CFA Portfolio Management & Construction 3 — Questions and Answers
Question 1: A portfolio manager wants to reduce systematic risk without selling equity holdings. The most appropriate strategy is to:
- Increase the bond allocation
- Short equity index futures (Correct answer)
- Buy call options on individual stocks
- Increase cash holdings by redeeming bonds
Correct answer: Short equity index futures
Shorting equity index futures reduces market exposure (beta) without liquidating the underlying equity positions.
Question 2: Factor-based investing (smart beta) primarily seeks to:
- Replicate market-cap weighted index returns at zero cost
- Systematically capture documented risk premia such as value, size, and momentum (Correct answer)
- Eliminate all systematic risk through diversification
- Generate alpha purely through security selection
Correct answer: Systematically capture documented risk premia such as value, size, and momentum
Smart beta strategies systematically tilt portfolios toward factors (value, size, momentum, quality) that have historically provided return premia.
Question 3: The 'Black-Litterman' model improves on traditional MVO by:
- Eliminating the need for a risk-free rate
- Blending market equilibrium returns with investor views to generate stable return estimates (Correct answer)
- Requiring only historical return data as inputs
- Maximizing the information ratio rather than the Sharpe ratio
Correct answer: Blending market equilibrium returns with investor views to generate stable return estimates
Black-Litterman starts from market equilibrium (implied returns) and then blends in the manager's subjective views, reducing input sensitivity.
Question 4: In a multi-asset portfolio, which correlation scenario provides the greatest diversification benefit?
- Correlation of +1.0 between all assets
- Correlation of 0 between all assets
- Correlation of -1.0 between two assets (Correct answer)
- Correlation of +0.5 between all assets
Correct answer: Correlation of -1.0 between two assets
A perfect negative correlation of -1.0 between two assets allows complete risk elimination through proper weighting.
Question 5: Which of the following best describes 'tracking error' in portfolio management?
- The difference between the portfolio's alpha and beta
- The standard deviation of the portfolio's active returns relative to its benchmark (Correct answer)
- The total return minus the risk-free rate
- The maximum drawdown relative to the benchmark
Correct answer: The standard deviation of the portfolio's active returns relative to its benchmark
Tracking error is the standard deviation of (portfolio return − benchmark return), measuring how closely a portfolio follows its benchmark.
Question 6: When an endowment adopts the 'Yale Model' of portfolio management, it typically emphasizes:
- Heavy allocation to domestic large-cap equities and government bonds
- Broad diversification into alternative assets including private equity, hedge funds, and real assets (Correct answer)
- Market timing using tactical asset allocation overlays
- Minimizing illiquidity to preserve spending flexibility
Correct answer: Broad diversification into alternative assets including private equity, hedge funds, and real assets
The Yale Model (pioneered by David Swensen) favors illiquid alternative assets for their diversification and return premium over traditional stocks and bonds.
Question 7: A portfolio's beta is 1.3 and the market rises by 10%. Using the CAPM, the portfolio's expected excess return above the risk-free rate is approximately:
- 10%
- 13% (Correct answer)
- 3%
- 7.7%
Correct answer: 13%
Expected excess return = beta × market excess return = 1.3 × 10% = 13%.
CFA Portfolio Management & Construction 3
A portfolio manager wants to reduce systematic risk without selling equity holdings.
The most appropriate strategy is to: