CFA CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA level 3 finquiz item set questions, study session 7, reading 17

Reading 17

Principles of Asset Allocation

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CFA Level III Item-set - Question
Study Session 8
June 2018

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Reading 17

Principles of Asset Allocation

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FinQuiz Item-set ID: 134419
Questions 1(134420) through 6(134425) relate to Reading 17

Paulus Manufacturing Case Scenario
Paulus Manufacturing is a manufacturer of doors and panels. The company has a base of 4,000
employees which are covered by a defined benefit pension plan. Stephanie Gill is the plan’s chief
investment officer. Gill summarizes details concerning the pension plan in Exhibit 1.
Exhibit 1: Paulus Manufacturing’s
Defined Benefit Pension Plan Details
Plan status
Ongoing and open to new
participants
Funded status
Underfunded by $0.5
million
Risk tolerance
Conservative
Time horizon
25 years
Current sponsor None
contributions
After collecting details, Gill designs a strategic asset allocation for the policy portfolio. She
refrains from determining the allocation using Markowitz’s mean variance optimization (MVO)
because she feels the approach fails to consider an investor’s risk tolerance, rebalancing costs
and taxes as well as leads to poorly diversified portfolios. She compares the asset-only and
liability-relative approaches for deriving allocations.
Next, Gill considers the inclusion of private equity in the allocation. She recognizes that the lack
of accurate indexes for illiquid asset classes such as private equity makes it difficult to make
capital market projections, which are essential in deriving expected returns and volatilities
estimates for the asset classes in an allocation. As a consequence, Gill decides to employ a
private equity fund for fulfilling the strategic asset allocation.
After considerable deliberation, Gill concludes that a liability-relative approach will more

comprehensively address the manufacturer’s funding objectives compared to an asset-only
approach. She bases her selection of the most suitable liability-relative approach on rebalancing
costs and taxes.
Gill proceeds to compare the possibility of employing a factor-based with an asset-class based
optimization in a liability-relative asset allocation framework. She identifies economic changes
and inflation as the most important factors to influence the plan’s liabilities. Exhibit 2 illustrates
the strategic asset allocation with rebalancing corridors designed by her for the plan. Gill intends
to rebalance the allocation using the percent-range rebalancing approach.

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Reading 17

Principles of Asset Allocation

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Exhibit 2: Strategic Asset Allocation for
Paulus Manufacturing’s Defined Benefit Pension Plan
Asset Class
Weight (%)
Corridor
Domestic equities
10
± 5.0
Hedge funds

15
± 2.0
Private equity investment vehicle
2
± 0.5
Emerging market equities
3
± 1.2
25-year Treasury bonds
40
± 8.0
Long-term B-rated corporate bonds
10
± 2.5
Tax-exempt municipal bonds
20
± 3.0
Total
100
Gill explains the factor-based optimization approach to Paulus Manufacturing’s board stating,
“The approach is only appropriate in an integrated liability-relative asset allocation framework as
the latter is sophisticated enough to link factor exposures to asset and liability returns.”

FinQuiz Question ID: 134420

1.   Considering the reasons identified by Gill, which of the following least likely justifies why
Markowitz’s MVO approach is unsuitable for determining the policy portfolio’s asset
allocation?
A.   Leads to poorly diversified allocations
B.   Does not consider an investor’s risk tolerance

C.   Does not consider the impact of rebalancing costs and taxes
FinQuiz Question ID: 134421

2.   A drawback of using an investment vehicle to represent private equity is that:
A.   the strategy is costly to implement.
B.   there is a lack of availability of investment vehicles.
C.   there is high correlation between the vehicle and the asset class it is intended to represent.
FinQuiz Question ID: 134422

3.   Using the data in Exhibit 1 and considering Gill’s rebalancing concerns which liabilityrelative approach will be most suitable for the pension plan?
A.   Surplus optimization
B.   Hedging/return seeking portfolio
C.   Integrated asset-liability approach

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Reading 17

Principles of Asset Allocation

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FinQuiz Question ID: 134423

4.   Which of the following reasons accurately identifies why the allocation in Exhibit 2 is
inappropriate?
A.   Poor diversification

B.   25-year Treasury bonds are not positively correlated with the risk factors
C.   An underfunded plan requires a higher growth component to reduce sponsor concerns for
funding future liabilities
FinQuiz Question ID: 134424

5.   Based on Gill’s comments concerning factor-based allocation, she is most likely:
A.   correct.
B.   incorrect, a factor-based approach can be implemented with any liability-relative asset
allocation approach.
C.   incorrect, the integration approach makes asset allocation decisions independently of
liabilities which is inconsistent with the fundamentals of factor-based allocation.
FinQuiz Question ID: 134425

6.   Using the data in Exhibit 2 and considering transaction costs, will a simultaneous increase in
correlation between domestic equities with the rest of the portfolio and volatility require an
adjustment to the asset class’s corridor width?
A.   No.
B.   Yes, the width should be increased.
C.   Yes, the width should be decreased.

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