Chapter 8 - Portfolio Performace and Review

Question 1

Which of the following factors is NOT typically considered in portfolio performance review?

A) Risk-adjusted returns
B) Tracking error
C) Inflation correlation
D) Investor’s personal tax situation

Answer 1

Answer: C) Inflation correlation

Explanation: While inflation impact is important in long-term investing, portfolio performance reviews focus on risk-adjusted returns, tracking error, and tax efficiency rather than direct correlation with inflation.

Question 2

What is the primary purpose of benchmarking in portfolio management?

A) To maximise absolute returns
B) To compare portfolio performance against an index or peer group
C) To eliminate systematic risk
D) To ensure 100% capital preservation

Answer 2

Answer: B) To compare portfolio performance against an index or peer group

Explanation: Benchmarking allows investors and fund managers to evaluate how a portfolio performs relative to a chosen standard, which may be a market index or peer group.

Question 3

What is the main difference between time-weighted return (TWR) and money-weighted return (MWR)?

A) TWR accounts for timing of cash flows, MWR does not
B) MWR is more commonly used in performance benchmarking
C) TWR removes the impact of external cash flows, MWR does not
D) MWR is better for comparing fund managers

Answer 3

Answer: C) TWR removes the impact of external cash flows, MWR does not

Explanation: Time-weighted return (TWR) neutralises the effect of cash inflows and outflows, making it suitable for comparing fund managers, whereas money-weighted return (MWR) is influenced by cash flow timing.

Question 4

Under GIPS, which of the following is required for firms claiming compliance?

A) Reporting all historical performance data for at least 20 years
B) Applying benchmarks selectively based on client objectives
C) Including all fee structures in reported returns
D) Adhering to a verified set of global standards for performance reporting

Answer 4

Answer: D) Adhering to a verified set of global standards for performance reporting

Explanation: GIPS requires firms to follow standardised performance reporting principles, but they must report at least 5 years of historical performance, not 20.

Question 5

The CAPS and WM benchmarks are primarily used to evaluate the performance of:

A) Hedge funds
B) Private equity investments
C) UK pension and wealth management portfolios
D) High-frequency trading strategies

Answer 5

Answer: C) UK pension and wealth management portfolios

Explanation: CAPS (Combined Actuarial Performance Services) and WM (Wealth Management Association) benchmarks help measure pension and wealth management performance in the UK.

Question 6

What distinguishes MSCI PIMFA benchmarks from broader market indices?

A) They are designed specifically for wealth management portfolios
B) They exclude emerging markets
C) They have lower volatility than FTSE 100
D) They focus only on ethical investments

Answer 6

Answer: A) They are designed specifically for wealth management portfolios

Explanation: MSCI PIMFA benchmarks cater specifically to discretionary wealth management portfolios and include different risk-return profiles.

Question 7

Which of the following indices is considered a price-weighted index?

A) FTSE 100
B) MSCI World
C) S&P 500
D) Nikkei 225

Answer 7

Answer: D) Nikkei 225

Explanation: Unlike market-cap-weighted indices like the S&P 500, the Nikkei 225 is price-weighted, meaning higher-priced stocks have more influence on the index.

Question 8

The FTSE Actuaries UK Gilts Index Series is primarily used to measure:

A) Corporate bond performance
B) UK government bond (gilt) performance
C) High-yield bond movements
D) UK equity market performance

Answer 8

Answer: B) UK government bond (gilt) performance

Explanation: This index series measures the performance of UK government bonds across different maturities.

Question 9

Which of the following is NOT a common ethical investment exclusion criterion?

A) Weapons manufacturing
B) Fossil fuel industries
C) High-frequency trading firms
D) Tobacco companies

Answer 9

Answer: C) High-frequency trading firms

Explanation: Ethical investment indices commonly exclude sectors like weapons, tobacco, and fossil fuels, but high-frequency trading firms are not typically excluded.

Question 10

Which metric measures a portfolio’s performance relative to a benchmark, adjusted for risk?

A) Sharpe ratio
B) Information ratio
C) Alpha
D) Sortino ratio

Answer 10

Answer: B) Information ratio

Explanation: The information ratio compares the excess return of a portfolio over a benchmark, adjusted for tracking error.

Question 11

Which of the following is an absolute return measure?

A) Alpha
B) Benchmark-adjusted return
C) Annualised return
D) Tracking error

Answer 11

Answer: C) Annualised return

Explanation: Absolute return refers to the raw return generated by a portfolio over a period, whereas relative return compares performance to a benchmark.

Question 12

Asset allocation is responsible for approximately what percentage of a portfolio’s returns, according to academic studies?

A) 20%
B) 40%
C) 60%
D) 90%

Answer 12

Answer: D) 90%

Explanation: Studies (e.g., Brinson, Hood, Beebower) suggest that asset allocation accounts for around 90% of a portfolio’s long-term return variability.

Question 13

What impact does a depreciating domestic currency have on foreign investments?

A) Increases the value of foreign holdings
B) Decreases the value of foreign holdings
C) No impact if the investor is unhedged
D) Reduces portfolio diversification

Answer 13

Answer: A) Increases the value of foreign holdings

Explanation: A weaker domestic currency makes foreign investments more valuable in local currency terms.

Question 14

A risk/reward ratio of 1:3 implies:

A) 1 unit of risk generates 3 units of return
B) 3 units of risk generate 1 unit of return
C) The investment has a Sharpe ratio of 3
D) The investment has negative alpha

Answer 14

Answer: A) 1 unit of risk generates 3 units of return

Explanation: A 1:3 risk/reward ratio means that for every unit of risk, the investor expects three times the reward.

Question 15

Which measure adjusts for the impact of new capital contributions on performance?

A) Modified Dietz method
B) Jensen’s alpha
C) Value at Risk (VaR)
D) Treynor ratio

Answer 15

Answer: A) Modified Dietz method

Explanation: The Modified Dietz method accounts for external cash flows in portfolio performance calculation.

Question 16

Which of the following is a key drawback of peer group benchmarking in portfolio performance evaluation?

A) It is difficult to calculate risk-adjusted returns
B) It does not account for survivorship bias
C) It ignores the impact of market conditions
D) It can be manipulated by selecting specific peer groups

Answer 16

Answer: D) It can be manipulated by selecting specific peer groups

Explanation: Peer group benchmarking can be distorted if the group is selectively chosen to make performance look better than it actually is. Additionally, survivorship bias can skew results.

Question 17

When constructing a customised benchmark for pension funds, what is the most important consideration?

A) Ensuring the benchmark tracks global indices
B) Matching the benchmark to the fund’s investment objectives and liabilities
C) Keeping the benchmark as simple as possible
D) Avoiding alternative asset classes

Answer 17

Answer: B) Matching the benchmark to the fund’s investment objectives and liabilities

Explanation: A pension fund’s benchmark should reflect its specific investment objectives and liability profile to ensure appropriate risk and return expectations.

Question 18

What is the key reason why after-tax benchmarking is critical for high-net-worth investors?

A) Tax treatments differ across asset classes and jurisdictions
B) It ensures portfolios generate the highest nominal returns
C) Taxation has no impact on long-term portfolio growth
D) Capital gains tax is always a fixed percentage

Answer 18

Answer: A) Tax treatments differ across asset classes and jurisdictions

Explanation: After-tax benchmarking is important because tax efficiency can significantly impact net returns, especially for high-net-worth individuals with complex tax obligations.

Question 19

Which of the following challenges is most relevant when benchmarking alternative investments like private equity or hedge funds?

A) Market efficiency leads to constant alpha generation
B) Frequent liquidity events make performance comparison simple
C) Standardised benchmarks do not exist for many alternative assets
D) Alternatives always outperform public markets

Answer 19

Answer: C) Standardised benchmarks do not exist for many alternative assets

Explanation: Unlike equities or bonds, alternative investments often lack widely accepted benchmarks, making performance evaluation more complex.

Question 20

What is the key limitation of using the Sharpe ratio as a standalone performance measure?

A) It does not consider total return
B) It assumes risk is only measured by volatility
C) It cannot be used to compare different asset classes
D) It is unaffected by changes in interest rates

Answer 20

Answer: B) It assumes risk is only measured by volatility

Explanation: The Sharpe ratio relies on standard deviation (volatility) as the sole measure of risk, which may not fully capture downside risk or other factors affecting investment performance.

Question 21

Which of the following is the PRIMARY reason for conducting a portfolio review?

A) To ensure that the portfolio’s asset allocation is identical to the original recommendation
B) To confirm that all investments have performed exactly as projected
C) To assess whether the portfolio still aligns with the client’s objectives and risk tolerance
D) To verify that all investments are in positive territory

Answer 21

Answer: C) To assess whether the portfolio still aligns with the client’s objectives and risk tolerance

Explanation: A portfolio review is essential to ensure it remains suitable for the client’s financial goals, risk tolerance, and market conditions. Market fluctuations and changes in personal circumstances often necessitate adjustments.

Question 22

Which of the following is LEAST likely to require an immediate portfolio review?

A) The client changes their employment status
B) The client’s portfolio suffers a 2% decline in one week
C) New tax regulations impact investment structures
D) A client unexpectedly inherits a large sum of money

Answer 22

Answer: B) The client’s portfolio suffers a 2% decline in one week

Explanation: Short-term market fluctuations do not necessarily warrant an immediate portfolio review. However, significant life events and regulatory changes may have lasting implications requiring adjustments.

Question 23

How often should a portfolio review be conducted under normal circumstances?

A) Monthly
B) Quarterly
C) Annually
D) Only when the client requests it

Answer 23

Answer: C) Annually

Explanation: While reviews can be conducted more frequently if needed, an annual review is standard practice to ensure alignment with the client’s goals, risk profile, and market conditions.

Question 24

Which of the following is NOT a primary factor requiring a portfolio review?

A) Changes in interest rates
B) Launch of a new stock exchange
C) Changes in the client’s financial goals
D) Introduction of new investment products

Answer 24

Answer: B) Launch of a new stock exchange

Explanation: While new stock exchanges may impact global markets, they do not directly affect an individual client’s portfolio the way interest rates, personal circumstances, and product innovations do.

Question 25

What is the MAIN goal of portfolio rebalancing? A) To maximise short-term gains B) To maintain the target asset allocation in line with risk tolerance C) To liquidate underperforming assets immediately D) To avoid capital gains tax at all costs

Answer 25

Answer: B) To maintain the target asset allocation in line with risk tolerance Explanation: Over time, asset allocations can drift due to market performance. Rebalancing ensures the portfolio remains aligned with the client’s risk profile and investment objectives.

Question 26

If a client’s risk tolerance decreases, what is the most appropriate course of action? A) Increase the proportion of equities B) Reduce exposure to fixed-income investments C) Shift towards lower-risk assets such as bonds or cash equivalents D) Do nothing, as risk tolerance is unlikely to change investment outcomes

Answer 26

Answer: C) Shift towards lower-risk assets such as bonds or cash equivalents Explanation: If a client’s risk tolerance declines, reducing exposure to volatile assets like equities and increasing safer investments ensures their portfolio aligns with their updated preferences.

Question 27

Which type of investment change would most likely trigger a portfolio review? A) A company within the portfolio announces a new CEO B) An investment fund changes its underlying strategy C) A stock in the portfolio experiences a temporary decline D) A mutual fund manager appears in a financial news interview

Answer 27

Answer: B) An investment fund changes its underlying strategy Explanation: A shift in an investment’s strategy could alter its risk-return profile, necessitating a review to ensure continued suitability for the client.

Question 28

What is a potential drawback of frequent portfolio rebalancing? A) Increased exposure to market volatility B) Higher transaction costs and tax implications C) Reduced ability to adapt to new investment opportunities D) Portfolio drift due to lack of activity

Answer 28

Answer: B) Higher transaction costs and tax implications Explanation: Frequent rebalancing may result in higher trading fees and tax liabilities, potentially eroding portfolio returns.

