AIP Portfolio Management & Asset Allocation 3 — Questions and Answers
Question 1: A pension fund must match future liabilities with asset cash flows. This approach is best described as:
- Growth-oriented allocation
- Liability-driven investing (LDI) (Correct answer)
- Momentum-based tactical allocation
- Satellite-only strategy
Correct answer: Liability-driven investing (LDI)
Liability-driven investing structures the portfolio to hedge against changes in liability values, ensuring assets track or exceed future obligations.
Question 2: Which of the following best explains why adding an asset with low correlation to a portfolio can reduce overall portfolio risk?
- It increases expected return proportionally
- Diversification benefits arise when asset returns do not move in lockstep (Correct answer)
- Low-correlation assets always have lower individual risk
- It eliminates systematic risk entirely
Correct answer: Diversification benefits arise when asset returns do not move in lockstep
Modern portfolio theory shows that combining assets with low or negative correlations reduces portfolio variance even if individual asset risks remain unchanged.
Question 3: An investor's policy statement specifies a maximum portfolio drawdown of 15%. Which portfolio construction tool directly addresses this constraint?
- Mean-variance optimization ignoring drawdown
- Value at Risk (VaR) and drawdown-constrained optimization (Correct answer)
- Equal-weight allocation
- Single-factor beta targeting
Correct answer: Value at Risk (VaR) and drawdown-constrained optimization
Drawdown-constrained optimization and VaR-based frameworks explicitly limit worst-case losses, directly implementing the investor's stated risk tolerance.
Question 4: Which factor in the Fama-French three-factor model explains the tendency of small-cap stocks to outperform large-cap stocks over time?
- HML (High Minus Low)
- SMB (Small Minus Big) (Correct answer)
- MOM (Momentum)
- BAB (Betting Against Beta)
Correct answer: SMB (Small Minus Big)
The SMB factor captures the size premium, reflecting the historical tendency of small-capitalization stocks to generate higher returns than large-cap stocks.
Question 5: A portfolio has an expected return of 10% and a standard deviation of 12%. The risk-free rate is 2%. What is its Sharpe ratio?
- 0.50
- 0.67 (Correct answer)
- 0.83
- 1.25
Correct answer: 0.67
Sharpe ratio = (10% - 2%) / 12% = 8% / 12% = 0.67, representing the excess return earned per unit of total risk.
Question 6: In mean-variance optimization, what is the 'efficient frontier'?
- The set of all possible portfolios plotted in risk-return space
- The set of portfolios offering maximum return for each level of risk (Correct answer)
- A line connecting the risk-free asset to the market portfolio
- The minimum variance portfolio only
Correct answer: The set of portfolios offering maximum return for each level of risk
The efficient frontier represents the upper boundary of the feasible set, containing portfolios with the highest expected return for each given level of standard deviation.
Question 7: Which alternative investment class is most commonly used to provide inflation protection and low correlation to traditional equity and bond portfolios?
- Hedge funds using long/short equity
- Real assets such as commodities and real estate (Correct answer)
- Private equity buyout funds
- Short-duration fixed income
Correct answer: Real assets such as commodities and real estate
Real assets like commodities and real estate tend to appreciate with inflation and have low correlations to stocks and bonds, making them effective portfolio diversifiers.
AIP Portfolio Management & Asset Allocation 3
A pension fund must match future liabilities with asset cash flows.
This approach is best described as: