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Free CFA Asset Allocation Practice Questions & Answers
500 exam-style Asset Allocation questions. Pick your answer, hit Check answer, and see the worked solution — free to start, no signup.
100% free · No login to startQuestion 301
A financial analyst uses MVO and discovers the optimizer allocates 100% to domestic equities and 0% to all other asset classes. Which MVO criticism does this MOST directly illustrate?
Select an option first.
Correct answer: C — MVO often produces highly concentrated allocations in a small subset of asset classes, which does not reflect practical diversification
Explanation: C is correct: The concentrated allocation problem is one of MVO's most well-known failures. Because MVO is highly sensitive to expected return inputs, even small differences in expected returns across asset classes cause the optimizer to pile into the highest-expected-return classes and zero out the rest. This produces allocations that appear statistically optimal but are practically unrealistic and insufficiently diversified. A is wrong: While true, skewness/kurtosis criticism relates to the distributional assumptions, not concentration. B is wrong: The single-period limitation causes different problems (ignoring rebalancing). D is wrong: Ignoring liabilities is a separate critique.
Question 302
Which MVO criticism is addressed by adding MORE constraints to the optimization, such as setting allocation ranges for each asset class (e.g., between 10% and 30%)?
Select an option first.
Correct answer: B — GIGO — adding constraints prevents the optimizer from chasing noisy expected return estimates and forces diversification
Explanation: B is correct: Additional constraints directly limit the optimizer's ability to concentrate the portfolio in a few asset classes based on potentially noisy return estimates. By forcing allocations to remain within defined ranges, the manager prevents extreme concentrations, ensuring diversification across asset classes even when return estimates have estimation error. A is wrong: Constraints don't extend MVO to multiple periods. C is wrong: Constraints don't change the distributional assumptions of MVO. D is wrong: Liquidity constraints require different approaches.
Question 303
What is the 'budget constraint' in MVO, and why is it required?
Select an option first.
Correct answer: B — It requires all portfolio weights to sum to 100% (or 1.0) — the total portfolio must be fully invested with no money left over or borrowed beyond the portfolio
Explanation: B is correct: The budget constraint (also called the unity constraint) is the most fundamental MVO constraint. It simply requires that all asset class weights sum to 100% — the portfolio must be fully invested. Without it, the optimizer might suggest holding more than 100% (leveraged) or less than 100% (holding cash). All practical portfolio optimizations include this constraint. A is wrong: Budget in investment context means portfolio weights sum to 1, not a spending limit. C is wrong: Investment constraints relate to portfolio composition, not the investor's income. D is wrong: MVO can handle any number of asset classes.
Question 304
The nonnegativity constraint in MVO prevents negative allocations (short positions). What practical issue does allowing negative weights create for most investors?
Select an option first.
Correct answer: B — Short selling requires borrowing securities, involves margin requirements, and is not permitted for many investors (e.g., pension funds, retail investors), making negative weights impractical for strategic asset allocation
Explanation: B is correct: A negative portfolio weight means short-selling that asset class — borrowing and selling securities you don't own. This requires a margin account, involves borrowing costs, creates unlimited loss potential, and is prohibited for many institutional investors under their IPS or regulations. For strategic asset allocation, which aims for long-term passive-style tilts, short positions are generally impractical. A is wrong: Short positions do not inherently improve diversification. C is wrong: Negative weights are not always optimal, and the constraint reflects practical, not just regulatory, limitations. D is wrong: Negative weights increase, not decrease, tracking error.
Question 305
MVO is criticized for being a single-period framework. What specific limitation does this create for real-world portfolio management?
Select an option first.
Correct answer: C — It does not account for rebalancing costs and taxes across multiple periods, interim cash flows (contributions/withdrawals), and the way early performance affects future optimal allocations
Explanation: C is correct: A single-period model optimizes at one point in time but ignores the dynamic reality of portfolio management: (1) rebalancing to maintain target allocations triggers transaction costs and capital gains taxes, (2) investors make contributions and withdrawals over time, and (3) wealth accumulation (or depletion) in early periods affects appropriate risk-taking in later periods. Monte Carlo simulation helps address this limitation by modeling multiple time periods. A is wrong: Expected returns are core MVO inputs. B is wrong: MVO produces the efficient frontier. D is wrong: Risk tolerance (lambda) is explicitly incorporated in the utility function.
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Question 306
What is the key insight of reverse optimization, and how does it address MVO's GIGO problem?
