Review

Case study 1

Mark is an investment strategist who develops capital market expectations for a pension fund that invests across asset classes and global markets. Mark started his career when the global markets were experiencing significant volatility and poor returns; as a result, he is now careful to base his conclusions on objective evidence and analytical procedures to mitigate any potential biases. Mark’s approach to economic forecasting utilizes a structural model in conjunction with a diffusion index to determine the current phase of a country’s business cycle. This approach has produced successful predictions in the past, thus Mark has high confidence in his predictions. Mark also determines whether any adjustments need to be made to his initial estimates of the respective aggregate economic growth trends based on historical rates of growth for Countries X and Y (both developed markets) and Country Z (a developing market).

Exhibit 1 summarizes Mark’s analysis of economic conditions

               Country X                              Country Y                              Country Z

          Initial recovery                       Contraction                        Late Upswing

Mark assumes short-term interest rates adjust with expected inflation and are procyclical. Mark reviews the historical short-term interest rate trends for each country, which further confirms his analysis shown in Exhibit 1.

Mark decides to focus on Country Y to determine the path of nominal interest rates, the potential economic response of Country Y’s economy to this path, and the timing for when Country Y’s economy may move into the next business cycle. Mark makes the following observations:

  • Observation 1: Monetary policy has been persistently loose for Country Y, while fiscal policies have been persistently tight.
  • Observation 2: Country Y is expected to significantly increase transfer payments and introduce a more progressive tax regime.
  • Observation 3: The current yield curve for Country Y suggests that the business cycle is in the slowdown phase, with bond yields reflecting contractionary conditions.

 

Question 1
For which country will forecasting future growth probably be most challenging?

A) Country X
B) Country Y
C) Country Z

 

Question 2
Based on exhibit 1 and Mark’s assumptions about short-term rates and expected inflation, short-term rates in Country X are most likely to be:

A) low and bottoming.
B) approaching a peak.
C) above average and rising.

 

Question 3
Based on Exhibit 1, what capital market effects is Country Z most likely to experience in the short term?

A) Cyclical assets attract investors
B) Monetary policy becomes more restrictive
C) Yield curve steepens substantially

 

Question 4
Based on Observation 3, Mark is least likely to forecast in country Y

A) Monetary tightening will lead to higher short-term rates
B) Monetary loosening will lead to lower short-term rates
C) Slowdown should end leading to yield curve steepening

 

Question 5
Given exhibit 1 which bond market would Mark most probably consider as having the best expected future return in local currency:

A) Country X
B) Country y
C) Country Z

 

Case Study 2
Historical & Current Capital Market Data and Expectations

  • Average government bond returns: 2.8%
  • 10-year government bond yield: 2.3%
  • Expected annual inflation: 2.3%
  • Average annual equity return: 4.6%
  • Trailing twelve months equity return: −9.4%
  • Average annual inflation rate: 2.3%
  • Expected annual inflation rate: 2.5%
  • Trailing twelve months inflation rate: 2.1%
  • Expected annual dividend income return: 2.4%
  • Equity market P/E (beginning of period): 15.0 x
  • Current equity market P/E: 14.5x
  • Expected equity market P/E: 14.0x
  • Expected annual real earnings growth: 5.0%
  • Average annual dividend income return: 2.6%
  • Average annual real earnings growth: 6.0%

 

Question 6
The historical Equity premium is:

A) 1.8%
B) 2.3%
C) More information is required

 

Question 7
The historical average real return of Government bonds is:

A) 0.0%
B) 0.5%
C) More information is required

 

Question 8
The expected change in market valuation is closest to:

A) -3.5%
B) 6.0%
C) 8.6%

 

Question 9
The expected nominal earnings growth is closest to:

A) 4.5%
B) 8.1%
C) 7.5%

 

Question 10
The expected return on equity is closest to:

A) 3.4%
B) 6.4%
C) 9.4%

 

Question 11
The expected equity premium is closest to

A) Previous answer less average bond returns
B) Previous answer less inflation
C) Previous answer less 10-Y Government Bond Yield

 

 

Case Study 3

Matt Ske is a consultant hired to provide advice to ACME Pension Fund’s board of directors on asset allocation issues. Matt is first interrogated on the role of Strategic Asset Allocation (SAA) in achieving its mission of safely delivering the promised benefits to pensioners and – if possible – to offer Cost-Of-Living-Adjustments.

