L3 mock sample exam CFA level III guideline answers 2002

LEVEL III, QUESTION Topic: Minutes: Portfolio Management 26 Reading References: “Determination of Portfolio Policies: Institutional Investors,” Ch 4, Keith P Ambachtsheer, John L Maginn, and Jay Vawter, 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 “Mid-South Trucking Company”: Case p 26, Guideline Answers p 75 B “Universal Products Inc.”: Case p 39, Guideline Answers p 90 C “Good Samaritan Hospital (A)”: Case p 45, Guideline Answers p 101 D “Good Samaritan Hospital (B)”: Case p 49, Guideline Answers p 103 E “Good Samaritan Hospital (C)”: Case p 50, Guideline Answers p 106 Question 13, including Guideline Answer, 1996 CFA Level III Examination (AIMR), 2002 CFA Level III Candidate Readings Managing Investment Portfolios: A Dynamic Process, 2nd edition, John L Maginn and Donald L Tuttle, eds (Warren, Gorham & Lamont, 1990) A “Asset Allocation,” Ch 7, pp 7-1 through 7-27, William F Sharpe Purpose: To test the candidate’s ability to formulate an investment policy statement and recommend an asset allocation for an endowment fund LOS: The candidate should be able to “Determination of Portfolio Policies: Institutional Investors” (Study Session 10) b) appraise and contrast the factors that affect the investment policies of pension funds, endowment funds, insurance companies, and commercial banks c) differentiate among the return objectives, risk tolerances, constraints, regulatory environment, and unique circumstances of endowment funds, pension funds, insurance companies, and commercial banks Cases in Portfolio Management (Study Session 10) a) formulate the overall portfolio management process leading to an investment policy statement and an asset allocation decision for an institutional investor, including developing objectives and constraints and analyzing capital market expectations b) compare and contrast the investment objectives and constraints of institutional investors in different economic circumstances c) create a formal investment policy statement for an institutional investor d) recommend and justify an asset allocation that would be appropriate for an institutional investor Question 13, including Guideline Answer, 1996 (Study Session 10) a) formulate the overall portfolio management process leading to an investment policy statement and an asset allocation decision for an institutional investor, including developing objectives and constraints and analyzing capital market expectations b) critique an existing investment policy statement and its associated asset allocation 2002 Level III Guideline Answers Morning Session - Page c) create a formal investment policy statement for an institutional investor d) recommend and justify a general asset allocation that would be appropriate for a particular institutional investor “Asset Allocation” (Study Session 11) b) discuss the major steps in asset allocation c) formulate the basic elements of the strategic asset allocation process Guideline Answer: A Prepare the components of an appropriate investment policy statement for the Jarvis University endowment fund as of June 1, 2002 OBJECTIVES Return The required total rate of return for the JU endowment fund is the sum of the spending rate and the expected long-term increase in educational costs • The spending rate = $126 million (current spending need) / ($2,000 million current fund balance less $200 million library payment) = $126 million / $1,800 million = percent The expected educational cost increase is percent The sum of the two components is 10 percent Achieving this relatively high return would ensure that the endowment’s real value is maintained Risk Evaluation of risk tolerance requires an assessment of both the ability and the willingness of the endowment to take risk Ability: Average Risk • Endowment funds are long-term in nature, having infinite lives This long time horizon by itself would allow for above-average risk • However, creative tension exists between the JU endowment’s demand for high current income to meet immediate spending requirements and the need for long-term growth to meet future requirements This need for a spending rate (exceeds percent) and the university’s heavy dependence on those funds allow for only average risk Willingness: Above Average Risk • University leaders and endowment directors have set a spending rate in excess of percent To achieve their percent real rate of return, the fund must be invested in above-average risk securities Thus the percent spending rate indicates a willingness to take above-average risk • In addition, the current portfolio allocation, with its large allocations to direct real estate and venture capital, indicates a willingness to take above-average risk Taking both ability and willingness into consideration, the endowment’s risk tolerance is best characterized as “above average” 2002 Level III Guideline Answers Morning Session - Page CONSTRAINTS Time Horizon A two-stage time horizon is needed The first stage recognizes short-term liquidity constraints ($200 million library payment in eight months) The second stage is an infinite time horizon (endowment