CFA® Level III FOR AIMR USE ONLY Examination Book 1999 Morning Section Candidate Number: _ _ _ _ _ _ © 1999 Association for Investment Management and Research All rights reserved This book is the property of: Association for Investment Management and Research Post Office Box 3668 Charlottesville VA 22903-0668 (804) 980-3668 The following list contains the command words used on the Morning Section of the 1999 Level III Examination Candidates may want to refer to this list as they formulate their answers calculate: To ascertain or determine by mathematical processes compare: To examine the character or qualities of for the purpose of discovering, primarily, resemblances construct: To create by organizing ideas or concepts logically and coherently critique: To offer a critical review or commentary; to criticize 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 evaluate: To determine or fix the value of; to determine the significance or worth of, usually by careful appraisal and study formulate: To put into a systematized statement or expression; to prepare according to a formula identify: To establish the identity of; to show or prove the sameness of justify: To prove or show to be valid, sound, or conforming to fact or reason; to furnish grounds or evidence for list: To enumerate select: To choose from a number or group—usually, by fitness, excellence, or other distinguishing feature show: To set forth in a statement, account, or description; to make evident or clear state: To express in words The Morning Section of the 1999 CFA Level III Examination has 11 questions For grading purposes, the maximum point value for each question is equal to the number of minutes allocated to that question Question 10 11 Topic Portfolio Management Portfolio Management Portfolio Management Portfolio Management Portfolio Management Portfolio Management Portfolio Management Economics Global Markets and Instruments Ethics Ethics Total Minutes 24 12 16 24 33 15 12 18 14 180 Questions through relate to Peter and Andrea Mueller, individual investors A total of 82 minutes is allocated to these questions Use the first few minutes to review the Introduction below Candidates should answer these questions in the order presented INTRODUCTION Peter and Andrea Mueller, U.S residents, are reviewing their financial plan The Muellers, both age 53, have one daughter, age 18 With their combined after-tax salaries totaling $100,000 a year, they are able to meet their living expenses and save $25,000 after taxes annually They expect little change in either their incomes or expenses on an inflation-adjusted basis other than the addition of their daughter’s college expenses Their only long-term financial goal is to provide for themselves and for their daughter’s education The Muellers both wish to retire in ten years Their daughter, a talented musician, is now entering an exclusive five-year college program This program requires a $50,000 contribution, payable now, to the college’s endowment fund Thereafter, her tuition and living expenses, to be paid entirely by the Muellers, are estimated at $40,000 annually The Mueller’s personal investments total $600,000, and they plan to continue to manage the portfolio themselves They prefer “conservative growth investments with minimal volatility.” One-third of their portfolio is in the stock of Andrea’s employer, a publicly traded technology firm with a highly uncertain future The shares have a very low-cost basis for tax purposes The Muellers, currently taxed at 30 percent on income and 20 percent on net realized capital gains, have accumulated losses from past unsuccessful investments that can be used to fully offset $100,000 of future realized gains In ten years, Peter will receive a distribution from a family trust His portion is now $1.2 million and is expected to grow prior to the distribution Peter receives no income from the trust and has no influence over, or responsibility for, its management The Muellers know that these funds will change their financial situation materially but have excluded the trust from their financial planning QUESTION HAS ONE PART FOR A TOTAL OF 24 MINUTES Construct the objectives and constraints portion of an investment policy statement for the Muellers, addressing each of the following: i ii iii iv v vi Return objective Risk tolerance Time horizon Liquidity Taxes Unique circumstances (24 minutes) QUESTION HAS ONE PART FOR A TOTAL OF MINUTES As part of their financial planning, the Muellers have been seeking advice from friends and relatives This advice includes the following comments: • “An investment policy statement won’t help you make any money.” • “The key to successful investing is simply to select investments that earn an annual return higher than the stock market’s return.” • “All hired investment managers will routinely change everything you have been Discuss a potential benefit of using a written investment policy statement that contradicts each of the above comments (Note: Three different benefits are required.) (6 minutes) QUESTION