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Reading 18 Asset Allocation with Real-World Constraints FinQuiz.com FinQuiz.com CFA Level III Item-set - Solution Study Session June 2018 Copyright © 2010-2018 FinQuiz.com All rights reserved Copying, reproduction or redistribution of this material is strictly prohibited info@finquiz.com FinQuiz.com © 2017 - All rights reserved Reading 18 Asset Allocation with Real-World Constraints FinQuiz.com FinQuiz Level III 2018 – Item-sets Solution Reading 18: Asset Allocation with Real-World Constraints Question ID: 134473 Correct Answer: A A is correct The asset allocation proposed for JM carries a high liquidity cost because a funding ratio which is less than 1.00 will require contributions from the plan sponsor to make up for any shortfall Therefore, including an illiquid asset class such as alternative investment securities in JM’s current asset allocation is inappropriate when liquidity is a significant constraint B is incorrect The asset allocation proposed for RC has lower short- and long-term contribution risk relative to JM because the duration of the bond portfolio is more closely matched to the time horizon of the plan’s liabilities and the equity allocation is higher C is incorrect A higher equity allocation supports a higher discount rate and therefore lower pension cost Relative to RC’s equity allocation (80%), JM’s equity allocation is lower (50%) and entails lower pension cost Question ID: 134474 Correct Answer: B Item has failed to consider the difference between JM’s and RC’s asset size when proposing an increase in allocation to alternative investments RC is a smaller investor, with an asset base of $25 million, and a direct investment to the asset class may be constrained by this factor Reid should consider recommending an indirect allocation to alternative investments via commingled funds which considers the pension fund’s circumstances and constraints Question ID: 134475 Correct Answer: C Reid is correct regarding Conclusion and Although high-yield and investment grade bonds have high tax rates relative to equities, their respective low correlations with the asset class (0.1 and – 0.5) will mean that the two bonds will generate diversification benefits for the taxable account comprising equities Correlation assumptions need not be adjusted when modeling asset allocation choices for the taxable asset owner However, taxes affect the standard deviation assumptions for each asset class by truncating both the high and low ends of the distribution of returns FinQuiz.com © 2017 - All rights reserved Reading 18 Asset Allocation with Real-World Constraints FinQuiz.com Question ID: 134476 Correct Answer: A A is correct To compare the impact of taxes on asset class volatility, the ratio of expected after-tax volatility should be compared to expected pre-tax volatility Expected post-tax volatility = Expected pre-tax standard deviation × (1 – tax rate) Expected post-tax volatility: IG bonds = 18% (1 – 0.50) = 9.0% HY bonds = 19% (1 – 0.50) = 9.5% Equities = 25% (1 – 0.30) = 17.5% Relative volatility: IG bonds = 9.0%/18.0% = 0.50 HY bonds = 9.5%/19.0% = 0.50 Equities = 17.5%/25.0% = 0.70 The relative volatility of equities is highest signaling that the after-tax volatility is least affected by taxes compared to the other two asset classes Question ID: 134477 Correct Answer: C Prior to determining which asset class requires rebalancing, the pre-tax rebalancing range needs to be adjusted for taxes as follows: After-tax rebalancing range = Pre-tax rebalancing range/(1 – tax rate) After-tax rebalancing range: Equities = 5%/(1 – 0.30) = 7.14% Bonds = 10%/(1 – 0.50) = 20.00% Alternative investments = 5%/(1 – 0.25) = 6.67% The minimum and maximum after-tax limits for alternative investments are 26.67% (10.00% – 6.67%) and 16.67% (10.00% + 6.67%), respectively, and an allocation of 32% to this asset class is outside this range The minimum and maximum after-tax limits for bonds are 20% (40% – 20%) and 60% (40% + 20%), respectively, and an allocation of 32% to this asset class is well within range The minimum and maximum after-tax limits for equities are 42.86% (50.00% – 7.14%) and 57.14% (50.00% + 7.14%), respectively, and an allocation of 43% to this asset class is well within range FinQuiz.com © 2017 - All rights reserved Reading 18 Asset Allocation with Real-World Constraints FinQuiz.com Question ID: 134477 Correct Answer: C C is correct Reid is subject to representativeness bias as evident from his ignorance of the asset class’s historical volatility record and focus on the most recent returns when considering an increase in allocation to the asset class Return chasing is a common manifestation of representative bias and results in overweighting asset classes with good recent performance A is incorrect Availability bias is an information processing bias in which people estimate the probability of an event based on how easily the outcome comes to mind Easily recalled outcomes are perceived as being more likely than those that are harder to recall or understand Reid is not subject to this bias B is incorrect The illusion of control bias involves a tendency to overestimate one’s ability to control events There is little evidence that Reid is subject to an overconfidence bias such as the illusion of control bias FinQuiz.com © 2017 - All rights reserved .. .Reading 18 Asset Allocation with Real-World Constraints FinQuiz. com FinQuiz Level III 2 018 – Item- sets Solution Reading 18: Asset Allocation with Real-World Constraints Question ID: 134 4 73. .. allocation of 43% to this asset class is well within range FinQuiz. com © 2017 - All rights reserved Reading 18 Asset Allocation with Real-World Constraints FinQuiz. com Question ID: 134 477 Correct... of the distribution of returns FinQuiz. com © 2017 - All rights reserved Reading 18 Asset Allocation with Real-World Constraints FinQuiz. com Question ID: 134 476 Correct Answer: A A is correct
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