funds are established to provide permanent support) Liquidity Generally, endowment funds have long time horizons and little liquidity is needed in excess of annual distribution requirements However, the JU endowment requires liquidity for the upcoming library payment in addition to the current year’s contribution to the operating budget Liquidity needs for the next year are: Library Payment +$200 million Operating Budget Contribution +$126 million Annual Portfolio Income –$ 29 million* Total +$297 million *Annual portfolio income = (.04 × $40 million) + (.05 × $60 million) + (.01 × $300 million) + (.001 × $400 million) + (.03 × $700 million) = $29 million Taxes U.S endowment funds are tax-exempt Legal/Regulatory U.S endowment funds are subject to predominantly state (but some federal) regulatory and legal constraints, and standards of prudence generally apply Restrictions imposed by Bremner may pose a legal constraint on the fund (no more than 25 percent of the initial share of Bertocchi Oil and Gas shares may be sold in any one-year period) Unique Circumstances Only 25 percent of donated Bertocchi Oil and Gas shares may be sold in any one-year period (constraint imposed by donor) A secondary consideration is the need to budget the one-time $200 million library payment in eight months 2002 Level III Guideline Answers Morning Session - Page B Asset U.S Money Market Fund Determine the most appropriate revised allocation percentage for each asset as of June 1, 2002 15 (14-17) % Justify each revised allocation percentage with one reason Liquidity needs for the next year are: Library payment +$200 million Operating budget contribution +$126 million Annual portfolio income –$ 29 million* Total +$297 million Total liquidity of at least $297 million is required (14.85 percent of current endowment assets) Additional allocations (more than percent above the suggested 15 percent) would be overly conservative This cushion should be sufficient for any transaction needs (i.e., mismatch of cash inflows/outflows) Intermediate Global Bond Fund 20 (15-25) % *Annual portfolio income = (.04 × $40 million) + (.05 × $60 million) + (.01 × $300 million) + (.001 × $400 million) + (.03 × $700 million) = $29 million To achieve a 10 percent portfolio return, the fund needs to take above average risk (e.g., 20 percent in Global Bond Fund and 30 percent in Global Equity Fund) An allocation below 15 percent would involve taking unnecessary risk that would put the safety and preservation of the endowment fund in jeopardy An allocation in the 21-25 percent range could still be tolerated because the slight reduction in portfolio expected return would be partially compensated by the reduction in portfolio risk An allocation above 25 percent would not satisfy the endowment fund return requirements 2002 Level III Guideline Answers Morning Session - Page Global Equity Fund 30 (25-35) % Bertocchi Oil and Gas Common Stock 15% Direct Real Estate Venture Capital Total 10% 10% 100% To achieve a 10 percent portfolio return, the fund needs to take above average risk (e.g., 30 percent in Global Equity Fund and 20 percent in Global Bond Fund) An allocation above 35 percent would involve taking unnecessary risk that would put the safety and preservation of the endowment fund in jeopardy An allocation in the 25-29 percent range could still be tolerated, as the slight reduction in portfolio expected return would be partially compensated by the reduction in portfolio risk An allocation below 25 percent would not satisfy the endowment fund return requirements There is a single issuer concentration risk associated with the current allocation, and a 25 percent reduction ($100 million), which is the maximum reduction allowed by the donor, is required ($400 million – $100 million = $300 million remaining) Not required Not required 2002 Level III Guideline Answers Morning Session - Page The suggested allocations (point estimates) would allow the JU endowment fund to meet the 10 percent return requirement, calculated as follows: Asset U.S Money Market Fund Intermediate Global Bond Fund Global Equity Fund Bertocchi Oil and Gas Common Stock Direct Real Estate Venture Capital TOTAL Suggested Allocation 0.15 0.20 0.30 0.15 0.10 0.10 1.00 Expected Return Weighted Return 4.0% 5.0% 10.0% 15.0% 11.5% 20.0% 0.60% 1.00% 3.00% 2.25% 1.15% 2.00% 10.00% The allowable allocation ranges, taken in proper combination, would also be consistent with the 10 percent return requirement 2002 Level III Guideline Answers Morning Session - Page LEVEL III, QUESTION Topic: Minutes: Portfolio Management 11 Reading References: “Dynamic Strategies for Asset Allocation,” Andre Perold and William Sharpe, Financial Analysts Journal (AIMR, January/February 1988), 2002 CFA Level III Candidate Readings Purpose: To test the candidate’s understanding of the dynamic strategies available to rebalance a portfolio in the context of changes in general market conditions, investor return objectives and risk tolerance, and the transaction costs associated with rebalancing LOS: The candidate should be able to “Dynamic Strategies for Asset Allocation” (Study Session 11) a) contrast