of return
Explanation: A 1:3 risk/reward ratio means that for every unit of risk, the investor expects three times the reward.
Which measure adjusts for the impact of new capital contributions on performance?
A) Modified Dietz method
B) Jensen’s alpha
C) Value at Risk (VaR)
D) Treynor ratio
Answer: A) Modified Dietz method
Explanation: The Modified Dietz method accounts for external cash flows in portfolio performance calculation.
Which of the following is a key drawback of peer group benchmarking in portfolio performance evaluation?
A) It is difficult to calculate risk-adjusted returns
B) It does not account for survivorship bias
C) It ignores the impact of market conditions
D) It can be manipulated by selecting specific peer groups
Answer: D) It can be manipulated by selecting specific peer groups
Explanation: Peer group benchmarking can be distorted if the group is selectively chosen to make performance look better than it actually is. Additionally, survivorship bias can skew results.
When constructing a customised benchmark for pension funds, what is the most important consideration?
A) Ensuring the benchmark tracks global indices
B) Matching the benchmark to the fund’s investment objectives and liabilities
C) Keeping the benchmark as simple as possible
D) Avoiding alternative asset classes
Answer: B) Matching the benchmark to the fund’s investment objectives and liabilities
Explanation: A pension fund’s benchmark should reflect its specific investment objectives and liability profile to ensure appropriate risk and return expectations.
What is the key reason why after-tax benchmarking is critical for high-net-worth investors?
A) Tax treatments differ across asset classes and jurisdictions
B) It ensures portfolios generate the highest nominal returns
C) Taxation has no impact on long-term portfolio growth
D) Capital gains tax is always a fixed percentage
Answer: A) Tax treatments differ across asset classes and jurisdictions
Explanation: After-tax benchmarking is important because tax efficiency can significantly impact net returns, especially for high-net-worth individuals with complex tax obligations.
Which of the following challenges is most relevant when benchmarking alternative investments like private equity or hedge funds?
A) Market efficiency leads to constant alpha generation
B) Frequent liquidity events make performance comparison simple
C) Standardised benchmarks do not exist for many alternative assets
D) Alternatives always outperform public markets
Answer: C) Standardised benchmarks do not exist for many alternative assets
Explanation: Unlike equities or bonds, alternative investments often lack widely accepted benchmarks, making performance evaluation more complex.
What is the key limitation of using the Sharpe ratio as a standalone performance measure?
A) It does not consider total return
B) It assumes risk is only measured by volatility
C) It cannot be used to compare different asset classes
D) It is unaffected by changes in interest rates
Answer: B) It assumes risk is only measured by volatility
Explanation: The Sharpe ratio relies on standard deviation (volatility) as the sole measure of risk, which may not fully capture downside risk or other factors affecting investment performance.
Which of the following is the PRIMARY reason for conducting a portfolio review?
A) To ensure that the portfolio’s asset allocation is identical to the original recommendation
B) To confirm that all investments have performed exactly as projected
C) To assess whether the portfolio still aligns with the client’s objectives and risk tolerance
D) To verify that all investments are in positive territory
Answer: C) To assess whether the portfolio still aligns with the client’s objectives and risk tolerance
Explanation: A portfolio review is essential to ensure it remains suitable for the client’s financial goals, risk tolerance, and market conditions. Market fluctuations and changes in personal circumstances often necessitate adjustments.
Which of the following is LEAST likely to require an immediate portfolio review?
A) The client changes their employment status
B) The client’s portfolio suffers a 2% decline in one week
C) New tax regulations impact investment structures
D) A client unexpectedly inherits a large sum of money
Answer: B) The client’s portfolio suffers a 2% decline in one week
Explanation: Short-term market fluctuations do not necessarily warrant an immediate portfolio review. However, significant life events and regulatory changes may have lasting implications requiring adjustments.
How often should a portfolio review be conducted under normal circumstances?
A) Monthly
B) Quarterly
C) Annually
D) Only when the client requests it
Answer: C) Annually
Explanation: While reviews can be conducted more frequently if needed, an annual review is standard practice to ensure alignment with the client’s goals, risk profile, and market conditions.
Which of the following is NOT a primary factor requiring a portfolio review?
A) Changes in interest rates
B) Launch of a new stock exchange
C) Changes in the client’s financial goals
D) Introduction of new investment products
Answer: B) Launch of a new stock exchange
Explanation: While new stock exchanges may impact global markets, they do not directly affect an individual client’s portfolio the way interest rates, personal circumstances, and product innovations do.
What is the MAIN goal of portfolio rebalancing?
A) To maximise short-term gains
B) To maintain the target asset allocation in line with risk tolerance
C) To liquidate underperforming assets immediately
D) To avoid capital gains tax at all costs
Answer: B) To maintain the target asset allocation in line with risk tolerance
Explanation: Over time, asset allocations can drift due to market performance. Rebalancing ensures the portfolio remains aligned with the client’s risk profile and investment objectives.
