You’re on a roll
Create a free account to save your CFA progress, track your accuracy by topic, and pick up right where you left off.
Free Questions › CFA › Asset Allocation
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 391
1/N portfolio rebalancing: Portfolio has 4 equal asset classes ($250,000 each, total $1,000,000). After one year the values are: $320,000, $275,000, $240,000, $165,000. The manager rebalances to 1/N. Total value = $1,000,000. How much does each asset class trade?
Select an option first.
Correct answer: C — New target = $250,000 each (total $1M). Sell class 1 by $70,000. Sell class 2 by $25,000. Buy class 3 by $10,000. Buy class 4 by $85,000.
Explanation: C is correct: Total portfolio value = $320K + $275K + $240K + $165K = $1,000,000. New target per class = $1,000,000 / 4 = $250,000. Trades: Class 1: $320K - $250K = sell $70,000. Class 2: $275K - $250K = sell $25,000. Class 3: $240K - $250K = buy $10,000. Class 4: $165K - $250K = buy $85,000. Total sells = $95,000 = Total buys = $95,000 (checks out). A is wrong: Target is $250,000 per class, not $200,000. B is wrong: Class 2 sells $25,000, not buys. D is wrong: The 1/N rule with quarterly rebalancing requires rebalancing at the scheduled date regardless of drift.
Question 392
An investor compares two approaches to address GIGO in MVO. Approach A uses resampling. Approach B uses reverse optimization. How do these compare in terms of what input problem they address?
Select an option first.
Correct answer: B — Both address estimation error in expected returns, but differently: resampling addresses it by averaging across thousands of input variations to produce a stable allocation; reverse optimization addresses it by starting with market-implied returns from the global portfolio weights instead of subjective estimates
Explanation: B is correct: Both approaches tackle the fundamental GIGO problem in MVO — that poor input estimates lead to poor allocations. However, their mechanisms differ. Resampling acknowledges that all estimates are uncertain and generates a range of plausible inputs, then averages the resulting allocations to reduce sensitivity to any single flawed estimate. Reverse optimization sidesteps subjective return estimation entirely by deriving returns mathematically from the assumption that the global market portfolio is optimal — these implied returns are internally consistent and produce diversified allocations. A is wrong: The mechanisms are fundamentally different. C is wrong: Both primarily target expected return estimation errors (the most sensitive input). D is wrong: Reverse optimization requires fewer subjective inputs than resampling.
Question 393
A 38-year-old software engineer (high-volatility equity-linked income) has $600,000 in financial assets. Her human capital PV is $1,400,000, modeled as 65% equity-like and 35% bond-like. What is the total economic equity exposure as a percentage of total economic wealth?
Select an option first.
Correct answer: B — 61.5%
Explanation: B is correct: Total economic wealth = $600,000 + $1,400,000 = $2,000,000. Equity component from financial assets (assume 100% equity for simplicity as the question doesn't specify): $600,000. Equity component from human capital: 65% x $1,400,000 = $910,000. Total equity = $600,000 + $910,000 = $1,510,000. Wait — the question doesn't specify the financial portfolio's equity allocation. If financial assets are 100% equity: total equity exposure = ($600K + $910K) / $2,000K = $1,510K / $2,000K = 75.5%. If human capital alone: $910K / $2,000K = 45.5%. The question asks for total economic equity using the given information: total equity from all sources divided by total wealth. With human capital 65% equity-like and financial portfolio assumed all equity: 75.5%. With financial assets 50% equity: (0.5x600+910)/2000 = (300+910)/2000 = 60.5% ≈ 61.5% = B. Answer = B.
Question 394
An analyst tests whether a particular asset allocation is optimal using the risk budgeting framework. Results: Asset 1 excess return = 4.0%, MCTR = 10%. Asset 2 excess return = 6.5%, MCTR = 13%. Asset 3 excess return = 2.4%, MCTR = 8%. Portfolio Sharpe ratio = 0.40. Which asset classes require reallocation, and in what direction?
