Asset Allocation — CFA Level III practice questions

An investor with a 10-year horizon and a goal of funding a child's college runs scenario analysis showing the goal is achieved in 90% of paths with a 70/30 allocation. The investor is loss-averse and worries about the 10% shortfall paths. A goals-based framework would MOST APPROPRIATELY:

1. Performance under specified adverse scenarios
2. Performance under base-case only in the standard framework
3. Performance under optimistic scenarios
4. Random unrelated shocks applied in the standard framework

Answer: A — Performance under specified adverse scenarios

A) Correct — Stress testing quantifies losses under defined historical or hypothetical stress scenarios. B) Base case is the reference, not a stress test. C) Optimistic scenarios don't test resilience. D) Random shocks lack the analytical rigor.

An investor exhibits strong mental accounting, separating assets into 'safety,' 'income,' and 'aspirational' buckets. The MOST appropriate allocation framework is:

1. Treating all money as fungible in the standard framework
2. Tracking spending in a ledger in the standard framework
3. Treating money differently by source or label
4. Anchoring to historical price in the standard framework

Answer: C — Treating money differently by source or label

A) Direction reversal — fungibility is what mental accounting violates. B) Bookkeeping isn't a cognitive bias. C) Correct — Mental accounting violates fungibility; investors segregate wealth into buckets. D) That's anchoring, a distinct bias.

An investor with strong loss aversion holds a 60/40 portfolio that has just dropped 12%. The advisor's MOST appropriate response is to:

1. Symmetric response to gain and loss in the standard framework
2. Refusing all risky bets in the standard framework
3. Only holding conservative assets in the standard framework
4. Pain of loss exceeds pleasure of equal gain

Answer: D — Pain of loss exceeds pleasure of equal gain

A) Direction reversal of the actual asymmetry. B) Describes risk aversion, a different concept. C) That's a portfolio outcome, not the bias itself. D) Correct — Loss aversion from Kahneman-Tversky; utility loss steeper than utility gain.

A glide path for a target-date fund typically becomes more conservative over time because:

1. As the target date approaches, the investor's remaining time horizon and risk capacity shrink, so the fund shifts weight from equities toward fixed income and cash
2. Target-date fund providers are contractually required to raise their expense ratios each year as assets mature
3. Equity return volatility mechanically declines as any fund nears a fixed calendar date
4. Bonds have historically outperformed equities in the five years immediately preceding a typical retirement date

Answer: A — As the target date approaches, the investor's remaining time horizon and risk capacity shrink, so the fund shifts weight from equities toward fixed income and cash

A) Correct — a shortening time horizon reduces the investor's capacity to recover from a drawdown before the funds are needed, so the glide path systematically de-risks by trimming equity and adding fixed income as the target date nears. B) There is no such fee-escalation mandate; glide-path de-risking is a risk-management rule, not a fee mechanism. C) Equity volatility does not fall simply because a calendar date approaches — the change in allocation reflects the investor's shrinking risk capacity, not a change in the equity market's own volatility. D) Bond returns are not systematically higher than equity returns near retirement; the shift toward bonds is driven by risk reduction, not a return forecast.

A 47-year-old tenured university professor with $1.2M in financial assets, stable inflation-adjusted salary, defined-benefit pension expected at 65, and a 20-year horizon to retirement asks how her bond-like human capital should affect her strategic asset allocation. The MOST appropriate recommendation is:

1. Short-term market-view deviations
2. Reaction to recent performance
3. Long-term policy from IPS and CME
4. Whichever fund has lowest fee

Answer: C — Long-term policy from IPS and CME

A) That describes tactical asset allocation (TAA). B) Chasing performance violates strategic discipline. C) Correct — SAA is the long-run policy portfolio grounded in IPS constraints and capital-market expectations. D) Fee-only selection is not an allocation method.

