IAR Portfolio Management 2 — Questions and Answers
Question 1: Which portfolio management approach attempts to replicate the performance of a market index rather than outperform it?
- Active management
- Tactical asset allocation
- Passive management (Correct answer)
- Concentrated portfolio strategy
Correct answer: Passive management
Passive management (indexing) seeks to match index returns with minimal trading, based on the belief that markets are efficient and consistent outperformance is difficult.
Question 2: A client invests a fixed dollar amount in a mutual fund every month regardless of price. This strategy is known as:
- Value averaging
- Dollar-cost averaging (Correct answer)
- Tactical rebalancing
- Systematic market timing
Correct answer: Dollar-cost averaging
Dollar-cost averaging involves investing a fixed amount at regular intervals, automatically buying more shares when prices are low and fewer when prices are high.
Question 3: The Capital Market Line (CML) represents the risk-return trade-off for portfolios that combine:
- Two risky assets with negative correlation
- The risk-free asset and the market portfolio (Correct answer)
- High-yield bonds and investment-grade bonds
- Domestic equities and international equities
Correct answer: The risk-free asset and the market portfolio
The CML shows the expected return of efficient portfolios formed by combining the risk-free asset with the market portfolio, plotted against standard deviation.
Question 4: When two assets have a correlation coefficient of -1.0, combining them in a portfolio will:
- Double the portfolio's systematic risk
- Have no effect on portfolio volatility
- Potentially eliminate all portfolio risk at a certain weighting (Correct answer)
- Reduce expected return to zero
Correct answer: Potentially eliminate all portfolio risk at a certain weighting
A perfect negative correlation of -1.0 means the assets move in exactly opposite directions, and there exists a weighting that produces a portfolio with zero variance.
Question 5: Duration is a measure used primarily to assess which type of portfolio risk?
- Credit risk in equity portfolios
- A fixed-income portfolio's sensitivity to interest rate changes (Correct answer)
- The liquidity risk of small-cap holdings
- Currency risk in international bond portfolios
Correct answer: A fixed-income portfolio's sensitivity to interest rate changes
Duration measures how much a bond or bond portfolio's price will change in response to a change in interest rates; higher duration means greater interest rate sensitivity.
Question 6: Tax-loss harvesting in a portfolio management context involves:
- Selling appreciated securities to lock in capital gains
- Deferring dividend income into the next tax year
- Selling securities at a loss to offset capital gains and reduce tax liability (Correct answer)
- Moving assets into tax-exempt municipal bonds
Correct answer: Selling securities at a loss to offset capital gains and reduce tax liability
Tax-loss harvesting deliberately realizes losses on securities to offset taxable gains, reducing a client's current tax liability while maintaining overall market exposure.
Question 7: An adviser wants to reduce portfolio risk by adding an asset class. Which characteristic of the new asset would provide the GREATEST diversification benefit?
- High expected return
- Low correlation with existing portfolio holdings (Correct answer)
- High liquidity and low bid-ask spread
- A beta greater than 1.0 relative to the S&P 500
Correct answer: Low correlation with existing portfolio holdings
Diversification benefit is driven by correlation; adding an asset with low (or negative) correlation to existing holdings reduces overall portfolio volatility most effectively.
IAR Portfolio Management 2
Which portfolio management approach attempts to replicate the performance of a market index rather than outperform it?