WMS Portfolio Management & Strategy 3 — Questions and Answers
Question 1: A portfolio manager identifies that small-cap value stocks have historically outperformed the market. This phenomenon is best explained by which framework?
- Capital Asset Pricing Model (CAPM)
- Fama-French Three-Factor Model (Correct answer)
- Efficient Market Hypothesis
- Arbitrage Pricing Theory (single factor)
Correct answer: Fama-French Three-Factor Model
The Fama-French Three-Factor Model adds size (SMB) and value (HML) factors to the market factor to explain cross-sectional return differences.
Question 2: An endowment uses the Yale model. Which allocation is most consistent with this approach?
- 60% U.S. equities, 40% investment-grade bonds
- Heavy allocation to private equity, hedge funds, and real assets (Correct answer)
- 100% passive index funds to minimize costs
- Short-term money market instruments for safety
Correct answer: Heavy allocation to private equity, hedge funds, and real assets
The Yale model emphasizes illiquid alternative assets—private equity, real assets, and absolute return strategies—to capture illiquidity premiums.
Question 3: Which risk measure captures only downside volatility, making it preferred by investors concerned with losses rather than gains?
- Standard deviation
- Beta
- Semi-deviation (downside deviation) (Correct answer)
- Tracking error
Correct answer: Semi-deviation (downside deviation)
Semi-deviation measures volatility of returns below a target (often zero or the mean), focusing solely on the downside investors want to avoid.
Question 4: A wealth manager employs a 'barbell' fixed-income strategy. This means the portfolio is concentrated in:
- Intermediate-duration bonds exclusively
- Short-duration and long-duration bonds with little in the middle (Correct answer)
- Only floating-rate notes to manage interest rate risk
- Investment-grade corporate bonds across all maturities
Correct answer: Short-duration and long-duration bonds with little in the middle
A barbell strategy combines very short-term and very long-term bonds, avoiding the middle of the yield curve to balance liquidity and yield.
Question 5: Which of the following best describes the information ratio (IR)?
- Excess return per unit of total portfolio risk
- Active return divided by tracking error (Correct answer)
- Portfolio return minus the risk-free rate, divided by beta
- The ratio of winning trades to total trades
Correct answer: Active return divided by tracking error
The information ratio measures a manager's active return (alpha) per unit of active risk (tracking error), assessing consistency of outperformance.
Question 6: In Monte Carlo simulation for retirement planning, the primary output used to evaluate plan viability is:
- The single median projected portfolio value
- The probability of achieving financial goals across thousands of scenarios (Correct answer)
- The worst-case single scenario outcome
- The arithmetic mean return across all simulations
Correct answer: The probability of achieving financial goals across thousands of scenarios
Monte Carlo simulation generates probability distributions across many scenarios, and the success rate (probability of not running out of money) is the key planning metric.
Question 7: A portfolio has a Jensen's alpha of +2.5%. This means the portfolio:
- Underperformed the risk-free rate by 2.5%
- Outperformed the return predicted by CAPM by 2.5% (Correct answer)
- Had a tracking error of 2.5% vs. its benchmark
- Returned 2.5% in excess of the market index
Correct answer: Outperformed the return predicted by CAPM by 2.5%
Jensen's alpha measures the excess return above (or below) what CAPM predicts, with a positive alpha indicating manager skill or factor exposure beyond market beta.
WMS Portfolio Management & Strategy 3
A portfolio manager identifies that small-cap value stocks have historically outperformed the market.
This phenomenon is best explained by which framework?