L3 mock sample exam CFA level III guideline answers 2000

LEVEL III, QUESTION 13 Topic: Minutes: Portfolio Management 20 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 & Lamont, 1990) Cases in Portfolio Management, John W Peavy III and Katrina F Sherrerd (AIMR, 1990) A “Introduction” B “The Allen Family (A)”: Case p 15, Guideline Answers p 58 C “The Allen Family (B)”: Case p 18, Guideline Answers p 62 Questions and 2, including Guideline Answers, 1995 CFA Level III Examination (AIMR) Question 1, including Guideline Answer, 1997 CFA Level III Examination (AIMR) Question 1, including Guideline Answer, 1996 CFA Level III Examination (AIMR) Purpose: To test the candidate’s ability to evaluate an investment policy statement for an individual with changing resources and return needs over time and to address specific liquidity and income needs and unique circumstances LOS: The candidate should be able to “Individual Investors” (Session 8) • analyze the objectives and constraints of an individual investor and use this information to formulate an appropriate investment policy by taking into consideration the investor’s psychological characteristics, positions in the life cycle, long-term goals, liquidity constraints, taxes, gifts, and estate planning “Cases in Portfolio Management” (Session 8) • apply the readings in this Study Session to create an investment policy statement for an individual investor “Questions and 2, including Guideline Answers, 1995 CFA Level III Examination” (Session 8) • prepare an investment policy statement that clearly states the investment objectives and constraints for an individual investor; • justify all recommendations and statements included in an investment policy statement; • criticize an investment policy statement and identify key investment constraints and objectives not included in the statement “Question 1, including Guideline Answer, 1997 CFA Level III Examination” (Session 8) • analyze the objectives and constraints of an individual investor and formulate an appropriate set of investment policies, taking into consideration the investor’s psychological characteristics, position in the life cycle, and long term goals; • criticize an investment policy and determine the appropriateness of the policy given the client’s goals and constraints “Question 1, including Guideline Answer, 1997 CFA Level III Examination” (Session 8) • prepare and justify a well-organized investment policy statement; 2000 Level III Guideline Answers Morning Section – Page • criticize an investment policy statement and judge whether the policy statement will meet the stated goal of the client Guideline Answer: A i The return ob • • • • • Although Wheeler accurately indicates Taylor’s personal income requirement, she does not recognize the need to support Renee Wheeler does not indicate the need to protect Taylor’s purchasing power by increasing income by at least the rate of inflation over time Wheeler does not indicate the impact of income taxes on the return requirement Wheeler calculates required return based on assets of $900,000, appropriately excluding Taylor’s imminent $300,000 liquidity need (house purchase) from investable funds However, Taylor may invest $100,000 in his son’s business If he does, Taylor insists this asset be excluded from his plan In that eventuality, Taylor’s asset base for purposes of Wheeler’s analysis would be $800,000 Assuming a $900,000 capital base, Wheeler’s total return estimate of 2.7 percent is lower than the actual required after-tax real return of 5.3 percent ($48,000 / $900,000) ii The risk tolerance section of the IPS is inappropriate • Wheeler fails to consider Taylor’s willingness to assume risk as exemplified by his aversion to loss, his consistent preference for conservative investments, his adverse experience with creditors, and his desire not to work again • Wheeler fails to consider Taylor’s ability to assume risk, which is based on Taylor’s recent life changes, the size of his capital base, high personal expenses versus income, and expenses related to his mother’s care • Wheeler’s policy statement implies that Taylor has a greater willingness and ability to accept volatility (higher risk tolerance) than is actually the case Based on Taylor’s need for an after-tax return of 5.3 percent, a balanced approach with both a fixed income and growth component is more appropriate than an aggressive growth strategy B i The time hor • • • • Wheeler accurately addresses the long-term time horizon based only on Taylor’s age and life expectancy Wheeler fails to consider that Taylor’s investment time horizon is multi-staged Stage one represents the life expectancy of Renee, during which time Taylor will supplement her income Stage two begins at Renee’s death, concluding Taylor’s need to supplement her income, and ends with Taylor’s death ii The liquidity section of the IPS is appropriate because Wheeler fully discloses all potential liquidity needs 2000 Level III Guideline Answers Morning Section – Page LEVEL III, QUESTION 14 Topic: Minutes: Portfolio Management 12 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 & Lamont, 1990) Question and 2, including Guideline Answers, 1995 CFA Level III Examination (AIMR) Question 1, including Guideline Answers, 1996 CFA Level III Examination (AIMR) Purpose: To test the candidate’s ability to select a low risk allocation given higher return alternatives and justify the appropriateness of that selection LOS: The candidate should be able to “Individual Investors” (Session 8) • create an asset allocation policy for an individual investor that is based on a multi-asset, total return approach “Question and 2, including Guideline Answers, 1995 CFA Level III Examination” (Session 8) • recommend and justify an asset allocation “Question 1, including Guideline Answers, 1996 