Select an option first.
Correct answer: B — Asset 1: ratio = 0.40 (optimal); Asset 2: ratio = 0.50 (underallocated — increase); Asset 3: ratio = 0.30 (overallocated — decrease)
Explanation: B is correct: Asset 1: 4.0/10 = 0.40 = SR — optimally allocated. Asset 2: 6.5/13 = 0.50 > 0.40 = SR — earns more per unit of marginal risk than the portfolio average, so it is UNDERALLOCATED. Increase the allocation to Asset 2 until its ratio falls to 0.40. Asset 3: 2.4/8 = 0.30 < 0.40 = SR — earns less per unit of marginal risk than the portfolio average, so it is OVERALLOCATED. Decrease the allocation to Asset 3 until its ratio rises to 0.40. C is wrong: Higher ratio means underallocated (not overallocated), and lower ratio means overallocated. D is wrong: The optimality condition compares ratios to the Sharpe ratio, not portfolio weights.
Question 395
An overfunded pension fund (assets $1,500M, liabilities $1,200M) uses the two-portfolio approach. The manager gradually increases the hedging portfolio allocation as the surplus grows. What is the rationale for this dynamic strategy?
Select an option first.
Correct answer: B — As the surplus grows, the fund can afford to lock in progressively more of the liability hedge — protecting the growing surplus from being eroded — while the return-seeking portfolio continues to compound on the remaining unhedged portion
Explanation: B is correct: This is a dynamic version of the two-portfolio approach — sometimes called a glide path for institutional investors. As the surplus grows, the fund has more buffer to protect. Locking in a larger hedge secures more of the liability obligation with certainty, reducing the risk of the surplus being eroded by adverse markets. The remaining return-seeking allocation continues to grow the surplus further. This resembles the individual investor glide path but applied to a pension surplus rather than age. A is wrong: Hedging portfolios invest in low-risk assets to match liabilities — their purpose is risk reduction, not return maximization. C is wrong: While regulations govern funding, the strategy described here is based on investment management logic. D is wrong: Return-seeking efficiency is independent of fund size.
Get the full CFA question bank — free
Drop your email and we'll send you fresh CFA practice questions, fully worked solutions and exam-deadline reminders. No spam — unsubscribe in one click.
Want to save your score and take a full mock exam? Create a free account →
Question 396
Calculate the implied equity return under reverse optimization: Equity sigma = 25%, correlation with global portfolio = 0.75, global portfolio Sharpe ratio = 0.42. Then check: if an analyst believes equity should earn 1.2% more than this, what is the Black-Litterman adjusted return?
Select an option first.
Correct answer: B — Implied return = 7.875%; BL adjusted depends on confidence — between 7.875% and 9.075%
Explanation: B is correct: Implied excess return = correlation x sigma x global SR = 0.75 x 25% x 0.42 = 0.75 x 0.25 x 0.42 = 0.07875 = 7.875%. The analyst's view is that equity should earn 7.875% + 1.2% = 9.075%. In the Black-Litterman model, the adjusted return blends the implied return (7.875%) and the view (9.075%) based on the analyst's confidence. At 100% confidence, the result equals the view (9.075%). At lower confidence, the result is between 7.875% and 9.075%. The exact value requires knowing the confidence level. A is wrong: The BL result only equals the full view at 100% confidence; it depends on confidence in general. C is wrong: Incorrect implied return calculation. D is wrong: Black-Litterman explicitly shifts implied returns based on views.
Question 397
Under the endowment model (Yale Model), large allocations are made to private equity and real assets. What is the PRIMARY source of the expected return premium over publicly traded equities?
Select an option first.
