L3 mock sample exam CFA level III essay questions 1999

Level III: Question Topic: Minutes: Individual Investor Policy Statements 24 Reading References: “Individual Investors,” Ch 3, Ronald W Kaiser, Managing Investment Portfolios: A Dynamic Process, 2nd edition, John L Maginn and Donald L Tuttle, eds (Warren, Gorham and Lamont, 1990) Cases in Portfolio Management, John W Peavy III and Katrina F Sherrerd, (AIMR, 1990) Questions and 2, including Guideline Answers, 1995 Level III Examination (AIMR) Purpose: To test the candidate’s ability to develop a long-term investment policy statement for a family with changing resources and return needs over time Specific tax and unique circumstances are included for consideration LOS: The candidate should be able to “Individual Investors” (Session 13) • analyze the objectives and constraints of a particular individual investor and use the investor’s psychological characteristics, position in the life-cycle, long-term goals and particular constraints (such as liquidity, taxes, gifts and estate planning) to formulate appropriate investment policies for the investor; • create a set of portfolio policies that is based on a multi-asset, total return approach to individual investing Cases in Portfolio Management (Session 22) • create a formal investment policy statement for an investor 1995 CFA Level III Examination (Session 22) • prepare an investment policy statement that clearly states the investment objectives and constraints of a client; • justify all recommendations and statements included in the investment policy statement Guideline Answer: The objectives and constraints portion of the Muellers’ investment policy statement should include the following objectives and constraints: Objectives: i Return Objective The Muellers’ return objective should be a total return approach that is a combination of capital appreciation and capital preservation After retirement, they will need approximately $75,000 (adjusted for inflation) annually to maintain their current standard of living Given their limited needs and asset base, preserving their financial position on an inflation-adjusted basis may be a sufficient objective However, their long life expectancy and undetermined retirement needs lead to the likely need for some growth of assets over time, at least to counter any effects of inflation 1999 Level III Guideline Answers Morning Section – Page Although the Muellers wish to exclude the future trust distribution from their current planning, that distribution will substantially increase their capital base and dramatically alter the return objective of their future investment policy statement, primarily by reducing their needed return level ii Risk Tolerance The Muellers are in the middle stage of their investor life cycle Their relationship of income to expenses, total financial resources, and long time horizon give them the ability to assume at least an average, if not an above average, level of risk in their investments However, their stated preference of “minimal volatility” investments apparently indicates a below average willingness to assume risk The large realized losses incurred in previous investments may be a contributing factor to their desire for safety Also, their need for continuing cash outflow to meet their daughter’s college expenses may temporarily and slightly reduce their ability to take risk Two other issues affect the Muellers’ ability to take risk First, the holding of Andrea’s company stock represents a large percentage of the Muellers’ total investable assets and thus is an important risk factor for their portfolio Reducing the size of this holding or otherwise reducing the risk associated with a single large holding should be a priority for the Muellers Second, the future trust distribution will substantially increase their capital base and therefore increase their ability to assume risk However, the larger capital base would reduce their need for higher returns, and the corresponding higher risk levels Constraints: iii Time Horizon Overall, the Mueller’s ages and long life expectancies indicate a long time horizon However, they face a multi-stage time horizon because of their changing cash flow and resource circumstances Their time horizon can be viewed as three distinct stages: the next five years (some assets, negative cash flow because of their daughter’s college expenses), the following five years (some assets, positive cash flow), and beyond ten years (increased assets from a sizable trust distribution, decreased income because they plan to retire) iv Liquidity The Muellers need both immediate liquidity and ongoing funds over the next five years They need to have $50,000 available now for the contribution to the college’s endowment fund Alternatively, they may be able to contribute $50,000 of Andrea’s low cost basis stock to meet the endowment obligation In addition, they expect the regular annual college expenses to exceed their normal annual savings (combined incomes minus usual living expenses) by approximately $15,000 for each of the next five years This relatively low cash flow requirement of 2.7 percent ($15,000/$550,000 asset base after $50,000 contribution) can be substantially met through income generation from their portfolio, further reducing the need for sizable cash reserves Once their daughter has completed college, their liquidity needs should be minimal until retirement because their income more than adequately covers their living expenses v Taxes The Muellers are subject to a 30 percent marginal tax rate for ordinary income and a 20 percent rate for realized capital gains The difference in the rates makes investment returns in the form of capital gains preferable to equivalent amounts of taxable dividends and interest 1999 Level III Guideline Answers Morning Section – Page While taxes on capital gains would normally be a concern to investors with low cost basis stock, this is not a major concern for the Muellers because they have a tax loss carry forward of $100,000 The Muellers can offset up to $100,000 in realized gains with the available tax loss carry forward without experiencing any cash outflow or any reduction in asset base vi Unique Circumstances The large holding of the low-basis stock in Andrea’s company, a “technology firm with a highly uncertain future,” is a key factor to be included in the evaluation of the risk level of the Mueller’s portfolio and the future management of their assets In particular, the family should systematically reduce the size of the investment in this single stock Because of the existence of the tax loss carry forward, the stock position can be reduced by at least 50 percent (perhaps more depending on the exact cost basis of the stock) without reducing the asset base to pay a tax obligation In addition, the trust distribution in 10 years presents special circumstances for the Muellers, although they prefer to ignore these future assets in their current planning The trust will provide significant assets to help meet their long term return needs and objectives Any long-term investment policy for the family must consider this circumstance and