Practice: Basics of Portfolio Planning and Construction
Portfolio Management. 25 question(s) in this unit's pool
(0 above the exam). Free up to ten a day; the coach picks which ones based on what you have
already answered and when each is next due.
Portfolio ManagementBasics of Portfolio Planning and Construction
Pick an answer, say how sure you are, then reveal. Every wrong choice gets its own
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Question 1Exam level
An investor has a long-term target allocation of 60% equities and 40% fixed income specified in her Investment Policy Statement. After a prolonged equity bull market, the portfolio has shifted to 74% equities and 26% fixed income. The portfolio manager sells equities and purchases bonds to return the portfolio to the 60/40 target. This action is most likely described as:
How sure are you?
Correct: C. Rebalancing is the process of restoring actual portfolio weights back to the SAA target weights after market movements have caused drift. The manager is moving TOWARD the IPS target. TAA would involve deliberately moving AWAY from the SAA target based on a market view.
A. Both TAA and rebalancing involve changing asset class weights. You might confuse any weight adjustment with TAA. TAA deliberately moves weights AWAY from the SAA target. This action moves weights TOWARD the target. The direction is opposite.
B. The portfolio is being changed, which seems like a strategy revision. SAA revision requires an IPS update driven by a change in investor objectives. Not market movement. No IPS change occurred here.
A pension fund's Investment Policy Statement specifies a target allocation of 55% domestic equity, 25% international equity, and 20% fixed income. The fund reviews its portfolio quarterly. If any asset class weight deviates by more than 5 percentage points from target, the manager rebalances. This rebalancing approach is most likely described as:
How sure are you?
Correct: B. The quarterly review is the calendar element. The 5-percentage-point drift condition before action is taken is the threshold element. Because BOTH triggers must be present (review occurs AND threshold exceeded), this is a hybrid approach. Pure calendar rebalancing would act at every quarterly review regardless of drift.
A. The 5% deviation trigger sounds like threshold rebalancing. Pure threshold rebalancing would require continuous monitoring and act whenever the threshold is breached, with no scheduled review component.
C. Periodic review with active decisions sounds like TAA. TAA involves deliberate deviations FROM target based on market views. Rebalancing returns weights TO target. The opposite of TAA.
According to the Brinson, Hood, and Beebower (1986) study, asset allocation policy explained approximately 93.6% of, most likely:
How sure are you?
Correct: B. BHB found that asset allocation policy explained 93.6% of the VARIATION in quarterly returns (the R-squared of returns over time). This is not the same as saying asset allocation produces 93.6% of total return. The study measured what drove fluctuations in returns, not the level of returns.
A. You might misremember or misread the BHB finding as applying to total return level. BHB measured return variation (R-squared) not total return. Asset allocation explains WHY returns fluctuate, not how high they are in absolute terms.
C. BHB is often cited in active vs passive management debates. BHB was not a study of active vs passive. It was a study of what factors explain return variation across pension portfolios.
A portfolio manager believes that domestic equities will outperform international equities over the next six months due to anticipated central bank policy changes. She increases the domestic equity allocation from 40% to 47%, within pre-defined deviation limits documented in the IPS. This action is most likely described as:
How sure are you?
Correct: A. TAA is a deliberate, short-term deviation from SAA targets based on a near-term market view, operating within pre-defined deviation limits. All TAA criteria are met: deliberate deviation (not market-forced), short horizon (six months), market view basis (central bank policy), within documented limits.
B. The allocation is being changed, which sounds like a strategy revision. SAA revision requires an IPS update driven by changes in investor objectives. A six-month market view does not warrant an IPS revision.
C. Making bets on central bank policy sounds like market timing. Market timing has no guardrails. This action has pre-defined deviation limits and is documented in the IPS. The distinction that separates TAA from market timing.
Which of the following statements about threshold rebalancing is MOST accurate?
How sure are you?
Correct: B. Threshold rebalancing requires continuous (ongoing) monitoring because drift can breach the threshold band at any time. Calendar rebalancing only requires periodic monitoring at scheduled review dates. Threshold therefore requires MORE monitoring effort, not less.
A. It is intuitive to assume that rebalancing less frequently means monitoring less frequently. This is the classic reversal trap. Threshold rebalancing trades less frequently but must be watched continuously. Monitoring frequency and trading frequency are not the same.
C. Threshold rebalancing does reduce unnecessary trades compared to calendar rebalancing. It reduces unnecessary trades (lower transaction costs). But this does not eliminate transaction costs. Trades still occur when the threshold is breached.
