CFA Level 1 - Portfolio Management Session 12 - Reading 46

CFA Level 1 - Portfolio Management Session 12 - Reading 46 (Notes, Practice Questions, Sample Questions) 1. Which of the following is NOT a rationale for the importance of the policy statement in investing? It: A)helps investors understand the risks and costs of investing. B)identifies specific stocks the investor may wish to purchase. C)forces investors to understand their needs and constraints. Explanation: The policy statement outlines broad objectives and constraints but does not get into the details of specific stocks for investment 2. Which of the following is NOT a rationale for the importance of the policy statement in investing? It: A)allows the investor to judge performance by objective standards. B)specifies a benchmark against which to judge performance. C)forces investors to take risks. Explanation: By no means should the policy statement force the investor to take risks. The statement forces investors to understand the risks of investing 3. Which of the following best describes the importance of the policy statement? It: A)outlines the best investments. B)limits the risks taken by the investor. C)states the standards by which the portfolio's performance will be judged. Explanation: The policy statement should state the performance standards by which the portfolio's performance will be judged and specify the benchmark that represents the investors risk preferences 4. Brian Nebrik, CFA, meets with a new investment management client. They compose a statement that defines each of their responsibilities concerning this account and choose a benchmark index with which to evaluate the account’s performance. Which of these items should be included in the client’s Investment Policy Statement (IPS)? A)Neither of these items. B)Both of these items. C)Only one of these items Explanation: Two of the major components of an IPS should be a statement of the responsibilities of the investment manager and the client, and a performance evaluation benchmark 5. Which of the following statements about the importance of risk and return in the investment objective is least accurate? A)The return objective may be stated in dollar amounts even if the risk objective is stated in percentages. B)Expressing investment goals in terms of risk is more appropriate than expressing goals in terms of return. C)The investor’s risk tolerance is likely to determine what level of return will be feasible Explanation: Expressing investment goals in terms of risk is not more appropriate than expressing goals in terms of return. The investment objectives should be stated in terms of both risk and return. Risk tolerance will likely help determine what level of expected return is feasible 6. Which of the following statements about risk and return is NOT correct? A)Return-only objectives provide a more concise and efficient way to measure performance for investment managers. B)Return objectives should be considered in conjunction with risk preferences. C)Return objectives may be stated in dollar amounts Explanation: Return-only objectives may actually lead to unacceptable behavior on the part of investment managers, such as excessive trading (churning) to generate excessive commissions 7. Which of the following statements about risk and return is NOT correct? . A)Specifying investment objectives only in terms of return may expose an investor to inappropriately high levels of risk. B)Return objectives may be stated in absolute terms. C)Risk and return may be considered on a mutually exclusive basis Explanation: Risk and return must always be considered together when expressing investment objectives. Return objectives may be expressed either in absolute terms (dollar amounts) or in percentages 8. Which of the following factors is least likely to affect an investor’s risk tolerance? A)Number of dependent family members. B)Level of insurance coverage. C)Level of inflation in the economy. Explanation: The level of inflation in the economy should be considered in determining the return objective. Risk tolerance is a function of the investor's psychological makeup and the investor's personal factors such as age, family situation, existing wealth, insurence coverage, current cash reserves and income 9. Which of the following statements about risk is NOT correct? Generally, greater: A)insurance coverage allows for greater risk. B)spending needs allows for greater risk. C)existing wealth allows for greater risk. Explanation: Greater spending needs usually allow for lower risk because there is a definite need to ensure that the return may adequately fund the spending needs (a “fixed” cost) 10. Which of the following statements is NOT consistent with the assumption that individuals are risk averse with their investment portfolios? A)Higher betas are associated with higher expected returns. B)Many individuals purchase lottery tickets. C)There is a positive relationship between expected returns and expected risk. Explanation: Investors are risk averse. Given a choice between two assets with equal rates of return, the investor will always select the asset with the lowest level of risk. This means that there is a positive relationship between expected returns (ER) and expected risk and the risk return line (capital market line [CML] and security market line [SML]) is upward sweeping. However, investors can be risk averse in one area and not others, as evidenced by their purchase of lottery tickets 11. While assessing an investor’s risk tolerance, a financial adviser is least likely to ask which of the following questions? A)“How much insurance coverage do you have?” B)“Is your home life stable?” C)“What rate of investment return do you expect?” Explanation: While the degree of risk tolerance will have an affect on expected returns, assessing the risk tolerance comes first, and the resulting set of feasible returns follows. The other questions address risk tolerance 12. All of the following affect an investor’s risk tolerance EXCEPT: A)tax bracket. B)family situation. C)years of experience with investing in the markets. Explanation: Tax concerns play an important role in investment planning. However, these constitute an investment constraint, not an investment objective (i.e. risk tolerance) 13. Which of the following statements about investment constraints is least accurate? A)Diversification efforts can increase tax liability. B)Unwillingness to invest in gambling stocks is a constraint. C)Investors concerned about time horizon are not likely to worry about liquidity. Explanation: Investors with a time horizon constraint may have little time for capital appreciation before they need the money. Need for money in the near term is a liquidity constraint. Time horizon and liquidity constraints often go hand in hand. Diversification often requires the sale of an investment and the purchase of another. Investment sales often trigger tax liability. Younger investors should take advantage of tax deferrals while they have time for the savings to compound, and while they are in their peak earning years. Many retirees have little income and face less tax liability on investment returns 14. Which of the following should least likely be included as a constraint in an investment policy statement (IPS)? A)Constraints put on investment activities by regulatory agencies. B)Any unique needs or preferences an investor may have. C)How funds are spent after being withdrawn from the portfolio. Explanation: How funds are spent after withdrawal would not be a constraint of an IPS 15. All of the following are investment constraints EXCEPT: A)pension plan contributions of the employer. B)tax concerns. C)liquidity needs. Explanation: Investment constraints include: liquidity needs, time horizon, tax concerns, legal and regulatory factors and unique needs and preferences. While employer contributions may be of interest, and an issue in some instances, it is not classified as a specific investment constraint 16. Which of the following is least likely to be considered a constraint when preparing an investment policy statement? A)Liquidity needs. B)Risk tolerance. C)Tax concerns. Explanation: The constraints are: liquidity needs, time horizon, taxes, legal and regulatory factors, and unique needs and preferences. Risk tolerance is included in the investment objectives of the policy statement, not in the constraints 17. When preparing a strategic asset allocation, how should asset classes be defined with respect to the correlations of returns among the securities in each asset class? A)Low correlation within asset classes and high correlation between asset classes. B)Low correlation within asset classes and low correlation between asset classes. C)High correlation within asset classes and low correlation between asset classes. Explanation: The portfolio diversification benefits from strategic asset allocation result from low correlations of returns between asset classes. Asset classes should consist of assets with similar characteristics and investment performance, which means correlations within an asset class are relatively high 18. An investment manager has constructed an efficient frontier based on a client’s investable asset classes. The manager should choose one of these portfolios for the client based on: A)relative valuation of the asset classes. B)the investment policy statement (IPS). C)a risk budgeting process. Explanation: After defining the investable asset classes and constructing an efficient frontier of possible portfolios of these asset classes, the manager should choose the efficient portfolio that best suits the investor’s objectives as defined in the IPS. The investor’s strategic asset allocation can then be defined as the asset allocation of the chosen portfolio. Tactical asset allocation based on relative valuation of asset classes would require the manager to deviate from the strategic asset allocation. Risk budgeting refers to the practice of determining an overall risk limit for a portfolio and allocating the risk among strategic asset allocation, tactical asset allocation, and security selection