Question 29

Which of the following is an example of an administrative change that may require a portfolio review? A) The client’s investment advisor changes firms B) The client reads an article predicting a market crash C) A stock in the portfolio announces a dividend cut D) The client’s employer offers a new pension scheme

Answer 29

Answer: A) The client’s investment advisor changes firms Explanation: Changes in financial advisors or firms could impact investment management and require adjustments to ensure consistency in strategy.

Question 30

When assessing a portfolio’s benchmark, what is the MOST important consideration? A) The benchmark must include only the highest-performing assets B) The benchmark should be risk-adjusted and appropriate for the portfolio’s strategy C) The benchmark should outperform the market consistently D) The benchmark must remain unchanged over time

Answer 30

Answer: B) The benchmark should be risk-adjusted and appropriate for the portfolio’s strategy Explanation: A well-chosen benchmark reflects the risk-return characteristics of the portfolio and serves as a relevant performance comparison tool.

Question 31

Which factor is MOST important when reviewing a portfolio’s performance against its benchmark? A) Nominal returns B) The client’s satisfaction with their returns C) Risk-adjusted returns relative to the benchmark D) The total number of assets in the portfolio

Answer 31

Answer: C) Risk-adjusted returns relative to the benchmark Explanation: Comparing risk-adjusted returns helps evaluate whether performance is achieved efficiently given the level of risk taken.

Question 32

Which change in the financial environment is MOST likely to impact a portfolio’s fixed-income allocation? A) A rise in inflation expectations B) Increased mergers and acquisitions in the tech sector C) A regulatory change in the cryptocurrency market D) A company issuing a stock buyback program

Answer 32

Answer: A) A rise in inflation expectations Explanation: Higher inflation generally leads to rising interest rates, which negatively impact bond prices and may necessitate a review of fixed-income allocations.

Question 33

If a portfolio review identifies excessive turnover, what is the most appropriate action? A) Increase investment in high-frequency trading strategies B) Reduce trading frequency to minimise costs and tax impact C) Reallocate to illiquid assets to avoid short-term trading D) Ignore it, as turnover is irrelevant to long-term performance

Answer 33

Answer: B) Reduce trading frequency to minimise costs and tax impact Explanation: Excessive turnover can lead to high costs and potential tax inefficiencies, requiring a shift towards a more strategic, long-term approach.

Question 34

What is a key reason why regulatory changes require portfolio reviews? A) Compliance breaches can lead to penalties B) They always increase investment returns C) They only impact institutional investors D) They have no impact on portfolio construction

Answer 34

Answer: A) Compliance breaches can lead to penalties Explanation: Regulatory changes can affect investment suitability, tax treatments, and reporting requirements, making portfolio reviews essential for maintaining compliance.

Question 35

Which of the following is the PRIMARY reason why a client’s portfolio allocation may need to change as they approach retirement? A) They need more exposure to high-growth stocks B) Their investment time horizon shortens, reducing risk tolerance C) They should shift entirely to cash holdings D) Their investment risk tolerance increases

Answer 35

Answer: B) Their investment time horizon shortens, reducing risk tolerance Explanation: As clients near retirement, their ability to recover from market downturns decreases, often requiring a shift towards more stable, lower-risk investments.

Question 36

What are the three primary reasons why performance benchmarks are important? A) They provide a way to compare portfolios, assess risk levels, and ensure tax efficiency B) They measure performance, assess risk-adjusted returns, and evaluate investment strategy suitability C) They identify underperforming asset classes, track short-term market fluctuations, and optimize tax liabilities D) They are used solely for compliance purposes, fund marketing, and to maximize absolute returns

Answer 36

Answer: B) They measure performance, assess risk-adjusted returns, and evaluate investment strategy suitability Explanation: Benchmarks help investors understand how a portfolio is performing relative to its objectives, ensure returns are reasonable given the level of risk, and determine if the chosen strategy remains effective.

Question 37

What need do Global Investment Performance Standards (GIPS) meet? A) They establish a universal accounting framework for listed companies B) They standardize portfolio reporting to ensure fair and transparent performance comparisons C) They enforce tax rules on global investments D) They provide guidelines for pricing derivatives in emerging markets

Answer 37

Answer: B) They standardize portfolio reporting to ensure fair and transparent performance comparisons Explanation: GIPS were created to ensure consistency, fairness, and comparability in performance reporting across different investment firms and regions.