An investor's IPS is revised to reflect a change in her risk tolerance from aggressive to moderate following retirement. As a result, the target equity allocation is reduced from 70% to 50%. This change is most likely described as:
How sure are you?
Correct: B. An SAA revision is triggered by a change in investor objectives, risk tolerance, time horizon, or constraints. Requiring an IPS update. The IPS was explicitly revised here. TAA responds to short-term market views; rebalancing corrects drift back to an existing target. This represents a new target being set.
A. The equity allocation is being reduced, which involves changing asset weights. TAA is based on short-term market views, not changes to investor objectives. TAA operates WITHIN an existing SAA; this changes the SAA itself.
C. The allocation changed by 20 percentage points, which exceeds any typical threshold. Threshold rebalancing responds to market-driven drift. This change was driven by investor circumstances, not market movement.
Which statement most likely distinguishes tactical asset allocation (TAA) from portfolio rebalancing?
How sure are you?
Correct: B. The defining distinction is directional: TAA intentionally moves weights AWAY from the SAA benchmark based on a market view. Rebalancing restores weights BACK TO the SAA benchmark after market-driven drift. They are opposite in intent and direction.
A. Equity is often the asset class that drifts most in bull markets. Both TAA and rebalancing apply to all asset classes in a portfolio. There is no asset class restriction.
C. SAA is long-term, so candidates associate TAA with something longer. TAA is short-term (market-view-based). SAA is long-term. Rebalancing has no fixed time horizon. It triggers on drift.
A university endowment fund with a 60% equity/40% bond SAA uses a corridor of plus or minus 5 percentage points around each target weight. When equity markets rise and push the equity allocation to 68%, the manager takes no action because the 65% upper corridor bound has not been breached. This approach is most likely described as:
How sure are you?
Correct: B. Threshold (corridor) rebalancing defines acceptable drift bands around the SAA target. Weights within the corridor require no action. At 68%, equity is within the 55%-65% acceptable corridor (60% +/- 5%), so no action is correct under the policy.
A. The manager appears to be riding equity momentum. TAA requires a deliberate decision to deviate based on a market view. No active decision is being made here. The manager is simply within the defined corridor.
C. The allocation has changed due to market appreciation. SAA revision requires an IPS update from changed investor objectives. Allowing drift within a pre-defined corridor is not an SAA revision.
An investor's IPS specifies a target of 50% domestic equity, 20% international equity, and 30% bonds. Actual weights are 56% domestic equity, 18% international equity, and 26% bonds. The manager considers whether to rebalance. Which factor would MOST likely support a decision NOT to rebalance immediately?
How sure are you?
Correct: A. The decision to rebalance involves a cost-benefit analysis. Transaction costs (including bid-ask spreads, commissions, and tax impacts) can erode or eliminate the benefit of restoring target weights when drift is modest. If transaction costs exceed the expected benefit of reduced risk from rebalancing, deferring rebalancing is rational.
B. Continuing outperformance of domestic equities would reinforce the current overweight. Anticipating continued outperformance to justify not rebalancing is TAA reasoning. Not a legitimate rebalancing cost-benefit argument.
C. Being above the equity target is exactly the condition for rebalancing. Being above target is a reason to rebalance, not a reason to delay. This argues FOR action.
A large public pension fund's Investment Policy Statement is updated when the board revises the fund's return objective from 6.5% to 7.5% annually. The fund's asset allocation subsequently changes from 50% equity/50% bonds to 65% equity/35% bonds. This sequence is most likely described as:
How sure are you?
Correct: B. An SAA revision is triggered by a change in investor objectives (here, an upward revision to the return objective) and requires an IPS update (which occurred). The new 65/35 allocation becomes the new policy portfolio. Not a temporary deviation. This is the full IPS-to-SAA update cycle.
A. Increasing equity allocation could reflect an equity market outlook. TAA is short-term and market-view-based, without an IPS update. This change followed an IPS revision driven by changed objectives. Not a market view.
C. Bond underperformance may have caused drift. Threshold rebalancing returns weights to the original target. Here the target itself is changing. No new IPS is written for threshold rebalancing.
Which of the following BEST describes the primary purpose of Strategic Asset Allocation (SAA)?
How sure are you?
Correct: B. SAA establishes the long-term policy portfolio: the target weights for each asset class that reflect the investor's risk tolerance, return objectives, and constraints as documented in the IPS. SAA has a multi-year horizon (3 to 10 years) and is the benchmark from which TAA deviates and toward which rebalancing returns.