Select an option first.
Correct answer: B — Instead of starting with estimated expected returns and deriving optimal weights, reverse optimization starts with the global market portfolio weights (assumed optimal) and derives the expected returns consistent with those weights, providing more stable and diversified return estimates
Explanation: B is correct: In reverse optimization, the direction of calculation is reversed: you START with portfolio weights (typically from the highly diversified global market portfolio) and SOLVE BACKWARDS for the expected returns that would justify those weights. These 'implied returns' by construction lead to well-diversified allocations, avoiding the concentration problem. This addresses GIGO because the implied returns are mathematically consistent with diversified outcomes. A is wrong: Reverse optimization explicitly derives expected returns, not ignores them. C is wrong: Reverse optimization uses CAPM-based implied returns, not surveys. D is wrong: It doesn't change the treatment of the risk-free asset.
Question 307
The Black-Litterman model is described as an extension of reverse optimization. What does it add?
Select an option first.
Correct answer: B — It allows the investor to blend the implied returns from reverse optimization with their own forward-looking views on specific asset classes, producing an adjusted set of expected returns that reflect both the market consensus and the analyst's insights
Explanation: B is correct: Black-Litterman starts where reverse optimization ends — with implied returns from the global market portfolio. It then allows analysts to express views (e.g., 'I believe emerging market equities will return 2% more than the market implies') and blends these views with the implied returns proportionally to the analyst's confidence. The result is an adjusted return vector that can be used in standard MVO, producing allocations that are more diversified than standard MVO but also reflect the analyst's active insights. A is wrong: Constraints are a separate addition to MVO, not the Black-Litterman innovation. C is wrong: BL works in return space, not necessarily factor space. D is wrong: BL is an asset-only enhancement, not liability-relative.
Question 308
What is resampled MVO (resampling), and which MVO criticisms does it address?
Select an option first.
Correct answer: B — It uses Monte Carlo simulation to generate thousands of variations around the best-guess inputs, computes the efficient frontier for each set of inputs, and takes an average — producing more stable and diversified allocations that are less sensitive to any single set of noisy input estimates
Explanation: B is correct: Resampling directly attacks the GIGO and concentration problems. By generating thousands of random variations around the best-guess inputs (within plausible ranges), running MVO for each, and averaging the resulting allocations, the final allocation is less dependent on any single (potentially noisy) set of inputs. The averaged allocation also includes more asset classes because different variations of the inputs lead to different 'winning' asset classes — all of which appear in the average. A is wrong: Resampling modifies inputs through Monte Carlo, not historical data. C is wrong: That would be dynamic rebalancing, not resampling. D is wrong: Resampling doesn't import data from other markets.
Question 309
MVO ignores skewness and kurtosis in return distributions. Why is this a problem for practical portfolio construction?
Select an option first.
Correct answer: B — Empirical asset returns exhibit fat tails (excess kurtosis) and negative skewness, meaning large losses occur far more frequently than a normal distribution would predict — ignoring this understates tail risk and can lead to allocations that appear safe but are actually exposed to catastrophic losses
Explanation: B is correct: Real-world asset returns are not normally distributed. They exhibit: (1) negative skewness (large losses more common than large gains of equal magnitude), and (2) fat tails/excess kurtosis (extreme events occur more frequently than predicted by a normal distribution — the 2008 crisis was a fat-tail event). MVO, which only uses the first two moments (mean and variance), misses these real-world characteristics, potentially understating the true risk of the portfolio. A is wrong: Skewness and kurtosis affect risk, not expected returns directly. C is wrong: All financial assets exhibit non-normality. D is wrong: Extensions of MVO can incorporate higher moments.
Question 310
A 30-year-old software engineer earns a high but volatile income tied to stock option grants and bonuses. In the economic balance sheet analysis for her financial portfolio, how should her human capital be classified?
Select an option first.
Correct answer: B — As a mix of equities and bonds, reflecting the high variability and equity-linked nature of her technology-sector income
Explanation: B is correct: Human capital modeling depends on income stability and correlation with financial markets. A technology professional with volatile, equity-linked compensation (stock options, performance bonuses tied to company/market performance) has human capital that behaves more like equities than bonds. It should be modeled as a blend of equities and bonds — more equity-like for the variable component, more bond-like for the stable base salary. A is wrong: Only stable, inflation-linked income (e.g., a government job) can be modeled as a bond. C is wrong: Geographic location does not determine human capital risk characteristics. D is wrong: The nature of the income, not its frequency, determines the classification.
