IFC Constructing Investment Portfolios 5 — Questions and Answers
Question 1: Which of the following scenarios best illustrates the concept of 'sequence of returns risk'?
- A young investor experiences strong early returns followed by poor later returns
- A retiree experiences poor early returns while making withdrawals, depleting capital faster (Correct answer)
- A portfolio generates the same average return each year
- An investor reinvests dividends automatically over 30 years
Correct answer: A retiree experiences poor early returns while making withdrawals, depleting capital faster
Sequence of returns risk is most damaging in retirement when early poor performance combined with withdrawals permanently reduces the portfolio base, limiting recovery even if later returns improve.
Question 2: A portfolio manager is evaluating two funds with identical returns. Fund A has a Sharpe ratio of 0.9 and Fund B has a Sharpe ratio of 0.6. What can be concluded?
- Fund A took more risk to achieve the same return
- Fund A is more efficient — it earned more return per unit of risk (Correct answer)
- Fund B had lower management fees
- Fund B has a higher alpha
Correct answer: Fund A is more efficient — it earned more return per unit of risk
A higher Sharpe ratio means better risk-adjusted performance; Fund A generated the same return with less total volatility, making it the more efficient portfolio.
Question 3: Which of the following is an example of a quantitative constraint that might appear in an Investment Policy Statement?
- The client prefers ethical investing
- No single equity position shall exceed 5% of the total portfolio (Correct answer)
- The client wants to retire in 15 years
- The client has moderate risk tolerance
Correct answer: No single equity position shall exceed 5% of the total portfolio
A maximum position size limit (e.g., 5% cap per holding) is a specific, measurable constraint that restricts concentration risk in the IPS.
Question 4: In portfolio construction, what is the main purpose of including alternative investments such as infrastructure or private equity?
- To eliminate all equity risk from the portfolio
- To provide return streams with low correlation to traditional stocks and bonds (Correct answer)
- To guarantee capital preservation
- To reduce the portfolio's MER
Correct answer: To provide return streams with low correlation to traditional stocks and bonds
Alternatives often have low correlation with public equities and bonds, providing diversification and potentially improving the portfolio's overall risk-adjusted return.
Question 5: A client's liquidity constraint means a portfolio manager should:
- Maximize the allocation to illiquid private placements
- Ensure sufficient liquid assets are available to meet near-term cash needs (Correct answer)
- Avoid fixed-income securities entirely
- Concentrate holdings in a single highly liquid stock
Correct answer: Ensure sufficient liquid assets are available to meet near-term cash needs
A liquidity constraint requires the manager to maintain enough easily sellable assets to fund the client's anticipated cash outflows without forced selling at a loss.
Question 6: Which of the following best describes 'dollar-cost averaging' as a portfolio construction technique?
- Investing a lump sum at market highs to maximise units purchased
- Investing a fixed dollar amount at regular intervals regardless of market price (Correct answer)
- Buying more securities when prices are high and fewer when prices are low
- Rebalancing the portfolio to target weights once per year
Correct answer: Investing a fixed dollar amount at regular intervals regardless of market price
Dollar-cost averaging involves committing a fixed amount at regular intervals, automatically purchasing more units when prices are low and fewer when prices are high.
Question 7: When a Canadian investor holds foreign equities in a non-registered account, which additional risk factor must be considered in portfolio construction?
- Inflation risk
- Currency (foreign exchange) risk (Correct answer)
- Liquidity risk
- Interest rate risk
Correct answer: Currency (foreign exchange) risk
Foreign equity holdings expose non-registered account investors to currency risk, as fluctuations in the CAD relative to foreign currencies affect the Canadian-dollar value of returns.
IFC Constructing Investment Portfolios 5
Which of the following scenarios best illustrates the concept of 'sequence of returns risk'?