If a client’s risk tolerance decreases, what is the most appropriate course of action?
A) Increase the proportion of equities
B) Reduce exposure to fixed-income investments
C) Shift towards lower-risk assets such as bonds or cash equivalents
D) Do nothing, as risk tolerance is unlikely to change investment outcomes
Answer: C) Shift towards lower-risk assets such as bonds or cash equivalents
Explanation: If a client’s risk tolerance declines, reducing exposure to volatile assets like equities and increasing safer investments ensures their portfolio aligns with their updated preferences.
Which type of investment change would most likely trigger a portfolio review?
A) A company within the portfolio announces a new CEO
B) An investment fund changes its underlying strategy
C) A stock in the portfolio experiences a temporary decline
D) A mutual fund manager appears in a financial news interview
Answer: B) An investment fund changes its underlying strategy
Explanation: A shift in an investment’s strategy could alter its risk-return profile, necessitating a review to ensure continued suitability for the client.
What is a potential drawback of frequent portfolio rebalancing?
A) Increased exposure to market volatility
B) Higher transaction costs and tax implications
C) Reduced ability to adapt to new investment opportunities
D) Portfolio drift due to lack of activity
Answer: B) Higher transaction costs and tax implications
Explanation: Frequent rebalancing may result in higher trading fees and tax liabilities, potentially eroding portfolio returns.
Which of the following is an example of an administrative change that may require a portfolio review?
A) The client’s investment advisor changes firms
B) The client reads an article predicting a market crash
C) A stock in the portfolio announces a dividend cut
D) The client’s employer offers a new pension scheme
Answer: A) The client’s investment advisor changes firms
Explanation: Changes in financial advisors or firms could impact investment management and require adjustments to ensure consistency in strategy.
When assessing a portfolio’s benchmark, what is the MOST important consideration?
A) The benchmark must include only the highest-performing assets
B) The benchmark should be risk-adjusted and appropriate for the portfolio’s strategy
C) The benchmark should outperform the market consistently
D) The benchmark must remain unchanged over time
Answer: B) The benchmark should be risk-adjusted and appropriate for the portfolio’s strategy
Explanation: A well-chosen benchmark reflects the risk-return characteristics of the portfolio and serves as a relevant performance comparison tool.
Which factor is MOST important when reviewing a portfolio’s performance against its benchmark?
A) Nominal returns
B) The client’s satisfaction with their returns
C) Risk-adjusted returns relative to the benchmark
D) The total number of assets in the portfolio
Answer: C) Risk-adjusted returns relative to the benchmark
Explanation: Comparing risk-adjusted returns helps evaluate whether performance is achieved efficiently given the level of risk taken.
Which change in the financial environment is MOST likely to impact a portfolio’s fixed-income allocation?
A) A rise in inflation expectations
B) Increased mergers and acquisitions in the tech sector
C) A regulatory change in the cryptocurrency market
D) A company issuing a stock buyback program
Answer: A) A rise in inflation expectations
Explanation: Higher inflation generally leads to rising interest rates, which negatively impact bond prices and may necessitate a review of fixed-income allocations.
If a portfolio review identifies excessive turnover, what is the most appropriate action?
A) Increase investment in high-frequency trading strategies
B) Reduce trading frequency to minimise costs and tax impact
C) Reallocate to illiquid assets to avoid short-term trading
D) Ignore it, as turnover is irrelevant to long-term performance
Answer: B) Reduce trading frequency to minimise costs and tax impact
Explanation: Excessive turnover can lead to high costs and potential tax inefficiencies, requiring a shift towards a more strategic, long-term approach.
What is a key reason why regulatory changes require portfolio reviews?
A) Compliance breaches can lead to penalties
B) They always increase investment returns
C) They only impact institutional investors
D) They have no impact on portfolio construction
Answer: A) Compliance breaches can lead to penalties
Explanation: Regulatory changes can affect investment suitability, tax treatments, and reporting requirements, making portfolio reviews essential for maintaining compliance.
Which of the following is the PRIMARY reason why a client’s portfolio allocation may need to change as they approach retirement?
A) They need more exposure to high-growth stocks
B) Their investment time horizon shortens, reducing risk tolerance
C) They should shift entirely to cash holdings
D) Their investment risk tolerance increases
Answer: B) Their investment time horizon shortens, reducing risk tolerance
Explanation: As clients near retirement, their ability to recover from market downturns decreases, often requiring a shift towards more stable, lower-risk investments.
What are the three primary reasons why performance benchmarks are important?
