The model portfolio for Yazbeck Capital Management consists of the following allocation:
Asset Class__Allocation Intermediate U.S. Government bonds 45% Intermediate U.S. Corporate bonds 45% Large Cap U.S. equities 10%
One of the primary tenets of Yazbeck’s Investment Process is to rebalance portfolios based on a percentage-of-portfolio approach with tolerance corridors for each asset class. Two of Yazbeck’s portfolio managers, Justin Croniser and Kevin Hopkins are discussing the size of the corridor width for each asset class. Croniser states, “The high correlation between U.S. Government bonds and U.S. Corporate bonds implies that both asset classes should stay within acceptable limits even if we decide to set relatively small corridors.” Hopkins replies, “Even if that were true, the high liquidity of U.S. Government bonds implies that the corridor for that asset class should be relatively wide.” The founder of Yazbeck Capital Management, Shadya Yazbeck is listening to their conversation. Yazbeck should:
A) disagree with Croniser’s statement and disagree with Hopkins’ statement. B) agree with Croniser’s statement and agree with Hopkins’ statement. C) agree with Croniser’s statement, but disagree with Hopkins’ statement.
Croniser is correct, because due to the high correlation, letting one of the asset classes exceed the corridor will result in the other asset class possibly exceeding its corridor, resulting in an off-balance portfolio.
Hopkins is incorrect, because one of the purposes of allowing wide corridors is to avoid costly transaction costs when rebalancing back to the target allocation. Since U.S. Gov. bonds are highly liquid, transaction costs become less of a factor, so there’s less reason to have wide corridors.
Yes this is crafted just like a CFA exam question - everyone will be so trained on explaining that a wider band is tolerated when there are strong asset class correlations that they will forget to comment on the point that is being observed!
I think Yazbeck should ask Croniser to explain his statement better because based solely on Cronisers’ statement it cannot be conclusively concluded that he understands the principle.
The whole point of setting wide corridors for highly correlated asset classes is so that if/when they do deviate from each other a rebalancing acivity doesn’t need to take place.
I read the statement about 5 times before answering, now reading it for the 6-10th time I wonder what the question is testing. Is it asking if we know the level III material on corridor widths, or is it asking if we know what correlation means (level I)?
If Croniser was writing the Level III CFA test in June and wrote this answer down in the morning session I would guess he would get it marked wrong.
The actual width for the first statement is irrelevant, hence the comment “…even if we decide to set relatively small corridors”. All that matters is that the high correlations will result in two asset classes simultaneously exceeding their corridors (regardless of how small/big the corridor is), which is detrimental to the portfolio. So no, I don’t think this has anything to do with the fact that a 45% may or may not justify a small width. They’re not talking about whether a small width is justified or not.
Per the book - a bigger correlation would lead to a larger asset class width.
High Liquidity - means that asset class can be rebalanced more frequently without incurring too much of transaction costs - so a smaller width is justified. So Part B is wrong.
But that does not make Part A right by itself. So what is the reasoning behind Croniser’s statement being right?
cpk, as has been mentioned in the comments, this question is deceptively NOT testing on correlation’s effect on “asset class width”. The statement made by Croniser specifically says “…even if we decide to set relatively small corridors”. Croniser isn’t saying “setting relatively small corridors is correct/incorrect”. He is saying is, all else equal, high correlations between 2 asset classes raises the negative consequence of one of those classes exceeding its width/corridor. This is correct because if one asset exceeds its width/corridor, it is likely that the other one as well due to high correlation.
This is also why FinNinja mentioned how this question sounds like its testing on the definition of “correlation” rather than a L3 concept, because it’s rather obvious that as one asset class moves up and away from its target width, the other will as well if they’re highly correlated.
“The high correlation between U.S. Government bonds and U.S. Corporate bonds implies that both asset classes should stay within acceptable limits even if we decide to set relatively small corridors.”
High Correlation - wider Width = Wider Corridor - is all I understand. What you have said is all the more reason why a narrow width on the corridor will not work. The width needs to be wider. The guy is stating with narrow width and high correlation - it WILL stay within limits - the book says it will NOT, and that is all I understand. So the statement is WRONG. How is he saying anything else.
cpk, I repeat, the guy is not making any statement about what the width should or should not be. Even if narrow width would not work, that doesn’t matter. All that matters is, for a given width (small or big), it becomes more important for an asset class to stay within its width because if it doesn’t, then the other asset class will also move past its width and thus create a very off-balance portfolio.
You say “the width needs to be wider”. Maybe so, but the statement doesn’t care about what the optimal width is. That’s why he says “…even if we decide to [choose a small width]”.
You say “The guy is stating…it WILL stay within limits”. He never said that - he said it SHOULD stay within limits and by “should”, he doesn’t mean “is likely to stay within limits”, he means “it is important to make sure it stays within limits”.
I do think this has something to do with a language barrier and I hope the CFA doesn’t actually make questions like these on the real exam because I can see how it’s confusing to non-native speakers. “Should” does not mean “will” or “is likely” in this case. “Should” means “it is important that”.