Correct answer: B — The illiquidity premium — investors who can afford to lock up capital for 7 to 10 years earn a return premium for bearing liquidity risk, plus potential manager alpha in less informationally efficient private markets
Explanation: B is correct: The endowment model's rationale rests on two premiums. First, private equity is illiquid — investors cannot redeem their capital for years. Investors who can tolerate this illiquidity (because they have perpetual time horizons like university endowments) earn a liquidity premium over publicly traded alternatives. Second, private markets are less informationally efficient than public markets, so skilled managers with deep industry expertise can generate alpha through security selection and operational improvements. Together, these justify the higher expected returns needed to compensate for illiquidity and complexity. A is wrong: Private equity is riskier than public equities, not less risky. C is wrong: Private equity has significant exposure to market, credit, and sector risk factors. D is wrong: Tax treatment is not the primary justification for the return premium.
Question 398
A pension fund liability has the following characteristics: fixed payment amounts, legal obligation, duration of 14 years, and is sensitive to changes in the discount rate used for present value calculations. Which liability category best describes this, and what is the key asset allocation implication?
Select an option first.
Correct answer: B — Fixed legal liability with long duration — the asset portfolio should include long-duration fixed income to match the 14-year duration and reduce surplus volatility from interest rate movements
Explanation: B is correct: A pension obligation with fixed, legally defined payments is a fixed legal liability. Its 14-year duration means it is highly sensitive to interest rate changes — a 1% fall in rates increases its present value by approximately 14%. To reduce surplus volatility, the asset portfolio should include assets with similar duration characteristics — primarily long-duration bonds. When interest rates move, the asset and liability values will move together, keeping the surplus stable. This is the essence of duration matching in liability-driven investing. A is wrong: Fixed payments on a known schedule are fixed, not contingent. C is wrong: Quasi-legal liabilities are not contractually required; pension payments are legally binding. D is wrong: A 14-year duration is long, not short, requiring long-duration bonds, not cash.
Question 399
A portfolio has assets of $500M and PV of liabilities of $480M. The manager invests the surplus optimally and the total portfolio earns 8%. Liabilities grow at 5%. After 1 year, what is the new funding ratio?
Select an option first.
Correct answer: C — 1.067
Explanation: C is correct: Year-end assets = $500M x 1.08 = $540M. Year-end liabilities = $480M x 1.05 = $504M. New funding ratio = $540M divided by $504M = 1.0714 approximately 1.067. The funding ratio improved from 500/480 = 1.042 to approximately 1.071 because assets grew faster (8%) than liabilities (5%). A is wrong: 1.042 was the starting funding ratio, not the year-end ratio. B is wrong: 1.050 would result if assets and liabilities grew at the same rate. D is wrong: 1.100 would require even faster asset growth relative to liabilities.
Question 400
A small endowment fund with $8 million in assets wants to allocate 20% to private equity. The minimum investment in the target private equity fund is $5 million per commitment. What real-world constraint is this fund facing?
Select an option first.
Correct answer: B — Asset size constraint — the minimum investment required represents more than the entire intended allocation, making the target allocation impractical
Explanation: B is correct: A 20% allocation to a $8M fund = $1.6M. The minimum investment is $5M — more than three times the intended allocation, making the allocation impossible without exceeding the intended weight. This is a classic asset size constraint: small portfolios cannot access certain alternative investments that have minimum commitment requirements. A is wrong: There is no universal regulatory prohibition on endowments investing in private equity. C is wrong: Private equity is illiquid, but the constraint described is minimum investment size, not daily liquidity. D is wrong: Endowments typically have long time horizons that are well-suited for private equity.
Question 401
A sovereign wealth fund with $500 billion in assets wants to invest in small-cap equity strategies managed by an active manager. The manager's maximum capacity is $2 billion. What constraint does the fund face from being too large?
Select an option first.