any recommended investment strategy will need to be adjusted before the distribution takes place 1999 Level III Guideline Answers Morning Section – Page Level III: Question Topic: Minutes: Investment Policy Statements Reading references: “Developing an Investment Policy Statement,” including Appendix, Ch 5, The Management of Investment Decisions, Donald B Trone, William R Allbright and Phillip R Taylor (Irwin, 1996) Cases in Portfolio Management, John W Peavy III and Katrina F Sherrerd, (AIMR, 1990) Purpose: To test the candidate’s knowledge of why investment policy statements are important in achieving long term financial objectives and encouraging a healthy client/manager relationship LOS: The candidate should be able to: “Developing an Investment Policy Statement” (Session 12) • explain why creating an investment policy statement is good discipline, virtually indispensable, and also sometimes legally required Cases in Portfolio Management (Session 22) • discuss the overall portfolio management process leading to the asset allocation decision, including the stage devoted to investor information requirements (i.e., objectives and constraints) and the stage devoted to analyzing capital market expectations Guideline Answer: A potential benefit of using a written investment policy statement that contradicts each of the comments is: • A policy statement identifies the pertinent investment objectives and constraints Clearly identified objectives and constraints help an investor, and investment manager, to focus on appropriate investment strategies among the universe of possible strategies The result should be an optimal balance between return seeking and risk taking and an increased probability of success in achieving investment goals • An investment policy statement provides a long-term plan for an investor and a basis for making disciplined investment decisions over time The absence of a policy statement reduces decision making to an individual event basis and often leads to chasing short-term opportunities that may not contribute to, or may even take away from, reaching long-term goals The presence of a policy encourages all parties to maintain their focus on the long-term nature of the investment process, especially during turbulent times • A written policy statement can provide continuity from current manager(s) to future ones In the Mueller’s case, this could contribute to meeting long-term goals if they decide in the future to hire an investment manager or if the control of their assets passes to their daughter or others acting on their behalf A well thought out policy will evolve over time but likely will not be subject to a complete overhaul because of a change in managers Similarly, a policy statement can enhance communication between an investment manager and client by clarifying issues of importance and concerns to either party Improved communication, in turn, increases the likelihood that the investment manager will faithfully implement the agreed-upon plan 1999 Level III Guideline Answers Morning Section – Page Level III: Question Topic: Minutes: Asset Allocation 12 Reading References: “Asset Allocation,” Ch 7, William F Sharpe, Managing Investment Portfolios: A Dynamic Process, 2nd edition, John L Maginn and Donald L Tuttle, eds (Warren, Gorham & Lamont, 1990), pp 7-1 through 7-27 Cases in Portfolio Management, John W Peavy III and Katrina F Sherrerd, (AIMR, 1990) Questions and 2, including Guideline Answers, 1995 CFA Level III Examination (AIMR) Question 1, including Guideline Answer, 1996 CFA Level III Examination (AIMR) Purpose: To test the candidate’s knowledge of asset allocation issues by using a common example of investors, who have built up a collection of assets over time, seeking advice from a portfolio manager on the strengths and weaknesses of their portfolio asset allocation LOS: The candidate should be able to “Asset Allocation” (Session 12) • formulate major steps in the asset allocation process Cases in Portfolio Management (Session 22) • recommend and justify a general asset allocation that would be appropriate for an investor 1995 CFA Level III Examination (Session 22) • recommend an asset allocation and justify the recommendation; • justify the use of specific asset classes and relate the asset allocation to the investment policy statement 1996 CFA Level III Examination (Session 22) • recommend and justify an asset allocation and clearly state any assumptions, especially the risk tolerance of the client, that contributed to the recommendation Guideline Answer: The Muellers’ portfolio can be evaluated in terms of the following criteria: i Preference for “Minimal Volatility.” The volatility of the Muellers’ portfolio is likely to be much greater than minimal The asset allocation of 95 percent stocks and percent bonds indicates that substantial fluctuations in asset value will likely occur over time The asset allocation’s volatility is exacerbated by the fact that the beta coefficient of 90 percent of the portfolio (i.e., the four growth stock allocations) is substantially greater than 1.0 Thus the allocation to stocks should be reduced, as should the proportion of growth stocks or higher beta issues Furthermore, the percent allocation to bonds is in a long-term zero coupon bond fund that will be highly volatile in response to long-term interest rate changes; this bond allocaton should be exchanged for one with lower volatility (perhaps shorter maturity, higher grade issues) 1999 Level III Guideline Answers Morning Section – Page ii Equity Diversification The most obvious equity diversification issue is the concentration of 35 percent of the portfolio in the high beta small cap stock of Andrea’s company, a company with a highly uncertain future A substantial portion of the stock can and should be sold, which can be done free or largely free of tax liability because of the available tax loss carry forward Another issue is the 90 percent concentration in high beta growth stocks, which contradicts the Muellers’ preference for minimal volatility investments The same is true of the portfolio’s 45 percent allocation to higher volatility small cap stocks Finally, the entire portfolio is concentrated in the domestic market Diversification away from Andrea’s company’s stock, into more value stocks, into more larger cap stocks, and into at least some international stocks is warranted iii Asset Allocation (including cash flow needs) The portfolio has a large equity weighting that appears to be much too aggressive given the Muellers’ financial situation and objectives Their below average risk tolerance and limited growth objectives indicate that a more conservative, balanced allocation is more appropriate The Muellers are not invested in any asset class other than stocks and the small bond fund holding A reduction in equity investments, especially growth and small cap equities, and an increase in debt investments is warranted to produce more consistent and desired results over a complete market cycle In addition, the Muellers have no cash reserve or holdings of short-term high grade debt assets In the very near future, the Muellers will need $50,000 (up front payment) and at least part of $40,000 (first year’s tuition and living expenses) for their daughter’s college education, as well as some reserve against normal expenses In addition, they expect to have negative cash flow each year their daughter is in college, which should lead them to increase their cash reserves The current portfolio is likely to produce a low level of income because of the large weighting in growth stocks and because the only bond holding is a long-term zero coupon fund Also, the marketability of Andrea’s company stock is unknown and could present a liquidity problem if it needs to be sold quickly After their immediate cash needs are met, the Muellers will need a modest, ongoing allocation to cash equivalents 1999 Level III Guideline Answers Morning Section – Page Level III: Question Topic: Minutes: Tax/Mutual Fund Issues 16 Reading References: “Mutual Fund Misclassification: Evidence Based on Style Analysis,” Dan DiBartolomeo and Erik Witkowski, Financial Analysts Journal (AIMR, September/October 1997) “Tax Considerations in Investing,” Ch 8, Robert H Jeffrey, The Portable MBA in Investment, Peter L Bernstein, ed (John Wiley & Sons, 1995) Purpose: To test the candidate’s understanding of how tax and mutual fund considerations affect investment returns and investment strategies LOS: The candidate should be able to “Mutual Fund Misclassification: Evidence Based on Style Analysis” (Session 11) • discuss why a mutual fund could be misclassified in regard to its investment guidelines “Tax Considerations in Investing” (Session 13) • explain the importance of taxation on investment policy and discuss taxes as an investment expense; • differentiate capital gains and dividends and compare the taxation of each; • analyze the impact of turnover on the portfolio when taxes are considered and calculate the effect of turnover at a given tax rate; • analyze the profile of an individual investor, discuss the impact of spending requirements on overall investment performance, discuss the probability of realizing capital gains taxes, and discuss the benefits of deferring capital gains taxes; • discuss the advantages and disadvantages of realizing losses Guideline Answer: A Compared to the Superior Growth and Income Fund, the Exceptional Growth and Income Fund is more consistent with the Muellers’ goal with regard to both the return volatility and the expected one-year after-tax return i Return Volatility The Exceptional Fund has had a substantially lower beta than the Superior Fund Based on the betas, Exceptional has been slightly less volatile than the overall market while Superior has been considerably more volatile than average Exceptional has also exhibited more consistent performance in the past, producing a lower return in up markets and a higher return in down markets ii Expected One-Year After-Tax Return (assuming all turnover resulted in gains) The Exceptional Fund’s expected one-year after-tax return is 9.73 percent and the Superior Fund’s comparable return is 9.50 percent Each fund’s gross (pre-tax) total return is composed of the fund’s capital appreciation and dividend yield The gross appreciation rate is the expected realized capital gains (estimated by the fund’s turnover rate) taxed at the client’s capital gains tax rate (20% in the case of the Muellers) The gross dividend return is 1999 Level III Guideline Answers Morning Section – Page reduced by the client’s applicable ordinary income tax rate (30% for the Muellers) The expected after-tax return can be estimated by: = = = = taxed capital gain + taxed dividend yield + non-taxed capital gain OR [(total return – yield) × (turnover rate) × (1 – capital gains tax rate)] + [yield × (1 – income tax rate)] + [(total return – yield) × (1 – turnover rate)] OR (total return – yield) × (1 – turnover rate × capital gains tax rate) + [yield × (1 – income tax rate)] total return – (yield × ordinary tax rate) – [(total return – yield) × turnover × capital gains tax rate] The Exceptional Fund’s expected after-tax return is: = = = = = [(0.105 – 0.02) × (1 – 0.10 × 0.20)] + [0.02 × (1 – 0.30)] [0.085 × (1 – 0.02)] + [0.02 × 0.70] [0.085 × 0.98] + 0.014 0.0833 + 0.014 0.0973, or 9.73% The Superior Fund’s expected after-tax return is: = = = = = [(0.11 – 0.01) × (1 – 0.60 × 0.20)] + [0.01 × (1 – 0.30)] [0.10 × (1 – 0.12)] + [0.01 × 0.70] [0.10 × 0.88] + 0.007 0.088 + 0.007 0.095, or 9.50% B Realized losses can add value to a portfolio Realized losses can be used as a direct offset to capital gains already realized or to those to be realized in the future In effect, realized losses can be exchanged for monies that would otherwise be paid to the taxing authority, creating additional “cash in the bank” The greatest tax benefit and addition to portfolio value is likely to occur if losses are realized whenever they are available rather than waiting until the end of a tax year to sell any losers Obviously, realizing losses can add to the value of a portfolio only as long as the tax benefit is greater than the trading costs that are incurred Otherwise, realizing tax losses does have a negative effect on portfolio value 1999 Level III Guideline Answers Morning Section – Page Level III: Question Topic: Minutes: Investment Policy Statement 12 Reading References: “Asset Allocation,” Ch 7, pp 7-1 through 7-27, William F Sharpe, Managing Investment Portfolios: A Dynamic Process, 2nd edition, John L Maginn and Donald L Tuttle, eds (Warren, Gorham & Lamont, 1990) Cases in Portfolio Management, John W Peavy III and Katrina F Sherrerd, (AIMR, 1990) Questions and 2, including Guideline Answers, 1995 CFA Level III Examination (AIMR) Question 1, including Guideline Answer, 1996 CFA Level III Examination (AIMR) Purpose: To test the candidate’s ability to select appropriate asset allocation strategies for various clients’ objectives and constraints LOS: The candidate should be able to “Asset Allocation” (Session 12) • formulate major steps in the asset allocation process Cases in Portfolio Management (Session 22) • recommend and justify a general asset allocation that would be appropriate for an investor 1995 CFA Level III Examination (Session 22) • recommend an asset allocation and justify the recommendation; • justify the use of specific asset classes and relate the asset allocation to the investment policy statement 1996 CFA Level III Examination (Session 22) • recommend and justify an asset allocation and clearly state any assumptions, especially regarding the risk tolerance of the client, that contributed to the recommendation Guideline Answer: A Personal Portfolio Portfolio A is the most appropriate portfolio for the Muellers Because their pension income will not cover their annual expenditures, the shortfall will not likely be met by the return on their investments so the 10 percent cash reserve is appropriate As the portfolio depletes over time, it may be prudent to allocate more than 10 percent to cash equivalents The income deficit will be met each year via a combination of investment return and principal invasion Now that their daughter is financially independent, the Mueller’s sole objective