Question:
Practice problem 1 in the asset allocation reading states:
(the context is an pension plan that has set asset class allocation targets with permissible range within which the allocation target can vary)
"An institutional analyst makes a presentation to the Investment Committee showing promising past results from an investment program based on the following two variables, measured quarterly:
X = (Earnings yield - Real short-term bond yield) - Past average difference
Y = Change in OECD leading indicators
The analyst proposes that the weightings of domestic and international equities be adjusted quarterly within a band +/- 10 percentage points of their target portfolio weights based on the values of X and Y."
We are asked to identify the type of investment program being suggested and to critique the proposal.
Answer:
“The institutional analyst is proposing a tactical asset allocation program because it involves making short-term adjustments to asset-class weights based on short-term expected relative performance differences between domestic and international equities. A problem with the TAA program is that the band of asset weights within which the proposed TAA would operate is too wide in relation to the permissible range for international equities determined by the Investment Policy Committee.”
What I would have said:
The point about the TAA is clear. The point about the range that is too wide makes sense because international equities have a target allocation of 10% so a range of +/- 10% is 0% to 20%, which means we can allocate twice as much money to them as their target allocation… obviously this a bit too broad.
But I would have entered into lot’s of other considerations to address the question, like:
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Variable X is providing information for a relative value analysis and we can assume it will be used to assess if an asset is overvalued or undervalued assuming reversal to the mean. Such assumption may be wrong, especially if there has been a change of regime, i.e. that the data series is non-stationary, i.e. that different parts of the data series reflect different underlying statistical properties, i.e. that the parameters describing the return generating process have changed.
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The use of variable Y may also be limited for the following reasons: such indicators may not be available in a timely manner; historically, using leading indicators has no consistently worked as relationships between inputs change; it can provide false signals.
Well basically, critics that are in the curriculum elsewhere. And we could probably find much more.
Do I get any points for that?
Now I am trying to understand how the CFA defines the grades:
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do you agree with my answers
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would it had been a loss of time if I had answered that because it was not what they had in mind?
Maybe the answer provided was just very limited because it was part of the chapter “asset allocation” and they wanted to stick to that.
Extra clarification Do you use “i.e.” in English?
Thanks guys!