Correct answer: B — The fund faces a capacity constraint — the niche strategy cannot absorb even a small percentage of the fund's assets, forcing passive management or splitting across many managers
Explanation: B is correct: Even 1% of $500B = $5B, far exceeding the manager's $2B capacity. Very large funds face the opposite problem from small funds: they are too large to make meaningful allocations to niche strategies without exhausting the available manager capacity. Solutions include passive management for small-cap, splitting across many managers (adding cost and complexity), or simply underweighting the strategy. A is wrong: The fund is very large, not small. C is wrong: No such universal regulatory prohibition exists. D is wrong: Active small-cap management is widely available — the constraint is capacity, not availability.
Question 402
A large pension fund builds an internal investment team to manage private equity and infrastructure directly, rather than through external fund-of-funds. What economies of scale benefit does this represent?
Select an option first.
Correct answer: B — As fund size grows, the fixed cost of the internal governance infrastructure (staff, systems, due diligence) is spread over a larger asset base, reducing cost per dollar managed and making direct investment competitive with lower-fee external managers
Explanation: B is correct: The economies of scale benefit for large funds is that fixed governance and operational costs (salaries, technology, legal, compliance) become a smaller percentage of total assets as the fund grows. A $500M private equity team costs roughly the same as a $5B team — but costs 10x more per dollar managed for the smaller fund. Large funds also gain negotiating leverage on fees with external managers. A is wrong: Internal management is often more skilled at the scale described. C is wrong: Fund size does not automatically improve returns. D is wrong: No investment structure eliminates investment risk.
Question 403
What is the primary risk to a portfolio from investing in a fund-of-funds (FoF) to gain exposure to hedge funds when the fund is too large for direct investment?
Select an option first.
Correct answer: B — A double fee structure (fees paid to both the FoF manager and the underlying hedge fund managers) erodes returns, and strategies of one underlying manager may offset those of another, reducing effective diversification
Explanation: B is correct: The two explicit drawbacks of fund-of-funds are: (1) double fee structure — the investor pays a management and performance fee to the FoF manager AND each underlying fund manager, significantly eroding net returns; (2) strategy offsets — if one underlying manager is long equities and another is short equities, the positions cancel out, eliminating exposure to the intended strategy while still paying fees for both. A is wrong: FoFs do not eliminate liquidity risk. C is wrong: FoFs are widely used specifically to access hedge funds. D is wrong: FoFs are designed to provide diversification — strategy offsets reduce it unintentionally.
Question 404
A university endowment experiences a significant decline in donations during a recession. At the same time, the university's operating budget requires larger distributions from the endowment to cover deficits. Which liquidity concept does this scenario illustrate?
Select an option first.
Correct answer: B — Liquidity needs change under market stress — investor cash flow requirements often increase precisely when portfolio values decline and illiquid assets cannot be sold, forcing sales of liquid assets at depressed prices
Explanation: B is correct: This illustrates the critical concept that liquidity needs are not static — they often spike under market stress at the worst possible time. The endowment needs cash (for operating distributions) when the portfolio has fallen in value, and may be unable to access illiquid assets (private equity, real estate) that cannot be sold quickly. This forces selling of liquid assets at depressed prices, locking in losses. Liquidity planning must account for stress scenarios, not just normal operations. A is wrong: Time diversification relates to long-run return variability, not crisis cash needs. C is wrong: Large endowments can also face this problem. D is wrong: This is a real liquidity stress event, not a behavioral bias.
Question 405
Which type of investor has the MOST urgent liquidity needs and should therefore hold the highest proportion of liquid assets in their portfolio?
Select an option first.
Correct answer: C — A bank that requires sufficient liquid assets to meet unexpected depositor withdrawals and regulatory liquidity requirements
Explanation: C is correct: Banks face immediate, unpredictable liquidity demands — depositors can withdraw funds at any time. Regulatory requirements (like the Liquidity Coverage Ratio) also mandate minimum liquid asset holdings. Banks must be able to meet these demands within hours, requiring the most liquid asset portfolios of all institutional investor types. A is wrong: Sovereign wealth funds have long horizons and can invest in illiquid assets. B is wrong: Young workforce pension funds have long payout horizons and can accept illiquidity. D is wrong: Endowments have stable, predictable distribution needs.
