CPM Asset Allocation & Diversification 1 — Questions and Answers
Question 1: The primary goal of strategic asset allocation (SAA) is to:
- Maximize short-term trading profits
- Establish long-term target weights for asset classes aligned with investor objectives (Correct answer)
- Replicate a market-cap-weighted index
- Minimize tax liability
Correct answer: Establish long-term target weights for asset classes aligned with investor objectives
SAA sets long-term target allocations across asset classes based on an investor's goals, risk tolerance, and time horizon, forming the foundation of the portfolio.
Question 2: Tactical asset allocation (TAA) differs from strategic asset allocation in that it:
- Is set once and never changed
- Makes short-term adjustments to exploit perceived market opportunities (Correct answer)
- Ignores risk tolerance
- Only applies to fixed income
Correct answer: Makes short-term adjustments to exploit perceived market opportunities
TAA involves temporary deviations from the SAA targets to capitalize on short-term market inefficiencies or changing economic conditions.
Question 3: The efficient frontier represents portfolios that:
- Earn the highest return regardless of risk
- Offer the maximum expected return for a given level of risk (Correct answer)
- Are equally weighted across all asset classes
- Hold only risk-free assets
Correct answer: Offer the maximum expected return for a given level of risk
The efficient frontier, from Modern Portfolio Theory, shows the set of optimal portfolios that deliver the highest expected return for each level of risk.
Question 4: Which of the following is the primary benefit of international diversification?
- Elimination of all currency risk
- Reduction of portfolio risk by including assets with low correlation to domestic holdings (Correct answer)
- Higher guaranteed returns
- Simplified tax reporting
Correct answer: Reduction of portfolio risk by including assets with low correlation to domestic holdings
International diversification reduces total portfolio risk when foreign assets have low correlations with domestic assets, though it does introduce currency and geopolitical risks.
Question 5: In a mean-variance optimization framework, which input has the greatest impact on portfolio construction outcomes?
- Risk-free rate
- Expected return estimates (Correct answer)
- Dividend yields
- Expense ratios
Correct answer: Expected return estimates
Mean-variance optimization is highly sensitive to expected return estimates; small changes in return assumptions can lead to dramatically different optimal portfolio weights.
Question 6: Which of the following asset classes typically provides the best inflation hedge in a long-term portfolio?
- Cash equivalents
- U.S. Treasury bills
- Real assets such as real estate, commodities, and TIPS (Correct answer)
- Short-duration bonds
Correct answer: Real assets such as real estate, commodities, and TIPS
Real assets like commodities, real estate, and TIPS (Treasury Inflation-Protected Securities) have returns that tend to rise with inflation, providing effective long-term inflation protection.
CPM Asset Allocation & Diversification 1
The primary goal of strategic asset allocation (SAA) is to: