L3 mock sample exam CFA level III essay questions 2002

Exhibit 1-1 Jarvis University Endowment Fund Asset Allocation as of May 31, 2002 Asset Current Allocation millions Current Allocation Percentage Current Yield Expected Annual Return

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2002 CFA ® Level III Examination

Morning Session – Essay

FOR AIMR USE ONLY

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The following list contains the command words used on the Morning Session of

the 2002 Level III examination Candidates may want to refer to this list as they formulate their answers

Calculate: To ascertain or determine by mathematical processes

Describe: To transmit a mental image, an impression, or an understanding of the nature

and characteristics of

Determine: To come to a decision as the result of investigation or reasoning; to settle or

decide by choice among alternatives or possibilities

Discuss: To discourse about through reasoning or argument; to present in detail

Explain: To give the meaning or significance of; to provide an understanding of; to give

the reason for or cause of

Formulate: To put in a systematized statement or expression; to prepare according to a

formula

Identify: To establish the identity of; to show or prove the sameness of

Indicate: To point out or point to with more or less exactness; to show or make known

with a fair degree of certainty

Justify: To prove or show to be valid, sound, or conforming to fact or reason; to

furnish grounds or evidence for

Prepare: To put into written form; to draw up

Recommend: To bring forward as being fit or worthy; to indicate as being one’s choice for

something or as otherwise having one’s approval or support

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The Morning Session of the 2002 CFA Level III Examination has 9 questions For grading purposes, the maximum point value for each question is equal to the number of minutes allocated to that question

Question Topic Minutes

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Questions 1 through 4 relate to the endowment fund of Jarvis University A total of 75

minutes is allocated to these questions Candidates should answer these questions in the

order presented

QUESTION 1 HAS TWO PARTS FOR A TOTAL OF 26 MINUTES

Jarvis University (JU) is a private, multi-program U.S university with a $2 billion endowment

fund as of fiscal year-end May 31, 2002 With little government support, JU is heavily

dependent on its endowment fund to support ongoing expenditures, especially because the

university’s enrollment growth and tuition revenue have not met expectations in recent years

The endowment fund must make a $126 million annual contribution, which is indexed to

inflation, to JU’s general operating budget The U.S Consumer Price Index is expected to rise

2.5 percent annually and the U.S higher education cost index is anticipated to rise 3 percent

annually The endowment has also budgeted $200 million due on January 31, 2003, representing the final payment for construction of a new main library

In a recent capital campaign, JU only met its fundraising goal with the help of one very

successful alumna, Valerie Bremner, who donated $400 million of Bertocchi Oil and Gas

common stock at fiscal year-end May 31, 2002 Bertocchi Oil and Gas is a large-capitalization, publicly traded U.S company Bremner donated the stock on the condition that no more than 25 percent of the initial number of shares may be sold in any fiscal year No substantial additional donations are expected in the future

Given the large contribution to and distributions from the endowment fund, the endowment

fund’s Investment Committee has decided to revise the fund’s investment policy statement The Investment Committee also recognizes that a revised asset allocation may be warranted The

asset allocation in place for the JU endowment fund as of May 31, 2002, is given in Exhibit 1-1

Exhibit 1-1 Jarvis University Endowment Fund Asset Allocation as of May 31, 2002 Asset

Current Allocation (millions)

Current Allocation Percentage

Current Yield

Expected Annual Return

Standard Deviation

of Returns

U.S Money Market Fund $40 2% 4.0% 4.0% 2.0% Intermediate Global Bond Fund $60 3% 5.0% 5.0% 9.0% Global Equity Fund $300 15% 1.0% 10.0% 15.0% Bertocchi Oil and Gas Common Stock $400 20% 0.1% 15.0% 25.0% Direct Real Estate $700 35% 3.0% 11.5% 16.5% Venture Capital $500 25% 0.0% 20.0% 35.0%

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A Prepare the components of an appropriate investment policy statement for the Jarvis

University endowment fund as of June 1, 2002, based only on the information given

Note: Each component in your response must specifically address circumstances of the

JU endowment fund

Answer Question 1-A in the Template provided on pages 5, 6, and 7

(14 minutes)

B Determine the most appropriate revised allocation percentage for each asset in Exhibit

1-1 as of June 1, 2002 Justify each revised allocation percentage with one reason

Note: Your response should include only one allocation percentage for each asset The revised allocation percentages for Direct Real Estate and Venture Capital are provided in the Template on page 8

Answer Question 1-B in the Template provided on page 8

(12 minutes)

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Answer Question 1 on This Page

Template for Question 1-A

Prepare the components of an appropriate investment policy statement for the

Jarvis University endowment fund as of June 1, 2002

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Template for Question 1-A (continued)

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Template for Question 1-A (continued)

CONSTRAINTS

4

5

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Template for Question 1-B

Your response should include only one allocation percentage for each asset The revised allocation percentages for Direct Real Estate and Venture Capital are provided in the template

Asset

Determine the

most appropriate

revised allocation percentage for

each asset as of

June 1, 2002

Justify each revised allocation percentage with one reason

U.S Money Market Fund

Intermediate Global Bond

Fund

Global Equity Fund

Bertocchi Oil and Gas

Common Stock

Direct Real Estate 10% Not required Venture Capital 10% Not required

Total 100%

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Five years have passed and the Jarvis University endowment fund’s willingness and ability to assume risk have increased The endowment fund’s Investment Committee asks its consultant, James Chan, to discuss and recommend a rebalancing strategy to incorporate the new risk tolerance Chan’s outlook is for a bull market in growth assets over the next three to five years

He also believes that volatility will be below historical averages during that same time period The Investment Committee directs Chan to incorporate his views into his recommendation The Committee also does not want the market value of the portfolio to decline more than 15 percent below its current market value

A Describe the following three primary rebalancing strategies:

i Buy-and-hold

ii Constant-mix

iii Constant-proportion

(6 minutes)

B Determine which one of the three rebalancing strategies in Part A Chan should

recommend for the Jarvis University endowment fund Justify your response with two

reasons based on the circumstances described above

(5 minutes)

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QUESTION 3 HAS THREE PARTS FOR A TOTAL OF 22 MINUTES

James Chan is reviewing the performance of the global equity managers of the Jarvis University endowment fund Williamson Capital is currently the endowment fund’s only large-

capitalization global equity manager Performance data for Williamson Capital are shown in Exhibit 3-1

Exhibit 3-1 Williamson Capital Performance Data 1990–2001

Average Annual Rate of Return 22.1%

Beta 1.2Standard Deviation of Returns 16.8%

Chan also presents the endowment fund’s Investment Committee with performance information for Joyner Asset Management, which is another large-capitalization global equity manager Performance data for Joyner Asset Management are shown in Exhibit 3-2

Exhibit 3-2 Joyner Asset Management Performance Data 1990–2001

Beta 0.8Standard Deviation of Returns 20.2%

Performance data for the relevant risk-free asset and market index are shown in Exhibit 3-3

Exhibit 3-3 Relevant Risk-free Asset and Market Index

Performance Data 1990–2001

Risk-free Asset

Market Index

Standard Deviation of Returns 13.8%

A Calculate the following two performance measures for both Williamson Capital and

Joyner Asset Management:

i Sharpe ratio

ii Treynor measure

(4 minutes)

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B Calculate the following five components of investment performance for Joyner Asset

Management, using only the performance data contained in Exhibits 3-2 and 3-3:

C Explain why different rankings of Williamson Capital and Joyner Asset Management

could result from using:

i The Sharpe ratio versus the Treynor measure

ii Overall performance versus net selectivity

(8 minutes)

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Template for Question 3-B

Selected components of investment performance for Williamson Capital are calculated in the

first row of the template

Calculate the following five components of investment performance for

Joyner Asset Management

i

Overall performance

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Bristol Capital Management is the intermediate global fixed income manager for the Jarvis

University endowment fund Bristol has prepared the performance report shown in Exhibit 4-1

James Chan reviews the report and tells the endowment fund’s Investment Committee that the

report is not Global Investment Performance Standards (GIPS®) compliant

Exhibit 4-1 Bristol Capital Management Performance Results: Intermediate Global Fixed Income Composite

January 1, 1997 through March 31, 2002

Year Total

return (%)

Benchmark return (%)

Number

of portfolios

Composite dispersion (%)

Total assets

at end of period (US$

millions)

Percentage

of firm assets (%)

Total firm assets (US$

Bristol Capital Management has prepared and presented this report in compliance with the Global

Investment Performance Standards®, except for the use of cash basis accounting for the recognition of

interest income

Notes:

1 Bristol Capital Management is an independent investment management firm founded in

November 1995

2 Performance results are presented before investment management and custodial fees

3 Valuations are computed quarterly and are denominated in U.S dollars

4 Bristol Capital Management utilizes derivative products to enhance portfolio returns

5 All Intermediate Global Fixed Income accounts over $1 million are included in the

composite at the beginning of the first full quarter under management

6 Several non-fee paying accounts are included in the Intermediate Global Fixed Income

composite

7 Allied Verification, Ltd has verified the Bristol Capital Management Intermediate

Global Fixed Income composite to be GIPS® compliant

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A Identify four items included in the Bristol Capital Management performance report that

are not compliant with GIPS

Note: Omissions are not valid responses

(8 minutes)

B Identify four omissions that prevent the Bristol Capital Management performance report

from being in compliance with GIPS

(8 minutes)

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Questions 5 through 7 relate to Claire Pierce A total of 73 minutes is allocated to these

questions Candidates should answer these questions in the order presented

QUESTION 5 HAS FOUR PARTS FOR A TOTAL OF 36 MINUTES

Claire Pierce, a vice president for Spencer Design, is a 42-year-old widow who is a resident of the U.S She has two children: a daughter, aged 21, and a son, aged 7 She has a $2,200,000 portfolio; half of the portfolio is invested in Spencer Design, a publicly traded common stock, which has a cost basis of $350,000 Despite a substantial drop in the value of her portfolio over the last two years, her long-term annual total returns have averaged 7 percent before tax The recent drop in value has caused her great anxiety, and she believes that she could no longer tolerate an annual decline greater than 10 percent

Pierce intends to retire in 20 years, and her goals, in order of priority, over the next 20 years are:

• Funding the cost of her daughter’s upcoming final year of college, which has a

present value of $18,000, and her son’s future college costs, which have a present value of $91,000

• Increasing the portfolio to a level that will fund her retirement living expenses,

which she estimates to be $180,000 after tax for the first year of her retirement

• Building her “dream house” in five years, the cost of which (including land) has a

present value of $375,000

• Giving, if possible, each of her children $1,000,000 when they reach age 40

After subtracting the present value (before tax) of her children’s education costs and her

homebuilding costs, the present value of her portfolio is $1,509,000 With continued annual growth of 7 percent before tax, the portfolio’s value will be approximately $3,928,000 at the end

of 20 years

Pierce’s annual salary is $145,000, her annual living expenses are currently $100,000, and both are expected to increase at an inflation rate of 3 percent annually Taxes on income and short-term capital gains (holding period one year or less) are substantially higher than taxes on long-term capital gains (holding period greater than one year) For planning purposes, Pierce wants to assume that all returns are fully taxable and that her average tax rate on all income and gains is

30 percent The inflation and tax rates are expected to remain constant Currently, Pierce rents a townhouse, has no debt, and adamantly intends to remain debt-free Spencer Design has no pension plan, but provides company-paid medical insurance for executives for life and for their children to age 25 After tax, Pierce’s salary just covers her living expenses and therefore does not allow her to make further meaningful capital contributions to her portfolio

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Pierce has prepared the following investment policy statement:

Claire Pierce Investment Policy Statement

The portfolio should be invested conservatively, as I want to protect its

principal value My salary covers my current living expenses, but the

portfolio will need a moderate level of liquidity to cover the college

expenses My desire to give each of my children one million dollars when

they reach age 40 requires the portfolio to have a long-term focus but allows

for a low return objective in keeping with my low risk tolerance Because of

my tax circumstances, the portfolio should focus on securities that generate

little or no taxable income

A Prepare the objectives portion of a new investment policy statement for Pierce

Indicate how each of your two objectives addresses a different weakness in Pierce’s

current investment policy statement

(12 minutes)

B Prepare the constraints portion of a new investment policy statement for Pierce

Indicate how each of your four constraints addresses a different weakness in Pierce’s

current investment policy statement

Note: The legal and regulatory constraint is not applicable and should not be included

among the constraints addressed in your response

(12 minutes)

Pierce indicates that Spencer Design has a leading and growing market share, as the industry is

quite fragmented The company has shown steady fundamental growth trends, and Pierce

intends to hold her Spencer Design stock, which is expected to return at least 9 percent annually

before tax with a standard deviation of returns of 20 percent Pierce has decided to invest the

balance of her assets in one of the three alternative portfolios described in Exhibit 5-1

Exhibit 5-1 Claire Pierce Alternative Portfolios for Balance of Assets

Portfolio A Portfolio B Portfolio C

Expected Annual Return (before tax)

Standard Deviation

of Returns

Money Market $51,000 $51,000 $550,000 4.2% 2.5%

Bonds $491,000 $792,000 $330,000 6.4% 7.8% Equities $558,000 $257,000 $220,000 10.8% 17.8%

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