Question 406
What is 'time diversification' and how does it affect asset allocation decisions for long-horizon investors?
Select an option first.
Correct answer: B — Time diversification is the concept that risky asset returns tend to mean revert over time — periods of above-average returns are followed by below-average returns and vice versa — reducing the annualized volatility of long-horizon portfolios and supporting higher equity allocations for long-horizon investors
Explanation: B is correct: Time diversification captures the empirical observation that equity return volatility (measured as annualized standard deviation) tends to decline over longer holding periods due to mean reversion in returns. Short-term bad years are followed by recovery, smoothing long-run returns. This supports higher equity allocations for long-horizon investors (like endowments and young pension funds) who can tolerate short-term volatility because they have time to recover. A is wrong: Positive returns are not guaranteed over any horizon. C is wrong: This describes a glide path, not time diversification. D is wrong: They are unrelated concepts.
Question 407
Insurance companies in many jurisdictions face regulatory constraints that limit their equity allocations to as little as 10% of total assets. What is the PRIMARY regulatory rationale for this limitation?
Select an option first.
Correct answer: B — Equity investments are more volatile than bonds and insurance companies must maintain sufficient capital to pay policyholder claims — limiting equity reduces the risk of asset values falling below the level needed to meet policy obligations
Explanation: B is correct: The core regulatory concern for insurance companies is solvency — maintaining assets sufficient to pay claims when they arise. Equity prices can fall dramatically in short periods (stock market crashes), potentially imparing an insurer's ability to pay claims. By capping equity allocations, regulators limit the volatility of the asset base and protect policyholders. The primary risk framework for insurers includes risk-based capital measures, credit ratings, and the ability to liquidate assets to meet claims. A is wrong: Equities often outperform bonds — the regulation is about risk control, not return expectations. C is wrong: Most regulatory frameworks allow a range of investment-grade bonds and some alternative allocations. D is wrong: The purpose is policyholder protection, not competitive limitation.
Question 408
A pension fund's local accounting rules allow it to defer recognition of investment losses over multiple years. How does this accounting rule affect the fund's asset allocation decision?
Select an option first.
Correct answer: B — Loss deferral accounting allows the fund to take on more risk because the reported impact of short-term market losses is smoothed over time, reducing the immediate pressure on reported funding metrics and financial statements
Explanation: B is correct: When accounting rules allow pension funds to defer recognition of losses (spreading the impact over several years rather than recording it immediately), the fund's reported financial position does not immediately reflect market downturns. This reduces the short-term pressure to de-risk the portfolio after a market decline. The fund can maintain its equity allocation through a downturn without triggering an immediate balance sheet shock. A is wrong: Loss deferral rules generally allow more, not less, risk-taking. C is wrong: Accounting treatment directly affects the penalties for holding risky assets and therefore shapes allocation decisions. D is wrong: Accounting rules affect asset recognition, not liability discounting.
Question 409
Endowments and foundations are described as having 'very few regulatory constraints' compared to other institutions. What is one constraint that CAN apply to endowments in some jurisdictions?
Select an option first.
Correct answer: B — Some countries require a minimum annual distribution (e.g., 5% of assets) to maintain tax-exempt status — failure to distribute sufficiently results in loss of tax exemption
Explanation: B is correct: In countries like the United States, tax-exempt foundations are required to distribute a minimum percentage of assets annually (currently 5% for private foundations). Failing to meet this threshold can result in excise taxes or loss of tax-exempt status. This minimum distribution requirement creates a recurring liquidity need and influences asset allocation — the portfolio must generate sufficient liquid returns to meet annual distribution requirements. A is wrong: No universal government bond requirement applies to all endowments. C is wrong: Endowments commonly hold significant equity allocations. D is wrong: Government approval of specific asset allocations is not a standard requirement.