the risk-return tradeoffs of the alternative dynamic portfolio rebalancing strategies b) appraise the appropriateness of the alternative rebalancing strategies under various sets of investor risk tolerances and asset return expectations c) appraise the impact of rebalancing strategies on the return and risk of a portfolio Guideline Answer: A i Buy-and-hold strategy The buy-and-hold strategy maintains an exposure to equities that is linearly related to the value of equities in general The strategy involves buying, then holding, an initial mix (equities/bills) No matter what happens to relative values, no rebalancing is required; hence this is sometimes termed the “do nothing” strategy The investor sets a floor below which s/he does not wish portfolio value to fall An amount equal to the value of that floor is invested in some non-fluctuating asset (i.e., Treasury bills, money market funds) The payoff diagram for a buy-and-hold strategy is a straight line, so the value of the portfolio rises (falls) as equity values rise (fall), with a slope equal to the equity proportion in the initial mix The value of the portfolio will never fall below the specified floor, and the portfolio has unlimited upside potential Increasing equity prices favor a buy and hold strategy; the greater the equity proportion in the initial mix, the better (worse) the strategy will perform when equities outperform (underperform) bills The strategy is particularly appropriate for an investor whose risk tolerance above the specified floor varies with wealth, but drops to zero at or below that floor After the initial portfolio transaction, transaction costs are not an issue The strategy is tax efficient for taxable investors ii Constant-mix strategy The constant-mix strategy maintains an exposure to equities that is a constant percentage of total wealth Periodic rebalancing to return to the desired mix requires the purchase (sale) of equities as they decline (rise) in value This strategy, 2002 Level III Guideline Answers Morning Session - Page which generates a concave payoff diagram, offers relatively little downside protection and performs relatively poorly in up markets The strategy performs best in a relatively flat (but oscillating or volatile) market and capitalizes on market reversals The constantmix strategy performs particularly well in a time period when equity values oscillate greatly, but end close to their beginning levels; greater volatility around the beginning values accentuates the positive performance The constant-mix strategy is particularly appropriate for an investor whose risk tolerance varies proportionately with wealth; such an investor will hold equities at all levels of wealth This strategy requires some rule to determine when rebalancing takes place; typical approaches avoid transaction costs until either the value of a portion of the, or of the entire, portfolio has changed by a given percentage At this point, transaction costs are incurred to rebalance Taxes can be material for taxable investors iii Constant-proportion strategy The constant-proportion strategy maintains an exposure to equities that is a constant multiple of a “cushion” specified by the investor The investor sets a floor below which s/he does not wish assets to fall, and the value of that floor is invested in some non-fluctuating asset (i.e., Treasury bills, money market funds) Under normal market conditions the value of the portfolio will not fall below this specified floor The investor then selects a multiplier to be used The initial commitment to equities equals the multiplier times the “cushion” (the difference between the value of the total assets to be invested and the value of the floor) [e.g., $ in equities = multiplier × (assets – floor)] As equity values rise (fall), the constant-proportion strategy requires the investor to purchase (sell) additional equities Thus following this strategy (via the formula indicated above) keeps equities at a constant multiple of the cushion (assets – floor) and generates a convex payoff diagram The constant-proportion strategy tends to give good downside protection and performs best in directional, especially up, markets; the strategy does poorly in flat but oscillating markets and is especially hurt by sharp market reversals The strategy is particularly appropriate for an investor who has zero tolerance for risk below the stated floor but whose risk tolerance increases quickly as equity values move above the stated floor This strategy requires some rule to determine when rebalancing takes place; typical approaches avoid transaction costs until either the value of a portion of the, or of the entire, portfolio has changed by a given percentage At this point transaction costs are incurred to rebalance Taxes can be material for taxable investors 2002 Level III Guideline Answers Morning Session - Page B The constant-proportion strategy is the most appropriate rebalancing strategy for the JU endowment fund, taking into account the major circumstances described: the endowment’s increased risk tolerance, the outlook for a bull market in growth assets over the next five