The chairman of the board summarizes the current understanding of the board as

  1. Top-down strategies offer better results than bottom-up strategies.
  2. It is easier to achieve optimal risk diversification between asset classes than securities.
  3. SAA is the prime determinant of a Pension fund’s performance.
  4. SAA makes it easier to stabilize the target risk profile of the investment portfolio.
  5. Frequent rebalancing portfolio towards SAA target is typically beneficial in times of high market volatility.

Question 12
What are the two assertions Matt most likely wishes to discuss to soften or adjust the board’s beliefs

A) A and B
B) C and D
C) B and E

 

Matt suggests structuring his presentation by following these issues:

  1. Investment policy
  2. Defining asset classes
  3. Long term Capital market expectations
  4. Optimization and the Variance-Covariance Matrix
  5. Other risk management considerations
  6. Performance review

 

Regarding investment policy, Matt explains the general principles of Asset-Liability management to highlight the investment objective of the pension fund.

 

Question 13
What concepts will he most likely present (multiple answers):

    1. Sensitivity of the Present Value of liabilities to interest rates (Y/N)
    2. Sensitivity of the Present Value of liabilities to credit risk (Y/N)
    3. Sensitivity of the Present Value of liabilities to inflation (Y/N)
    4. Sensitivity of the Present Value of liabilities to equity markets (Y/N)

 

Question 14
He then also explains that Liability Driven Investing must also consider (multiple answers):

    1. Pension fund tax issues. (Y/N)
    2. The need to control for adequate liquidity. (Y/N)
    3. The need for the board to define its sensitivity to risk. (Y/N)
    4. The current state in the business cycle (Y/N)

 

Question 15
Lastly, he explains that the investment policy defined by the board must also state some core beliefs on capital markets such as (multiple answers):

    1. Market efficiency and capacity for asset managers to extract alpha. (Y/N)
    2. The greater stability of long term than short term forecasts. (Y/N)
    3. The importance of expenses and operational risks (Y/N)
    4. The level of commitment to Environment, Social and Governance issues (Y/N)

 

Question 16
He explains that asset classes to be selected for inclusion in the SAA should show (multiple answers):

    1. Consistency (high correlation within, low correlation without) (Y/N)
    2. Investability (no or low restrictions) (Y/N)
    3. Low risk and high diversification potential (Y/N)
    4. High probability of a risk premium (Y/N)

 

Matt then explains the core importance of defining Capital Market Assumptions (CMA)

 

Question 17
He explains that such CMAs can be produced by (multiple answers):

    1. Starting with historical returns as an anchoring point (Y/N)
    2. Acknowledging the pertinence of previous CMAs (Y/N)
    3. Analyzing average CMAs of the industry and produced by consultants (Y/N)
    4. In order to adjust for differing house views (Y/N)

 

Question 18
Regarding long-term expected returns for Equity, he explains that the standard structural constituents are (multiple answers):

    1. Income (Y/N)
    2. Real Growth of Earnings (Y/N)
    3. Inflation (Y/N)
    4. Expected market rebasing (P/CAPE for instance) (Y/N)

 

Question 19
Regarding long-term expected returns for Fixed Income, he explains that the standard structural constituents are (multiple answers):

    1. Current risk-free YTM (Y/N)
    2. Shape of the Yield Curve and roll-down effect (Y/N)
    3. Credit spreads and expected credit losses (Y/N)
    4. Repo rates (Y/N)

 

Question 20
Regarding asset class risk and correlation assumption, he explains that (multiple answers):

    1. Estimates often vary over time and should therefore be considered on a long-term basis (Y/N)
    2. The VIX and interest rate implied volatility can be used to stabilize estimates (Y/N)
    3. Very high positive or negative correlations should be avoided in order to avoid asset class long/short “arbitrage” (Y/N)
    4. Higher moments such as asymmetry and kurtosis may theoretically be used to control for extreme risk (Y/N)