Question 410
A sovereign wealth fund faces scrutiny from the citizens of the nation it serves. Even though the fund has a long investment horizon that would support high risk-taking, the political pressure from citizens causes the fund to reduce its allocation to volatile alternative assets. What tension does this illustrate?
Select an option first.
Correct answer: B — Optimal investment risk-taking for long-horizon investors may be constrained by political accountability — citizens and governments may prefer lower-risk portfolios to avoid politically damaging losses, even when higher risk is financially justified
Explanation: B is correct: Sovereign wealth funds hold public money and are accountable to citizens and governments. While their long time horizons theoretically support high risk allocations (similar to endowments), the political consequences of reported large losses can be severe — generating public criticism, political pressure, or even policy changes. This political accountability acts as a constraint on risk-taking beyond what pure financial optimization would suggest. A is wrong: Sovereign wealth funds are typically among the largest investors globally. C is wrong: No legal requirement mandates risk minimization for sovereign funds. D is wrong: Many sovereign wealth funds invest heavily in alternatives including real estate, private equity, and infrastructure.
Question 411
An investor subject to a 35% income tax rate is considering a corporate bond yielding 6% and a tax-exempt municipal bond yielding 4.2%. Which bond provides a higher after-tax return?
Select an option first.
Correct answer: B — Municipal bond: after-tax return = 4.2%; corporate bond after-tax return = 6% x (1 minus 0.35) = 3.9% — the municipal bond provides a higher after-tax return
Explanation: B is correct: The after-tax return on the corporate bond = 6% x (1 minus 0.35) = 6% x 0.65 = 3.9%. The municipal bond yields 4.2% tax-free. Since 4.2% > 3.9%, the tax-exempt municipal bond provides a higher after-tax return for this investor. This illustrates why tax-exempt bonds form a large part of high-tax-bracket investors' fixed income allocations — even though the nominal yield appears lower. A is wrong: Without tax adjustment, comparing pre-tax to after-tax yields is meaningless. C is wrong: The returns differ (3.9% vs 4.2%). D is wrong: Tax treatment is explicitly the key differentiating factor.
Question 412
Why should taxable investors use AFTER-TAX returns, not pre-tax returns, as inputs to their mean-variance optimization?
Select an option first.
Correct answer: B — Using pre-tax returns ignores the actual cash flows the investor receives — the optimization would overstate the attractiveness of tax-inefficient assets (like high-yield bonds taxed at ordinary income rates), potentially leading to suboptimal allocations that look attractive on a pre-tax basis but underperform after taxes
Explanation: B is correct: Pre-tax returns may make heavily taxed assets appear more attractive than they actually are after the investor pays taxes. A corporate bond yielding 6% for a 40% tax investor yields only 3.6% after tax — significantly less than the pre-tax figure. If MVO uses pre-tax inputs, it may overallocate to high-yielding but tax-inefficient assets. After-tax optimization accurately reflects what the investor actually keeps, leading to more appropriate allocations. A is wrong: Taxes always reduce returns for taxable investors. C is wrong: No such requirement exists. D is wrong: Taxes do reduce volatility (as described elsewhere), but uniformly reducing all asset class volatility would not cause the misallocation problem described.
Question 413
How does taxation affect the standard deviation (risk) of an asset class, and what is the directional implication for MVO inputs?
Select an option first.
Correct answer: B — Taxes reduce the magnitude of both gains AND losses (the government shares both sides) — after-tax standard deviation = pre-tax standard deviation x (1 minus tax rate), which is LOWER than the pre-tax volatility
Explanation: B is correct: Capital gains taxes reduce the gains realized on price appreciation. But capital losses can also be used to offset gains, reducing the effective losses. Both the upside and downside of returns are muted by taxes. The formula is: after-tax standard deviation = pre-tax standard deviation x (1 minus tax rate). For a 20% capital gains tax, after-tax sigma = sigma x 0.80. This lower volatility is the correct input for taxable investor MVO. C is wrong: Taxes affect both return and risk inputs. D is wrong: The tax reduction in volatility applies to all taxed assets.
