Asset Allocation Flashcards

Which asset allocation approach involves setting fixed target weights for each asset class and periodically rebalancing back to those targets?

Answer: Strategic asset allocation

Strategic asset allocation establishes long-term target weights based on an investor's objectives and risk tolerance, with periodic rebalancing to maintain those targets.

Tactical asset allocation (TAA) differs from strategic asset allocation primarily in that TAA:

Answer: Makes short-term deviations from strategic weights based on market views

Tactical asset allocation involves deliberately deviating from strategic weights in the short term to exploit perceived market mispricings or macroeconomic opportunities.

In the context of asset allocation, which method uses expected returns, variances, and covariances to identify the optimal portfolio on the efficient frontier?

Answer: Mean-variance optimization (MVO)

Mean-variance optimization, developed by Markowitz, uses expected returns, variances, and pairwise covariances to construct portfolios that maximize return for a given level of risk.

A major limitation of mean-variance optimization is that it:

Answer: Is highly sensitive to small changes in input estimates

MVO is notoriously sensitive to input estimates; small changes in expected returns or covariances can produce dramatically different optimal allocations, often leading to extreme, concentrated portfolios.

The Black-Litterman model improves on traditional MVO by:

Answer: Combining market equilibrium returns with investor views

Black-Litterman blends implied equilibrium returns (derived from market capitalization weights) with the investor's own views, producing more stable and intuitive optimal portfolios.

Which of the following best describes a 'risk parity' asset allocation approach?

Answer: Allocating capital so each asset class contributes equally to total portfolio risk

Risk parity allocates capital such that each asset class contributes equally to overall portfolio risk, typically resulting in higher allocations to lower-volatility assets like bonds.

When constructing an Investment Policy Statement (IPS), which of the following should be established FIRST before determining asset allocation?

Answer: Identifying the investor's objectives and constraints

An IPS must first capture the client's return objectives, risk tolerance, time horizon, liquidity needs, tax situation, legal constraints, and unique circumstances before any asset allocation decision is made.