for their personal portfolio is to provide for their living expenses Their willingness and need to take on risk is fairly low Clearly, there is no need to expose the Muellers to the possibility of a large loss Also, their time horizon has been shortened considerably because of their health situation Therefore, a 70 percent allocation to intermediate term high grade fixed income securities is warranted 1999 Level III Guideline Answers Morning Section – Page The income deficit will rise each year as the Muellers’ expenses rise with inflation but their pension income need remains constant The conservative 20 percent allocation to equities should provide diversification benefits and some protection against unanticipated inflation over the expected maximum 10-year time horizon Portfolio B, the second best portfolio, has no cash reserves so the Mueller’s liquidity needs would not be met Also, although it has a higher expected return, Portfolio B’s asset allocation results in a somewhat higher standard deviation of returns than Portfolio A Portfolios C and D offer higher expected returns but at markedly higher levels of risk and with relatively lower levels of current income The Mueller’s large income requirements and low risk tolerance preclude the use of Portfolios C and D B Trust Distribution Portfolio Portfolio B is the most appropriate portfolio for the trust assets Portfolio B’s expected return of 5.8 percent exceeds the required return of 5.4 percent, and the required return would actually decline if the surviving spouse lives longer than five years The time horizon for the portfolio is relatively short, ranging from a minimum of five years to a maximum of 10 years The Mueller’s sole objective for these funds is to provide adequate funds for the building addition Growth requirements for the portfolio are modest and the Mueller’s willingness to take on risk is low The portfolio would be unlikely to achieve its objective if large, even short term, losses were absorbed during the minimum five year time horizon Except for taxes, no principal or income disbursements are expected for at least five years; therefore, only a minimal or even zero cash reserve is required Accordingly, an allocation of 40 percent to equities to provide some growth and 60 percent to intermediate fixed income to provide stability and capital preservation is appropriate There is no second best portfolio Portfolio A’s cash level is higher than necessary and the portfolio’s expected return is insufficient to achieve the $2,600,000 value within the minimum 5-year time horizon Portfolio C has an expected return sufficient to achieve the $2,600,000 value in five years but it has a higher cash level than is necessary and, more importantly, it has a standard deviation of returns that is too high given the low risk tolerance of the trust portfolio Portfolio D has a high enough return and the appropriate cash level but a clearly excessive risk (standard deviation) level Portfolios C and D share the flaw of having excessive equity allocations that fail to recognize the relatively short time horizon and that generate risk levels that are much higher than necessary or warranted 1999 Level III Guideline Answers Morning Section – Page 10 ii Historical Simulation Method II Method: The Historical Simulation Method entails “simulating” past portfolio returns by using the returns of factors that influence the value of portfolio instruments For example, for a domestic bond, the primary risk factor is the level of domestic interest rates Risk factors are modeled based on the current portfolio composition to create simulated portfolio returns Then, an empirical frequency distribution is constructed by ranking the simulated portfolio returns into percentiles; the VAR is determined at the chosen confidence level given the portfolio’s current value Strengths: The Historical Simulation Method makes no explicit assumptions about the shape of the distributions (e.g., whether or not returns are normally distributed) or whether volatilities or correlations are stable This method does not require separate valuation models to price the assets or liabilities of the portfolio Market data necessary to compute Historical Simulation Method VAR should be readily available to the investment manager Weaknesses: The Historical Simulation Method is inflexible, in that it does not allow the analyst to try different values for volatilities and correlations to test the sensitivity of VAR to these assumptions It requires the mapping of the portfolio to risk factors, which subjects the analysis to mismatching and therefore may result in inaccurate risk characteristics The process may become cumbersome as the number of risk factors grows The use of a specified period of trading days of risk factor data may not be representative of future market movements VAR may be over or underestimated depending upon market history In addition, managers or portfolios often are not comparable, because the assumptions or risk factors utilized may be different iii Monte Carlo Simulation Method Method: The Monte Carlo Simulation Method involves identifying a number of risk factors that affect the portfolio and constructing a distribution for each risk factor Using the distributions, the method generates a large number of possible market scenarios (e.g., 10,000) that are consistent with expected volatilities and correlations While each scenario is different, the total simulations will aggregate to the overall statistical parameters chosen at the outset The portfolio positions are revalued under each scenario resulting in distributions of market value changes VAR is derived from the distribution produced by the Monte Carlo simulation analysis and the portfolio value Strengths: The Monte Carlo approach makes no set assumptions about linearity, normality, or position relationships It is a powerful approach, in that it is not constrained by assumptions about asset returns and generates many more scenarios than the Historical Simulation method Weaknesses: The Monte Carlo approach requires considerable computer power The greater the number of risk characteristics in the portfolio, the greater the number of scenarios required It requires sophisticated mathematical modeling and its results are only as good as the underlying assumptions In addition, managers or portfolios often are not comparable, because the assumptions or risk factors utilized may be different 1999 Level III Guideline Answers Afternoon Section – Page B The two consultants may obtain dramatically different VAR results for several reasons; the consultants may have: • used different past time periods over which the simulations were run • used different models, including different assumptions about pricing, distributions, and risk factors in the simulations • used different distributions to drive the simulation process Normal distributions, lognormal distributions, t-distributions, or actual historical distributions could be used to produce the simulations, each resulting in different VARs • used different statistical parameters to drive the simulation process Different empirical