 

Question 21
Regarding CMA revisions, he explains that (multiple answers):

    1. As a rule, CMAs should not be changed (Y/N)
    2. For that purpose, historical stress testing or by using alternative scenarios should be done to ensure capacity to withstand risk (Y/N)
    3. Yet, an annual review of the underlying scenarios and justifications should be made (Y/N)
    4. Leading to changes if and only if there is a strong conviction that conditions have substantially changed (Y/N)

 

Question 22
He explains that asset classes may conveniently be regrouped (multiple answers):

    1. By function in portfolio (e.g.: growth, inflation, risk dilution, liquidity…) (Y/N)
    2. By level of risk (Low, medium, high) (Y/N)
    3. By legal status (e.g. ownership/debt, listed or not) (Y/N)
    4. By investment style (Y/N)

 

Question 23
Regarding the optimization process, Matt explains the sensitivity to the necessary inputs. He explains that expected returns may be determined by assessing (multiple answers):

    1. Statistical analysis of historical data. (Y/N)
    2. Surveys among economists, portfolio managers and consultants (Y/N)
    3. Econometric models for growth, inflation and market rebasing (Y/N)
    4. Arbitrage opportunities that exist on markets (Y/N)

 

Question 24
Matt also explains that the Mean-Variance optimization process should be handled with great caution because (multiple answers):

    1. The underlying model is unproven (Y/N)
    2. It typically does not consider transactions costs (Y/N)
    3. It maximizes the consequences of forecasting errors. (Y/N)
    4. The utility function is subjective (Y/N)

 

Question 25
Then Matt wants to stress the necessity to define how rebalancing takes place. He explains that (multiple answers):

    1. Rebalancing can typically be beneficial in time of market extreme behavior, sell in the bubble / buy in the crash (Y/N)
    2. Rebalancing may also be useful in sideway markets but not when markets exhibit trend-like behavior (Y/N)
    3. Rebalancing entails trading costs that can be minimized if integrated to Tactical Asset Allocation
    4. Rebalancing may at times be done using derivatives overlay to minimize trading costs (Y/N)

 

Question 26
Matt explains the usefulness of stress testing the optimization result through procedures such as (multiple answers):

    1. Retrospective analysis of how portfolio would have performed in times of crisis (Y/N)
    2. Construction of hypothetical worst-case scenarios (Y/N)
    3. Analysis of serial correlation, especially in times of crisis (Y/N)
    4. Black-Litterman implicit returns. (Y/N)

 

Question 27
The investment process should end with a performance review that identifies (multiple answers):

    1. The performance of the strategic asset allocation (Y/N)
    2. The performance of the tactical divergence of asset allocation (Y/N)
    3. The performance for each asset class of the portfolio vs its benchmark (Y/N)
    4. The total internal and external expenses paid (Y/N)

 

After having clarified the importance and basic structure of defining a Strategic Asset Allocation, Matt then explains how Tactical allocation may add value to the investment portfolio.

 

Question 28
He explains that Tactical Asset Allocation could typically be limited by (multiple answers):

    1. Strict government regulation (Y/N)
    2. The liquidity of markets (Y/N)
    3. A tracking error constraint vs Strategic Asset Allocation. (Y/N)
    4. Minimum and maximum allocation bands; (Y/N)

 

Question 29
Tactical Asset Allocation is a process that can feed on (multiple answers):

    1. Economic analysis and in particular business cycle forecasts (Y/N)
    2. Geopolitical analysis, in particular to adjust the international exposure (Y/N)
    3. Calendar anomalies such as summer doldrum or Monday swoon (Y/N)
    4. Market valuation ratios, smoothed or adjusted for the business cycle (Y/N)

 

Lastly, Matt explains how performance should be examined, to eventually amend the process or assumptions

 

Question 30
The final performance review should identify and analyze the different sources of performance (multiple answers):

    1. Strategic Asset Allocation (Y/N)
    2. Tactical Asset Allocation (Y/N)
    3. Security Selection by internal or external managers (Y/N)
    4. And compare asset performance to changes in the liability (change in the funding ratio) (Y/N)
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