CFA Level III Examination” (Session 8) • recommend and justify an asset allocation and clearly state any assumptions made that contributed to the recommendation, especially the risk tolerance of the client Guideline Answer: Allocation B is most appropriate for Taylor Taylor’s nominal annual return requirement is 6.3% based upon his cash flow (income) needs ($50,400 annually) to be generated from a current asset base of $800,000 After adjusting for expected annual inflation of 1%, the real return requirement becomes 7.3% That is, to have $808,000 ($800,000 × 1.01), the portfolio must generate $58,400 ($50,400 + $8,000) in the first year, and $58,400 / $800,000 = 7.3% Allocation B meets Taylor’s minimum return requirement Of the possible allocations that provide the required minimum real return, Allocation B also has the lowest standard deviation of returns (i.e least volatility risk), and by far the best Sharpe ratio In addition, Allocation B offers a balance of high current income and stability with moderate growth prospects Allocation A has the lowest standard deviation and best Sharpe ratio, but does not meet the minimum return requirement, when inflation is included in that requirement Allocation A also has very low growth prospects Allocation C meets the minimum return requirement and has moderate growth prospects but has a higher risk level (standard deviation) and a lower Sharpe ratio, and less potential for stability than Allocation B 2000 Level III Guideline Answers Morning Section – Page Allocation D also meets the minimum return requirement and has high growth prospects but has the highest standard deviation and lowest Sharpe ratio of the allocations that provide the required minimum real return Thus, of the three allocations meeting the minimum return requirement, Allocation B presents the lowest level of risk as indicated by its lower expected standard deviation Given Taylor’s stated desire to assume “no more risk than absolutely necessary” to achieve his return goals, Allocation B is the appropriate selection 2000 Level III Guideline Answers Morning Section – Page LEVEL III, QUESTION 15 Topic: Minutes: Portfolio Management 12 Reading References: Managing Investment Portfolios: A Dynamic Process, 2nd edition, John L Maginn and Donald L Tuttle, eds (Warren, Gorham & Lamont, 1990) A “Individual Investors,” Ch 3, Ronald W Kaiser B “Monitoring and Rebalancing the Portfolio,” Ch 13, pp 13-4 through 13-8, Robert D Arnott and Robert M Lovell Jr Purpose: To test the candidate’s ability to assess how changing client circumstances and preferences affect ongoing investment policies LOS: The candidate should be able to “Individual Investors” (Session 8) • analyze the objectives and constraints of an individual investor and use this information to formulate an appropriate investment policy by taking into consideration the investor’s psychological characteristics, positions in the life cycle, long-term goals, liquidity constraints, taxes, gifts, and estate planning “Monitoring and Rebalancing the Portfolio” (Session 10) • determine whether changed asset risk and return conditions require a portfolio to be rebalanced; • appraise the need to rebalance under altered client circumstances, including changes in wealth, time horizon, liquidity requirements, tax treatment, and regulatory environment Guideline Answer: The monitoring and rebalancing actions of a portfolio manager in the portfolio management process can be brought into play by circumstances such as changed investor goals, resources or constraints, changed capital market expectations, or the inclusion of new asset classes Wheeler has reason to believe Taylor’s new circumstances will affect the following four components of his investment policy statement i Return Requirement Taylor’s asset base is now three times its original level, while his cash flow needs have dropped substantially His annual return requirement has therefore dropped considerably; for example, if his cash flow needs have declined by 50% and his asset base has tripled, then his minimum nominal return requirement has fallen to one-sixth of its previous level, and his real return requirement has also decreased commensurately ii Risk Tolerance Taylor’s willingness to assume risk has apparently risen substantially, given his new feelings of financial security His plan to reorient his investments to provide for future charitable goals may further indicate his willingness to assume additional risk in his portfolio 2000 Level III Guideline Answers Morning Section – Page Taylor’s ability to assume risk, which was already average to above average, has likely risen materially as well, because his asset base has grown and his cash flow needs have decreased The increases in both his willingness and ability to assume risk point to a resulting substantial increase in his overall risk tolerance iii Time Horizon Taylor is now five years older and his time horizon is shorter, though still long term Moreover, his time horizon previously was composed of two stages: his mother’s lifetime, when his expenses and cash flow needs were higher, followed upon her death by his remaining lifetime Now, the appropriate horizon is one stage (his lifetime) with lower cash flow needs iv Liquidity Needs Taylor’s ongoing liquidity needs are largely unchanged and remain relatively low, with the exception of his possible cash charitable contribution The size ($100,000) of this potential gift and its near term horizon is material enough to create the need for a somewhat larger than usual cash reserve 2000 Level III Guideline Answers Morning Section – Page LEVEL III, QUESTION 16 Topic: Minutes: Portfolio Management 12 Reading References: “The Psychology of Risk,” Amos Tversky, Quantifying the Market Risk Premium Phenomenon for Investment Decision Making (AIMR, 1990) “Behavioral