CFA Level III Asset Allocation Practice Questions
Question 1
A trustee holds US large-cap equity, high-yield bonds and listed real estate and regards them as three diversifying asset classes. A risk analysis shows that most of each holding's volatility is explained by equity-market and credit-spread factors that rise together in downturns. What would a factor-based approach conclude?
- A. Diversification is adequate because each holding has a different label, benchmark and manager
- B. The portfolio is less diversified than the asset-class labels suggest, with risk concentrated in a common growth factor
- C. Factors cannot inform allocation because they are not directly investable securities, so asset-class weights remain the working unit
- D. Factor correlations matter for liquidity planning, while asset-class weights remain the best measure of diversification
Show answer and explanation
Correct answer: B. The portfolio is less diversified than the asset-class labels suggest, with risk concentrated in a common growth factor
Factor-based allocation looks through asset-class labels to underlying risk drivers. Assets loading on the same factor provide little diversification when that factor falls.
- A. Labels do not create diversification; common factor exposure does.
- B. Correct: the holdings share exposure to the same underlying factor.
- C. Factors can be accessed through factor-tilted or long-short strategies and are used in allocation.
- D. Factor correlations bear directly on diversification, not just liquidity.
Question 2
A committee proposes adding high-dividend stocks as a separate asset class. The holdings are spread across the domestic large-cap universe and the group has a 0.97 correlation with the broad large-cap index. Which criterion for a useful asset class does the proposal most clearly fail?
- A. Sufficient liquidity to hold meaningful positions without moving prices when the portfolio trades
- B. Homogeneity of the securities within the group
- C. Low correlation with the other asset classes in the policy
- D. A long enough return history to estimate risk and return
Show answer and explanation
Correct answer: C. Low correlation with the other asset classes in the policy
A useful asset class should be diversifying, with low correlation to other classes. A group correlated 0.97 with large-cap equity adds little diversification, so it is better treated as a tilt within equity.
- A. Large-cap dividend stocks are generally liquid, so liquidity is not the problem.
- B. Homogeneity is not the main issue raised by the 0.97 correlation.
- C. Correct: the high correlation shows little diversification benefit.
- D. History length is unrelated to the facts given.
Question 3
A pension plan begins the year with assets of 900 and a present value of liabilities of 1,000 (EUR millions). Assets return 8.0% and the liabilities grow 5.0% for the year. There are no contributions or benefit payments. What is the funded ratio at year end?
- A. 93.0%
- B. 90.0%
- C. 92.6%
- D. 97.2%
Show answer and explanation
Correct answer: C. 92.6%
Ending assets = 900 x 1.08 = 972. Ending liabilities = 1,000 x 1.05 = 1,050. Funded ratio = 972 / 1,050 = 92.6%. The plan remains underfunded because liabilities grew.
- A. Adds the 3-point return gap to the starting 90.0% ratio, which ignores compounding on different bases.
- B. Reports the starting funded ratio, ignoring that assets and liabilities both changed.
- C. Correct: 972 / 1,050 = 92.6%.
- D. Divides ending assets by the starting liabilities, ignoring liability growth.
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Ines evaluates a candidate portfolio with an expected return of 7.0% and a standard deviation of 12.0%. Her risk aversion coefficient is 4, and she uses the mean-variance utility U = E(R) - 0.005 x lambda x variance, with return and standard deviation in percent. What is the portfolio's utility?
- A. 6.76
- B. 4.12
- C. 5.56
- D. 9.88
Show answer and explanation
Correct answer: B. 4.12
Variance is 12.0 squared = 144. Penalty = 0.005 x 4 x 144 = 2.88. Utility = 7.0 - 2.88 = 4.12. Risk aversion of 4 scales the variance penalty.
- A. Uses the standard deviation (12) rather than the variance (144) in the penalty.
- B. Correct: 7.0 - 0.005 x 4 x 144 = 4.12.
- C. Uses 0.01 and ignores risk aversion, giving 7.0 - 1.44.
- D. Adds the risk penalty instead of subtracting it.