A. Asset allocation decisions are associated with performance optimization. Exploiting short-term inefficiencies describes TAA, not SAA. SAA is not driven by market views.
C. Selecting securities is part of portfolio construction. SAA specifies asset class weights, not individual securities. Security selection occurs within each asset class after SAA is established.
A portfolio manager argues that threshold rebalancing is superior to calendar rebalancing because it avoids unnecessary rebalancing trades when drift is minimal. Which of the following is the MOST significant disadvantage the critic of this approach would cite, most likely?
How sure are you?
Correct: B. The primary disadvantage of threshold rebalancing is that it requires continuous monitoring to detect when drift bands are breached. Calendar rebalancing only requires checking at predetermined intervals. The monitoring burden of threshold rebalancing is its key trade-off against reduced unnecessary trading.
A. Transaction costs are a rebalancing consideration. Threshold rebalancing typically results in FEWER transactions than calendar rebalancing. Not more.
C. CFA Institute standards are familiar territory to candidates. CFA Institute imposes no prohibition on threshold rebalancing. Both approaches are discussed in the curriculum.
An Investment Policy Statement (IPS) is most likely described as a document that:
How sure are you?
Correct: A. The IPS is the governing document that records investment objectives (return and risk) and constraints (time horizon, taxes, liquidity, legal, unique circumstances). It does NOT specify individual securities. That is the role of the portfolio construction step that follows the IPS. It makes no return guarantees (C is wrong) and is not primarily a custodian instruction (D is wrong).
B. You might be tempted by choice B if you associate investment documents with performance guarantees, but the IPS does not offer any return guarantees; it focuses on setting objectives and constraints without promising specific outcomes, unlike a guaranteed investment contract.
C. You might be tempted by choice C if you associate the IPS with legal documents, but the IPS does not provide legally binding instructions to the custodian; instead, it focuses on investment objectives and constraints, making it distinct from custodial agreements that handle asset custody.
An investor states: 'I need my portfolio to grow enough to fund my retirement in 20 years, and I want to ensure my children receive an inheritance.' Which IPS component does the inheritance goal MOST likely fall under?
How sure are you?
Correct: B. Leaving a bequest to children is a unique personal circumstance that does not fit neatly into standard return or risk objectives. The unique circumstances constraint captures personal preferences, restrictions, and goals that are specific to the individual client and not covered by the other six IPS components. The retirement funding goal is the return objective; the 20-year timeline is the time horizon.
A. Choosing the time horizon constraint might seem logical if you think about the long-term nature of the goal, but the time horizon constraint focuses on the investment period, not specific personal goals like leaving an inheritance, which falls under unique circumstances.
C. You might select D because they think 'inheritance goal' sounds like a financial return objective. But the return objective quantifies required return. The inheritance goal is a qualitative personal constraint.
A portfolio manager is constructing an IPS for a client. The client says, 'I hate seeing my account value go down. It makes me very anxious.' This statement is most likely captured under which risk objective component?
How sure are you?
Correct: A. The client's emotional statement about 'hating' account declines reflects willingness to bear risk, which is a subjective psychological assessment. Ability to bear risk is based on objective financial factors (time horizon, income stability, net worth). The CFA curriculum distinguishes the two explicitly: willingness is attitudinal/psychological; ability is financial/objective. When the two conflict, ability takes precedence in determining the overall risk objective.
B. You might be tempted by B because it seems to directly address the client's fear of losses with a specific numerical limit, but an absolute risk objective is a quantitative constraint on portfolio performance, not a measure of the client's emotional tolerance for risk, which is what willingness to bear risk captures.
C. Choosing C might seem logical if you associate the client's concern with performance anxiety, but relative risk objectives focus on outperforming a benchmark, not on emotional responses to account value declines, which is more aligned with willingness to bear risk.
A client has a high ability to bear risk but a low willingness to bear risk. According to the CFA curriculum, the portfolio manager should most likely set the overall risk objective as:
How sure are you?
Correct: A. When ability and willingness conflict, the CFA curriculum specifies that the manager should use the more conservative of the two. When ability is high but willingness is low, the overall risk objective is LOW. The manager should work to educate the client about risk and potentially adjust the willingness assessment over time, but should not override the client's expressed preferences. Ability constrains regardless. When they conflict, use the lower.
B. Choosing moderate risk by averaging ability and willingness might seem balanced, but it overlooks the CFA guideline that emphasizes respecting the client's lower willingness to bear risk, ensuring the portfolio aligns with their comfort level.