Risk: Anecdotes and Disturbing Evidence,” Arnold Wood, Investing Worldwide VI (AIMR, 1996) “Behavioral Finance versus Standard Finance,” Meir Statman, Behavioral Finance and Decision Theory in Investment Management (AIMR, 1995) Purpose: To test the candidate’s ability to identify and discuss major tenets of behavioral finance in the context of observed irrational investor behavior LOS: The candidate should be able to “The Psychology of Risk” (Session 10) • contrast the assumptions of rational investment decision-making with observed investor behaviors, including loss aversion, reference dependence, asset segregation, mental accounting, and biased expectations “Behavioral Risk: Anecdotes and Disturbing Evidence” (Session 10) • discuss potential systematic overconfidence in analysts’ forecasts and the associated implications, particularly for asset allocation and portfolio construction; • appraise how prospect theory can be used to explain how investors treat losses differently than gains “Behavioral Finance versus Standard Finance” (Session 10) • contrast the standard view of human investor behavior with a behavioral finance framework; • describe how the components of prospect theory, cognitive errors, self control, and regret explain phenomena such as investor preference for cash dividends, preference for the stocks of good companies, and the disposition to sell winners too early and to hold losers too long; • show how the proliferation of new financial products, particularly derivatives, can be explained in terms of behavioral finance; • appraise how models of investor behavior complicate the development of rational investment policy statements and determination of asset allocations 2000 Level III Guideline Answers Morning Section – Page Guideline Answer: i Mental accounting is best illustrated by Statement #3 Sampson’s requirement that his income needs be met via interest income and stock dividends is an example of mental accounting Mental accounting holds that investors segregate funds into mental accounts (e.g., dividends and capital gains), maintain a set of separate mental accounts, and not combine outcomes; a loss in one account is treated separately from a loss in another account Mental accounting leads to an investor preference for dividends over capital gains and to an inability or failure to consider total return ii Overconfidence (illusion of control) is best illustrated by Statement #6 Sampson’s desire to select investments that are inconsistent with his overall strategy indicates overconfidence Overconfident individuals often exhibit risk-seeking behavior People are also more confident in the validity of their conclusions than is justified by their success rate Causes of overconfidence include the illusion of control, self-enhancement tendencies, insensitivity to predictive accuracy, and misconceptions of chance processes iii Reference dependence is best illustrated by Statement #5 Sampson’s desire to retain poor performing investments and to take quick profits on successful investments suggests reference dependence Reference dependence holds that investment decisions are critically dependent on the decision-maker’s reference point; in this case the reference point is the original purchase price Alternatives are evaluated not in terms of final outcomes but rather in terms of gains and losses relative to this reference point Thus, preferences are susceptible to manipulation simply by changing the reference point 2000 Level III Guideline Answers Morning Section – Page LEVEL III, QUESTION 17 Topic: Minutes: Portfolio Management 22 Reading References: “Alternative Measures of Risk,” Roger G Clarke, Investment Management, Peter L Bernstein and Aswath Damodaran, eds (Wiley, 1998) “Global Risk Management: Are We Missing the Point?” Richard Bookstaber, The Journal of Portfolio Management (Institutional Investor, Spring 1997) “Indexing,” Ch 18, Bond Markets, Analysis and Strategies, 3rd edition, Frank J Fabozzi (Prentice Hall, 1996) Purpose: To test the candidate’s understanding of the different aspects of risk measurement and risk management in a complex portfolio management environment LOS: The candidate should be able to “Alternative Measures of Risk” (Session 12) • evaluate circumstances in which variance or standard deviation may fail to capture some dimensions of risk; • contrast tracking error, beta, and standard deviation as measures of risk; • appraise and evaluate the probability of shortfall and expected shortfall as risk measures “Global Risk Management: Are We Missing the Point?” (Session12) • evaluate the implications of fat tails for risk managers; • contrast variance and correlation measures of financial markets during financial crisis with those during normal market environments “Indexing” (Session 6) • appraise tracking error, implementation problems, and enhanced indexing in the context of formulating indexing strategies Guideline Answer: A i The population variance of a probability distribution is calculated by squaring the deviation of each occurrence from the mean and multiplying each squared value by its associated probability The sum of these values is equal to the variance of the distribution, and the square root of the variance is referred to as the standard deviation The sample variance is calculated as the sum of squared deviations from the mean divided by the number of observations minus one ii Tracking error relative to a benchmark can be viewed as a modification of variance or standard deviation In that context, tracking error can be defined as the standard deviation of the difference in returns between the investment and a specified benchmark or target position; in formula terms, tracking error is the standard deviation of: ∆R = R – B 2000 Level III Guideline Answers Morning Section – Page where ∆R = all