Portfolio Construction/Asset Allocation Flashcards
Diversification of a portfolio among asset classes:
A. increases the rate of return achieved over the investment time horizon
B. reduces the rate of return achieved over the investment time horizon
C. reduces the variability of the rate of return over the investment time horizon
D. increases the variability of the rate of return over the investment time horizon
The best answer is C.
Diversification reduces the variability of investment returns over the investment time horizon. In a diversified portfolio, some investments will be under-performing and some will be over-performing, tending to average out the rate of return. Thus, variability of the rate of return is reduced.
Which of the following investment portfolios is LEAST liquid?
A. An aggressive growth fund
B. A U.S. Government securities fund
C. A money market fund
D. An income fund
The best answer is A.
Aggressive growth stocks are usually too small to be NYSE listed; they might be found on NASDAQ, which has lower listing standards than the NYSE; or on the OTCBB - the Over-the-Counter Bulletin Board - which has no listing standards. The OTCBB is a much less liquid market than NASDAQ; and NASDAQ’s liquidity is not as good as the NYSE’s. Thus, aggressive growth stocks would be the least liquid securities of the choices offered. Government securities and money market securities are actively traded and are extremely liquid. Income funds are composed of high yielding preferred stocks and bonds. These are more liquid than aggressive growth stocks, though not as liquid as NYSE listed issues.
Which of the following would be least important in determining the level of diversification in a corporate bond portfolio?
A. Bond ratings
B. Industries represented in portfolio
C. Domicile of issuers
D. Maturities of the bonds in the portfolio
The best answer is C.
The “domicile” of an issuer is the state where the issuer legally resides. It has no bearing on the quality of the issuer’s securities. Bond rating, type of industry, and maturity would all be considered when examining the diversification of a bond portfolio.
A customer holds a large portfolio of corporate bonds. The customer is worried about capital risk. Which diversification strategy would be least effective to minimize capital risk for this customer?
A. Diversification among differing issuers in differing states
B. Diversification among differing industries
C. Diversification among differing maturities
D. Diversification among differing coupon rates
The best answer is D.
Effective methods of diversifying away the unsystematic risk of a portfolio would be to diversify among different issuers, different states, and different industries. Thus, if one issuer, industry or economic region has problems, this would only affect a small portion of the portfolio.
Diversification among differing maturities also provides a measure of risk management. If market interest rates rise, short term maturities (under 1 year) will decline in price by a minimal amount compared with longer maturities. Thus, a mix of maturities helps to minimize capital risk.
Diversification among different coupon rates would be the least effective means of minimizing risk. As a generalization, the lower the coupon rate, the more volatile the bond’s price movements in response to interest rate movements. However, if market interest rates rise, all of the bonds in the portfolio will drop in value (with the lower coupon rate bonds dropping faster). Thus, this type of diversification really does not protect much against market risk.
The portfolio management technique that uses a market index as a performance benchmark that the asset manager must meet is called:
A. Passive asset management
B. Active asset management
C. Strategic asset management
D. Tactical asset management
The best answer is A.
Active asset management is the management of a portfolio to exceed a benchmark return (say the return of a comparable index fund). The manager’s “active” return is any incremental return achieved over the benchmark return. In contrast, passive asset management is simply the management of a portfolio to match the benchmark return (the “passive return”). Active managers believe that underpriced securities can be found in the market and that performance of the benchmark can be exceeded. Passive managers believe that the market is efficient at pricing securities and that one cannot do any better than the “market” return as measured by a relevant index.
The portfolio management technique that uses a market index as a performance benchmark that the asset manager must exceed is called:
A. Passive asset management
B. Active asset management
C. Strategic asset management
D. Tactical asset management
The best answer is B.
Active asset management is the management of a portfolio to exceed a benchmark return (say the return of a comparable index fund). The manager’s “active” return is any incremental return achieved over the benchmark return. In contrast, passive asset management is simply the management of a portfolio to match the benchmark return (the “passive return”). Active managers believe that underpriced securities can be found in the market and that performance of the benchmark can be exceeded. Passive managers believe that the market is efficient at pricing securities and that one cannot do any better than the “market” return as measured by a relevant index.
The setting of specific goals for an investment plan to be created for a customer is known as:
A. Strategic asset management
B. Tactical asset management
C. Dollar cost averaging
D. Portfolio rebalancing
The best answer is A.
Strategic asset management is the setting of the investment “strategy” under an asset allocation scheme.
Tactical asset management is the permitted variation to the established strategy, to take advantage of market opportunities.
