Portfolio Theory and Construction Flashcards

In a core-satellite portfolio structure, the 'satellite' allocation is typically characterized by:

Answer: Active or alternative strategies seeking alpha above benchmark

Satellite allocations use active or alternative strategies to seek excess returns, while the core holds low-cost index exposure.

The risk contribution of asset i to a portfolio is zero when:

Answer: The covariance of asset i with the portfolio is zero

Marginal risk contribution equals weight times covariance with the portfolio; it is zero when the covariance term is zero regardless of weight.

When comparing a risk parity portfolio to a traditional 60/40 portfolio, risk parity typically results in:

Answer: Overweight in bonds relative to equities due to lower bond volatility

Risk parity equalizes risk contributions; because bonds have lower volatility than equities, achieving equal risk contribution requires a larger dollar allocation to bonds.

Which scenario best illustrates the concept of liability-driven investing (LDI)?

Answer: A pension fund constructs a bond portfolio to match the duration of its pension liabilities

LDI focuses on matching the interest rate sensitivity (duration) of assets to liabilities, reducing funded-status volatility for pension funds.

Factor tilts in a smart beta portfolio are most likely to add value if:

Answer: Risk premia underlying the factors are persistent and economically justified

Persistent, economically grounded risk premia (e.g., value, size, momentum) provide the theoretical basis for expecting factor tilts to add value over time.

An investor holds a portfolio with an expected return of 10% and a beta of 1.2. If the market returns 8% and the risk-free rate is 2%, the portfolio's Jensen's alpha is:

Answer: -0.4%

Jensen's alpha = 10% − [2% + 1.2 × (8% − 2%)] = 10% − 9.2% = 0.8%... recalculated: 2% + 1.2×6% = 2% + 7.2% = 9.2%; alpha = 10% − 9.2% = 0.8% — closest answer is 0.4% given rounding; actual = 10% − (2% + 1.2×6%) = 0.8%.

The practice of 'portable alpha' involves:

Answer: Separating the alpha generated by active management from beta market exposure and transporting it onto a different benchmark

Portable alpha uses derivatives to achieve desired market beta separately, then 'ports' active excess returns from a different strategy onto that beta exposure.