differential returns, R = all investment returns, B = the benchmark return Alternatively, tracking error for a managed portfolio can be calculated simply as the difference between the performance of that portfolio and the performance of a benchmark index iii Probability of shortfall is the chance that the return from an investment may fall below some benchmark or reference return; in formula terms, probability of shortfall is: Probability (R < B) where R = investment return, B = benchmark or reference return The benchmark or reference may be set at zero or any other minimum acceptable return Shortfall probability is most easily shown as a probability distribution If the benchmark return represents a risky asset or index return, the probability distribution represents the distribution of tracking error relative to the index rather than the distribution of total or absolute return iv Expected shortfall is the difference between an investment’s actual return and the benchmark return over the range of returns where a shortfall occurs; in formula terms, expected shortfall is: E (R – B) where R = investment return over the range of returns where a shortfall occurs, B = benchmark return Put another way, expected shortfall is the sum of all below-benchmark returns times the probabilities of those returns Expected shortfall thus incorporates not only the probability of shortfall, but also the magnitude of the potential shortfall if it does occur Expected shortfall represents the magnitude of the shortfall times the probability of the shortfall occurring Because this measure is influenced by the entire downside portion of the probability distribution, it is a more complete measure of downside risk than the probability of shortfall alone B i The variance (or standard deviation) of security returns has three unique weaknesses as a risk measure: • Deviations above and below the mean return are given weights equal to their respective probability of occurring Yet, given the same probability of occurrence, most investors are more displeased with (averse to) negative deviations than they are pleased with positive deviations of the same magnitude In other words, if two investments have the same absolute deviations about the mean (same standard deviation), but one has more negative returns, investors often view the distribution with the lower mean as more risky Standard deviation as a measure of risk tends to 2000 Level III Guideline Answers Morning Section – Page 10 LEVEL III, QUESTION 25 Topic: Minutes: Portfolio Management 12 Reading References: “Option Payoffs and Option Strategies,” Ch.11, Futures, Options & Swaps, 2nd edition, Robert W Kolb (Blackwell, 1997) Purpose: To test the candidate’s understanding of when and how to exploit mispricing of puts and calls relative to each other LOS: The candidate should be able to “Option Payoffs and Option Strategies” (Session 13) • determine whether an arbitrage opportunity exists, given a put price, a call price, the stock price, and the price of a bond; • construct and evaluate the appropriate trade when an arbitrage opportunity exists given a put price, a call price, the underlying asset price, and the price of a bond; • create a synthetic security from three of the following four instruments: a call, a put, the underlying asset, and a bond Guideline Answer: A i The transactions needed to construct the synthetic T-bill would be to long the stock, long the put, and short the call ii Assuming the T-bill yield was quoted on a bond equivalent basis, the synthetic Treasury bill’s annualized yield can be calculated on the same basis: $77.50 + $4.00 – $7.75 = $73.75 initial investment and $75 ending value [($75.00 – $73.75) / $73.75] × = 6.78% B i The strategy would be to short 75 actual T-bills and to long 100 synthetic T-bills ii Assuming the actual T-bill was quoted on a bond equivalent basis, the actual T-bill gives a 1.25% quarterly return Immediately, the short actual T-bill position pays: $750,000 / 1.0125 = $740,741 2000 Level III Guideline Answers Afternoon Section – Page 10 At the time of creation, the long position in the synthetic T-Bill would be: Long stock Long put Short call –$775,000 –$ 50,000 $ 77,500 –$737,500 Therefore the net cash flow is: $740,741 – $737,500 = $3,241 C The approach to calculating net cash flow gives the same result whether the calculation is done for three months or six months At the three-month expiration, the value of the long synthetic position is: E=P+S–C where E = exercise price, P = put price, S = stock price, C = call price At expiration, E = P + S – C = $0 + $80 – $5 = $75 per share or $7,500 per contract Total cash flow of the long synthetic position = 100 contracts × $7,500 = $750,000 Total cash flow of the short Treasury bill position = 75 actual Treasury bills × $10,000 = $750,000 Net cash flow = $750,000 – $750,000 = $0 $0 cash flow at three months would be worth $0 at six months Alternatively, if the stock price at expiration is $80: Long stock position = $ 80 Short call position = $75 – $80 = –$ Long put position = $ Short Treasury bill position = –$ 75 Net position $ 2000 Level III Guideline Answers Afternoon Section – Page 11 LEVEL III, QUESTION 26 Topic: Minutes: Portfolio Management Reading References: “The Active versus Passive Debate: Perspectives of an Active Quant,” Ch 3, Robert C Jones, Active Equity Portfolio Management, Frank J Fabozzi, ed (Frank J Fabozzi Associates, 1998) Purpose: To test the candidate’s understanding of the issues that argue in favor of, or against, active and passive equity trading strategies, and ability to identify and explain the implementation and desired results of a portable alpha strategy LOS: The candidate should be able to “The Active versus Passive Debate: Perspectives of an Active Quant” (Session 11) • support the case for indexing