A) They provide a way to compare portfolios, assess risk levels, and ensure tax efficiency
B) They measure performance, assess risk-adjusted returns, and evaluate investment strategy suitability
C) They identify underperforming asset classes, track short-term market fluctuations, and optimize tax liabilities
D) They are used solely for compliance purposes, fund marketing, and to maximize absolute returns
Answer: B) They measure performance, assess risk-adjusted returns, and evaluate investment strategy suitability
Explanation: Benchmarks help investors understand how a portfolio is performing relative to its objectives, ensure returns are reasonable given the level of risk, and determine if the chosen strategy remains effective.
What need do Global Investment Performance Standards (GIPS) meet?
A) They establish a universal accounting framework for listed companies
B) They standardize portfolio reporting to ensure fair and transparent performance comparisons
C) They enforce tax rules on global investments
D) They provide guidelines for pricing derivatives in emerging markets
Answer: B) They standardize portfolio reporting to ensure fair and transparent performance comparisons
Explanation: GIPS were created to ensure consistency, fairness, and comparability in performance reporting across different investment firms and regions.
When would a portfolio use a peer group average instead of an index as a performance benchmark?
A) When the portfolio contains highly liquid assets with minimal risk
B) When the portfolio is actively managed and does not closely track any single market index
C) When the investor prefers absolute return strategies over relative performance comparisons
D) When the portfolio consists only of government bonds and fixed-income securities
Answer: B) When the portfolio is actively managed and does not closely track any single market index
Explanation: A peer group benchmark is useful when a portfolio’s composition or strategy differs significantly from standard market indices, making direct comparisons inappropriate.
What is the best definition of ‘relative return’?
A) The absolute percentage return achieved by a portfolio over a fixed period
B) The return of a portfolio compared to a specific benchmark or index
C) The total return generated after accounting for inflation and currency fluctuations
D) The risk-free return achieved in relation to central bank interest rates
Answer: B) The return of a portfolio compared to a specific benchmark or index
Explanation: Relative return measures how well a portfolio performs against a benchmark, helping assess whether active management adds value.
What does the term ‘maximum drawdown’ refer to?
A) The largest percentage loss from a portfolio’s peak value to its lowest point before recovering
B) The total capital withdrawn from an investment over its lifetime
C) The highest daily loss experienced by an investor due to market fluctuations
D) The maximum allowable withdrawal from a retirement fund without penalties
Answer: A) The largest percentage loss from a portfolio’s peak value to its lowest point before recovering
Explanation: Maximum drawdown (MDD) is a key risk measure that helps investors understand the worst-case downside scenario for their portfolio.
An investor’s portfolio provides a holding period return (HPR) of 25% in foreign currency terms. If the HPR gained on the currency exchange is -10%, what is the HPR in domestic currency terms?
A) 15%
B) 12.5%
C) 10%
D) 22.5%
Answer: A) 15%
Explanation: The formula for HPR in domestic terms is:
(1+HPR foreign) x (1+ HRP Currency) - 1
(1.25 x 0.9) - 1 = 1.125 - 1 = 0.15 = 15%
Which ratio is commonly used to compare the expected returns on an investment with the level of risk taken?
A) Sharpe ratio
B) Price-to-Earnings (P/E) ratio
C) Dividend yield ratio
D) Treynor ratio
Answer: A) Sharpe ratio
Explanation: The Sharpe ratio measures risk-adjusted return by comparing excess return (above the risk-free rate) to portfolio volatility. A higher ratio indicates better risk-adjusted performance.
How frequently should the management of a client’s portfolio be reviewed?
A) Quarterly
B) Annually
C) Only when markets experience volatility
D) At the client’s discretion
Answer: B) Annually
Explanation: An annual review ensures that the portfolio aligns with the client’s risk tolerance, financial objectives, and market conditions. Additional reviews may be needed for major life or market changes.
Which of the following is NOT a typical factor that would require a client’s portfolio review?
A) A significant change in the client’s financial circumstances
B) A global market downturn impacting all asset classes
C) A minor price fluctuation in an individual stock within the portfolio
D) The introduction of new tax regulations affecting investments
Answer: C) A minor price fluctuation in an individual stock within the portfolio
Explanation: Short-term stock price movements do not typically require a full portfolio review unless they indicate broader risks or fundamental shifts.
Under what circumstances may a review of the portfolio benchmark be required?
A) If the benchmark has consistently underperformed the market
B) If the portfolio strategy or asset allocation changes significantly
C) If the client’s portfolio has outperformed the benchmark for three consecutive years
D) If the benchmark index is discontinued and replaced by a new version
Answer: B) If the portfolio strategy or asset allocation changes significantly
Explanation: A benchmark must remain aligned with the portfolio’s investment approach. Changes in strategy, asset allocation, or risk profile may necessitate a new benchmark for accurate performance assessment.