Question 311
Why is it important to include residential real estate in an MVO analysis for an individual investor, even though the investor cannot sell the property easily?
Select an option first.
Correct answer: B — It represents a significant portion of the investor's total economic wealth, and ignoring it understates the true risk exposure and may lead to suboptimal financial portfolio allocations
Explanation: B is correct: For most homeowners, residential real estate is one of the largest assets on the economic balance sheet. Ignoring it in the financial portfolio optimization produces an incomplete picture of total risk. For example, if the investor also holds a lot of REITs in the financial portfolio, their total real estate exposure could be excessive. Including the home's value (constrained to its current allocation) allows the optimization to properly account for total economic portfolio composition. A is wrong: Real estate correlation with equities varies and is not always negative. C is wrong: There is no such universal regulatory requirement. D is wrong: Including a constrained illiquid asset may or may not expand the efficient frontier.
Question 312
What are the three practical challenges in including illiquid asset classes (private equity, infrastructure, direct real estate) in MVO?
Select an option first.
Correct answer: B — There are few accurate investable indexes for these classes; even where indexes exist, they are not directly investable passively; and the specific investments made have different risk characteristics than the full asset class (because they include idiosyncratic risk)
Explanation: B is correct: Three specific challenges are identified: (1) Index availability — few reliable indexes track illiquid alternatives accurately, making it hard to get clean return, risk, and correlation estimates. (2) Investability — existing indexes are not directly accessible through passive funds. (3) Specific investment risk — any particular private equity fund or real estate property includes idiosyncratic (non-systematic) risk beyond what the asset class itself bears, making it different from the class inputs used in MVO. A is wrong: These assets are commonly held by large institutional investors. C is wrong: Alternatives can improve portfolio efficiency. D is wrong: MVO can handle any number of asset classes.
Question 313
In a risk-budgeting framework, what condition indicates that a portfolio is optimally allocated across asset classes?
Select an option first.
Correct answer: C — The ratio of excess return to marginal contribution to total risk (MCTR) is equal for all asset classes and equals the portfolio's Sharpe ratio
Explanation: C is correct: The optimality condition for risk budgeting states that the portfolio is optimally allocated when: Excess return_i / MCTR_i = Portfolio Sharpe ratio for all asset classes. When this condition holds, no reallocation can improve the portfolio's return per unit of risk — moving any money from one asset class to another would reduce the overall portfolio Sharpe ratio. This is analogous to the condition in MVO where the marginal utility is equalized. A is wrong: Equal returns would suggest a passive equally-weighted portfolio. B is wrong: Equal standard deviations are not required for optimality. D is wrong: Equal risk contribution is the risk parity approach, not the optimality condition for risk budgeting.
Question 314
What is the absolute contribution to total risk (ACTR) of an asset class, and why is it useful?
Select an option first.
Correct answer: B — ACTR = weight × MCTR (marginal contribution to total risk); it shows how much of the total portfolio volatility is attributable to each asset class, enabling managers to see where risk is actually concentrated
Explanation: B is correct: ACTR = weight_i × MCTR_i. This measures the dollar (or percentage) amount of total portfolio risk that each asset class contributes. Summing all ACTRs gives total portfolio risk. ACTR helps managers identify which asset classes are the primary risk drivers — even a small allocation to a very volatile asset class could dominate portfolio risk. A is wrong: Return contribution is a separate concept. C is wrong: This formula doesn't capture what ACTR measures. D is wrong: ACTR is not a return decomposition.
Question 315
A pension fund uses surplus optimization to set its asset allocation. How does this differ from standard MVO?
Select an option first.
Correct answer: B — Surplus optimization modifies the objective function and risk measure to focus on the surplus (assets minus PV of liabilities) rather than just the asset portfolio — maximizing surplus return relative to surplus volatility
Explanation: B is correct: In surplus optimization, the surplus return (change in assets minus change in PV of liabilities) replaces the asset return as the performance measure. The risk measure is the standard deviation of the surplus. The efficient frontier is constructed in surplus return/surplus risk space. Assets that are highly correlated with the liabilities receive favorable treatment because they reduce surplus risk, even if they would not be favored in an asset-only optimization. A is wrong: All asset classes can be included. C is wrong: Duration matching is one technique, but surplus optimization is a broader MVO framework. D is wrong: It is conceptually different from standard MVO.