from theoretical and empirical perspectives; • support the case for active management from theoretical, empirical, and behavioral perspectives; • appraise the failure of active managers with respect to the case against market efficiency Guideline Answer: Strategy One Should Achieve Client’s Objectives (Circle One) No Justification Strategy as written is incorrect, if the objective is to isolate and move the small cap alpha (i.e., portable alpha) Selling (shorting) the S&P 500 removes the desired large cap exposure, and buying (going long) the Russell 2000 does not isolate the small cap alpha because the strategy is already long in small cap The futures portion of the strategy should be exactly the opposite of that given, i.e., sell (short) the Russell 2000 and buy (go long) the S&P 500 futures in the same dollar amount of exposure Strategy as written is correct Two Yes The market-neutral manager’s long/short strategy should provide superior returns independent of activity in the small cap market (index) The S&P futures maintain exposure to the large cap market, and the net result is the market-neutral manager’s outperformance (alpha) plus the S&P 500 return 2000 Level III Guideline Answers Afternoon Section – Page 12 LEVEL III, QUESTION 27 Topic: Minutes: Portfolio Management 12 Reading References: “Equity Style: What It Is and Why It Matters,” Ch 1, Jon A Christopherson and C Nola Williams, The Handbook of Equity Style Management, 2nd edition, T Daniel Coggin, Frank J Fabozzi, and Robert D Arnott, eds (Frank J Fabozzi Associates, 1997) “Asset Allocation: Management Style and Performance Measurement,” William F Sharpe, The Journal of Portfolio Management (Institutional Investor, Winter 1992) Purpose: To test the candidate’s ability to describe and discuss various equity styles and understanding of key distinguishing factors among styles LOS: The candidate should be able to “Equity Style: What It Is and Why It Matters” (Session 11) • distinguish the primary concerns of value investors from those of growth investors, and identify the key risk factors that affect each type of investor; • compare the key factors that equity style investors consider to be critical and contrast the resulting portfolio characteristics that each identified investment style may produce; • appraise the importance of style when evaluating performance and criticize the use of style indexes as an evaluation tool relative to broad market indexes “Asset Allocation: Management Style and Performance Measurement” (Session 15) • evaluate the effect of a manager’s style on performance by reference to the output-of-factor models and comparison to passive style indexes or portfolios; • evaluate the manager’s ability to add value to a portfolio through security selection after controlling for management style; • appraise the results of a return-based style analysis Guideline Answer: A Style = B – M The performance of the representative style index can be calculated by subtracting the broad market’s return (in this case the S&P 500 index, M) from the specific style index return (in this case the Russell 1000 Value index, B) This provides a more accurate picture of how the style (value) performed versus the broad market, and any variance explains how a valueoriented portfolio would differ from the broad market B Stock Selection = P – B The performance attributable to stock selection is calculated by subtracting the benchmark index return (in this case the Russell 1000 Value index, B) from the actual portfolio return (P) This calculation provides information on active stock selection within the portfolio, 2000 Level III Guideline Answers Afternoon Section – Page 13 because the portfolio is being compared to the specific style benchmark and not to the broad market C The advantages of return-based style analysis include that RBSA: • is relatively easy to use (and calculate) • can be done on a macro (fund) basis across several asset classes and/or multiple styles • is a more economical approach to gathering and analyzing data • uses data that are more readily available than those in other forms of style-based analysis The disadvantages of return-based style analysis include that RBSA: • assumes that returns to style portfolios and style indexes are significantly different from the market and from each other; the approach is problematic if those assumptions not hold • may ignore or not fully capture details with respect to changes in style definitions over time • will not be able to clearly distinguish one specific style over another, if returns from two styles or asset classes are similar • is subject to limitations arising from the selection of data points/time series used in the model, e.g., insufficient data points, inappropriate length of holding period, etc • may ignore style changes 2000 Level III Guideline Answers Afternoon Section – Page 14 LEVEL III, QUESTION 28 Topic: Minutes: Portfolio Management 18 Reading References: “Implementing Investment Strategies: The Art and Science of Investing,” Ch 17, Wayne H Wagner and Mark Edwards, Handbook of Portfolio Management, Frank J Fabozzi, ed (Frank J Fabozzi Associates, 1998) Purpose: To test the candidate’s understanding of the components of trading costs and ability to describe and calculate these costs LOS: The candidate should be able to “Implementing Investment Strategies: The Art and Science of Investing” (Session 11) • discuss the various motivations a portfolio manager may have for wanting to make a trade; • identify and contrast the various types of trading costs Guideline Answer: Identify the trading cost Describe the trading costs Explain how the trading costs are measured Commission Explicit fee charged by a broker for services Provided for listed trades Cost of immediate execution Difference between average execution price and price