Investment Policy & Portfolio Construction Flashcards

What is the primary purpose of an Investment Policy Statement (IPS)?

Answer: To communicate portfolio objectives and constraints

An Investment Policy Statement (IPS) is a crucial document that clearly outlines a client's investment philosophy, objectives, and constraints for their portfolio. Its primary purpose is to communicate the client's financial goals, risk tolerance, time horizon, and any specific restrictions or preferences. This ensures alignment between the client and the investment manager, guiding all investment decisions.

Which factor is most relevant when determining a client's risk tolerance?

Answer: Client's financial capacity and emotional attitude

When assessing a client's risk tolerance, it is paramount to consider both their financial capacity to absorb potential losses and their emotional attitude towards market fluctuations. Financial capacity refers to their ability to withstand losses without jeopardizing financial goals, while emotional attitude reflects their psychological comfort with risk. A comprehensive evaluation ensures the investment strategy aligns with both aspects of the client's risk profile.

What is strategic asset allocation primarily based on?

Answer: Long-term investor goals and risk profile

Strategic asset allocation is a long-term investment approach focused on establishing target allocations for various asset classes, such as stocks, bonds, and real estate. This strategy is primarily based on an investor's long-term goals, risk tolerance, and time horizon. It aims to create a diversified portfolio that aligns with the investor's fundamental characteristics, rather than reacting to short-term market conditions.

Which of the following best describes tactical asset allocation?

Answer: Short-term adjustments to take advantage of market conditions

Tactical asset allocation involves making deliberate, short-term deviations from a strategic asset allocation. This is done to capitalize on perceived temporary market inefficiencies or short-term opportunities, aiming to enhance returns or mitigate risks based on current market views. It contrasts with strategic allocation, which is long-term and fixed.

What is the main objective of portfolio diversification?

Answer: Reducing unsystematic risk

Portfolio diversification is the strategy of investing in a variety of assets to minimize risk. Its primary goal is to reduce unsystematic risk, also known as specific or idiosyncratic risk, which is unique to a particular company or industry. By combining different assets, the negative performance of one asset can be offset by the positive performance of another, thereby smoothing overall portfolio returns.

In portfolio construction, which metric measures the return relative to the risk taken?

Answer: Sharpe ratio

The Sharpe ratio is a widely used metric in finance to measure a portfolio's risk-adjusted return. It quantifies the amount of excess return (above the risk-free rate) generated per unit of total risk, as measured by standard deviation. A higher Sharpe ratio indicates better risk-adjusted performance, making it a key tool for comparing investment opportunities.