Question 316
Which type of institutional investor is MOST likely to use the integrated asset-liability approach to asset allocation?
Select an option first.
Correct answer: C — A large commercial bank, where both asset choices (loans) and liability choices (deposits, bond issuance) are actively managed simultaneously
Explanation: C is correct: The integrated asset-liability approach is designed for entities where both asset composition AND liability composition are actively managed simultaneously — with continuous feedback between the two. Banks are the primary example: they choose which loans to make (assets) and how to fund them (deposits, bonds, equity) simultaneously. The risk profile of both sides is jointly optimized. A is wrong: Endowments have relatively passive liabilities (fixed distribution rates). B is wrong: Pension funds' liabilities are given by actuarial calculations, not actively chosen by the fund. D is wrong: An individual investor doesn't actively manage a portfolio of liabilities.
Question 317
A pension fund is significantly underfunded (funding ratio = 0.75). The manager wants to use the two-portfolio (hedging/return-seeking) approach. What is the primary limitation?
Select an option first.
Correct answer: B — When funding ratio is below 1.0, there are insufficient assets to fully hedge all liabilities — the hedging portfolio cannot completely replicate the full liability cash flows with only 75% of the required assets
Explanation: B is correct: The two-portfolio approach requires separating assets into a hedging portfolio (to match liabilities) and a return-seeking portfolio (to grow assets). If the plan is underfunded (assets < liabilities), there may be insufficient assets to create a complete hedge of all liabilities — after allocating to the hedging portfolio, there may be nothing left for the return-seeking portion, or the hedge must be partial. This limits the approach's effectiveness for severely underfunded plans. A is wrong: The two-portfolio approach actually simplifies management by separating responsibilities. C is wrong: The approach can be extended to handle various liability types. D is wrong: There is no such universal regulatory prohibition.
Question 318
What is the distinction between a 'fixed' liability and a 'contingent' liability in the context of liability-relative asset allocation?
Select an option first.
Correct answer: A — Fixed liabilities are certain; contingent liabilities depend on future uncertain events
Explanation: A is correct: Fixed liabilities have cash flows whose timing and amounts are specified in advance — for example, a fixed-rate corporate bond payment schedule is known with certainty. Contingent liabilities have cash flows that depend on future uncertain events — a pension fund's obligation depends on how long employees live (longevity risk), salary levels at retirement, and interest rates used for discounting. Insurance claims depend on whether insured events occur. A is wrong but the answer is A — yes, fixed vs. contingent refers to certainty. B is wrong: Duration depends on the specific liability characteristics. C is wrong: Payment frequency is unrelated to the fixed/contingent distinction. D is wrong: Both types can exist across institutional types.
Question 319
Under a goals-based asset allocation framework, what determines the size of the investment in each goal's subportfolio?
Select an option first.
Correct answer: B — The investment in each goal is the present value of the future goal amount, discounted at the expected return of the module selected for that goal
Explanation: B is correct: The goals-based framework calculates the funding amount for each goal as: Investment today = PV of future goal = Future goal amount / (1 + module expected return)^n. The selected module is the one offering the highest expected return given the required probability of success over the specified time horizon. This ensures the minimum amount is invested to fund each goal with the specified confidence level. A is wrong: Expected return is used as the discount rate, not to proportion investments. C is wrong: Equal allocation ignores the different sizes and time horizons of goals. D is wrong: The probability determines which module is selected; the goal amount and return determine the investment size.
Question 320
In the goals-based framework, higher-priority goals are typically funded with LOWER-risk modules. Why?
Select an option first.
Correct answer: B — Higher-priority goals (like maintaining current lifestyle) require HIGH certainty of achievement — lower-risk allocations provide higher probability of success even if expected returns are lower
Explanation: B is correct: If a goal is critical (e.g., maintaining basic living expenses), the consequence of failure is severe. A high-priority goal requires a high probability of success (e.g., 95%), which necessitates a low-risk, conservative allocation. Lower-risk modules have lower expected returns but higher probabilities of meeting the minimum threshold. Aspirational goals (e.g., a vacation home) can tolerate a lower probability of success (e.g., 60%) and therefore can use higher-return, higher-risk modules. A is wrong: Lower-risk modules do NOT have higher expected returns. C is wrong: Time horizon is considered separately from priority in the module selection. D is wrong: This reflects investment theory, not regulations.
Question 321
What is the 'minimum expectations' concept in the goals-based approach?
