Portfolio Management & Asset Allocation Flashcards

The Black-Litterman model improves on traditional mean-variance optimization primarily by:

Answer: Combining market equilibrium returns with investor views to reduce estimation error

Black-Litterman blends CAPM-implied equilibrium returns with the manager's specific views, producing more stable and intuitive portfolio weights than raw optimization.

A risk parity portfolio weights assets so that:

Answer: Each asset contributes an equal amount of risk to total portfolio risk

Risk parity equalizes each asset's marginal contribution to portfolio volatility, typically resulting in large allocations to low-risk assets like bonds and smaller equity allocations.

Which of the following describes 'factor investing' or 'smart beta' as an asset allocation approach?

Answer: Systematic exposure to return-driving factors like value, momentum, and quality

Factor or smart beta strategies systematically tilt portfolios toward well-documented return premia (value, size, momentum, quality, low volatility) using rules-based methodologies.

An investor has a high liquidity need and a short time horizon. Which asset allocation adjustment is most appropriate compared to an investor with low liquidity needs?

Answer: Shift toward liquid instruments such as short-duration bonds and money market funds

High liquidity needs require holding assets that can be quickly converted to cash without significant price impact, favoring short-duration and highly liquid instruments.

What is the primary disadvantage of mean-variance optimization when applied in practice?

Answer: It produces highly concentrated, unstable portfolios sensitive to small input changes

MVO is notoriously sensitive to expected return estimates; small estimation errors can lead to extreme, unintuitive portfolio weights that change drastically with minor input adjustments.

Which of the following is a key advantage of including Treasury Inflation-Protected Securities (TIPS) in a portfolio?

Answer: Their principal adjusts with CPI, providing explicit inflation protection

TIPS principal is indexed to CPI, so the real value of principal and coupon payments is preserved even as inflation erodes the purchasing power of nominal bonds.

In portfolio construction, 'tracking error' refers to:

Answer: The standard deviation of the difference between portfolio and benchmark returns

Tracking error quantifies how consistently a portfolio follows its benchmark; high tracking error indicates significant active deviation from the benchmark's return pattern.