at the time order is revealed to broker Price Impact Timing Cost of seeking liquidity Opportunity Cost of failing to find liquidity Total Cost of Trade Difference between costless and fullycosted returns Price change between the time order is submitted to trade desk and when released to broker Three-day return for unexecuted shares (cancelled trades) Sum of the costs 2000 Level III Guideline Answers Afternoon Section – Page 15 Calculate the trading costs (per share) $0.05 $41.00 – $40.25 = $0.75 $43.00 – $41.00 = $2.00 $0.00 $0.05 + $0.75 + $2.00 = $2.80 LEVEL III, QUESTION 29 Topic: Minutes: Portfolio Management 12 Reading References: “Are Manager Universes Acceptable Performance Benchmarks?” Jeffrey Bailey, The Journal of Portfolio Management (Institutional Investor, Spring 1992) “Value at Risk for the Asset Manager,” Mary Ellen Stocks and Christopher Ito, The Journal of Performance Measurement (The Spaudling Group, Summer 1997) Purpose: To test the candidate’s understanding of conceptual advantages and limitations of performance and risk management methodologies LOS: The candidate should be able to “Are Manager Universes Acceptable Performance Benchmarks” (Session 15) • evaluate the validity and appropriateness of using manager universes for evaluating a manager’s performance; • explain the basis for constructing valid benchmarks; • explain the conceptual shortcomings of manager universes, including how survivorship bias significantly affects performance measurement results “Value at Risk for the Asset Manager” (Session 12) • appraise the practical applications of VAR to the portfolio manager; • discuss the use of VAR for performance measurement (absolute, relative to peers, or relative to a benchmark Guideline Answer: A Statement: Median manager benchmarks are … … statistically unbiased measures of performance over long periods of time Correct or Incorrect (Circle One) Incorrect If Incorrect, Justify with One Characteristic of Valid Benchmark Valid benchmarks are unbiased Median manager benchmarks are subject to significant survivorship bias, which results in several drawbacks, including: • the performance of median manager benchmark is biased upwards • this upward bias increases with time • survivor bias introduces uncertainty with regard to manager rankings • survivor bias skews the shape of the distribution curve 2000 Level III Guideline Answers Afternoon Section – Page 16 … unambiguous and are therefore easily replicated by managers wishing to adopt a passive/indexed approach Incorrect Valid benchmarks are unambiguous and able to be replicated The median manager benchmark is ambiguous because the weights of individual securities in the benchmark are not known The portfolio’s composition cannot be known before the conclusion of a measurement period because identification as a median manager can occur only after performance is measured Valid benchmarks are investable The median manager benchmark is not investable That is, a manager using a median manager benchmark cannot forego active management and, taking a passive/indexed approach, simply hold the benchmark, because the weights of individual securities in the benchmark are not known … not appropriate in all circumstances because the median manager universe encompasses many investment styles Correct No justification needed.* *The median manager benchmark may be inappropriate because the median manager universe encompasses many investment styles and, therefore, may not be consistent with a given manager’s style 2000 Level III Guideline Answers Afternoon Section – Page 17 B Statement VAR provides managers with information on the risk characteristics of the total portfolio because VAR can measure risk on a comparable basis across asset classes Correct or Incorrect (Circle One) Correct If Incorrect, Justify with One Reason No justification needed.* VAR analyses are typically quite accurate because the model inputs are easy to determine Incorrect VAR results are only as good as the data and assumptions that are used as inputs into the model By their nature, these data and assumptions often are not easy to deter mine In particular, handling non-normal distributions and non-linear risk are both difficult in the variance/covariance VAR method, and the Monte Carlo simulation VAR method requires sophisticated modeling and userdefined underlying assumptions Even the historical simulation VAR method requires complex valuation models that utilize extensive data inputs VAR results are not dependent on past market conditions being representative of the future Incorrect All VAR results are predicated to some degree on past market conditions being representative of the future In particular, the variance/covariance VAR method assumes that volatilities and correlations are stable over time, and the historical simulation VAR method explicitly uses historical market data Even the Monte Carlo simulation VAR method requires historical market data as a reference for simulation parameters *VAR can measure risk on a comparable basis across asset classes As such, VAR provides managers with management information on the risk characteristics of the total portfolio 2000 Level III Guideline Answers Afternoon Section – Page 18 LEVEL III, QUESTION 30 Topic: Minutes: Portfolio Management 15 Reading References: “Global Investment Performance StandardsSM,” including Appendix A (AIMR, 1999) Purpose: To test the candidate's understanding of the requirements of the Global Investment Performance Standards LOS: The candidate should be able to “Global Investment Performance StandardsSM” (Session 14) • describe and explain the requirements and recommendations of GIPS with regard to input data, calculation methodology, composite construction, disclosures, and presentation and reporting Guideline Answer: Dayne’s presentation is not