Portfolio Management and Wealth Planning

• Topic 01

  Portfolio Planning and the IPS: Advanced

  45 questions
• Topic 02

  Capital Market Expectations

  24 questions
• Topic 03

  Asset Allocation Principles

  51 questions
• Topic 04

  Risk Management Framework

  51 questions
• Topic 05

  Factor Investing

  27 questions
• Topic 06

  Liability-Relative Asset Allocation

  24 questions
• Topic 07

  Goals-Based Wealth Planning

  25 questions
• Topic 08

  Tax-Efficient Portfolio Management

  45 questions
• Topic 09

  Behavioural Finance in Portfolio Management

  28 questions

A few questions from this unit, with the answer and a full explanation. The complete bank is available when you start practising.

1. A pension fund manager implements the Black-Litterman model with two views: (1) an absolute view that global equities will return 8.5% (vs. equilibrium of 7.0%), and (2) a relative view that emerging market equities will underperform developed market equities by 1%. After computing the posterior expected returns, the optimal BL allocation differs from market-cap weights primarily in which direction, and why?

   • A
     The allocation underweights global equities and overweights fixed income because BL treats the absolute view of 8.5% as below-average when evaluated against the model's internally computed equity risk premium.
   • B
     The allocation overweights global equities relative to market cap (reflecting the bullish absolute view) and underweights emerging markets relative to developed markets within equities (reflecting the negative relative view), with the magnitude of deviations moderated by tau.
     Correct answer
   • C
     The allocation overweights emerging markets because the BL model interprets underperformance relative to developed markets as a positive absolute return signal.
   • D
     The allocation underweights all equity asset classes because the relative view on EM versus DM introduces contradictory signals that BL cannot reconcile.
   Explanation

   BL combines views additively through Bayesian updating. The absolute bullish view on global equities shifts all equity posterior returns upward relative to equilibrium, leading to a global equity overweight relative to market cap. The negative relative view specifically shifts the expected return of EM equities down and DM equities up within the equity bucket, resulting in an underweight to EM versus DM. The two views do not cancel each other because they target different assets and different directions. Tau moderates both deviations — lower tau keeps the allocation closer to market-cap weights. The model never interprets underperformance as positive; it adjusts returns in the direction stated.

2. Fund A has a gross annual return of 9% and a tax cost ratio of 2.5%. Fund B (an index fund) has a gross annual return of 8% and a tax cost ratio of 0.3%. Which fund produces the higher after-tax return, and by how much?

   • A
     Fund A produces a higher after-tax return because its gross return (9%) exceeds Fund B's (8%) by enough to overcome the tax cost difference.
   • B
     Fund A produces a higher after-tax return because active management generates tax alpha by timing realisation of gains and losses across the calendar year.
   • C
     Fund A produces a higher after-tax return of 6.5% vs. Fund B at 5.8% (8% − 2.2%), because Fund B's index approach incurs hidden transaction costs.
   • D
     Fund B produces a higher after-tax return: Fund A after-tax $= 9.0\% - 2.5\% = 6.5\%$; Fund B after-tax $= 8.0\% - 0.3\% = 7.7\%$; Fund B outperforms Fund A by 1.2% per year on an after-tax basis despite earning 1% less gross
     Correct answer
   Explanation

   After-tax return $=$ pre-tax return $-$ tax cost ratio. Fund A: $9.0% - 2.5% = 6.5%. Fund B: \8.0% - 0.3% = 7.7%$. Fund B outperforms by 1.2% per year despite earning 1% less gross. This illustrates the Jeffrey-Arnott insight: active management must generate sufficient pre-tax alpha to overcome both management fees and tax drag to add value on an after-tax basis. For a high-bracket taxable investor, the after-tax alpha hurdle for active management is substantially higher than the gross alpha.

3. An ERISA plan counsel is evaluating whether an IPS for a \$500 million DB pension fund satisfies the DOL's investment policy requirements. The IPS specifies: (1) a liability-relative return objective; (2) a 10% maximum allocation to a single alternative manager; (3) annual IPS review; (4) manager due diligence process. The plan has 50% in equities with no duration matching. Which element of the IPS is most likely to be found inadequate under ERISA's diversification and prudence requirements given the plan's current circumstances?

   • A
     The absence of a liability-hedging or duration-matching component is most likely inadequate: ERISA requires diversification that minimises the risk of large losses; holding 50% equities with no interest rate hedge exposes the funding ratio to significant duration risk, which conflicts with the stated liability-relative objective
     Correct answer
   • B
     The 10% single-manager cap is too restrictive and will be found inadequate because ERISA requires concentration in best-in-class managers.
   • C
     The performance benchmark using CPI+4% is inadequate because ERISA requires liability-linked benchmarks expressed in terms of the plan's discount rate.
   • D
     The annual review cycle is insufficient; ERISA mandates quarterly review of all DB pension fund IPS documents above $100 million.
   Explanation

   ERISA requires diversification that minimises the risk of large losses — the prudent expert applying current LDI principles for a liability-relative objective would recognise that unhedged interest rate risk creates substantial surplus volatility. A 50% equity allocation with no duration matching creates a large duration gap: if rates fall, liabilities increase more than assets, rapidly eroding the funding ratio. The IPS claims a liability-relative objective but does not implement the primary tool (LDI) for managing that risk, creating an internal inconsistency that a DOL auditor would likely flag. The 10% cap and annual review are reasonable governance provisions.