STEP Portfolio Management & Strategy 3 — Questions and Answers
Question 1: Which of the following best describes the 'Prudent Investor' standard as it applies to trust portfolio delegation?
- Trustees may never delegate investment functions to third parties
- Trustees may delegate investment management if they exercise care in selecting and supervising the agent (Correct answer)
- Delegation absolves the trustee of all liability for portfolio outcomes
- Only corporate trustees are permitted to delegate investment decisions
Correct answer: Trustees may delegate investment management if they exercise care in selecting and supervising the agent
Under the UPIA, trustees may delegate investment functions to agents, but must exercise prudence in selecting, establishing scope for, and monitoring the delegated agent.
Question 2: A trustee is evaluating whether to invest trust assets in private equity. Which factor is MOST important from a fiduciary perspective before making this allocation?
- Whether the trustee personally invests in private equity
- Whether the investment's illiquidity and risk are appropriate given the trust's distribution needs (Correct answer)
- Whether private equity has outperformed public markets in recent years
- Whether other trustees in the jurisdiction hold private equity
Correct answer: Whether the investment's illiquidity and risk are appropriate given the trust's distribution needs
Private equity's illiquidity and risk profile must be evaluated in the context of the trust's specific distribution requirements and overall investment strategy before allocation.
Question 3: In portfolio management, 'duration' is primarily used to measure a bond portfolio's sensitivity to:
- Credit rating changes
- Equity market movements
- Interest rate changes (Correct answer)
- Currency fluctuations
Correct answer: Interest rate changes
Duration measures the sensitivity of a bond's price to changes in interest rates; a higher duration indicates greater price volatility for a given interest rate change.
Question 4: A trust portfolio includes both US equities and international bonds denominated in foreign currencies. The trustee wants to reduce currency exposure without liquidating positions. The appropriate strategy is:
- Convert all international bonds to US dollar-denominated equivalents
- Use currency forward contracts or currency hedges to offset foreign exchange risk (Correct answer)
- Allocate only to domestic assets going forward
- Accept currency risk as an unavoidable component of international investing
Correct answer: Use currency forward contracts or currency hedges to offset foreign exchange risk
Currency forward contracts or hedging instruments allow the trustee to reduce foreign exchange exposure while maintaining the desired portfolio composition.
Question 5: Which portfolio construction concept states that combining assets with low or negative correlations reduces overall portfolio risk?
- Capital Asset Pricing Model (CAPM)
- Modern Portfolio Theory (MPT) (Correct answer)
- Efficient Market Hypothesis (EMH)
- Arbitrage Pricing Theory (APT)
Correct answer: Modern Portfolio Theory (MPT)
Modern Portfolio Theory, developed by Markowitz, demonstrates that combining assets with low or negative correlations can reduce portfolio risk without sacrificing expected return.
Question 6: A STEP practitioner reviews a trust's portfolio and finds that the manager has been trading frequently, generating significant transaction costs. From a fiduciary perspective, this primarily raises concern about:
- Market timing ability
- Violation of the trustee's duty of loyalty
- Excessive costs undermining the portfolio's net return (Correct answer)
- Inadequate diversification
Correct answer: Excessive costs undermining the portfolio's net return
Excessive transaction costs from frequent trading can erode net returns, which is a fiduciary concern because trustees must manage portfolio costs as part of their duty of prudence.
Question 7: Which benchmark type is most appropriate for evaluating the performance of a trust's diversified multi-asset portfolio?
- A single-index benchmark such as the S&P 500 alone
- A blended benchmark matching the portfolio's target asset allocation (Correct answer)
- The risk-free Treasury bill rate only
- The portfolio manager's personal return target
Correct answer: A blended benchmark matching the portfolio's target asset allocation
A blended benchmark that mirrors the portfolio's target asset allocation is the most appropriate comparison because it reflects the actual investment policy and risk profile of the portfolio.
STEP Portfolio Management & Strategy 3
Which of the following best describes the 'Prudent Investor' standard as it applies to trust portfolio delegation?