years, the expectation of lower than normal volatility, and the endowment’s desire to limit downside risk • The constant-proportion strategy is consistent with higher risk tolerance, because the strategy calls for purchasing more equities as equities increase in value; higher risk tolerance is reflected in the resulting increased allocation to equities over time • The constant-proportion strategy will well in an advancing equities market; by buying equities as their values rise, each marginal purchase has a high payoff • The constant-proportion strategy would poorly in a higher volatility environment for equities, because the strategy would sell on weakness but buy on strength, only to experience reversals; conversely, the strategy does much better in the face of lower volatility • The constant-proportion strategy provides good downside protection, because the strategy sells on weakness and reduces exposure to equities as a given floor is approached In summary, given that JU receives little other funding support, the endowment fund must produce the maximum return for a specified level of risk Given that the level of acceptable risk is generally higher, although with a very specific downside floor, the market outlook suggests that the constant-proportion strategy is the endowment fund’s best rebalancing strategy 2002 Level III Guideline Answers Morning Session - Page LEVEL III, QUESTION Topic: Minutes: Portfolio Management 22 Reading Reference: “Evaluation of Portfolio Performance,” Ch 24 (omit pp 658-664), Modern Portfolio Theory and Investment Analysis, 5th edition, Edwin Elton and Martin Gruber (John Wiley & Sons, 1995), 2002 CFA Level III Candidate Readings “Evaluation of Portfolio Performance,” Ch 27, Investment Analysis and Portfolio Performance, 5th Edition, Frank K Reilly and Keith C Brown (Dryden, 1997), 2002 CFA Level III Candidate Readings Purpose: To test the candidate’s understanding of: 1) the different approaches to performance measurement and attribution, and 2) the Sharpe, Treynor, and Jensen measures of performance LOS: The candidate should be able to “Evaluation of Portfolio Performance” (Study Session 16) b) compare and contrast the Sharpe ratio, the Treynor measure, and Jensen’s alpha c) calculate the Sharpe ratio and the Treynor measure d) appraise investment manager performance using the Sharpe ratio, the Treynor measure, and Jensen’s alpha e) evaluate a manager’s performance after that performance has been attributed to diversification effect, market timing effect, and other sources of return “Evaluation of Portfolio Performance” (Study Session 16) a) prepare a performance attribution analysis for a portfolio and determine whether value was added through allocation effects (market timing or sector rotation) and /or selection effects Guideline Answer: A i Sharpe ratio = (portfolio return – risk-free rate) / standard deviation Sharpe ratio: Williamson Capital = (22.1% – 5.0%) / 16.8% = 1.02 Sharpe ratio: Joyner Asset Management = (24.2% – 5.0%) / 20.2% = 0.95 ii Treynor measure =(portfolio return – risk-free rate) / portfolio beta Treynor measure: Williamson Capital = (22.1% – 5.0%) / 1.2 = 14.25 Treynor measure: Joyner Asset Management = (24.2% – 5.0%) / 0.8 = 24.00 2002 Level III Guideline Answers Morning Session - Page 10 Asset Money Market Bonds Equities Spencer Stock TOTAL Expected Returns 4.2% 6.4% 10.8% 9.0% Portfolio A Weights Weighted Returns 0.023 0.097% 0.223 1.427% 0.254 2.743% 0.500 4.500% 8.767% Portfolio B Portfolio C Weights Weighted Weights Weighted Returns Returns 0.023 0.097% 0.250 1.050% 0.360 2.304% 0.150 0.960% 0.117 1.264% 0.100 1.080% 0.500 4.500% 0.500 4.500% 8.165% 7.600% Therefore, the appropriate portfolio is more directly determined by risk and liquidity issues Portfolio A initially appears to be a reasonable asset mix Cash is percent, bonds 45 percent, and equities 50 percent However, when the Spencer Design stock is included in the portfolio, the mix changes to 2.3 percent cash, 22.3 percent bonds, and 75.4 percent equities The cash reserve level is appropriate given her low short-term liquidity needs However, given her overall risk tolerance (especially her low willingness to assume risk), having 75 percent of her assets in equities, even given her long time horizon, is too aggressive and leaves her inadequately diversified with respect to other asset classes Portfolio C is overly conservative, with 50 percent cash, 30 percent bonds, and only 20 percent equities When the Spencer stock is added, the mix appears more reasonable, with 15 percent bonds and 60 percent equities, but the remaining 25 percent cash is still excessive Even considering her plan to build her “dream house” in five years (not a short-term liquidity need), it is inappropriate to hold this level of reserves and forego the additional return potential in the meantime Portfolio B initially appears to be very conservative with percent cash, 72 percent bonds, and only 23 percent equities, but only if the Spencer Design stock is not considered When the Spencer stock is incorporated, the asset mix is percent cash, 36 percent bonds, and 62 percent equities The level