HAS ONE PART FOR A TOTAL OF 12 MINUTES Candidates should use information from the Introduction on page and Exhibit 3-1 below to answer Question The Muellers built up their $600,000 investment portfolio over many years through regular purchases of mutual funds holding only U.S securities Each purchase was based on personal research but without consideration of their other holdings They would now like advice on their total portfolio Exhibit 3-1 Mueller Investment Portfolio Andrea’s company stock Blue Chip Growth Fund Super Beta Fund Conservative Fund Index Fund No-Dividend Fund Long-Term Zero-Coupon Fund Type Stock Stock Stock Stock Stock Stock Bond Market Sector Small-cap growth Large-cap growth Small-cap growth Large-cap value Large-cap index Large-cap growth Government Beta 1.40 1.20 1.60 1.05 1.00 1.25 — Evaluate the Mueller’s portfolio in terms of the following criteria: i ii iii Preference for “minimal volatility.” Equity diversification Asset allocation (including cash flow needs) (12 minutes) Percent of Total 35 20 10 25 QUESTION HAS TWO PARTS FOR A TOTAL OF 16 MINUTES The Muellers are reviewing growth and income mutual funds in order to choose one for a new investment Their goal is to select a fund that will minimize volatility while maximizing after-tax returns They have narrowed the choice to the two funds in Exhibit 4-1 Assume the Muellers are subject to a 30 percent tax rate on all income except net realized capital gains, which are taxed at 20 percent The Muellers no longer have any tax losses available to offset realized capital gains Exhibit 4-1 Potential New Investments for the Muellers Superior Growth Exceptional Growth and Income Fund and Income Fund 10-Year Historical Averages Total return 12.0% 9.0% Return in up markets 23.0% 14.0% Return in down markets –10.0% –1.0% Beta 1.25 0.98 Forecasted Data Expected dividend yield 1.0% 2.0% Expected annual total return 11.0% 10.5% Expected annual turnover 60.0% 10.0% A Select and justify which of the above funds is more consistent with the Mueller’s goal by addressing both of the following criteria: i ii Return volatility (No calculations required.) Expected one-year after-tax return (Assume all turnover resulted in gains, and show calculations.) (12 minutes) B Discuss whether realizing losses can add value to a portfolio (4 minutes) QUESTION HAS TWO PARTS FOR A TOTAL OF 24 MINUTES Ten years have passed The Muellers, now both age 63, will retire this year The distribution from Peter’s family trust will occur now The Mueller’s current circumstances are summarized in Exhibit 5-1 below Exhibit 5-1 The Mueller’s Revised Circumstances Personal Circumstances and Assets Trust Distribution Assets • Pension income will total $100,000 a year • The trust distribution totals $2,000,000 and will not increase with inflation and occurs now No tax liability is created by the distribution • Annual expenses will total $180,000 initially and will increase with inflation • The Muellers will maintain separate accounts for their personal assets and the • Inflation is expected to be percent a year trust distribution • Their personal investments now total • They not plan to withdraw income or $1,000,000 (excluding trust distribution) principal • The Muellers will rely on this $1,000,000 • Tax liabilities produced by these assets portfolio to support their lifestyle and will be paid from this portfolio not wish to reduce their level of spending • They plan to donate these assets to an arts • The Muellers have health problems and society when the surviving spouse dies neither is expected to live more than ten They have made a minimum pledge of years All health care expenses will be $2,600,000 towards construction of a new covered by insurance building • The Muellers’ daughter is now financially • The Muellers assume that at least one of independent, and their sole investment them will live at least five years and that objective is to meet their spending needs neither will live more than ten years • The Muellers are not concerned with • An after-tax annual return of 5.4 percent growing or maintaining principal The is required over five years to meet the income deficit may be met with both minimum pledge investment income and by invading principal • The Muellers are concerned only that a minimum gift of $2,600,000 is available A Select and justify with three reasons the most appropriate of the four portfolios from Exhibit 5-2 as an asset allocation strategy for the Muellers’ $1,000,000 personal assets (12 minutes) B Select and justify with three reasons the most appropriate of the four portfolios from Exhibit 5-2 as an asset allocation strategy for the Muellers’ $2,000,000 trust distribution assets (12 minutes) Exhibit 5-2 Alternative Portfolios for the Muellers (in percent) Portfolios A B C Asset Allocation Domestic large-cap stocks Domestic small-cap stocks Foreign stocks Intermediate-term fixed income Cash equivalents Total Expected annual return (nominal after-tax returns) Annual standard deviation 14 3 70 10 100 4.2 6.0 30 5 60 