C. Choosing C might seem reasonable if you think a waiver can override the client's low willingness to bear risk, but the CFA curriculum emphasizes respecting the client's willingness as a non-negotiable constraint, making any attempt to increase risk levels despite a low willingness inappropriate and unethical.
A university endowment fund has total assets of $500 million. The fund must distribute $25 million per year for scholarships and operating costs (5% spending rate). The long-run expected inflation rate is 2.5%. Investment management fees are estimated at 0.5% of assets annually. The endowment's MINIMUM required annual return is closest to:
How sure are you?
Correct: B. Required return = Spending rate + Inflation + Fees = 5.0% + 2.5% + 0.5% = 8.0%. The endowment must earn 8% just to maintain real purchasing power after meeting its spending obligation and paying fees. This is the standard return objective calculation for institutional endowments. The IPS would state: 'The portfolio shall target a minimum annual return of 8.0% to preserve corpus in real terms while meeting spending commitments.'
A. You might select A (5.0%) because they only count the spending rate. You might select B (7.5%) because they forget to add fees. The full formula is Spending + Inflation + Fees. All three components must be included.
C. Choosing 5.5% might seem plausible if you only considered the spending rate and inflation, but it neglects the additional drag of management fees, which is crucial for accurately calculating the minimum required return to preserve the endowment's purchasing power.
Which of the following BEST illustrates the liquidity constraint in an IPS?
How sure are you?
Correct: A. The liquidity constraint reflects the portfolio's NEED to meet specific near-term cash flow obligations. It is about financial necessity, not preference. The $50,000 annual requirement means the portfolio must be structured to provide that cash without forced liquidation at unfavorable prices. This is a hard constraint derived from the client's actual spending needs. Option A is a preference (unique circumstances), not a liquidity constraint.
B. You might find B tempting because it mentions the ability to sell assets quickly, but this choice describes market liquidity, which refers to the ease of buying or selling assets, not the portfolio's need to meet specific cash flow obligations like the $50,000 annual requirement in A.
C. You might be tempted by choice C because it mentions cash, which is often associated with liquidity, but this option describes a discretionary decision by the portfolio manager rather than a hard liquidity constraint imposed by the client's spending needs.
A wealthy individual has the following profile: age 35, stable employment income of $300,000/year, investment portfolio of $2 million, no near-term major expenses, and is saving for retirement at age 65. Which constraint is most likely relevant to note in this client's IPS?
How sure are you?
Correct: A. The dominant constraint for a 35-year-old saving for retirement at 65 is the 30-year time horizon. This long horizon means the portfolio can tolerate higher risk (more equity), ride out short-term volatility, and pursue long-term growth. There is no stated liquidity need (A is not relevant), no unusual legal restrictions mentioned (C is generic), and while taxes apply to everyone (D), they are not the MOST relevant differentiating constraint for this specific profile.
B. You might be tempted by the legal obligations that come with professional advice, thinking it significantly impacts the investment strategy, but the legal aspect does not directly influence the core investment decision as much as the long time horizon does, which allows for a more aggressive investment approach.
C. You might be tempted by taxes due to the client's substantial income and portfolio, but taxes are a universal consideration and not the most pressing constraint for someone with a long 30-year investment horizon who can focus on long-term growth and risk tolerance.
The return objective of a portfolio is most likely described as:
How sure are you?
Correct: A. The return objective is a derived calculation. It answers the question: 'What return does this portfolio NEED to achieve for the client to reach their goals?' For an endowment, it is spending + inflation + fees. For an individual, it may be the growth rate needed to fund a future liability. It is NOT simply what the client wants (A), nor is it about maximizing return (C).
B. Choosing B might seem logical if you think the portfolio's goal is to maximize returns within a set risk level, but this overlooks the fundamental purpose of a return objective, which is to ensure the portfolio meets specific financial goals rather than aiming for the highest possible return.
C. Choosing C might be tempting if you associate return objectives with performance fees, but this confuses the return objective, which is about meeting financial goals, with the incentive structure for portfolio managers.
Which of the following IPS constraints would MOST likely restrict a corporate pension fund from investing in equities of a competitor company?
How sure are you?
Correct: B. Legal and regulatory constraints capture restrictions arising from laws, regulations, fiduciary duty, or contractual obligations. A corporate pension fund is governed by ERISA (in the US) or equivalent legislation, which imposes fiduciary duties. Investing in a competitor's stock may violate antitrust regulations, securities law (if insider information is possible), or fiduciary duty standards. This is a legal/regulatory restriction, not a personal preference (D) or a cash flow issue (A).