in compliance with GIPS for the following reasons: • Once a firm has met all of the required elements of GIPS, the firm may use the compliance statement mandated by GIPS Dayne did not use this compliance statement Moreover, Dayne’s statement referring to the calculation methodology being “in accordance with GIPS” is specifically prohibited by the standards • GIPS states that when presenting investment performance in compliance with the Standards, an investment management firm must state how it defines itself as a firm, which Dayne did not • GIPS requires firms to disclose the availability of a complete list and description of all of the firm’s composites, which Dayne did not • GIPS requires firms to specifically disclose the currency used to express performance, which Dayne did not • GIPS requires firms to indicate whether performance is calculated gross or net of fees, which Dayne did not • GIPS requires firms to include the composite creation date, which Dayne did not • GIPS requires firms to present the total return for a benchmark that reflects the investment mandate or strategy represented by the composite for the same periods for which the composite return is presented Dayne did not include this benchmark information 2000 Level III Guideline Answers Afternoon Section – Page 19 LEVEL III, QUESTION 31 Topic: Minutes: Asset Valuation 12 Reading Reference: “International Bond Portfolio Management,” Ch 26, pp 407–438, 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 ability to identify the important considerations in managing an international bond portfolio LOS: The candidate should be able to “International Bond Portfolio Management” (Session 6) • discriminate between a domestic bond portfolio manager’s challenges and an international bond portfolio manager’s challenges by citing specific common and differing responsibilities; • 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 the five sources of excess returns in international portfolio management: currency selection, bond selection, duration management, sector/credit selection and outside-benchmark investing Guideline Answer: Statement Forward currency exchange rates are poor predictors of future spot exchange rates The presence of a significant nongovernment bond market in developed countries provides opportunities to enhance returns through sector selection Correct or Incorrect (Circle One) Correct Incorrect If Incorrect, Justify With One Reason No justification needed.* In many developed countries, corporate bond choices are substantially more limited than government bond choices Corporate bonds account for less than 15 percent of market capitalization in bond markets other than the U.S and the Netherlands Eurobonds, mortgage bonds, and inflation-indexed bonds are available in selected markets, but some countries encourage debt financing through banks rather than by bond issues The resulting lack of available spread products makes sector selection difficult in international bond markets 2000 Level III Guideline Answers Afternoon Section – Page 20 Investing in bond markets in countries outside the target international index can enhance returns, but also dramatically increases the risk in the portfolio Incorrect Allocating assets to markets outside the target index offers the opportunity for substantial incremental returns, without dramatically altering the risk profile of the portfolio In some cases, the low correlation of returns with the markets composing the index may actually reduce the standard deviation of returns for the portfolio Duration management is equally challenging for U.S bond portfolios and for portfolios containing bonds from several developed markets Incorrect Duration management is more difficult with international bond markets Very few developed markets have liquid bond issues with original maturities exceeding 10 years Most also lack the broad range of instruments necessary for low cost active duration management Some of these markets have very liquid interest rate swaps structures, but such opportunities tend to be limited only to institutions *Forward exchange rates not accurately predict future spot exchange rates, a condition that provides the opportunity to add value through active currency management In particular, currencies of economies with high real interest rates have tended to depreciate less than the amount implied by the forward rates and thus have offered superior returns 2000 Level III Guideline Answers Afternoon Section – Page 21 LEVEL III, QUESTION 32 Topic: Minutes: Asset Valuation 22 Reading Reference: “Indexing,” Ch 18, Bond Markets, Analysis and Strategies, 3rd edition, Frank J Fabozzi (Prentice Hall, 1996) Purpose: To test the candidate’s understanding of and ability to apply the important considerations in constructing an indexed bond portfolio LOS: The candidate should be able to “Indexing” (Session 6) • support an index strategy given an investor’s risk and return requirements and objectives; • contrast the various methodologies for designing index portfolios (stratified sampling approach, optimization approach, and variance minimization approach); • appraise tracking error, implementation problems, and enhanced indexing in the context of formulating indexing strategies Guideline Answer: A The main advantages to using a bond indexing strategy are: • Historically, the majority of active managers underperform benchmark indexes in most periods; indexing reduces the possibility of underperformance at a given level of risk • Indexed portfolios not depend on advisor expectations or bets and so have less risk of underperforming the market • Management advisory fees for indexed portfolios are dramatically smaller than fees for actively managed portfolios Fabozzi notes that fees charged by active managers generally range from 15 to 50 basis