100 5.8 8.0 40 10 10 30 10 100 7.5 13.0 D 30 25 25 20 100 8.5 18.0 QUESTION HAS FIVE PARTS FOR A TOTAL OF 33 MINUTES June Klein, CFA, manages a $100 million (market value) U.S government bond portfolio for an institution She anticipates a small, parallel shift in the yield curve and wants to fully hedge the portfolio against any such change Exhibit 6-1 Portfolio and Treasury Bond Futures Contract Characteristics Portfolio Value/ Conversion Factor Futures Contract for Cheapest to Modified Basis Point Price Deliver Bond Duration Value Security Portfolio U.S Treasury bond futures contract 10 years $100,000 Not applicable $100,000,000 years $75.32 94-05 A Discuss two reasons for using futures rather than selling bonds to hedge a bond portfolio No calculations required (6 minutes) B Formulate Klein’s hedging strategy using the futures contracts in Exhibit 6-1 only Calculate the number of futures contracts to implement the strategy Show all calculations (6 minutes) C Determine how each of the following would change in value if interest rates increase by 10 basis points as anticipated Show all calculations i ii iii The original portfolio The Treasury bond futures position The newly hedged portfolio (9 minutes) D State three reasons why Klein’s hedging strategy might not fully protect the portfolio against interest rate risk (6 minutes) E Describe a zero-duration hedging strategy using only the government bond portfolio and options on U.S Treasury bond futures contracts No calculations required (6 minutes) QUESTION 15 HAS TWO PARTS FOR A TOTAL OF 24 MINUTES 15 A Describe the following three methods of calculating the value at risk (VAR) of an investment Identify one unique strength and one unique weakness of each method i ii iii Variance/covariance Historical simulation Monte Carlo simulation (18 minutes) Two consultants use the Monte Carlo simulation method to calculate monthly value at risk for the same portfolio B Discuss two reasons why the consultants may obtain dramatically different VAR results for the same portfolio (6 minutes) QUESTION 16 HAS TWO PARTS FOR A TOTAL OF 12 MINUTES 16 Jerod Jacob is the senior investment officer for a large, fully funded U.S pension fund that uses external management and currently invests only in domestic securities The fund has aggressive return objectives and a high tolerance for risk Jacob believes that global fixed-income markets provide additional opportunity for increasing the fund’s returns through active bond management and wants to expand the fund’s exposure to include international bonds As a result, Jacob has decided to fully hedge the currency exposure in his global fixed-income portfolio A Discuss one advantage and one disadvantage of using a fully hedged portfolio strategy (6 minutes) B Evaluate Jacob’s decision to use a fully hedged portfolio strategy, given his fund’s return objectives and risk tolerance (6 minutes) QUESTION 17 HAS TWO PARTS FOR A TOTAL OF 14 MINUTES 17 A consultant suggests that the weighted-average portfolio duration calculation for a global bond portfolio is the same as for a domestic bond portfolio A State whether the use of portfolio duration in international bond portfolio management is more limiting than in domestic bond portfolio management Support your conclusion with two reasons (8 minutes) The consultant recognizes that currency, duration, and investing outside the benchmark are possible sources of excess return in global bond management He is also curious about additional methods of adding value through global bond management B List and discuss two additional potential sources of excess return (6 minutes) QUESTION 18 HAS THREE PARTS FOR A TOTAL OF 22 MINUTES 18 Alex Andrew, who manages a $95 million large-capitalization U.S equity portfolio, currently forecasts that equity markets will decline soon Andrew prefers to avoid the transactions costs of making sales but wants to hedge $15 million of the portfolio’s current value using S&P 500 futures Because Andrew realizes that his portfolio will not track the S&P 500 Index exactly, he performs a regression analysis on his actual portfolio returns versus the S&P futures returns over the past year This regression analysis indicates a risk-minimizing beta of 0.88 with an R2 of 0.92 Exhibit 18-1 Futures Contract Data S&P 500 futures price S&P 500 Index S&P 500 Index multiplier A 1,000 999 250 Calculate the number of futures contracts required to hedge $15 million of Andrew’s portfolio, using the data in Exhibit 18-1 State whether the hedge is long or short Show all calculations (6 minutes) B Identify two alternative methods (other than selling securities from the portfolio or using futures) that replicate the futures strategy in Part A Contrast each of these methods with the futures strategy (10 minutes) Three months later, Andrew’s revised forecast indicates that a rebound in the market is imminent Also, $5 million of cash has just been added to the portfolio Andrew is considering investing the cash in U.S Treasury bills until he decides which additional