of cash reserves is appropriate, given the minimal near-term liquidity needs, which are only her daughter’s upcoming final year of college (present value of $18,000) Given that Portfolio B earns more than a sufficient expected return, the cash reserve level in Portfolio B is more appropriate than in Portfolio C and the equity exposure and diversification in Portfolio B are more appropriate than in Portfolio A, especially given Pierce’s overall risk tolerance (ability and willingness taken together) All these factors considered together strongly suggest that Portfolio B is the most appropriate choice D Because of Pierce’s tax circumstances and the fact that each of the managers is expected to have very similar average market returns, standard deviation characteristics, and fees, the primary differentiating factor for Pierce should be the tax implications of the portfolio turnover that results from each manager’s investment approach On that basis, Manager H is most appropriate for Pierce Manager H would likely experience the lowest turnover H is an active manager whose average holding period of seven years equates to an annual turnover of only 14.3 percent 2002 Level III Guideline Answers Morning Session - Page 19 With low annual turnover, capital gains are deferred and most often are long-term in nature and therefore taxed at a lower rate than would be the case for short-term gains Also, as an active manager, the portfolio manager can focus on after-tax return strategies, including selling stocks at a loss to offset gains, reducing Pierce’s tax obligation further Manager F holds a portfolio of stocks that is equally weighted Therefore, at the end of each quarter the manager will reduce the positions of stocks that outperformed the overall portfolio and purchase the stocks that underperformed These sales and purchases will likely result in numerous rebalancing transactions each quarter Although G manages a market-weighted value index portfolio, which would seemingly imply low turnover, G tracks the half of the index with the lowest price-to-book ratios As relative price-to-book ratios change, the index will be rebalanced quarterly In so doing, G’s strategy may cause significant turnover to accommodate the addition and deletion of stocks in the value portion of the index Both Managers F and G will incur significant quarterly rebalancing costs Also, as F and G sell the outperforming stocks as the portfolios are rebalanced, they will tend to realize gains It is likely that many of these gains will be taxed at the higher short-term capital gain rates rather than the lower long-term capital gain rates In addition, neither manager will be able to pursue any after-tax return maximization strategy, such as loss harvesting to offset gains, because this would increase tracking error relative to the respective indexes 2002 Level III Guideline Answers Morning Session - Page 20 LEVEL III, QUESTION Topic: Minutes: Portfolio Management 15 Reading References: “The Psychology of Risk,” Amos Tversky, Quantifying the Market Risk Premium Phenomenon for Investment Decision Making (AIMR, 1990), 2002 CFA Level III Candidate Readings “Behavioral Risk: Anecdotes and Disturbing Evidence,” Arnold Wood, Investing Worldwide VI (AIMR, 1996), 2002 CFA Level III Candidate Readings “Behavioral Finance: Past Battles and Future Engagements,” Meir Statman, Financial Analysts Journal (AIMR, November/December 1999), 2002 CFA Level III Candidate Readings Purpose: To test the candidate’s ability to identify and contrast major principles of behavioral finance and traditional or standard finance LOS: The candidate should be able to “The Psychology of Risk” (Study Session 14) a) contrast the assumptions of rational investment decision making and observed investor behaviors such as loss aversion, reference dependence, asset segregation, mental accounting, and biased expectations “Behavioral Risk: Anecdotes and Disturbing Evidence” (Study Session 14) a) discuss potential systematic overconfidence in analysts’ forecasts and the associated implications, particularly for asset allocation and portfolio construction b) appraise how prospect theory can be used to explain how investors treat losses differently than gains “Behavioral Finance: Past Battles and Future Engagements” (Study Session 14) a) contrast the standard finance view of human investor behavior and a behavioral finance framework 2002 Level III Guideline Answers Morning Session - Page 21 Guideline Answer: Identify three behavioral finance concepts illustrated in Pierce’s comments Overconfidence (Biased Expectations and Illusion of Control) Describe each of the three concepts Discuss how an investor practicing standard or traditional finance would challenge each of the three concepts Pierce is basing her investment strategy for supporting her parents on her confidence in the economic forecasts This is a cognitive error reflecting overconfidence in the form of both biased expectations and an illusion of control Pierce is likely more confident in the validity of those forecasts than is justified by the accuracy of prior forecasts Analysts’ consensus forecasts