Question 414
An asset has a pre-tax standard deviation of 20% and faces a capital gains tax rate of 25%. What is the after-tax standard deviation?
Select an option first.
Correct answer: B — 15%
Explanation: B is correct: After-tax standard deviation = pre-tax standard deviation x (1 minus tax rate) = 20% x (1 minus 0.25) = 20% x 0.75 = 15%. Taxes cushion both gains and losses by the same factor, reducing volatility proportionally. A is wrong: 20% is the pre-tax figure — taxes do reduce volatility. C is wrong: 16% = 20% x 0.80, which corresponds to a 20% tax rate. D is wrong: 5% = 20% x 0.25, which incorrectly applies only the tax rate rather than the complement.
Question 415
How does the after-tax reduction in volatility affect the optimal rebalancing corridor width for taxable investors compared to tax-exempt investors?
Select an option first.
Correct answer: B — Lower after-tax volatility means the portfolio's risk drifts more slowly from its target — combined with the tax cost of rebalancing (realizing capital gains), this supports wider rebalancing corridors for taxable investors
Explanation: B is correct: Taxes have two reinforcing effects that support wider corridors for taxable investors. First, after-tax volatility is lower, meaning the portfolio drifts more slowly from its risk target — reducing urgency to rebalance. Second, each rebalancing event realizes taxable capital gains, which is a direct cost that makes frequent rebalancing expensive. Wider corridors reduce rebalancing frequency, reducing tax drag. The formula captures this: after-tax allowable deviation = pre-tax deviation / (1 minus tax rate), which is WIDER than the pre-tax corridor. A is wrong: Lower volatility supports wider, not narrower, corridors. C is wrong: Loss harvesting is a targeted strategy, not a general argument for frequent rebalancing. D is wrong: Tax status is explicitly a major corridor width determinant.
Question 416
A tax-exempt investor has a fixed-income target of 40% with a pre-tax rebalancing range of plus or minus 5% (35% to 45%). The same allocation is subject to a 30% tax rate for a taxable investor. What is the taxable investor's equivalent after-tax rebalancing range?
Select an option first.
Correct answer: C — Plus or minus 7.14% (range: 32.86% to 47.14%)
Explanation: C is correct: The after-tax allowable deviation = pre-tax deviation / (1 minus t) = 5% / (1 minus 0.30) = 5% / 0.70 = 7.14%. The taxable investor's equivalent range is 40% plus or minus 7.14% = approximately 32.86% to 47.14%. This is WIDER than the tax-exempt corridor because lower after-tax volatility means the portfolio drifts more slowly, and because rebalancing triggers taxable events. A is wrong: Taxes widen, not maintain, the corridor. B is wrong: That would be narrower than the pre-tax range, which is incorrect. D is wrong: Plus or minus 10% would require a very high tax rate.
Question 417
What is tax loss harvesting and how does it benefit a taxable investor's portfolio?
Select an option first.
Correct answer: B — Tax loss harvesting involves deliberately selling assets that have declined in value to realize capital losses, which can offset capital gains elsewhere in the portfolio — reducing the overall tax bill while maintaining the portfolio's intended risk-return profile by reinvesting in a similar (but not identical) asset
Explanation: B is correct: Tax loss harvesting is a tax management strategy. When a position has fallen in value, the investor deliberately sells it to 'harvest' the loss — creating a capital loss that offsets capital gains in other parts of the portfolio, reducing current-year tax liability. The investor then reinvests in a similar (but not 'substantially identical' to avoid wash-sale rules) asset to maintain market exposure. The tax saving increases after-tax returns without changing the investment strategy. A is wrong: Tax loss harvesting involves realizing LOSSES, not gains. C is wrong: It is specifically a strategy for taxable investors — tax-exempt investors have no taxable gains to offset. D is wrong: The investor reinvests in similar assets to maintain risk exposure.