large-capitalization stocks to buy in anticipation of the market rebound Andrew is prohibited from leveraging the portfolio Exhibit 18-2 Capital Market Data S&P 500 Index U.S Treasury bill yield Synthetic S&P 500 Index fund (with futures) Expected Return 12.00% 6.00 11.80 C i Describe a cash management strategy for this equity portfolio that could be used as an alternative to holding Treasury bills ii Compute the cost to the portfolio (in percentage terms) of holding the excess $5 million cash in U.S Treasury bills, using the information in Exhibit 18-2 iii Compute the return enhancement (in percentage terms) of using a futures-based cash management strategy, using the data in Exhibit 18-2 (6 minutes) QUESTION 19 HAS TWO PARTS FOR A TOTAL OF 14 MINUTES 19 ECB Inc is a corporate pension fund sponsor Sloan & Company is ECB’s only U.S equity manager and operates under a mandate that allows Sloan to invest in any U.S equity ECB has historically measured the investment performance of Sloan against a “median manager” benchmark The benchmark performance is derived from a broad universe of U.S equity managers A Evaluate ECB’s use of the “median manager” approach to measure equity performance Justify your response by referencing each of four characteristics of an effective benchmark (10 minutes) As an alternative to the “median manager” approach, ECB’s treasurer has suggested using the S&P 500 Index as a benchmark for evaluating Sloan’s investment performance B Describe two problems with using the S&P 500 Index as an appropriate benchmark for evaluating Sloan’s investment performance (4 minutes) QUESTION 20 HAS ONE PART FOR A TOTAL OF MINUTES 20 The Board of Trustees of the Northern Company pension plan is considering the addition of direct real estate investments to its diversified US$ 500 million pension portfolio This would be accomplished by acquiring commercial office buildings, shopping centers, industrial warehouses, and residential properties A consultant has told the Board: “Our mean–variance computer model uses statistical data to optimize all asset classes Based on that model, I recommend an optimal portfolio for Northern containing a 40 percent allocation of the portfolio to direct real estate investments, given the risk and return objectives set by the board for the fund.” Evaluate the consultant’s statement by addressing the return and risk characteristics of the data and the resulting recommendation of the consultant (6 minutes) QUESTION 21 HAS TWO PARTS FOR A TOTAL OF 16 MINUTES 21 Anne Jennings is the portfolio manager for the Quality Growth Mutual Fund (the Fund) In the Fund’s prospectus, Jennings describes the Fund’s investment strategy as aggressive growth The Fund’s objective is to achieve a high level of asset growth by remaining fully invested in small and micro-cap stocks Shortly after becoming the Fund’s manager, Jennings invests 55 percent of the Fund’s assets in U.S Treasury bills Based on interest rate forecasts from her firm’s research department, she believes that a substantial long-term commitment in these securities will benefit the Fund Shortly after the Treasury bill purchase, Jennings invests percent of the Fund’s assets in Biocure stock Biocure is a small, thinly traded pharmaceutical research company Jennings already personally owns US $100,000 of stock in Biocure Despite the recent decline of the stock price, Jennings believes the investment will ultimately be a good long-term investment She justifies the investment in Biocure by pointing to long-term earnings projections from her firm’s research department that continue to be extremely positive A Discuss Jennings’ purchase of U.S Treasury bills for the Fund Given only the facts presented, address the following four concepts contained in the AIMR Standards of Professional Conduct: i ii iii iv Suitability Misrepresentation Client interests versus personal interests Disclosure of conflicts Answer Question 21A in the Template provided on page 57 (8 minutes) B Discuss Jennings’ purchase of Biocure stock for the Fund Given only the facts presented, address the following four concepts contained in the AIMR Standards of Professional Conduct: i ii iii iv Suitability Misrepresentation Client interests versus personal interests Disclosure of conflicts Answer Question 21B in the Template provided on page 59 (8 minutes) Template for Question 21A U.S Treasury Bill Investment Suitability: Misrepresentation: Client Interest/ Personal Interest: Disclosure of Conflicts: Template for Question 21B Biocure Investment Suitability: Misrepresentation: Client Interest/ Personal Interest: Disclosure of Conflicts: QUESTION 22 HAS ONE PART FOR A TOTAL OF 18 MINUTES 22 In 1994, Alex Halsey, an investment analyst, and Rachel Martin, a portfolio manager, both quit their jobs and formed HM Investment Advisors (HM) Initially, Martin brought a dozen of her clients from her previous firm, and several more clients were attracted by Halsey’s reputation as an analyst Since 1994, HM has had difficulty attracting new clients because