inputs—means, variances, and correlations—can have dramatic consequences, including markedly different VARs, for the simulation results • used different “risk factors” to model the portfolio For example, if one consultant used the 10-year U.S government bond yield to model interest rate risk while the other consultant used the 30-year U.S government bond yield, their computed VARs could be very different 1999 Level III Guideline Answers Afternoon Section – Page 10 Level III: Question 16 Topic: Minutes: Global Fixed Income 12 Readings: “International Bond Portfolio Management,” Ch 26, Christopher B Steward and J Hank Lynch, Managing Fixed Income Portfolios, Frank J Fabozzi, ed (Frank J Fabozzi Associates, 1997) Purpose: To test the candidate’s understanding of the effect of the currency hedging policy on the risk and return objectives of an international bond portfolio LOS: The candidate should be able to “International Bond Portfolio Management” (Session 10) • discriminate between a domestic bond portfolio manager’s challenges and an international bond portfolio manager’s challenges by citing specific common responsibilities and responsibilities that differ • discuss the fundamental steps in the investment process—setting objectives, establishing investment guidelines, developing portfolio strategy, constructing the portfolio, monitoring risk, and evaluating performance—as they apply to domestic and international bonds Guideline Answer A A fully-hedged international bond portfolio strategy offers better risk reduction for domestic investors because of the lower standard deviation of returns in home currency terms That is, it offers greater assurance of achieving an accurately estimated return in domestic currency terms However, a fully-hedged portfolio forfeits the potential performance enhancement from successful active currency management Depending on the nature of inter-bond correlations, even a partially-hedged strategy offers the potential for some return enhancement while preserving some diversification benefits B Jacob’s decision to fully hedge his portfolio contradicts the fund’s objectives The fund has aggressive return objectives and high tolerance for risk Eliminating the ability to add value through active currency management is counter to the return objective, and pursuing a strategy that attempts to eliminate currency risk entirely is counter to the risk tolerance objective 1999 Level III Guideline Answers Afternoon Section – Page 11 Level III: Question 17 Topic: Minutes: Global Fixed Income 14 Readings: “International Bond Portfolio Management,” Ch 26, Christopher B Steward and J Hank Lynch, Managing Fixed Income Portfolios, Frank J Fabozzi, ed (Frank J Fabozzi Associates, 1997) Purpose: To test the candidate’s understanding of the limitations of duration as a portfolio measure of interest rate sensitivity and the potential sources of excess return in international bond portfolio management LOS: The candidate should be able to “International Bond Portfolio Management” (Session 10) • discriminate between a domestic bond portfolio manager’s challenges and an international bond portfolio manager’s challenges by citing specific common responsibilities and responsibilities that differ; • discuss the fundamental steps in the investment process—setting objectives, establishing investment guidelines, developing portfolio strategy, constructing the portfolio, monitoring risk, and evaluating performance—as they apply to domestic and international bonds; • compare and contrast five broad strategies: currency selection, bond selection, duration management, sector/credit/security selection, and outside-benchmark investing Guideline Answer A The consultant is incorrect in suggesting that the weighted-average portfolio duration calculation is the same for both global and domestic bond portfolios The portfolio duration measure for international bond portfolios is far more limiting than for domestic portfolios A domestic portfolio’s duration can equal the weighted sum of its individual securities’ durations when all the yields and corresponding term structures are the same An international portfolio’s total duration, however, will rarely be equal to a simple sum of the duration-weighted components, because interest rate movements in different countries are not perfectly correlated Also, the differing volatility of interest rates across markets means that the contribution to duration from a given market is not entirely comparable to that of another market Finally, the yield curve structures and yields on the constituent bonds are also different across markets B Additional sources of excess return in global bond management are: • Bond Market Selection/Country Selection By correctly over or underweighting the best and worst performing countries/markets, the added return can be large and is arguably the largest source of potential excess return • Sector/Issue Selection Investing in corporate and other non-government issues can add incremental value However, these bonds are not as widely available in many markets as in the U.S and other developed markets 1999 Level III Guideline Answers Afternoon Section – Page 12 Level III: Question 18 Topic: Minutes: Portfolio Management - Derivatives (Study Session 17) 22 Readings: “Stock Index Futures: Refinements,” Ch 8, Futures, Options & Swaps, 2nd edition, Robert W Kolb, (Blackwell, 1997) “Minimizing Cash Drag with S&P 500 Index Tools,” Joanne M Hill and Rebecca Cheong, Equity Derivatives Research (Goldman, Sachs, June 11, 1996, revised) Purpose: To test the candidate’s knowledge of futures and alternative instruments by altering a portfolio’s expected return LOS: The candidate should be able to “Stock Index Futures: Refinements” (Session 17) • compute the correct number of index futures contracts required to partially or completely hedge an equity portfolio; • construct a strategy to decrease/increase the beta of a portfolio, including calculating the number of futures contracts; • create a synthetic T-bill or synthetic equity position using the appropriate futures contracts “Minimizing Cash Drag with S&P 500 Index Tools” (Session 17) • compare and contrast the two primary tools used in cash management of equity index portfolios; • design and evaluate a cash management strategy using futures; • calculate and appraise returns from a cash management strategy using index futures or S&P 500 Depository Receipts (SPDRs) with returns from leaving a portion of the portfolio in cash; • compare and contrast the cost of excess cash versus an appropriate cash management strategy using futures or SPDRs; • illustrate similar cash management strategies using alternative index instruments Guideline Answer A The number of futures contracts required is: N = (value of the portfolio/value of the index futures) × beta of the portfolio = [$15,000,000 / (1,000 × 250)] × 0.88 = [$15,000,000 / 250,000] × 0.88 = 60 × 0.88 = 52.8 contracts Selling (going short) 52 or 53 contracts will hedge $15,000,000 of equity exposure 1999 Level III Guideline Answers Afternoon Section – Page 13 B Alternative methods that replicate the futures strategy in Part A include: Shorting SPDRs SPDRs would be more expensive than futures to trade in terms of liquidity and transaction costs Tracking error, in theory, would be higher for futures than for SPDRs, because S&P 500 futures can close under and over fair value SPDRs not incur the cost of rolling over, which a position in futures would incur if held longer than one expiration date Creating a synthetic short futures position using a combination of calls and puts Either options on the underlying index or options on the future could be used Selling an index call option and purchasing an index put option with the same contract specifications would create a synthetic short futures position This strategy would likely be more costly than futures because two transactions are required Longer-term options tend to be less liquid than futures and SPDRs Unlike futures, the option combination can be traded either as a spread or separately If the call and put are traded separately, bid/ask spreads and market impact may increase the cost of the strategy Options on some index futures are American style, which may result in the call option being exercised at an inopportune time Creating a fixed equity swap in which Andrew pays the appreciation and dividends on the portfolio and receives a fixed rate The price of this transaction is negotiated between the two parties, but in general, the swap would be more costly than the futures hedge Also, equity swaps are not liquid and may prove difficult to reverse once entered Unlike futures, which are standardized contracts with no customization possible, this alternative has the advantage of customization; negotiable terms include length of contract, margin requirements, cost of closing position early, and timing of payments Shorting a forward contract on the S&P 500 index The price of this transaction is negotiated between the two parties Forwards are not liquid, may prove difficult to reverse once entered, and may involve counterparty risk Unlike futures, which are standardized contracts with no customization possible, this alternative has the advantage of customization; negotiable terms include length of contract, margin requirements, cost of closing the position early, and timing of payments C i Because Andrew anticipates an imminent rebound in stock prices, he will want to equitize his cash position as quickly as possible Even after transaction costs, the advantages of using SPDRs or futures (synthetic indexes) far outweigh the cost of holding cash in a rising market When a portfolio manager desires to be fully invested, excess cash should be invested temporarily in an appropriate synthetic equity position until the portfolio manager can perform stock selection This strategy will also minimize tracking error If a portfolio manager cannot use futures, the manager should use SPDRs to equitize the cash position Even with the SPDRs’ management fees and transaction costs, Andrew’s expected return would be higher by equitizing than leaving the $5 million in cash 1999 Level III Guideline Answers Afternoon Section – Page 14 ii The cost of holding the excess cash in U.S Treasury bills is: Cost = cash weight × (S&P 500 return – cash return) = 0.05 × (12% – 6%) = 0.30% iii The return enhancement of using a futures-based cash management strategy is: Return enhancement = cash weight × (synthetic index return − cash return) = 0.05 × (11.8% – 6%) = 0.29% 1999 Level III Guideline Answers Afternoon Section – Page 15 Level III: Question 19 Topic: Minutes: Performance Measurement and Attribution 14 Reading References: “Benchmark Portfolios and the Manager/Plan Sponsor Relationship,” Jeffrey Bailey, Thomas Richards, and David Tierney, Current Topics in Investment Management, Frank Fabozzi and T Dessa Fabozzi, eds (Harper Collins, 1990) “Are Manager Universes Acceptable Performance Benchmarks?” Jeffery V Bailey, The Journal of Portfolio Management (Institutional Investor, Spring 1992) “Evaluating Portfolio Performance,” Ch 14, pp 14-23 through 14-47, Peter Dietz and Jeannette Kirschman, Managing Investment Portfolios: A Dynamic Process, 2nd edition, John Maginn and Donald Tuttle, eds (Warren, Gorham & Lamont, 1990) Purpose: To test the candidate’s ability to evaluate investment performance relative to an appropriate benchmark LOS: The candidate should be able to “Benchmark Portfolios and the Manager/Plan Sponsor Relationship” (Session 21) • identify the characteristics of an effective benchmark portfolio and provide a critique of the practice of using the performance of the median manager, rather than a benchmark portfolio, in performance evaluation “Are Manager Universes Acceptable Performance Benchmarks?” (Session 21) • evaluate the validity and appropriateness of using benchmarks as a standard for evaluating manager or plan sponsor performance; • explain the conceptual basis for valid benchmarks; • explain how survivor bias significantly affects performance measurement results when median manager returns rather than benchmark returns are used as the comparison standard Guideline Answer A Generally, the correct benchmark portfolio is one that both the investment manager and the client agree fairly represents the manager’s investment process To be valid and effective in measuring a manager’s performance, a benchmark should be: Unambiguous The names and weights of securities comprising the benchmark can be clearly delineated Investable Investors can actually invest in the benchmark; that is, the option is available to forego active management and simply hold the benchmark Measurable The benchmark’s own return can be readily calculated on a reasonably frequent basis Appropriate The benchmark is consistent with the manager’s investment style or biases Reflective of current investment opinions The investment manager has current investment knowledge (be it positive, negative or neutral) of the securities that make up the benchmark 1999 Level III Guideline Answers Afternoon Section – Page 16 Specified in advance The benchmark is constructed prior to the start of an evaluation period The “median manager” approach is not a reasonable benchmark for measuring Sloan & Co.’s performance, because of the following weaknesses The median manager is ambiguous, in that the composition of the median manager’s portfolio is unavailable for inspection, either before or after the evaluation period The median manager is not investable, in that neither Sloan & Co nor any other portfolio manager has the option of investing in the median manager’s portfolio In the relative performance measurement industry, the median fund portfolio changes from quarter to quarter The performance of the median manager is measurable, but only by the data provider The median manager is not appropriate for the measurement of Sloan’s performance; there is a high probability that the median manager’s investment style differs markedly from that of Sloan The median manager will likely not be reflective of current investment opinions held by Sloan & Co The median fund portfolio will include many securities for which Sloan & Co has not formed a current investment opinion The median manager is not specified in