A. You might think that a pension fund with a long-term investment horizon could avoid equities in competitors to prevent conflicts of interest, but time horizon constraints relate to investment duration and liquidity needs, not competitive business practices, which fall under legal and regulatory constraints.
C. You might be tempted by unique circumstances because you think specific situations could prevent investment, but unique circumstances constraints refer to individual fund-specific conditions rather than legal or regulatory mandates that universally apply, making choice C incorrect in this context.
An IPS states: 'The portfolio return must exceed the Consumer Price Index by 4% per year on a rolling 5-year basis.' This return objective is most likely classified as:
How sure are you?
Correct: A. A relative return objective is expressed as a return relative to a benchmark. In this case, CPI + 4%. The portfolio must outperform the CPI benchmark by 4 percentage points. This is the standard structure for endowment and foundation IPS return objectives, where the goal is to preserve real purchasing power while funding spending. An absolute return objective would state a fixed percentage (e.g., 'the portfolio must earn 7% per year') with no reference to a benchmark.
B. You might be tempted by B because it sounds comprehensive, covering both income and capital gains, but a total return objective focuses on overall portfolio growth without referencing a specific benchmark like the CPI, which is central to the relative return objective described in the question.
C. You might be tempted by C because it sounds sophisticated, but a risk-adjusted return objective focuses on performance relative to risk taken, not to an inflation index like CPI, making it incorrect here where the objective is clearly benchmarked against CPI.
Which of the following statements about the IPS is MOST accurate according to the CFA curriculum?
How sure are you?
Correct: A. The IPS is a living document. It must be reviewed periodically (typically annually) and updated when material changes occur: a major inheritance, job loss, divorce, birth of a child, approaching retirement, or changes in tax law. The client must approve all material changes. It is a collaborative document owned by the client-manager relationship, not the manager alone. Regular review is an explicit CFA curriculum requirement.
B. You might think the IPS is solely the portfolio manager's responsibility, but the IPS is a collaborative document owned by both the client and the manager, and any updates require client approval, contrasting with the idea that the manager can act unilaterally.
C. Choosing C might seem logical if you think the IPS covers all client needs, but it overlooks the fact that the IPS is a foundational document that requires ongoing communication to address evolving client circumstances and preferences, contrary to the static nature implied by choice C.
A foundation has a perpetual investment horizon. Which of the following BEST describes how the time horizon constraint should be reflected in the foundation's IPS?
How sure are you?
Correct: A. A perpetual or infinite time horizon is a defining characteristic of foundations and endowments. It directly implies: (1) a higher ability to bear risk, as short-term volatility can be ridden out, (2) a higher allocation to growth assets (equities, private equity, real assets), and (3) lower liquidity needs beyond the annual spending requirement. The time horizon constraint must be explicitly stated in the IPS. It is the key driver of asset allocation for institutional investors.
B. Choosing B might seem reasonable if you are thinking about the need for periodic reviews, but a 10-year time horizon contradicts the perpetual nature of the foundation's investment horizon, which should support a long-term focus on growth assets rather than a short-term planning horizon.
C. Choosing C might tempt you if you think a perpetual horizon requires minimizing risk, but this overlooks the fact that a long time horizon actually allows for higher risk tolerance, supporting a greater allocation to growth assets rather than just fixed income.
Which of the following most likely distinguishes an absolute risk objective from a relative risk objective?
How sure are you?
Correct: A. An absolute risk objective limits portfolio volatility in standalone terms. Typically stated as a maximum standard deviation or maximum drawdown (e.g., 'portfolio standard deviation shall not exceed 12% per annum'). A relative risk objective constrains the portfolio's deviation from a benchmark. Measured as tracking error (e.g., 'active risk shall not exceed 3% relative to the Russell 1000'). Both types apply to both individuals and institutions (B is wrong). The classification is about the measurement framework, not the investor type.
B. You might be tempted to think that absolute risk is inherently higher because it measures overall volatility, but this overlooks the fact that both absolute and relative risks can vary in magnitude depending on the specific portfolio and benchmark; the key difference is in how the risk is measured, not its inherent level.
C. You might be tempted by choice C if you assume that risk measurement methods are tied to specific asset classes, but absolute risk, measured by standard deviation, and relative risk, measured by tracking error, can apply to any portfolio type, whether fixed income or equity.