PFS Investment Planning 3 — Questions and Answers
Question 1: Which of the following best describes the efficient frontier in modern portfolio theory?
- Portfolios with the highest return for any given level of risk (Correct answer)
- Portfolios with the lowest risk regardless of return
- The set of portfolios offering maximum return for every level of expected return
- Only portfolios consisting of risk-free assets
Correct answer: Portfolios with the highest return for any given level of risk
The efficient frontier represents the set of optimal portfolios that offer the highest expected return for a defined level of risk.
Question 2: A client's IPS specifies a maximum portfolio standard deviation of 12%. A proposed portfolio has an expected return of 9% and standard deviation of 14%. What should the advisor do?
- Accept it because the return exceeds inflation
- Reject it because it violates the IPS risk constraint (Correct answer)
- Accept it if the Sharpe ratio is above 1.0
- Reduce equity allocation and accept lower expected return
Correct answer: Reject it because it violates the IPS risk constraint
The proposed portfolio violates the client's stated maximum risk tolerance of 12% standard deviation and must be rejected as written.
Question 3: What is the primary advantage of using exchange-traded funds (ETFs) over mutual funds for taxable accounts?
- ETFs always outperform mutual funds
- ETFs are exempt from capital gains taxes
- ETFs are generally more tax-efficient due to in-kind redemption mechanism (Correct answer)
- ETFs have no expense ratios
Correct answer: ETFs are generally more tax-efficient due to in-kind redemption mechanism
ETF in-kind redemptions allow the fund to avoid realizing capital gains that would otherwise be distributed to shareholders.
Question 4: A retiree relies on portfolio income. Which sequence of returns scenario is MOST damaging?
- Strong early returns followed by weak later returns
- Weak early returns followed by strong later returns (Correct answer)
- Consistent moderate returns throughout retirement
- High volatility with average returns equal to benchmark
Correct answer: Weak early returns followed by strong later returns
Poor returns early in retirement, combined with ongoing withdrawals, permanently deplete capital before markets recover—this is sequence-of-returns risk.
Question 5: When comparing two portfolios with the same Sharpe ratio, the Treynor ratio will differ if:
- They have different alphas
- They have different betas (Correct answer)
- They have different correlation to risk-free rate
- They have different expense ratios
Correct answer: They have different betas
The Treynor ratio uses beta (systematic risk) in the denominator instead of standard deviation, so portfolios with the same Sharpe but different betas will have different Treynor ratios.
Question 6: Which statement about real estate investment trusts (REITs) is MOST accurate?
- REITs must distribute at least 50% of taxable income to avoid corporate tax
- REITs provide inflation protection and must distribute at least 90% of taxable income (Correct answer)
- REIT dividends are always qualified and taxed at preferential rates
- REITs cannot be held in tax-advantaged accounts
Correct answer: REITs provide inflation protection and must distribute at least 90% of taxable income
To qualify as a REIT, the entity must distribute at least 90% of taxable income to shareholders and provide some inflation hedge through real property ownership.
Question 7: A client has $200,000 in concentrated employer stock. The MOST tax-efficient strategy to diversify without triggering immediate full taxation may be:
- Selling all shares and reinvesting in index funds
- Donating shares to charity and claiming a deduction
- Using a charitable remainder trust or exchange fund (Correct answer)
- Transferring shares to a Roth IRA
Correct answer: Using a charitable remainder trust or exchange fund
Exchange funds and charitable remainder trusts are established tax-efficient techniques to diversify out of concentrated positions while deferring or reducing capital gains recognition.
PFS Investment Planning 3
Which of the following best describes the efficient frontier in modern portfolio theory?