CIC Portfolio Management & Asset Allocation 4 — Questions and Answers
Question 1: A pension fund must pay $50 million in liabilities in 10 years. Which strategy BEST ensures assets will meet this obligation regardless of interest rate movements?
- Cash-flow matching (dedication) (Correct answer)
- Tactical asset allocation
- Constant-proportion portfolio insurance
- Buy-and-hold equity investing
Correct answer: Cash-flow matching (dedication)
Cash-flow matching (dedication) purchases bonds whose coupon and principal payments exactly match the liability schedule, eliminating interest rate risk for known obligations.
Question 2: What is the primary purpose of a policy asset allocation (strategic asset allocation) in an IPS?
- To specify the exact securities to purchase each quarter
- To establish long-term target weights reflecting the client's risk/return objectives (Correct answer)
- To allow managers to deviate widely from benchmarks based on short-term views
- To determine the tax-loss harvesting schedule
Correct answer: To establish long-term target weights reflecting the client's risk/return objectives
Strategic (policy) asset allocation sets long-term target weights for asset classes based on the client's goals, risk tolerance, and time horizon.
Question 3: Which measure adjusts portfolio return for market risk (beta) rather than total risk, making it useful for comparing non-diversified portfolios or individual securities?
- Sharpe ratio
- Treynor ratio (Correct answer)
- Information ratio
- Sortino ratio
Correct answer: Treynor ratio
The Treynor ratio divides excess return by beta (systematic risk), making it appropriate for evaluating components within a larger diversified portfolio.
Question 4: An investor increases gold and TIPS allocations prior to expected inflation spikes. This is an example of:
- Strategic asset allocation
- Liability matching
- Tactical asset allocation using inflation hedges (Correct answer)
- Passive indexing
Correct answer: Tactical asset allocation using inflation hedges
Overweighting inflation-sensitive assets in anticipation of rising inflation is a tactical deviation from the strategic benchmark to hedge a specific macro risk.
Question 5: The Sortino ratio improves on the Sharpe ratio for asymmetric return distributions by:
- Replacing standard deviation with beta in the denominator
- Using only downside deviation (below a minimum acceptable return) in the denominator (Correct answer)
- Adding skewness to the numerator
- Annualizing returns before dividing by risk
Correct answer: Using only downside deviation (below a minimum acceptable return) in the denominator
The Sortino ratio penalizes only downside volatility (below the MAR), making it more appropriate when the return distribution is skewed.
Question 6: Which of the following BEST explains why adding a low-correlation asset to a portfolio can reduce total portfolio risk even if the asset itself has higher standalone volatility?
- Diversification eliminates all systematic risk
- The covariance effect can outweigh the asset's own variance contribution (Correct answer)
- Higher volatility assets always produce higher returns to compensate
- Portfolio risk equals the weighted average of individual asset risks
Correct answer: The covariance effect can outweigh the asset's own variance contribution
When correlation is sufficiently low, the negative covariance contribution can reduce overall portfolio variance even if the new asset has high individual volatility.
Question 7: A client with a 2-year investment horizon is MOST appropriately suited to which asset allocation?
- 100% small-cap equities for maximum growth
- A predominantly fixed-income, capital-preservation portfolio (Correct answer)
- A 60/40 equity/bond allocation identical to a 30-year-old's
- 100% alternatives for diversification benefits
Correct answer: A predominantly fixed-income, capital-preservation portfolio
A short 2-year horizon limits the time available to recover from equity losses, making capital preservation through fixed income most appropriate.
CIC Portfolio Management & Asset Allocation 4
A pension fund must pay $50 million in liabilities in 10 years.
Which strategy BEST ensures assets will meet this obligation regardless of interest rate movements?