Dollar cost averaging is the periodic (say monthly) investment of a fixed dollar amount into a given security. By using dollar cost averaging, the average cost per share purchased can be lower than the arithmetical average cost of the security over the same time frame - as long as the security’s price has been moving up and down (as the security’s price drops, the fixed periodic dollar amount buys proportionately more shares than when the security’s price rises).
Portfolio rebalancing is used in an asset allocation scheme when a chosen asset class outperforms the others, so that its percentage allocation increases beyond the strategic limit. The excess in that class is sold off and the proceeds reinvested in the other asset classes to rebalance the portfolio back to its strategically set percentages.
Which statements are TRUE?
I Strategic portfolio management is the determination of the asset allocation percentages among different asset classes in the portfolio II Strategic portfolio management is the determination of the permitted variance within each asset allocation percentage assigned to a specific asset class III Tactical portfolio management is the determination of the asset allocation percentages among different asset classes in the portfolio IV Tactical portfolio management is the determination of the permitted variance within each asset allocation percentage assigned to a specific asset class
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is B.
Strategic portfolio management is the determination of the percentage allocation to be given to each asset class - for example a portfolio might be strategically allocated as follows:
Money Market Instruments 10%
Corporate Bonds 30%
Large Cap Equities 50%
Small Cap Equities 10%
Tactical asset management is the permitted variance within each allocation percentage. For example, Large Cap equities are allocated 50%, but the manager may be tactically allowed to lower this percentage to, say, 40% or raise it to 60%. Thus, if the manager believes that Large Cap equities will under-perform the market, he or she can lower the allocation to 40%; and if the manager believes that they will outperform the market, he or she can raise the allocation to 60%. This gives the manager some ability to “time the market” when conditions are overbought or oversold.
Which statements are TRUE?
I Strategic portfolio management is the determination of the asset allocation percentages among differing asset classes in the portfolio II Strategic portfolio management is the determination of the permitted variance within each asset allocation percentage assigned to a specific asset class III Tactical portfolio management is the determination of the asset allocation percentages among differing asset classes in the portfolio IV Tactical portfolio management is the determination of the permitted variance within each asset allocation percentage assigned to a specific asset class
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is B.
Strategic portfolio management is the determination of the percentage allocation to be given to each asset class - for example a portfolio might be strategically allocated as follows:
Money Market Instruments 10%
Corporate Bonds 30%
Large Cap Equities 50%
Small Cap Equities 10%
Tactical asset management is the permitted variance within each allocation percentage. For example, Large Cap equities are allocated 50%, but the manager may be tactically allowed to lower this percentage to, say, 40% or raise it to 60%. Thus, if the manager believes that Large Cap equities will underperform the market, he or she can lower the allocation to 40%; and if the manager believes that they will outperform the market, he or she can raise the allocation to 60%. This gives the manager some ability to “time the market” when conditions are overbought or oversold.
Which statements are TRUE about asset classes and investment time horizons?
I Equity investments are the better choice for short term time horizons
II Interest bearing investments are the better choice for short term time horizons
III Equity investments are the better choice for long term time horizons
IV Interest bearing investments are the better choice for long term time horizons
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is C.
Equity investments typically produce a higher rate of return with higher volatility - thus a long time horizon is needed to achieve consistent results with equity investments. Interest bearing investments produce a lower rate of return with lower volatility - thus they are suitable for portfolios with short time horizons.
The time horizon to be used when constructing a portfolio for a person who will retire in a few years is the:
A. time remaining until retirement
B. expected time till the person cannot care for him or herself
C. expected lifetime of that person
D. expected lifetime of that person’s beneficiaries
The best answer is C.
If a portfolio is being constructed to fund a person’s retirement in a number of years, it must be able to provide retirement income to that person for his or her lifetime. This is the appropriate time horizon.
Value investors:
A. seek to find investments that are undervalued by the market
B. determine the value of a security through fundamental analysis
C. invest in securities included in the Value Line Index
D. make their investment decision based upon the market performance of the security
The best answer is A.
Value investors believe that the market is not completely efficient at pricing securities and that undervalued securities can be found in the marketplace. Once the market realizes the true worth of these undervalued companies, their prices should rise at a greater rate than the general market.
A value investor would consider all of the following EXCEPT a company’s:
A. Price / Earnings ratio
B. Price / Book Value ratio
C. Stock price growth rate
D. Market share
The best answer is C.