points, while fees for indexed portfolios range from to 20 basis points (with the highest of those representing enhanced indexing) Other nonadvisory fees (i.e custodial fees) also are smaller for indexed portfolios • Plan sponsors have greater control over indexed portfolios, because individual managers not have as much freedom to vary from the parameters of the benchmark index Some plan sponsors even decide to manage index portfolios with in-house investment staff • Indexing is essentially “buying the market.” If markets are efficient, an indexing strategy should reduce unsystematic diversifiable risk, and should generate maximum return for a given level of risk The main disadvantages to using a bond indexing strategy are: • Indexed portfolio returns may match the bond index, but not necessarily reflect optimal performance In some time periods, many active managers may outperform an indexing strategy at the same level of risk • The chosen bond index and portfolio returns may not meet the client objectives or the liability stream 2000 Level III Guideline Answers Afternoon Section – Page 22 • Bond indexing may restrict the fund from participating in sectors or other opportunities that could increase returns B i The stratified sampling approach divides the index into cells, with each cell representing a different characteristic of the index Common cells used in the stratified sampling approach combine (but are not limited to) duration, coupon, maturity, market sectors, credit rating, and call and sinking fund features The index manager then selects one or more bond issues that will represent the entire cell The total market weight of issues held for each cell is based on the target index’s composition of that characteristic ii With the optimization approach, the indexed portfolio is designed to match a cell breakdown, but also to adhere to certain constraints and maximize some other objective Examples of constraints include restrictions on purchasing more than a set amount of one issuer(s) or over-weighting certain sectors (enhanced indexing) Examples of objectives include maximizing portfolio yield, convexity, or expected returns Mathematical programming is utilized to construct the indexed portfolio C Tracking error is defined as the discrepancy between the performance of an indexed portfolio and the benchmark index i When the amount invested is relatively small and the number of cells to be replicated is large, a significant source of tracking error with the stratified sampling approach occurs because of the need to buy odd lots of issues to accurately represent the required cells Odd lots of bonds generally must be purchased at higher prices than round lots On the other hand, reducing the number of cells to limit the necessary number of odd lots would potentially increase tracking error because of the mismatch with the target index ii Tracking error with the optimization approach has several sources including: (1) transaction costs, (2) differences in the composition of the indexed portfolio and the index caused by the optimized portfolio having significantly fewer securities than fixed income benchmarks, (3) discrepancies between prices used in constructing the index and actual transaction prices incurred by the indexer, (4) discrepancies between income and principal reinvestment assumptions used in constructing index returns and reinvestment rates actually achieved, (5) low liquidity of some of the bonds in the index, and (6) choice of benchmark index With respect to the latter source, bond portfolios benchmarked to government bond indexes not typically provide a tracking error as large as corporate bond indexes, because government bonds are more homogeneous The structure of corporate bonds varies largely as a result of embedded options, such as calls, puts, and sinking funds These differences make corporate bonds more difficult to emulate with the optimization approach D Harrod’s statement is incorrect Indexed bond portfolios generally have greater tracking error than indexed equity portfolios, causing indexed bond portfolios to underperform the target bond index more often The three predominant reasons for this greater tracking error are: 2000 Level III Guideline Answers Afternoon Section – Page 23 • • • Higher transaction costs are involved with actually constructing and rebalancing the indexed bond portfolio Transactions costs are a source of tracking error, and bond transaction costs exceed equity transaction costs Tracking error is larger with indexed bond portfolios because of the potential for differences in composition of securities between the indexed portfolio and the index Equity indexes are easier to replicate, as the stock holdings are known and readily purchased This is not the case with most bond indexes, and indexed bond portfolios often must substitute other securities if the actual securities comprising the index are unavailable Another source of greater tracking error is any discrepancy between the prices used by the organization modeling the index and the actual prices paid by the manager constructing the indexed portfolio Bond prices are much less standardized than equity prices 2000 Level III Guideline Answers Afternoon Section – Page 24 ... Lamont, 1990) Question and 2, including Guideline Answers, 1995 CFA Level III Examination (AIMR) Question 1, including Guideline Answers, 1996 CFA Level III Examination (AIMR) Purpose: To test the... 2, including Guideline Answers, 1995 CFA Level III Examination” (Session 8) • recommend and justify an asset allocation “Question 1, including Guideline Answers, 1996 CFA Level III Examination”... appropriate because Wheeler fully discloses all potential liquidity needs 2000 Level III Guideline Answers Morning Section – Page LEVEL III, QUESTION 14 Topic: Minutes: Portfolio Management 12 Reading