CIMA Asset Allocation 1 — Questions and Answers
Question 1: Which asset allocation approach involves setting fixed target weights for each asset class and periodically rebalancing back to those targets?
- Strategic asset allocation (Correct answer)
- Tactical asset allocation
- Dynamic asset allocation
- Insured asset allocation
Correct answer: Strategic asset allocation
Strategic asset allocation establishes long-term target weights based on an investor's objectives and risk tolerance, with periodic rebalancing to maintain those targets.
Question 2: Tactical asset allocation (TAA) differs from strategic asset allocation primarily in that TAA:
- Uses fixed weights that never change
- Makes short-term deviations from strategic weights based on market views (Correct answer)
- Eliminates the need for rebalancing
- Focuses solely on fixed income assets
Correct answer: Makes short-term deviations from strategic weights based on market views
Tactical asset allocation involves deliberately deviating from strategic weights in the short term to exploit perceived market mispricings or macroeconomic opportunities.
Question 3: In the context of asset allocation, which method uses expected returns, variances, and covariances to identify the optimal portfolio on the efficient frontier?
- Black-Litterman model
- Mean-variance optimization (MVO) (Correct answer)
- Risk parity
- Factor-based allocation
Correct answer: Mean-variance optimization (MVO)
Mean-variance optimization, developed by Markowitz, uses expected returns, variances, and pairwise covariances to construct portfolios that maximize return for a given level of risk.
Question 4: A major limitation of mean-variance optimization is that it:
- Ignores expected returns entirely
- Is highly sensitive to small changes in input estimates (Correct answer)
- Cannot accommodate more than two asset classes
- Always produces undiversified portfolios
Correct answer: Is highly sensitive to small changes in input estimates
MVO is notoriously sensitive to input estimates; small changes in expected returns or covariances can produce dramatically different optimal allocations, often leading to extreme, concentrated portfolios.
Question 5: The Black-Litterman model improves on traditional MVO by:
- Eliminating the need for any return estimates
- Combining market equilibrium returns with investor views (Correct answer)
- Using only historical data without forecasting
- Restricting allocations to domestic equities and bonds
Correct answer: Combining market equilibrium returns with investor views
Black-Litterman blends implied equilibrium returns (derived from market capitalization weights) with the investor's own views, producing more stable and intuitive optimal portfolios.
Question 6: Which of the following best describes a 'risk parity' asset allocation approach?
- Equal dollar weighting across all asset classes
- Allocating capital so each asset class contributes equally to total portfolio risk (Correct answer)
- Maximizing return per unit of tracking error
- Weighting assets by their Sharpe ratios
Correct answer: Allocating capital so each asset class contributes equally to total portfolio risk
Risk parity allocates capital such that each asset class contributes equally to overall portfolio risk, typically resulting in higher allocations to lower-volatility assets like bonds.
Question 7: When constructing an Investment Policy Statement (IPS), which of the following should be established FIRST before determining asset allocation?
- Selecting specific securities
- Identifying the investor's objectives and constraints (Correct answer)
- Forecasting capital market assumptions
- Choosing a benchmark index
Correct answer: Identifying the investor's objectives and constraints
An IPS must first capture the client's return objectives, risk tolerance, time horizon, liquidity needs, tax situation, legal constraints, and unique circumstances before any asset allocation decision is made.
CIMA Asset Allocation 1
Which asset allocation approach involves setting fixed target weights for each asset class and periodically rebalancing back to those targets?