Value investors invest in undervalued companies - as measured by low Price/Earnings ratios and low Price/Book Value ratios - that have good market prospects. Thus, they also consider product line, market share, management, etc. Growth investors select investments based simply on growth in earnings or growth in market price; on the assumption that these will always be the best performing investments.
The investment strategy that involves paying a lower price for a security based on the expectation that the market is mispricing the issue is:
A. growth investing
B. value investing
C. passive investing
D. active investing
The best answer is B.
Value investing is the selection of equity investments based on finding securities that are fundamentally undervalued in the marketplace. These tend to be solid companies that are currently “out of favor.” Value investors look at such fundamental factors as the Price/Earnings ratio; and Price/Book Value ratio to find companies that are undervalued relative to their market sector.
Growth investors:
A. seek to find investments that are undervalued by the market
B. determine the value of a security through fundamental analysis
C. invest in securities included in growth funds
D. make their investment decision based upon the market performance of the security
The best answer is D.
Growth investors select investments based simply on growth in earnings or growth in market price; on the assumption that these will always be the best performing investments.
A growth investor would consider a company’s:
A. Price / Earnings ratio
B. Price / Book Value ratio
C. Stock price appreciation rate
D. Market share
The best answer is C.
Growth investors select investments based simply on growth in earnings or growth in market price; on the assumption that these will always be the best performing investments. Value investors invest in undervalued companies - as measured by low Price/Earnings ratios and low Price/Book Value ratios - that have good market prospects. Thus, they also consider product line, market share, management, etc.
If one asset class greatly underperforms another class in an asset allocation plan, the portfolio must be:
A. renegotiated
B. rebalanced
C. repositioned
D. realigned
The best answer is B.
When investment performance varies over time from one asset class to another, the target percentage allocations will shift from their optimal setting. To bring the portfolio back to these targets, it must be rebalanced - that is, a portion of the overperforming class(es) must be sold off and the proceeds reinvested in the underperforming class(es).
Which bond portfolio where all investment is made up front would be LEAST negatively affected by a sharp rise in interest rates?
A. Ladder
B. Bullet
C. Barbell
D. Balloon
The best answer is A.
Bullets, Bond Ladders, and Barbells are portfolio constructions that are used to limit interest rate risk.
The idea behind a bond ladder is to spread bond maturities in a portfolio over fixed intervals, typically 10 maturities in intervals of 2 years each. A typical ladder might have 10 maturities ranging from 2 to 20 years, with an average maturity of around 10 years. Because of this broad diversification by maturity, a rise in interest rates will not impact the portfolio as negatively as compared to a bullet or barbell portfolio construction. If interest rates rise, the loss on the longer term bonds in the portfolio is offset by the fact that shorter term bonds are maturing soon and the proceeds can be reinvested at higher rates.
A barbell portfolio only has 2 maturities - a very short term and a very long term - say 2 years and 20 years, for an average life around 10 years (actually 11 years here, but we are simplifying things). The longer term bonds give a higher yield but have higher interest rate risk. This risk is offset by the fact that the 2 year bonds will mature soon and the proceeds can be reinvested at higher rates. The big risk here is that long rates rise sharply as compared to short rates (a steepening of the yield curve). In this scenario, the loss on the long term bonds will be much greater than the fact that the short term bond proceeds can be reinvested in 2 years at somewhat higher rates.
A bullet portfolio construction only has a single maturity, typically in an intermediate range of around 10 years. The way that interest rate risk is offset here is that all of the investment is not made at one time - rather, the investment is made in installments at fixed intervals. If market interest rates rise, new investment will be made at higher rates, offsetting any loss on the already purchased bonds. Also note that this cannot be a correct answer to the question because all investment is not made up front - rather, the investment is made in stages.
A balloon is a type of bond issue structure, where most of the bonds mature as a “balloon” at a long term maturity date. It is not a type of bond portfolio construction.
All of the following are bond portfolio construction methods designed to reduce interest rate risk EXCEPT:
A. Ladder
B. Bullet
C. Barbell
D. Balloon
The best answer is D.
Bullets, Bond Ladders, and Barbells are portfolio constructions that are used to limit interest rate risk.
A bullet portfolio construction only has a single maturity, typically in an intermediate range of around 10 years. The way that interest rate risk is offset here is that all of the investment is not made at one time - rather, the investment is made in installments at fixed intervals. If market interest rates rise, new investment will be made at higher rates, offsetting any loss on the already purchased bonds.
