# 2009 Schwser Practice Exam V2 Exam 3 Q2

when decision is to made which portfolio is the best choice, the 1st & only consideration is the expected return (which shall be greater than the return objective) or the Sharpe Ratio (the highest one) ? In this question, A has expected return of 10.56% which is higher than the return objective of 10.41% but with SR of 0.62, while B has expected return of 10.34% which is lower than the return objective of 10.41% but with of SR 0.64 (higher than that of A). Risk-free is 3.0% (cash return) in this case. A is recommeded in the solution. Then, SR is irrelevant ? If it is irrelevant, then Standard Deviation is also irrelevant ?

I believe you basically goes with the return objective first. You client NEEDS that return for his annual spending or anything. As his adviser, you just explain him that higher return means higher risk and that is all about it

Have not looked closely at the exam, but the rule is - FIRST criteria: MUST have return > return objective. If not, eliminate does not matter which SR ratio it has. B does not meet thus cannot go to second round. - If meet FIRST criteria: then either SR (which already has SD incorporated) or other appropriate measurement dependent on specific IPS (could be Roy, VaR,…) - Also consider other criteria: cash available for liquidity,ethical investment,…

I know the rule as indicated by elcfa. But based on risk-adjusted return (which shall be most important in investment), SR or other measures of risk-adjusted return shall be 1st consideration, right ? Actually, what I am challenging is the RULE.

AMC It does not matter whether you are using SR or other risk-adj return first criteria or second. B still does not make it to the end: its absolute return is too low.

elcfa, What I mean is that it shall be risk-adjusted return which matters, not absolute return. In this case, SR of B is higher than that of A. The only risk-adjusted return abailable here is SR and SR is most commonly used risk-adjusted return. The RULE in CFAI text seems not in compliance with ethics of investment industry.

I think you misunderstand how to apply the criteria a bit. 1. Both matters, not one at the expense of the other: - absolute return MUST be above required return AND - the portfolio you pick must have the risk highest adjust return (among those who also fulfill the first criteria) Using the second criteria ONLY will lead you to choose cash deposit which has highest SF (indefinite) short term or ALM approach Cash flow matching for LT. This leads me to the second point. 2. Risk adjustment depends on the client’s risk appetite, as measured by client specific risk aversion factor. The (most) correct approach is to adjust to that client spec factor. Client with extremely highly risk willingness/ability has risk aversion factor =0, thus no adjustment for risk --> take only into account absolute return. CFA pg 267 and 268 v.3 demonstrate the two points and the need to calculate both absolute and risk adjust returns I have mentioned earlier. Since you don’t risk aversion factor for this case, you use SF as a substitute for risk adjustment among those meeting required return. Hope it is clearer.

elcfa, I agree with you that many ctiteria shall be met when recommending portfolio to investors. But only absolute return is considered in its solution to this question and in many other cases, this is a problem (I will advise you if I find anyone in CFAI text or other books). Also I think if the investor has other criteria of risk-adjusted return, the risk-adjusted return shall be 1st consideration rather than absolute return. On the other hand, if a portfolio has a highest SR or other risk-adjusted return which meet investor’s requirement but with a higher allocation to cash than investor’s desire, then why not recommend it to investor by advising the investor that risk-adjusted return shall be most important and allocation per se is not most important.