Portfolio Diversification Strategies Flashcards
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Read the first 7 Portfolio Diversification Strategies flashcards as text
Which of the following is a key limitation of Modern Portfolio Theory (MPT) in practice?
Answer: MPT assumes correlations and volatilities are stable over time, when in fact they shift
MPT relies on historical correlations and volatilities as inputs, but these parameters change over market cycles, making efficient frontiers unreliable guides in dynamic markets.
An investor wants to add an asset to their equity portfolio. All else equal, which candidate provides the greatest diversification benefit?
Answer: Asset with 0.10 correlation to the portfolio and 20% volatility
A low correlation (0.10) with the existing portfolio provides the greatest risk-reduction benefit, even if the asset itself is somewhat volatile.
What is 'tactical asset allocation' in the context of portfolio diversification?
Answer: Short-term, deliberate deviations from a strategic allocation based on market outlook
Tactical asset allocation involves temporarily adjusting the portfolio's mix to capitalize on perceived near-term opportunities or manage current risks, then returning to the strategic baseline.
A portfolio manager uses futures contracts on commodity indices to gain diversification. This technique is called:
Answer: Synthetic diversification
Using derivatives like futures to replicate the economic exposure of an asset class without directly owning it is called synthetic diversification.
When constructing a globally diversified portfolio, which risk remains even after holding equities from 50 different countries?
Answer: Currency risk for a USD-based investor
A U.S.-based investor holding foreign equities still faces currency risk from exchange rate fluctuations that affect the dollar value of those returns.
Which strategy involves systematically tilting a portfolio toward factors such as value, size, momentum, and quality?
Answer: Factor-based (smart beta) investing
Factor-based or smart beta investing targets specific return drivers (factors) that have historically delivered risk-adjusted premiums over market-cap-weighted benchmarks.
In the Markowitz efficient frontier framework, what does the 'minimum variance portfolio' represent?
Answer: The portfolio with the lowest possible risk for any level of return
The minimum variance portfolio is the point on the efficient frontier with the lowest standard deviation, regardless of expected return.