The idea behind a bond ladder is to spread bond maturities in a portfolio over fixed intervals, typically 10 maturities in intervals of 2 years each. A typical ladder might have 10 maturities ranging from 2 to 20 years, with an average maturity of around 10 years. Because of this broad diversification by maturity, a rise in interest rates will not impact the portfolio as negatively as compared to a bullet or barbell portfolio construction. If interest rates rise, the loss on the longer term bonds in the portfolio is offset by the fact that shorter term bonds are maturing soon and the proceeds can be reinvested at higher rates.
A barbell portfolio only has 2 maturities - a very short term and a very long term - say 2 years and 20 years, for an average life around 10 years (actually 11 years here, but we are simplifying things). The longer term bonds give a higher yield but have higher interest rate risk. This risk is offset by the fact that the 2 year bonds will mature soon and the proceeds can be reinvested at higher rates. The big risk here is that long rates rise sharply as compared to short rates (a steepening of the yield curve). In this scenario, the loss on the long term bonds will be much greater than the fact that the short term bond proceeds can be reinvested in 2 years at somewhat higher rates.
A balloon is a type of bond issue structure, where most of the bonds mature as a “balloon” at a long term maturity date. It is not a type of bond portfolio construction.
Customers A, B, C and D have their portfolio assets allocated as follows:
A B C D Money Markets 15% 5% 5% 0% Treasury Bonds 40% 10% 20% 20% Speculative Bonds 10% 30% 10% 30% Blue Chip Equities 15% 15% 20% 10% Small Cap. Equities 10% 10% 30% 5% Emerging Markets 10% 20% 10% 30% REITs 0% 10% 5% 5%
Which asset allocation is MOST appropriate for a risk-intolerant older customer with a short investment time horizon?
A. Customer A
B. Customer B
C. Customer C
D. Customer D
The best answer is A.
For an older, risk-intolerant customer, safe fixed income securities are the best recommendation. Customer A’s portfolio has the highest allocation of safe Treasury Bonds, which have the highest credit rating and give an assured income stream.
A 60 year old customer desires an investment that will provide for retirement income when she reaches age 65. The customer is able to invest $1,000 per month over that time period. Which of the following recommendations is most suitable?
A. The purchase of income bonds
B. The purchase of a variable annuity contract
C. The purchase of government bonds in an IRA account
D. The purchase of high yield bonds
The best answer is B.
A variable annuity contract places no dollar limit on contributions; and the income earned on investments is tax deferred during the accumulation period. Thus, the customer would be allowed to contribute $12,000 per year; and would receive the benefit of the tax deferred build up. At age 65, she could annuitize and convert the value of the account into an annuity contract that would make payments for her life. This is the best choice offered. Income bonds only pay income if the corporation earns enough, so these are not suitable for retirement income. An IRA account only allows a $6,000 contribution for an individual in 2019, so this does not meet the customer’s desire to invest $12,000 per year. Finally high yield bonds are speculative, and are not suitable for retirement income.
A customer is in the highest tax bracket and will possibly be subject to the AMT. Which of the following is the BEST investment recommendation?
A. 5.40% Municipal bond that is not subject to the AMT
B. 5.60% Municipal bond that is subject to the AMT
C. 6.00% Treasury bond with a long expiration
D. 6.00% Corporate bond mutual fund
The best answer is A.
Since this customer is in the highest Federal tax bracket (currently 37%), 37% of the return offered by taxable Treasury Bonds or Corporate Bonds would go to tax, and only 63% of the 6% return (3.78%) offered by these would be kept after-tax. Thus, the 5.40% or 5.60% tax-free municipal bonds are the best choices. Since this customer is possibly subject to the AMT (Alternative Minimum Tax), which adds back “tax preferences” to reported income and taxes the adjusted-up figure at a flat 26-28%, buying the bond that is NOT subject to the AMT is the way to go!
A registered representative has a client who is an exceptionally intelligent doctor of medicine. The doctor does most of his own investment research and makes many of his own investment decisions. The doctor is married, but his wife is not involved in the investment planning or decision-making process. When constructing a portfolio for this client, the registered representative should:
A. choose the investments in the portfolio based solely on the research conducted by the doctor
B. balance the portfolio in a manner that addresses the doctor’s investment strategy and that customizes the strategy to meet the needs of the spouse
C. charge fees on the assets held in the portfolio that were chosen by the representative without using the doctor’s research
D. disregard the doctor’s research because the doctor is not properly licensed to act as a representative
The best answer is B.
