Reading 5

Question 1

Comingled Investment Accounts

Answer 1

Pooling of money from a small group if investors. May be used by smaller funds to reach adequate size to diversify

Question 2

SWF potential limitations for self-governance

Answer 2

1. minimum investment requirements in socially or ethically acceptable assets
2. maximum investments in risky assets such as alternative investments
3. limits on investment allowed in certain currencies

Question 3

Ways in which current market value can be adjusted to reflect embedded tax liability or asset

Answer 3

1. subtract the value of the embedded capital gains tax from the current market value of the asset as if it were to be sold today.
2. assume the asset is to be sold in the future and discount the tax liability to its PV using the asset’s after tax return as a discount rate
3. assume the asset is to be sold in the future and discount the tax liability to its PV using after tax risk free rate

Question 4

After tax standard deviation of return

Answer 4

Std Dev * (1-tax rate)

Question 5

Rebalancing for taxable portfolios

Answer 5

should be less frequent due to reduction in volatility caused by taxation, while correlations remain unaltered.

Question 6

Acceptable rebalancing range after tax

Answer 6

allowable deviation from target = pre-tax deviation/ (1-t) –> usually higher deviation allowed

Question 7

Strategies to reduce implication of taxes

Answer 7

1. tax loss harvesting
2. strategic asset allocation - TEA and TDA

Question 8

Taxes and choice of accounts

Answer 8

1. assets subject to lowest tax rates (typically equity) should be first allocated to taxable accounts
2. assets subject to frequent trading and high tax rates should be allocated to tax advantaged accounts

Question 9

Tactical Asset Allocation (TAA)

Answer 9

short term deviations typically used to take advantage of cyclical conditions in the market or perceived mispricing in given asset class. assumed short term returns are prectiable rather than a random walk as for long term returns and its success is dependent on market or factor timing, not individual security selection. TAA will take into account risk constraint in the investment polict statement but will not consider specific goals or liabilities

Question 10

gauging market sentiment trough margin borrowing

Answer 10

increasing purchases on margin drives up prices and indicates inevstors are bullish, although if the level of margin buying gets too high, it can be a bearish sign and indicates investors are overenthusiastic

Question 11

short interest - aggregate amount of short selling as an indicator of market sentiment

Answer 11

increasing short interest drives down prices and indicates investors are bearish, although very high levels could indicate market is at or near a low

Question 12

volatility indices as a gauge of market sentiment

Answer 12

indicate level of fear int he market. can be calculated using bid-ask spread in index options. increases with more purchases of puts and decreases with more purchases of calls.

Question 13

momentum strategy

Answer 13

assumed that trends will persist, which is why recent price movements are used to indicate whether to overweight or underweight an asset class.

Question 14

momentum strategy indicators

Answer 14

1. most recent 12 month trend: a momentum strategy assumed this trend will persist for next 12 months
2. moving average crossover: shorter-term moving averages crossing above longer term moving averages indicates an uptrend and vice versa

Question 15

Recency Bias

Answer 15

when investors attach more importance to recent data than old data –> shift allocations to assets that have performed well recently

Question 16

framing bias

Answer 16

when the way information is presented affects the resulting decision.

Question 17

Are tax deferred portfolios rebalanced more or less frequently than taxable portfolios?

Answer 17

after tax volatility is lower than pre-tax return volatility, so it takes larger asset-class movements to materially alter the risk profile of a taxable portfolio. This suggests that rebalancing ranges for a taxable portfolio can be wider than those of a tax-exempt or deferred portfolio with a similar risk profile, this rebalancing occurs less frequently

Question 18

Which bias does an investor exhibit when they are unwilling to take money out of stocks because stocks have performed well recently?

Answer 18

Representative bias: tendency to overweight the importance of the most recent observations and information relative to a longer-dated or more comprehensive set of long-term observations and information. Return chasing is a common result of the bias, and it results in overweighting asset classes with strong recent performance.

Question 19

Systematic Tactical Asset Allocation

Answer 19

Using rules-based, quantitative signals, systematic tactical asset allocation attempts to capture asset-class level return anomalies that have been shown to have some predictability and persistence. Trend signals are widely used in systematic TAA. A moving-average crossover is a trend signal that indicates an upward (downward) trend when the moving average of the shorter time frame, 50 days is above (below) the moving average of the longer time frame, 200 days.

Question 20

Name a suitable measure for measuring the success of TAA versus SAA?

Answer 20

Sharpe Ratio

The success of TAA decisions can be evaluated by comparing the Sharpe ratio realized under the TAA with the Sharpe ratio that would have been realized under SAA.

Question 21

Can TAA go above upper and lower bounds of SAA asset allocation limits?

Answer 21

No

Question 22

Client says they do not want to allocate assets to EM equity because the family recently suffered losses. Which behavioral bias is this?

Answer 22

Availability bias: information-processing bias in which people take a mental shortcut when estimating the probability of an outcome based on how easily the outcome comes to mind.

Investors who personally experience an adverse event are likely to assign a higher probability to such an event occurring again

Question 23

If someone has separate accounts for unexpected needs, children’s education, retirement, etc. which bias is this?

Answer 23

under mental accounting bias, people treat one sum of money differently from another sum based solely on the mental account to which the money is assigned. In doing mental accounting, they set themselves up for the possibility of sub-optimal allocation by seeing accounts separately.

Question 24

Should you have wider or narrower corridor width of risky asset classes if transaction costs are a concern?

Answer 24

Theoretically, higher risk assets would warrant a narrow corridor because high-risk assets are more likely to stray from the desired strategic asset allocation. However, narrower corridors will likely result in more frequent rebalancing and increased transaction costs, so in practice corridor width is often specified to be proportionally greater the higher the asset class’s volatility. thus, higher risk assets should have a wider corridor to avoid frequent, costly rebalancing costs,

Question 25

Should less liquid assets have wider or narrower rebalancing corridors?

Answer 25

wider, to avoid frequent, costly rebalancing costs.

Question 26

Müller uses a risk parity asset allocation approach with a client’s four–asset class portfolio. The expected return of the domestic bond asset class is the lowest of the asset classes, and the returns of the domestic bond asset class have the lowest covariance with other asset class returns. Müller estimates the weight that should be placed on domestic bonds.

Answer 26

A risk parity asset allocation is based on the notion that each asset class should contribute equally to the total risk of the portfolio. Bonds have the lowest risk level and must contribute 25% of the portfolio’s total risk, so bonds must be overweight (greater than 25%)

Question 27

Yale model emphasizes traditional investments and a commitment to active management - true or false?

Answer 27

False

Yale model emphasizes investing in alternative assets (such as hedge funds, private equity and real estate) as opposed to investing in traditional asset classes like stocks and bonds

Question 28

Client’s asset allocation using 1/N rule depends on the investment characteristics of each asset class. true or false?

Answer 28

false.

The 1/N rule allocates an equal weight to each asset without regard to its investment characteristics, treating all assets as indistinguishable in terms of mean returns, volatility and correlations