advance, because compilers of manager peer groups can identify the median fund only ex post Before an evaluation period, there is no knowledge of the future median fund Due to the nature of producing the statistics associated with the median fund, the composition of the median fund will change from one measurement period to the next B The S&P 500 Index is based on only 500 relatively large firms from various industries, most of which are listed on the New York Stock Exchange (NYSE) Together, these 500 firms comprise approximately 80 percent of the total value of the stocks listed on the NYSE Although the S&P 500 Index is generally regarded as an acceptable comparative index for institutional portfolios, a number of technical problems reduce its usefulness as a universal benchmark Among these problems are: • a large capitalization bias; • double counting that results from (corporate) cross ownership of equities in the index; • failure to cover 100 percent of the value of all traded U.S securities, because it includes only common stocks, most of which are listed on the NYSE, and excludes many AMEX stocks and many over-the-counter (OTC) stocks • inclusion of some international (non-US based) companies Because Sloan & Co is the only U.S equity manager hired by ECB Inc and operates under the broad mandate of investing in any U.S equity securities, an index representing a broad universe of U.S equities would be the appropriate benchmark for comparative purposes To properly reflect that broad investment mandate, ECB Inc should work with Sloan to segment the portfolio so that Sloan’s assets may be more appropriately measured against indices such as the NASDAQ, AMEX, Russell 2000, and potentially other indices A custom benchmark that includes all U.S equities (e.g., a benchmark that consists of a weighted sum of existing indices) would be far more appropriate than either a median manager or a single index approach 1999 Level III Guideline Answers Afternoon Section – Page 17 Level III: Question 20 Topic: Minutes: Real Estate Readings: “Real Estate Investment Performance and Portfolio Considerations,” Ch 21, Real Estate Finance and Investments, 10th edition, William B Brueggerman and Jeffrey D Fisher, eds (Irwin, 1997) “Public and Private Real Estate: Performance Implications for Asset Allocation,” Ch 15, Real Estate Investment Trusts, David Geltner and Joe V Rodriguez (McGraw Hill, 1998) Purpose: To test the candidate’s ability to evaluate the addition of real estate to an investment portfolio in the context of modern portfolio theory LOS: The candidate should be able to “Real Estate Investment Performance and Portfolio Considerations” (Session 11) • evaluate the shortcomings of the various means of measuring real estate returns “Public and Private Real Estate: Performance Implications for Asset Allocation” (Session 11) • criticize the way data are analyzed in property markets; • evaluate the usefulness of the main real estate indexes; • compare the risk–return profile of real estate to that of the other investment categories; • prepare a summary of the problems in using real estate in the context of modern portfolio theory (MPT); • support a rationale in the MPT framework for including real estate in a portfolio Guideline Answer Because of the thin trading prevalent in property markets, return data for private real estate have been based on appraised values Appraisal-based valuations are inevitably subject to lagging and smoothing across time In addition, data on real estate transactions are incomplete Many costs are not included (e.g transaction costs, management fees) and leverage is not considered These and other data problems cause returns from real estate, as measured by mean-variance models, to appear to be higher, with less volatility and lower correlation with other asset classes, than is actually the case In addition, the private real estate market is not informationally efficient, which means that shortterm return statistics should not be used for long-term modern portfolio theory (MPT) analysis To properly conduct portfolio analysis for medium- to long-term horizon investors, MPT analysis must be applied using long-term return statistics Unfortunately, these data not exist in sufficient quantity or quality for direct real estate investments Consequently, MPT analysis using short-term return statistics biases the role of private real estate for a long-horizon investor and should not be used for long term investment decisions In view of the above weaknesses associated with real estate return and risk data, the 40 percent allocation to direct real estate investments suggested by the consultant is too high 1999 Level III Guideline Answers Afternoon Section – Page 18 Level III: Question 21 Topic: Minutes: Ethics 16 Readings: Standards of Practice Handbook, 7th Edition (AIMR, 1996) “The Consultant,” Jules A Huot, Standards of Practice Casebook (AIMR, 1996) Purpose: To test the candidate’s understanding of the AIMR Standards of Professional Conduct related to suitability of investments, misrepresentation, fiduciary duty, and conflicts of interest LOS: The candidate should be able to Standards of Practice Handbook (Session 2) • appraise behavior that could lead to potential or actual violations of the Code and Standards Standards of Practice Casebook (Session 4) • differentiate between ethical behavior that complies with the Code and Standards and conduct that violates the Code and Standards Guideline Answer: A Template for Question 21A U.S Treasury Bill Investment Suitability: By investing 55 percent of the Fund’s assets in U.S Treasury bills, Jennings is buying an inappropriate and unsuitable investment for her clients (the Fund’s shareholders), despite the positive outlook for these securities The Fund’s investment strategy, as described in the prospectus, is aggressive growth, to be achieved by remaining fully invested in small and micro cap stocks Investors in the Fund seek an aggressive, high growth investment Thus Jennings’ conservative investment in Treasury bills is clearly inconsistent with the Fund’s strategy and clients’ objectives Misrepresentation: Jennings misrepresented the services that she was providing to her clients (the Fund’s shareholders) when she stated in the prospectus that the Fund was an aggressive growth investment vehicle Specifically, her action of investing a majority of the Fund’s assets in U.S Treasury bills suggests that she misrepresented the Fund’s objective Client Interests/ Personal Interests: Based on the facts presented, buying Treasury bills for the Fund does not benefit Jennings’ personal interests in any way and would not skew her independence and objectivity with respect to client interests Thus no conflict exists between client interests and Jennings’ personal interests 1999 Level III Guideline Answers Afternoon Section – Page 19 Disclosure of Conflicts: Jennings’ purchase of Treasury bills for the Fund does not result in a conflict of interest Therefore, no disclosure is required to either her employer or her clients (the Fund’s shareholders) B Template for Question 21B Biocure Investment Suitability: The Fund’s