CFA Level III Portfolio Construction Practice Questions
Question 1
A bank funds a securities portfolio with short-term deposits that reprice quarterly. The portfolio is mostly fixed-rate bonds with an average remaining life of 7 years. Market short-term rates rise sharply. What is the most likely effect on the bank's net interest margin?
- A. It widens because higher market rates raise the yield on the existing fixed-rate bonds immediately
- B. It narrows because funding costs reset upward before the fixed asset yields can adjust
- C. It widens because the market value of the bonds falls and increases their yield
- D. It is unchanged because deposits and securities both reprice at the same pace
Show answer and explanation
Correct answer: B. It narrows because funding costs reset upward before the fixed asset yields can adjust
With short-term liabilities funding long fixed-rate assets, liability costs rise before asset income does, compressing the spread. Banks manage this repricing gap through asset-liability matching.
- A. Wrong: coupons on existing fixed-rate bonds do not change when market rates rise.
- B. Correct: short liabilities reprice faster than long fixed assets.
- C. Wrong: a price decline raises yield for new purchasers, not the income on holdings already owned.
- D. Wrong: the stem says deposits reprice quarterly and the bonds are long-dated, so repricing is mismatched.
Question 2
A client has both a taxable account and a tax-deferred retirement account. She holds an index equity fund with low turnover and a taxable bond fund that pays high ordinary income. Which asset location is generally most tax-efficient?
- A. Both holdings in the taxable account to simplify reporting
- B. Bond fund in the tax-deferred account and the equity index fund in the taxable account
- C. Both holdings in the tax-deferred account to maximize deferral
- D. Equity index fund in the tax-deferred account and bond fund in the taxable account
Show answer and explanation
Correct answer: B. Bond fund in the tax-deferred account and the equity index fund in the taxable account
Placing income-heavy, tax-inefficient assets in tax-deferred accounts and tax-efficient, low-turnover equity in taxable accounts typically raises after-tax wealth.
- A. Wrong: this wastes the tax-deferred shelter and leaves high ordinary income taxed currently.
- B. Correct: ordinary income is sheltered while equity gains defer and may receive lower rates.
- C. Wrong: it leaves no assets in the taxable account for liquidity and forgoes favorable treatment of equity gains.
- D. Wrong: this exposes high ordinary income to current tax and wastes the shelter on a tax-efficient holding.
Question 3
An investment committee is deciding where to place active versus passive mandates in a global equity program. It believes that large-capitalization developed-market stocks are priced very efficiently and that small-cap and emerging-market segments are less efficient. Which blend is most consistent with this view?
- A. A fully passive program because the committee's views on efficiency would reduce net alpha after fees
- B. Equal active risk across all segments since expected alpha cannot be predicted by market segment
- C. Active in the large-cap developed segment where information is abundant and passive elsewhere
- D. Passive in large-cap developed markets, with active risk concentrated in small-cap and emerging markets
Show answer and explanation
Correct answer: D. Passive in large-cap developed markets, with active risk concentrated in small-cap and emerging markets
Active management is most likely to add value net of costs where inefficiency and dispersion exist. Passive exposure is cost-efficient where markets are highly efficient.
- A. Wrong: the committee's view supports active management in some segments, not a blanket passive approach.
- B. Wrong: the stated view implies expected alpha opportunities differ by segment.
- C. Wrong: this reverses the efficiency view stated by the committee.
- D. Correct: allocate active risk to the less efficient segments.
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A plan sponsor allocates 50% each to two active managers with tracking errors of 8% and 6% against the same benchmark. Their active returns are uncorrelated. What is the tracking error of the combined portfolio?
- A. 10.0%
- B. 3.5%
- C. 7.0%
- D. 5.0%
Show answer and explanation
Correct answer: D. 5.0%
TE = sqrt(0.5^2 x 8^2 + 0.5^2 x 6^2) = sqrt(16 + 9) = sqrt(25) = 5.0%. Uncorrelated active returns diversify, so TE is below the 7.0% weighted average.
- A. Wrong: this adds the tracking errors without weights or diversification.
- B. Wrong: this halves the average and ignores the required squared terms.
- C. Wrong: this is the simple average of the two tracking errors, which assumes perfect correlation.
- D. Correct: with zero correlation, add weighted variances and take the square root.