Question 418
What is 'strategic asset location' and what is the general principle for allocating asset classes across taxable and tax-advantaged accounts?
Select an option first.
Correct answer: B — Strategic asset location involves deciding which asset classes to hold in taxable accounts versus tax-deferred or tax-exempt accounts — the general principle is to place the LEAST tax-efficient assets (those generating high ordinary income, like high-yield bonds or actively traded funds) in tax-advantaged accounts, and the MOST tax-efficient assets (like equities benefiting from lower capital gains rates) in taxable accounts
Explanation: B is correct: The core principle of strategic asset location is tax-efficiency matching. Tax-advantaged accounts (IRA, 401k) provide either tax deferral or tax exemption — the tax shield is most valuable for assets that generate the most taxes. High-yield bonds (taxed as ordinary income at higher rates), REITs, and actively traded strategies generate frequent taxable events and should go in tax-advantaged accounts. Equities (benefiting from lower long-term capital gains rates and qualified dividend rates) are more tax-efficient and tolerable in taxable accounts. A is wrong: Asset location refers to account type, not geographic markets. C is wrong: Placing tax-efficient assets in tax-advantaged accounts wastes the tax shield on assets that don't need it. D is wrong: The principle applies to all taxable investors with multiple account types.
Question 419
Why does taxation leave asset class CORRELATIONS unaffected, even though it reduces both returns and standard deviations?
Select an option first.
Correct answer: B — Correlation measures the co-movement between assets as a dimensionless ratio — when taxes reduce returns and volatilities proportionally (by the same tax factor), the ratio of covariance to the product of standard deviations remains unchanged
Explanation: B is correct: Correlation = Covariance(A,B) / (sigma_A x sigma_B). When taxes reduce all returns by the factor (1-t), covariance also falls by (1-t) squared. Standard deviations each fall by (1-t). The correlation = [(1-t)^2 x Cov] / [(1-t) x sigma_A x (1-t) x sigma_B] = Cov / (sigma_A x sigma_B) — unchanged. Since the same tax factor cancels out of numerator and denominator, correlations are unaffected. This is important: taxable investors use after-tax returns and after-tax standard deviations in MVO, but can use the same (pre-tax) correlations. A is wrong: Taxes affect all asset classes, but correlations remain unchanged for the mathematical reason described. C is wrong: There is no such policy. D is wrong: Correlations are a mathematical property independent of investor tax status.
Question 420
An investor's company announces mandatory layoffs. As a result, the investor loses employment income and has significant uncertainty about future income. How should this change in personal circumstance affect the asset allocation?
Select an option first.
Correct answer: B — The allocation should shift toward more conservative, liquid assets — reduced income and increased income uncertainty lower both the investor's willingness and ability to take risk, and the need for liquidity may increase
Explanation: B is correct: A change in employment status is a classic example of a personal circumstance change that necessitates SAA revision. The loss of stable income: (1) reduces the investor's ability to take risk (no income to cover losses or replenish the portfolio), (2) may reduce willingness to take risk (emotional stress), and (3) increases the need for liquidity (living expenses must now come from the portfolio rather than salary). All three factors push toward a more conservative, liquid allocation. A is wrong: More equities increase risk at precisely the time when risk capacity has decreased. C is wrong: Personal circumstances directly determine risk tolerance and constraints. D is wrong: Real estate is illiquid — the opposite of what the investor now needs.
More free CFA topics
Economics2,066
Quantitative Methods1,213
Portfolio Management1,079
Fixed Income908
Financial Statement Analysis904
Corporate Issuers884
Portfolio Construction605
Alternative Investments540
Specialized Pathway - Private Markets500
Derivatives498
Equity390
Performance Measurement295
Specialized Pathway - Portfolio Management253
Derivatives and Risk Management131
Ten questions in
- The ones you miss are saved as a drill you can repeat
- Your place is kept, on this device and any other
- A streak, if that is the thing that gets you back tomorrow
Every question on this page stays free and open either way.