prospectus states that the Fund is seeking to achieve a high level of asset growth by investing in small and micro cap stocks Based on the facts presented, Biocure’s stock meets these criteria and is a suitable investment The stock appears to be an appropriate investment based on the Biocure long-term earnings projections prepared by the research department of Jennings’ firm Misrepresentation: The prospectus states that the Fund would invest in small and micro cap stocks Because Biocure is such a stock, Jennings did not make any misrepresentation about Biocure stock or her purchase of the stock Client Interests/ Personal Interests: Jennings’ purchase of Biocure stock for the Fund gives rise to the appearance that she placed her own interests before her clients That is, Jennings’ ownership of Biocure stock could affect her judgment and place her personal interest in conflict with clients’ interests Because of the recent decline in Biocure’s stock price, Jennings’ large stock purchase on behalf of the Fund could be interpreted as an attempt to boost the value of her personal holding of Biocure stock Disclosure of Conflicts: Jennings’ purchase of Biocure stock for the Fund represents a potential conflict of interest because she personally owns $100,000 of this stock Therefore, Jennings must disclose her interest in the Biocure stock to both her employer and her clients (the Fund’s shareholders) 1999 Level III Guideline Answers Afternoon Section – Page 20 Level III: Question 22 Topic: Minutes: PPS/Portfolio Management 18 Readings: Performance Presentation Standards, 1st edition, including appendixes (AIMR, 1993) and Description of Change included in the CFA Level III Candidate Readings or AIMR Performance Presentation Standards Handbook, 2nd edition, including appendixes (AIMR, 1997) “AIMR’s Performance Presentation Standards,” Jonathan J Stokes, Journal of Performance Measurement (The Spaulding Group, Winter 1997/98) Purpose: To test the candidate’s understanding of the requirements of the AIMR Performance Presentation Standards LOS: The candidate should be able to AIMR Performance Presentation Standards Handbook (Session 20) • determine the role of the AIMR-Performance Presentation Standards (AIMR-PPSTM) in ensuring ethical presentations of investment returns; • evaluate a sample performance presentation to determine whether the presentation complies with the AIMR-PPS standards “AIMR’s Performance Presentation Standards” (Session 20) • explain the AIMR-PPS standards regarding composite creation, calculation of returns, presentation of results, and disclosures Guideline Answer Template for Question 22 Application of the AIMR-PPS Standards i Use of Martin’s investment record at her former firm: The AIMR-PPS standards state that the performance results of a past firm or affiliation cannot be used to represent the historical record of a new firm entity This requirement is especially true for HM because the prior performance record cannot be solely attributed to the manager or managers who are attempting to claim the record as their own That is, Martin was only a member of the stock selection committee of her previous firm and was not solely responsible for the performance results By using Martin’s investment record at her former firm, HM has failed to comply with AIMR-PPS standards 1999 Level III Guideline Answers Afternoon Section – Page 21 ii Use of the equity segments of the HM’s balanced accounts: The AIMR-PPS standards permit HM, when presenting performance return, to split its balanced accounts into separate portfolios based on asset class However, the AIMR-PPS standards also require that cash be allocated to the segment returns of a multiple-asset portfolio when segment returns are being presented either alone or as part of a single-asset composite as evidence of the firm’s ability to manage the segment by itself By not including cash with its equity segments, HM may be distorting the performance of those segments and has failed to comply with AIMR-PPS standards iii Use of HM’s balanced accounts currently under management: The AIMR-PPS standards require that composites must exclude terminated portfolios after the last full performance measurement period the portfolios were under management, but composites must continue to include terminated portfolios for all periods prior to termination For HM, information is not explicitly provided on whether the firm has had any terminated portfolios If HM had terminated portfolios, these portfolios must be included in an appropriate composite through the last full period they were under firm management Otherwise, by including only the performance history of all its balanced accounts currently under management, HM’s balanced return would not be in compliance because the return would show survivor-only performance results and be skewed by “survivorship bias.” By using only the balanced accounts currently under management, HM may have failed to comply with AIMR-PPS standards iv Use of model performance: According to the AIMR-PPS standards, composites must include only assets under management and may not link simulated and model portfolios with actual performance HM may present model results to a potential client as supplementary information, but the model results must be clearly identified as such and must not be linked to actual results v Use of three selected HM fixed income accounts: The AIMR-PPS standards require that firms present the performance history of portfolio composites and that they include all discretionary, fee-paying accounts in composites of like style and strategy This prevents firms such as HM from choosing their best performing portfolios as “representative accounts” without showing the firm’s overall performance HM’s current practice may distort fixed income returns By using only the performance history for three selected accounts to represent fixed income returns, HM has failed to comply with AIMR-PPS standards 1999 Level III Guideline Answers Afternoon Section – Page 22 vi Providing annual numbers from 1996 to the present: The AIMR-PPS standards require firms to show annual returns for 10 years or since inception of the firm if inception is less than 10 years This standard prevents managers from presenting only the selected times when the firm has excellent returns HM must present annual returns for all years from 1994 to present By presenting annual numbers only from 1996 to the present, HM has failed to comply with AIMR-PPS standards 1999 Level III Guideline Answers Afternoon Section – Page 23 ... Peavy III and Katrina F Sherrerd, (AIMR, 1990) Questions and 2, including Guideline Answers, 1995 CFA Level III Examination (AIMR) Question 1, including Guideline Answer, 1996 CFA Level III Examination... Peavy III and Katrina F Sherrerd, (AIMR, 1990) Questions and 2, including Guideline Answers, 1995 CFA Level III Examination (AIMR) Question 1, including Guideline Answer, 1996 CFA Level III Examination... time horizon and that generate risk levels that are much higher than necessary or warranted 1999 Level III Guideline Answers Morning Section – Page 10 Level III: Question Topic: Minutes: Derivatives