Question 38

When would a portfolio use a peer group average instead of an index as a performance benchmark? A) When the portfolio contains highly liquid assets with minimal risk B) When the portfolio is actively managed and does not closely track any single market index C) When the investor prefers absolute return strategies over relative performance comparisons D) When the portfolio consists only of government bonds and fixed-income securities

Answer 38

Answer: B) When the portfolio is actively managed and does not closely track any single market index Explanation: A peer group benchmark is useful when a portfolio’s composition or strategy differs significantly from standard market indices, making direct comparisons inappropriate.

Question 39

What is the best definition of ‘relative return’? A) The absolute percentage return achieved by a portfolio over a fixed period B) The return of a portfolio compared to a specific benchmark or index C) The total return generated after accounting for inflation and currency fluctuations D) The risk-free return achieved in relation to central bank interest rates

Answer 39

Answer: B) The return of a portfolio compared to a specific benchmark or index Explanation: Relative return measures how well a portfolio performs against a benchmark, helping assess whether active management adds value.

Question 40

What does the term ‘maximum drawdown’ refer to? A) The largest percentage loss from a portfolio’s peak value to its lowest point before recovering B) The total capital withdrawn from an investment over its lifetime C) The highest daily loss experienced by an investor due to market fluctuations D) The maximum allowable withdrawal from a retirement fund without penalties

Answer 40

Answer: A) The largest percentage loss from a portfolio’s peak value to its lowest point before recovering Explanation: Maximum drawdown (MDD) is a key risk measure that helps investors understand the worst-case downside scenario for their portfolio.

Question 41

An investor’s portfolio provides a holding period return (HPR) of 25% in foreign currency terms. If the HPR gained on the currency exchange is -10%, what is the HPR in domestic currency terms? A) 15% B) 12.5% C) 10% D) 22.5%

Answer 41

Answer: A) 15% Explanation: The formula for HPR in domestic terms is: (1+HPR foreign) x (1+ HRP Currency) - 1 (1.25 x 0.9) - 1 = 1.125 - 1 = 0.15 = 15%

Question 42

Which ratio is commonly used to compare the expected returns on an investment with the level of risk taken? A) Sharpe ratio B) Price-to-Earnings (P/E) ratio C) Dividend yield ratio D) Treynor ratio

Answer 42

Answer: A) Sharpe ratio Explanation: The Sharpe ratio measures risk-adjusted return by comparing excess return (above the risk-free rate) to portfolio volatility. A higher ratio indicates better risk-adjusted performance.

Question 43

How frequently should the management of a client’s portfolio be reviewed? A) Quarterly B) Annually C) Only when markets experience volatility D) At the client’s discretion

Answer 43

Answer: B) Annually Explanation: An annual review ensures that the portfolio aligns with the client’s risk tolerance, financial objectives, and market conditions. Additional reviews may be needed for major life or market changes.

Question 44

Which of the following is NOT a typical factor that would require a client’s portfolio review? A) A significant change in the client’s financial circumstances B) A global market downturn impacting all asset classes C) A minor price fluctuation in an individual stock within the portfolio D) The introduction of new tax regulations affecting investments

Answer 44

Answer: C) A minor price fluctuation in an individual stock within the portfolio Explanation: Short-term stock price movements do not typically require a full portfolio review unless they indicate broader risks or fundamental shifts.

Question 45

Under what circumstances may a review of the portfolio benchmark be required? A) If the benchmark has consistently underperformed the market B) If the portfolio strategy or asset allocation changes significantly C) If the client’s portfolio has outperformed the benchmark for three consecutive years D) If the benchmark index is discontinued and replaced by a new version

Answer 45

Answer: B) If the portfolio strategy or asset allocation changes significantly Explanation: A benchmark must remain aligned with the portfolio’s investment approach. Changes in strategy, asset allocation, or risk profile may necessitate a new benchmark for accurate performance assessment.