have proven routinely and widely inaccurate Pierce also appears to be overly confident that the recent performance of the Pogo Island economy is a good indicator of future performance Behavioral investors often conclude that a short track record is ample evidence to suggest future performance Standard finance investors understand that individuals typically have greater confidence in the validity of their conclusions than is justified by their success rate The calibration paradigm, which compares confidence to predictive ability, suggests that there is significantly lower probability of success than the confidence levels reported by individuals In addition, standard finance investors know that recent performance provides little information about future performance and are not deceived by this “law of small numbers.” 2002 Level III Guideline Answers Morning Session - Page 22 Loss Aversion (Risk Seeking) Pierce is exhibiting risk aversion in deciding to sell the Core Bond Fund despite its gains and favorable prospects She prefers a sure gain over a possibly larger gain coupled with a smaller chance of a loss Pierce is exhibiting loss aversion (risk seeking) by holding the High Yield Bond Fund despite its uncertain prospects She prefers the modest possibility of recovery coupled with the chance of a larger loss over a sure loss People tend to exhibit risk seeking rather than risk averse behavior when the probability of loss is large There is considerable evidence indicating that risk aversion holds for gains and risk seeking holds for losses and that attitudes toward risk vary, depending on particular goals and circumstances Pierce’s inclination to sell her Small Reference Dependence Company Fund once it returns to her original cost is an example of reference dependence Her sell decision is predicated on the current value as related to original cost, her reference point Her decision does not consider any analysis of expected terminal value or the impact of this sale on her total portfolio This reference point of original cost has become a critical but inappropriate factor in Pierce’s decision Standard finance investors are consistently risk averse and would systematically prefer a sure outcome over a gamble with the same expected value Such investors also take a symmetrical view of gains and losses of the same magnitude, and their sensitivity (aversion) to changes in value is not a function of some specified value reference point In standard finance, alternatives are evaluated in terms of terminal wealth values or final outcomes and not in terms of gains and losses relative to a reference point such as original cost Standard finance investors also consider the risk and return profile of the entire portfolio rather than anticipated gains or losses on any particular investment or asset class 2002 Level III Guideline Answers Morning Session - Page 23 LEVEL III, QUESTION Topic: Minutes: Portfolio Management 22 Reading References: Emerging Stock Markets: Risk, Return, and Performance, Christopher B Barry, John W Peavy III, and Mauricio Rodriguez (Research Foundation of the ICFA, 1997) C “Portfolio Construction Using Emerging Markets,” Ch D “Investability in Emerging Markets,” Ch “The Importance of the Investment Policy Statement” (AIMR, 1999), 2002 CFA Level III Candidate Readings “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 Managing Investment Portfolios: A Dynamic Process, 2nd edition, John L Maginn and Donald L Tuttle, eds (Warren, Gorham & Lamont, 1990) B “Monitoring and Rebalancing the Portfolio,” Ch 13, Robert D Arnott and Robert M Lovell, Jr Purpose: To test the candidate’s: 1) ability to appropriately modify an individual investor’s investment policy statement and asset allocation in response to important changes in the investor’s circumstances, and 2) understanding of potential benefits and risks associated with investing in emerging markets equity LOS: The candidate should be able to “Portfolio Construction Using Emerging Markets” (Study Session 5) a) appraise the impact on portfolio risk of adding emerging market stocks to a portfolio containing securities from developed markets b) discuss the variations of various correlations over time among different emerging markets and between emerging and developed markets 2002 Level III Guideline Answers Morning Session - Page 24 “Investability in Emerging Markets” (Study Session 5) a) describe the concept of “investability” in emerging markets b) discuss performance comparisons between indexes of investable securities and indexes of all securities in emerging markets c) contrast the portfolio characteristics of the emerging market investable security universe and the portfolio characteristics of all emerging market securities “The Importance of the Investment Policy Statement” (Study Session 9) a) explain the principal contents of a typical written investment policy statement and discuss their implications for portfolio management b) explain the importance of an investment policy statement “Individual Investors” (Study Session 9) c) 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, and any special circumstances such