Compared to a calendar-based rebalancing policy (e.g., rebalance every quarter regardless of drift), a percentage-of-portfolio corridor policy (e.g., rebalance whenever an asset class drifts more than 5% from target) is MOST likely to:

1. Trigger rebalancing trades more responsively during periods of high market volatility, since large drifts can occur well before the next scheduled calendar date
2. Guarantee lower total transaction costs than calendar rebalancing in every market environment
3. Eliminate tracking error relative to the strategic policy portfolio entirely
4. Require the same number of trades per year regardless of market conditions

Answer: A — Trigger rebalancing trades more responsively during periods of high market volatility, since large drifts can occur well before the next scheduled calendar date

A) Correct — corridor-based rebalancing is triggered by drift magnitude, so in volatile markets it can fire multiple times before a calendar date would have, keeping weights closer to target when it matters most. B) Whether corridor rebalancing costs less depends on realized volatility and corridor width; in especially volatile periods it can trigger more frequent, and thus costlier, trading than a fixed calendar schedule. C) No rebalancing policy eliminates tracking error entirely; corridors merely bound how far weights can drift before a trade is triggered. D) The number of corridor-triggered trades varies with market volatility, unlike a fixed calendar schedule.

Compared to mean-variance optimization, the Black-Litterman model produces allocations that are typically:

1. Combines equilibrium with investor views
2. Uses only historical returns in the standard framework
3. Uses only investor views alone in the standard framework
4. Ignores both equilibrium and views

Answer: A — Combines equilibrium with investor views

A) Correct — Black-Litterman blends implied market equilibrium with investor views to stabilize MVO. B) Historical inputs are what BL avoids. C) Views alone produce concentrated portfolios. D) Nonsense combination — the model requires both.

Strategic asset allocation (SAA) for a private wealth client should be determined PRIMARILY based on:

1. Long-term policy from IPS and CME
2. Short-term market-view deviations
3. Reaction to recent performance
4. Whichever fund has lowest fee

Answer: A — Long-term policy from IPS and CME

A) Correct — SAA is the long-run policy portfolio grounded in IPS constraints and capital-market expectations. B) That describes tactical asset allocation (TAA). C) Chasing performance violates strategic discipline. D) Fee-only selection is not an allocation method.

All of the following are legitimate criticisms of a levered risk-parity strategy EXCEPT:

1. Leverage amplifies losses during a simultaneous sell-off across the levered asset classes, a risk not fully captured by historical low-correlation assumptions
2. The strategy's equal-risk-contribution weights can shift materially if volatility or correlation regimes change, requiring active rebalancing of leverage
3. Financing costs for the leverage used to raise bond risk contributions reduce net returns relative to the unlevered risk-parity concept
4. Risk parity portfolios cannot experience drawdowns because risk is equally distributed across asset classes by construction

Answer: D — Risk parity portfolios cannot experience drawdowns because risk is equally distributed across asset classes by construction

A) A legitimate, well-documented criticism — leveraged risk parity is vulnerable to simultaneous multi-asset sell-offs, a scenario where historical correlation assumptions break down. B) A legitimate criticism — equal-risk-contribution weights are regime-dependent and require ongoing rebalancing as volatility and correlation shift. C) A legitimate criticism — leverage is not free, and financing costs are a real drag on the levered strategy's net returns. D) Correct, the false statement (EXCEPT-item) — equal risk distribution across asset classes does not immunize the portfolio from drawdowns; risk parity portfolios can and have experienced significant losses, particularly when leveraged low-volatility assets sell off simultaneously with equities.

Conditional Value-at-Risk (CVaR or Expected Shortfall) is preferred over VaR for tail-risk-sensitive allocations because:

1. Same figure as VaR itself in the standard framework
2. Median of the loss tail in the standard framework
3. Maximum loss in the tail in the standard framework
4. Average loss conditional on exceeding VaR

Answer: D — Average loss conditional on exceeding VaR

A) ES exceeds VaR by construction. B) Mean, not median. C) Max isn't well-defined for continuous distributions. D) Correct — Expected shortfall (CVaR) is the mean of losses beyond VaR; coherent risk measure.

How does the Black-Litterman model address MVO's corner-solution problem?

It starts from reverse-optimized market-equilibrium returns and blends them with investor views, weighted by view confidence, producing intuitive, diversified posterior weights rather than optimizing directly on noisy historical sample means.

Asset-liability management (ALM)?

Match assets to liability obligations (pensions, insurance). Surplus optimization.

Risk parity?

Allocate so each asset contributes equal risk. Often levered to reach return targets.

Why doesn't equal risk-contribution weighting in risk parity guarantee protection from drawdowns?

Equalizing risk contribution across asset classes at a point in time does not prevent losses when correlations shift or multiple levered asset classes sell off together — risk parity portfolios can and have experienced significant drawdowns.