Asset Allocation - CFA Level III

What is the long-term economic growth rate approximately equal to?

Population growth + labor force participation growth + new capital spending + total factor productivity growth.

What does the Taylor rule estimate?

A target nominal short-term interest rate based on the neutral real rate, expected inflation, the GDP growth gap, and the inflation gap.

What is the Taylor rule formula?

n_target = r_neutral + i_expected + 0.5(GDP_expected − GDP_trend) + 0.5(i_expected − i_target).

What is the risk-premium approach to expected bond return?

Risk-free rate + term premium + credit premium + liquidity premium.

What is the Grinold–Kroner model?

E(Re) ≈ dividend yield + change in earnings − change in shares outstanding + expected change in the P/E multiple.

What does D/P represent in the Grinold–Kroner model?

Dividend yield.

What does %ΔE − %ΔS represent in the Grinold–Kroner model?

Expected growth in earnings per share.

What does %ΔP/E represent in the Grinold–Kroner model?

Expected repricing return from a change in the valuation multiple.

Under the Singer–Terhaar model, what is the risk premium under full integration?

Asset correlation with the global market × asset volatility × market Sharpe ratio.

Under the Singer–Terhaar model, what is the risk premium under full segmentation?

Asset volatility × market Sharpe ratio.

How is the Singer–Terhaar weighted risk premium calculated?

Degree of integration × integrated risk premium + degree of segmentation × segmented risk premium.

What is the capitalization rate for commercial real estate?

NOI divided by property value.

What is the expected return on commercial real estate over an indefinite horizon?

Cap rate + expected NOI growth.

What is the expected return on commercial real estate over a finite period?

Cap rate + NOI growth − percentage increase in the cap rate.

What does an asset-only allocation approach focus on?

Asset returns and asset standard deviations.

What does a liability-relative allocation approach focus on?

Growth of the surplus and the volatility of that surplus.

What does a goals-based allocation approach do?

Uses separate subportfolios to fund specific investor goals.

What characteristics should a valid asset class have?

Assets within the class should be similar, not overlap with other classes, have low correlation with other classes, cover the investable universe, and be sufficiently liquid.

What is calendar rebalancing?

Rebalancing at a predetermined frequency.

What is percentage-range rebalancing?

Rebalancing when an asset-class weight moves outside a specified band.

When should rebalancing bands generally be wider?

When transaction costs or inter-asset correlations are higher, risk tolerance is higher, markets show momentum, or the asset class is less volatile.

What inputs does mean–variance optimization use?

Expected returns, standard deviations, and correlations.

What does mean–variance optimization produce?

An efficient frontier and a recommended asset allocation.

What are common pitfalls of mean–variance optimization?

Input-estimation error, highly concentrated allocations, and a single-period framework.

What does reverse optimization do?

Infers expected returns from observed market weights.

How does Black–Litterman modify reverse-optimized returns?

It blends equilibrium returns with investor views and then resolves for an efficient portfolio.

What does Monte Carlo simulation do in asset allocation?

Models how an allocation may perform through time under many simulated paths.

What is the utility-maximization formula shown in the sheet?

U_m = E(R_m) − 0.005 × λ × Var_m, with returns and variance expressed in percent terms.

What does lambda represent in the utility formula?

The investor’s risk-aversion coefficient.

What is the after-tax future value with annual accrual taxation?

[1 + R(1 − t_x)]^T.

What is the after-tax future value with tax deferral and no cost-basis adjustment?

(1 + R)^T(1 − t_cg) + t_cg.

What is the after-tax future value with tax deferral and a cost basis B?

(1 + R)^T(1 − t_cg) + B × t_cg.

What information belongs in the client-background section of a private-client IPS?

Relevant personal, financial, and tax information.

How should multiple private-client objectives be handled?

Classify them as planned, unplanned, ongoing, or one-off and rank them as primary or secondary.

What two elements determine risk tolerance?

Willingness and ability to take risk.

What types of goals are usually associated with low risk tolerance?

High-priority goals and near-term goals.

How should time horizon be expressed in a private-client IPS?

As a range, with a separate horizon for each major objective when appropriate.

What other investment parameters may appear in a private-client IPS?

Asset-class preferences, liquidity needs and cash reserve, and unique preferences.

What is the difference between strategic and tactical asset allocation?

Strategic allocation sets long-term targets; tactical allocation permits active deviations within specified ranges.

What implementation topics belong in a private-client IPS?

Discretionary authority, rebalancing, tactical changes, and acceptable investment vehicles.

What are key duties of a wealth manager?

Prepare and review the IPS, construct and monitor the portfolio, rebalance it, monitor costs and outside providers, and report performance.

What belongs in the appendix of a private-client IPS?

Modeled portfolio performance and capital-market expectations.

Who are the main stakeholders in a defined-benefit pension plan?

The employer, beneficiaries, investment staff, investment committee or board, governments, and shareholders.

What is the main liability of a defined-benefit pension plan?

The present value of future promised benefits.

What factors increase a defined-benefit pension liability?

Longer employee service, higher salaries, longer participant lifespans, lower turnover, and a lower discount rate.

When does a defined-contribution plan sponsor have no further liability?

After making the required contribution.

When is a defined-benefit plan’s investment horizon longer?

When the proportion of active workers is higher.

What raises liquidity needs in a defined-benefit plan?

More retirees, an older workforce, high funded status that may reduce contributions, and participant flexibility to switch plans.

What is the investment objective of a defined-benefit plan?

Earn a long-term target return with appropriate risk to meet contractual liabilities.

What is the investment objective of a defined-contribution plan?

Prudently grow assets to meet participants’ retirement spending needs.

What is the objective of a budget-stabilization sovereign wealth fund?

Capital preservation.

What is the objective of a development sovereign wealth fund?

Earn real growth above real GDP growth.

What is the objective of a savings sovereign wealth fund?

Maintain real perpetual spending for future generations.

What is the objective of a reserve sovereign wealth fund?

Grow faster than the yield paid on central-bank or government bonds.

What is the objective of a pension-reserve sovereign wealth fund?

Earn returns to meet future unfunded government pension payments.

Which sovereign wealth fund generally has the highest liquidity need?

A budget-stabilization fund.

Which sovereign wealth fund generally has the lowest liquidity need?

A savings fund.

What is the usual investment horizon of a university endowment?

Perpetual.

What is the typical liquidity need of a university endowment?

Low, often about 2%–4% of assets net of donations.

What return objective is typical for a university endowment?

A total real return of about 5% after HEPI inflation over a 3–5 year rolling period, with reasonable annual volatility.

What is the legally required minimum annual spending for a US private foundation?

Generally 5% of assets plus investment expenses.

How does a private foundation’s liquidity need compare with a university endowment’s?

It is usually higher.

What is the typical investment objective of a private foundation?

Earn a real return over CPI equal to the spending rate plus investment expenses.