When constructing a portfolio for a client, the representative can take into account a customer’s special expertise in a given area when selecting specific investments. For example, a doctor might have a special insight into the sales prospects for a medical device manufacturer, and could tell the representative that he wants to invest in this company. It is the role of the representative to review this investment decision and, if appropriate, to make sure that it is not overweighted in the portfolio. Because the doctor is married, the representative should construct the portfolio to meet both the needs of the doctor and his wife.
A couple wants to invest for the college education of their 4 children. The children are 1, 5, 10, and 16 years old. What is the biggest suitability concern when making an investment recommendation?
A. Tax deferral
B. Investment growth
C. Investment time horizon
D. Liquidity
The best answer is C.
The oldest child is 16 years old and will be entering college in 2 years. Any investment recommendation must take into account that liquidation of positions to pay for college must commence in 2 years. This is the investment time horizon that must be used for any recommendation. Liquidity is also a concern – any assets chosen as an investment must be able to be liquidated quickly when funds are needed in 2 years. However, first we must choose assets with a 2-year investment time horizon, and then second, these must be assets that can be liquidated easily (little liquidity risk).
A 25-year old client with a low risk tolerance wishes to invest in bonds. The client has invested in equities before, but has no experience investing in bonds. The BEST recommendation would be:
A. BB-rated short-term bonds
B. BB-rated intermediate-term bonds
C. AA-rated short-term bonds
D. AA-rated long-term bonds
The best answer is C.
This client has a low risk tolerance. Therefore, to minimize credit risk, investment grade bonds are appropriate (BBB or higher). To minimize interest rate risk, short-term maturities are better than long-term maturities. Both of these factors will result in a safer bond investment. However, the customer will get a lower yield, but that is not addressed in the question.
A married couple, the husband is age 27 and the wife is 25, have 2 young children, no retirement plan and no investments. Based on this information, an agent should:
A. tell the clients to establish a Roth IRA
B. tell the clients to establish 529 plans for their children
C. talk to the clients about their financial goals
D. determine that the clients have cash available for investment
The best answer is C.
We certainly don’t know much here from the information given. The best of the choices offered is to talk to the clients about their financial needs and goals and then establish an investment plan to get them there, based on the funds that they have available for investment, their risk tolerance, investment time horizon, etc. While determining that the customers have (or will have) cash available for investment is part of the process, Choice C is the better answer. Also note that specific investments (Choices A and B) cannot be recommended until the investment plan is completed.
A 60-year old man seeks an investment that gives safety, liquidity and income. The BEST recommendation would be:
A. Short-term Treasury Note
B. Blue Chip Stock
C. Bank CD
D. Zero-Coupon Bond
The best answer is A.
This customer seeks safety, liquidity and income. Liquidity means that the customer can easily cash-out the investment. A zero-coupon bond gives no income, so we can rule that one out. A bank CD gives income but is not liquid, in the sense that it cannot be sold in the market. Of course, it can be redeemed with the bank issuer, but the customer typically loses a few months of interest to do so. A blue chip stock is liquid, but the dividend income is not as great as that provided by a fixed income security. A Treasury note gives a fixed rate of income and also is highly liquid. It also is AAA rated, so credit risk is minimal. It is the best choice, (though a good argument could also be made for a bank CD!).
A 60-year old man who is living on social security payments inherits $250,000. He seeks an investment that gives growth and income. The BEST recommendation would be to:
A. buy a municipal bond fund
B. write covered calls
C. buy Treasuries and zero-coupon bonds
D. buy stocks and bonds
The best answer is D.
This customer seeks growth and income. A municipal bond fund gives income, but because this customer is in a low tax bracket, municipals are not suitable. This customer, living on social security, may not be sophisticated enough to sell calls against long stock positions (covered call writing). Furthermore, the sale of covered calls gives income, but it does not give growth. If the stock price appreciates, those shares will be called away. Treasury securities give safety and income; however zero-coupon bonds, while they appreciate based on the discount yield at which they are purchased, do not give “growth.”
Only equities give growth and bonds give income, so Choice D is the best one offered. This customer should be recommended a portfolio that consists of 60% bonds for income (the customer’s age) and 40% stocks.
A 79-year old customer in the highest tax bracket with $1,000,000 to invest is risk averse. Which investment recommendation would be appropriate?
A. Money market funds
B. Municipal bonds
C. A Dow Jones Industrial Average index fund
D. Certificates of deposit
The best answer is B.
Since this customer is in the highest tax bracket, and appears to be wealthy (with $1,000,000 to invest), tax-free municipal bonds are the best recommendation.