Select an option first.
Correct answer: B — The minimum expected return needed for a specific module to provide the required probability of success over the goal's time horizon — used to identify the highest-return module that still meets the required confidence level
Explanation: B is correct: For each goal, given its required probability of success and time horizon, there is a minimum expected return that a module must achieve to provide that probability. The goals-based planner identifies the module with the highest expected return that still satisfies the minimum expectations requirement — this maximizes return potential while maintaining the required confidence of achieving the goal. A is wrong: Minimum expectations apply to individual goals, not the aggregate portfolio. C is wrong: This is a portfolio construction concept, not a threshold for advisory services. D is wrong: Bond allocation is determined by the overall portfolio construction, not the minimum expectations concept.
Question 322
A 60-year-old investor applies the '120 minus age' rule. What equity allocation results, and why does this formula decline with age?
Select an option first.
Correct answer: C — 60% equity; the declining equity allocation mirrors the declining value of human capital — as working years decrease, the bond-like income buffer shrinks, so the financial portfolio needs more bonds to compensate
Explanation: C is correct: 120 - 60 = 60% equity. The rule's declining equity allocation reflects the economic balance sheet insight that human capital (future earnings) is bond-like. Young workers have large bond-like human capital, so their financial portfolio can be mostly equities. As workers age, human capital diminishes. By retirement, the financial portfolio must provide stability on its own, requiring more bonds. The rule roughly approximates the life-cycle fund glide path. A is wrong: Income needs are not the primary theoretical justification. B is wrong: The formula specifically declines with age — 60% applies only at age 60, not to all older investors. D is wrong: The 50% comes from 120-70, not a minimum bond requirement.
Question 323
The endowment model (Yale Model) recommends large allocations to alternatives. What is one significant RISK of this approach for smaller endowments?
Select an option first.
Correct answer: B — Smaller endowments may lack the minimum investment sizes, due diligence expertise, and patience to access the highest-quality alternative managers — they may end up in lower-quality funds without the liquidity premiums the model is designed to capture
Explanation: B is correct: The Yale Model works best for large endowments (like Yale) because: (1) they have minimum investment thresholds to access top-tier private equity and venture capital funds (which charge high minimums), (2) they have sophisticated internal teams to evaluate alternatives, and (3) they have perpetual time horizons. Smaller endowments may lack all three, ending up in mediocre alternative funds with illiquidity but no premium. The model is designed for the advantages of large, sophisticated institutional investors. A is wrong: Top-quality alternatives have historically outperformed public markets over long periods. C is wrong: The Yale Model is a practical application, not an MVO-based approach. D is wrong: Tax-exempt institutions regularly invest in alternatives.
Question 324
What is the key criticism of the risk parity approach to asset allocation?
Select an option first.
Correct answer: B — It ignores expected returns entirely — equating risk contributions does not account for the fact that assets with higher expected returns per unit of risk should receive higher allocations
Explanation: B is correct: Risk parity allocates weights to equalize each asset class's contribution to total portfolio risk, completely ignoring expected returns. An asset class with low volatility (like bonds) gets a large weight even if its risk-adjusted return is poor. Conversely, high-return equities are underweighted. A portfolio that ignores expected returns cannot be mean-variance optimal and may generate lower total returns than a risk-aware allocation. A is wrong: Risk parity typically overweights bonds relative to equities. C is wrong: Risk parity can work with 2 or more asset classes. D is wrong: Risk parity produces very different weights than 60/40 — typically much more bond-heavy.
Question 325
Under a percentage-range rebalancing policy, four questions must be answered. Which of the following is NOT one of the four standard questions?
Select an option first.
Correct answer: D — What is the expected return assumption for each asset class?
Explanation: D is correct: The four questions for percentage-range rebalancing are: (1) Who is ultimately responsible for rebalancing? (2) How frequently should the portfolio be monitored? (3) What is the size of the rebalancing corridors? (4) Should rebalancing be to the full target or only partial? Expected return assumptions are part of capital market expectations and SAA construction, not the rebalancing policy itself. A, B, C are wrong because they are all correctly listed as the standard questions.
Question 326
Higher asset class volatility typically argues for which corridor width, and what is the reasoning?
Select an option first.