their performance record was slightly worse than average To attract new clients, the firm prepared an investment performance presentation that includes the performance history for each of the firm’s three styles of management: equity, balanced, and fixed income For the equity return, the firm combines • the performance record of all HM equity accounts, • Martin’s performance record while she served on the stock selection committee of her previous firm, and • the performance record for the equity portion of the firm’s balanced accounts, excluding cash For the balanced return, the firm uses • the performance history of all its balanced accounts currently under management and • supplements these numbers with the simulated performance of a model portfolio For the fixed-income return, the firm only uses • the performance history for three selected accounts and • annual numbers from 1996 to the present Describe how the requirements of the AIMR Performance Presentation Standards (AIMR-PPS standards) apply to each of the following six actions of HM when presenting their performance, given only the facts presented: i ii iii iv v vi Use of Martin’s investment record at her former firm Use of the equity segments of HM’s balanced accounts Use of HM’s balanced accounts currently under management Use of model performance Use of three selected HM fixed-income accounts Providing annual numbers from 1996 to the present Answer Question 22 in the Template provided on pages 63, 64, and 65 (18 minutes) Template for Question 22 Application of the AIMR-PPS standards i Use of Martin’s investment record at her former firm: ii Use of the equity segments of HM’s balanced accounts: (Template for Question 22 continued on next page) iii Use of HM’s balanced accounts currently under management: iv Use of model performance: (Template for Question 22 continued on next page) v Use of three selected HM fixed-income accounts: vi Providing annual numbers from 1996 to the present: CFA Level III Examination 1999 Afternoon Section Important Instructions to Candidates Write your candidate number in the space provided on the cover of this booklet You must return this test booklet to the proctor before you leave the exam room If you remove any exam materials from this room, your exam will not be graded All test booklets containing your written answers become the property of AIMR They will not be returned to you in either original or copied form If you remove this test booklet from the exam room, you may be subject to dismissal from the CFA Program You must write all answers in the test booklet in the appropriately numbered section Label each subpart of your answer (for example, A, B, C, and/or i, ii, iii, etc.) Only answers written on the correct pages in the test booklet will be graded Write legibly, preferably in blue or black ink Do not write in the margins marked for “grader use only.” If you run out of room on the designated answer pages, you must check the box at the bottom of the last page of your answer and continue your answer on the unnumbered extra pages found in the back of the test booklet Label extra pages with the appropriate question number Attempt to answer all questions You may receive partial credit for correct work even though you not provide a complete response Remember, however, that inconsistent or illogical answers will not receive full credit Write only the required number of responses Providing more than the required number of responses to a question will not earn extra points Extra responses will be ignored Show all your calculations on the correct answer pages even if the question doesn’t specifically instruct you to so You will be able to check your work this way Also, if your answer is wrong, the grader can give partial credit where warranted if you show your calculations If the question specifically says “Show your work,” you must present your calculations and, for full credit, they must be correct No assistance in answering questions may be given to or received from others during this exam You may not use any reference materials during this exam You must leave all reference materials in the designated area prior to the start of the exam 10 You may use your own silent, hand-held, battery-operated, nonalphabetic keyboard calculator, but you must clear the programmable memory prior to the start of the exam Do Not Open This Book Until Instructed to Do So by the Proctor Do Not Remove This Book from the Exam Room ... the start of the exam Do Not Open This Book Until Instructed to Do So by the Proctor Do Not Remove This Book from the Exam Room CFA? ? Level III FOR AIMR USE ONLY Examination Book 1999 Afternoon... of the 1999 Level III Examination Candidates may want to refer to this list as they formulate their answers calculate: To ascertain or determine by mathematical processes compare: To examine... adopt to help ensure implementation of an adequate proxy voting policy (8 minutes) CFA Level III Examination 1999 Morning Section Important Instructions to Candidates Write your candidate number