Reading 17 Principles of Asset Allocation FinQuiz.com FinQuiz.com CFA Level III Item-set - Solution Study Session June 2017 Copyright © 2010-2017 FinQuiz.com All rights reserved Copying, reproduction or redistribution of this material is strictly prohibited info@finquiz.com FinQuiz.com © 2018 - All rights reserved Reading 17 Principles of Asset Allocation FinQuiz.com FinQuiz Level III 2017 – Item-sets Solution Reading 17: Principles of Asset Allocation Question ID: 134420 Correct Answer: B B is correct The traditional MVO framework incorporates an investor’s risk aversion coefficient as an input component for deriving an allocation’s expected utility and seeks to identify the allocation which maximizes utility for a given level of risk aversion Therefore, the risk tolerance of the investor is incorporated in this approach A is incorrect MVO tends to be highly concentrated in a subset of available asset classes and therefore leads to poorly diversified asset allocations C is incorrect A drawback of Markowitz’s MVO approach is that it is a single-period model which fails to consider the impact of rebalancing a portfolio over multiple periods with respect to rebalancing costs and taxes Question ID: 134421 Correct Answer: A A is correct A drawback of using investment vehicles when fulfilling the potential strategic asset allocation is that there are no low-cost passive investment vehicles to track the aggregate performance of less liquid asset classes Therefore, the strategy is costly to implement C is incorrect The risk and return characteristics of private equity funds is significantly different from the characteristics of the asset classes they are intending to represent which implies a low correlation between the investment vehicle and asset class Question ID: 134422 Correct Answer: C C is correct A portfolio model requires multiple periods if rebalancing decisions are directly incorporated into the model In this regard, an integrated asset-liability approach is appropriate given Gill’s requirement to consider rebalancing costs and taxes in the asset allocation framework On the other hand, both the surplus optimization and hedging/return-seeking portfolio approach rely on single-period models for deriving the strategic asset allocation A is incorrect A surplus optimization approach is applicable to investors with any level of risk aversion and funding ratio However, as mentioned above, the approach is a single-period model which fails to consider the multi-period implications of rebalancing on an asset allocation B is incorrect The hedging/return seeking portfolio approach is only appropriate for conservative investors and overfunded/fully funded investors that can fully hedge their liabilities Given the underfunded nature of Paulus Manufacturing’s pension plan, the investor cannot create a fully hedging portfolio unless there is a significantly large positive cash flow Since there are no current sponsor contributions, this approach is unsuitable FinQuiz.com © 2018 - All rights reserved Reading 17 Principles of Asset Allocation FinQuiz.com Question ID: 134423 Correct Answer: B B is correct Given the ongoing nature of the pension plan and the fact that it is open to new participants, inflation will be a factor which influences the growing pension plan’s liabilities The asset allocation design is flawed because it lacks an allocation to asset categories that are positively correlated with the underlying risk factors Gill should consider the addition of inflation-linked bonds as opposed to 25-year Treasuries which not adequately hedge the plan’s liabilities A is incorrect The asset allocation is adequately diversified as there is an allocation to a variety of asset class categories C is incorrect An extremely high allocation to high growth asset classes such as private equity or even hedge funds is inappropriate given the risk tolerance and underfunded nature of the pension plan The focus of the plan sponsor should be to generate sufficient cash flow from portfolio investments so that the plan shifts to a fully or slightly overfunded status and the sponsor is not required to make any future contributions to the plan Therefore, a moderate allocation to high growth assets is more suitable Question ID: 134424 Correct Answer: B B is correct Gill is incorrect with respect to her comments A factor-based allocation can be implemented with any of the three liability-relative approaches – surplus optimization, hedging/return-seeking portfolio, and integrated asset-liability approach Question ID: 134425 Correct Answer: The overall corridor width should be increased due to the following reasons: An increase in the correlation between domestic equities and the rest of the portfolio will increase the tendency of the asset class to move in sync with the portfolio and will decrease the probability of further divergence from target weights The higher the correlation, the wider the optimal corridor An increase in volatility will increase the frequency of divergence of an asset class from its target weight which should require a narrow corridor However, a narrow corridor implies more frequent rebalancing which will lead to higher rebalancing costs To keep rebalancing costs low, higher volatility calls for a wider optimal corridor FinQuiz.com © 2018 - All rights reserved .. .Reading 17 Principles of Asset Allocation FinQuiz. com FinQuiz Level III 2 017 – Item- sets Solution Reading 17: Principles of Asset Allocation Question ID: 134 420 Correct Answer:... contributions, this approach is unsuitable FinQuiz. com © 2018 - All rights reserved Reading 17 Principles of Asset Allocation FinQuiz. com Question ID: 134 4 23 Correct Answer: B B is correct Given... the characteristics of the asset classes they are intending to represent which implies a low correlation between the investment vehicle and asset class Question ID: 134 422 Correct Answer: C C