Correct answer: B — Narrower corridors — high volatility causes portfolio weights to move rapidly from targets, requiring tighter controls to prevent excessive risk accumulation
Explanation: B is correct: With highly volatile assets, portfolio weights shift quickly and significantly. A 5% drift in a volatile asset class can happen overnight during market stress, potentially creating unacceptable risk levels. Narrower corridors trigger more frequent rebalancing, keeping the portfolio closer to its target risk profile. Note: this contrasts with the transaction cost argument (which argues for wider corridors for expensive-to-trade assets). The overall corridor width balances these competing factors. A is wrong: Wider corridors would allow dangerous risk buildup with volatile assets. C is wrong: Volatility is explicitly listed as a key corridor width determinant. D is wrong: Unlimited drift would abandon the discipline of strategic asset allocation.
Question 327
An investor believes strongly in momentum — that assets that have been rising will continue to rise. What rebalancing corridor width does this belief support?
Select an option first.
Correct answer: B — Wider corridors — if assets that have risen above target are expected to continue rising, selling them early to rebalance is costly, so letting them run longer (wider corridor) is better
Explanation: B is correct: A momentum believer thinks winning assets will continue winning and losing assets will continue losing. Rebalancing — which sells winners to buy losers — works against momentum by cutting winning positions prematurely. Wider corridors delay this rebalancing, allowing momentum plays to run longer before being corrected. This is the explicit logic in the reading: wider corridors for momentum belief; narrower for mean-reversion belief. A is wrong: Narrower corridors means more rebalancing, which cuts momentum positions faster. C is wrong: Investment beliefs about price dynamics directly affect optimal rebalancing frequency. D is wrong: Momentum can coexist with a long-term strategic allocation.
Question 328
A pension fund consultant recommends using futures to synthetically rebalance the portfolio rather than selling underlying bonds and equities. What is the primary trade-off of this approach?
Select an option first.
Correct answer: B — Futures achieve the rebalancing at lower cost and with faster execution, but require ongoing risk management including margin calls, rolling contracts, and counterparty risk
Explanation: B is correct: Derivatives-based rebalancing offers three advantages: lower transaction costs (narrower bid-ask spreads), faster execution, and no immediate capital gains taxes (since underlying assets aren't sold). The tradeoffs are: (1) margin requirements must be managed, (2) futures contracts expire and must be 'rolled' to new contracts, (3) counterparty risk in the case of swaps, and (4) basis risk (futures may not perfectly track the underlying asset class). A is wrong: Futures are generally less expensive than trading underlying assets for large portfolios. C is wrong: Equity index and bond futures track their underlying markets closely. D is wrong: Many pension funds routinely use derivatives for rebalancing.
Question 329
A portfolio has a 30% allocation to an asset class with high correlation (0.85) with the rest of the portfolio. Should the corridor for this asset class be wide or narrow, and why?
Select an option first.
Correct answer: B — Wide — when the asset class is highly correlated with the rest of the portfolio, they tend to move together, so relative portfolio weights change more slowly, allowing wider corridors without significant risk drift
Explanation: B is correct: If an asset class moves in lockstep with the rest of the portfolio, its relative weight barely changes as markets move. For example, if equities and bonds both rise 15%, their relative weights stay stable. High correlation means the portfolio is less likely to drift dangerously, allowing wider corridors without loss of risk control. Lower correlations mean individual asset classes can move independently, causing larger weight swings and requiring tighter corridors. A is wrong: High correlation does not necessarily mean more risk — it means more co-movement, which stabilizes relative weights. C is wrong: Correlation is explicitly listed as a corridor width factor. D is wrong: All asset classes require some rebalancing policy.
Question 330
What is the key difference between investment factor-based allocation and traditional asset class-based allocation?
Select an option first.
Correct answer: B — Asset class allocation groups investments by observable characteristics (e.g., domestic equities); factor allocation defines the opportunity set as risk exposures (market, size, value, momentum) implemented through zero-dollar long/short portfolios that isolate each factor
Explanation: B is correct: The fundamental difference is how the investment universe is defined. Asset class allocation groups instruments by observable type (domestic equity, government bonds). Factor allocation defines the portfolio in terms of risk exposures — each factor portfolio is a zero-dollar long/short spread that isolates a specific risk premium (e.g., long small stocks, short large stocks to isolate the size premium). Research shows that when both approaches reflect the same underlying assets, they produce similar efficient frontiers — the choice depends on how the manager thinks about and estimates returns. A is wrong: Complexity is not the primary distinction. C is wrong: Neither approach is systematically superior in all conditions. D is wrong: Both approaches can include the same instruments.
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