as taxes, gifts, and estate planning Cases in Portfolio Management (Study Session 9) b) contrast the investment objectives and constraints of individual investors in several different economic circumstances c) create an investment policy statement for an individual investor in each case, using the concepts addressed in the readings in this study session “Monitoring and Rebalancing the Portfolio” (Study Session 11) a) determine whether changed asset risk and return conditions require a portfolio to be rebalanced b) appraise the need to rebalance under altered client circumstances, including changes in wealth, time horizon, liquidity requirements, tax treatment, and regulatory environment c) appraise the impact on the need to rebalance of such factors as the availability of new asset alternatives, changes in asset class expected returns and risks, and transaction costs d) contrast the merits and costs of rebalancing using such approaches as maintaining a 60/40 asset mix, letting an asset mix drift, and using a tactical asset allocation 2002 Level III Guideline Answers Morning Session - Page 25 Guideline Answer: A Component of Pierce’s investment policy statement Return Requirement Risk Tolerance Liquidity Time Horizon Indicate how each component of Pierce’s investment policy statement should change as a result of Pierce’s new circumstances (circle one) Higher Higher Higher Longer Justify each of your responses with two reasons based on Pierce’s new circumstances Pierce’s return must be higher* to: • fund her additional living expenses • meet her new retirement goals Pierce’s risk tolerance is higher because the: • longer time horizon leads to the ability to assume more risk • increase in assets leads to the ability to assume more risk Pierce has a higher liquidity requirement because of the cost of the: • surgery for her son • down payment for the house Pierce’s time horizon has lengthened because of: • her husband’s extended retirement date • the uncertainty of continued care for her son when she and her husband are incapable *The following calculations are not required, but provide basis for the statement that the return must be higher than the previous percent to generate a retirement portfolio that will support the desired retirement spending level (at a reasonable retirement spending rate) A return of approximately percent is now needed, depending on the retirement spending rate assumption made 2002 Level III Guideline Answers Morning Session - Page 26 Current portfolio (gross) $3,700,000 Less surgery $214,286 before tax Less house down payment $428,571 before tax Less living expenses $1,714,286 before tax Current portfolio (net) $1,342,857 After-tax return = Before-tax return (1–T) = 8.90% (0.7) = 6.23% Years = 25 Retirement portfolio $6,084,282 Retirement spending (after tax) $280,000 Retirement spending (before tax) $400,000 Spending rate (before tax) 6.57% 2002 Level III Guideline Answers Morning Session - Page 27 Calculations: $150,000 after tax / 0.7 $300,000 after tax / 0.7 $1,200,000 after tax / 0.7 $1,342,857 × (1.0623)25 given $280,000 / 0.7 $400,000 / $6,084,282 B Asset Current allocation percentage of combined portfolio Recommend whether the current allocation percentage should be decreased or increased as a result of Pierce’s new circumstances (circle one) Spencer Design Stock 39.1% Decreased Money Market 2.4% Increased Diversified Bond Fund 30.5% Increased Large Capitalization Equities 10.4% Increased Emerging Market Equities 11.0% Decreased Undeveloped Commercial Land 6.6% Decreased TOTAL Justify each of your responses with one reason based on Pierce’s new circumstances Having a large percentage of her portfolio in one risky and potentially illiquid equity security exposes the portfolio to unnecessary and significant security specific risk Pierce needs $300,000 for a house down payment, $150,000 for her son’s surgery, and the current year’s portion of the $1,200,000 present value of ongoing living expenses The Pierces’ portfolio must support the $1,200,000 present value of ongoing living expenses and can sustain only moderate portfolio volatility The regular income stream and diversification benefits offered by bonds are consistent with those needs Pierce requires growth and inflation protection to meet her current and future spending needs A diversified equity portfolio is likely to meet these requirements over time while not imparting unacceptable volatility to principal values Pierce requires high returns but cannot afford to sustain large losses Having a large percentage of total assets in volatile emerging markets securities is too risky for Pierce Pierce needs income and liquidity to meet ongoing portfolio disbursement requirements Undeveloped land requires cash payments (taxes, etc.) and is often illiquid 100.0% 2002 Level III Guideline Answers Morning Session - Page 28 LEVEL III, QUESTION Topic: Minutes: Asset Valuation 14 Reading References: “The Reality of Hedge Funds,” pp 26-34 (up to “Hedge Fund Performance”), Appendix B, and Appendix C, Dave Purcell and Paul Crowley, Journal of Investing (Institutional Investor, Fall 1999), 2002 CFA Level III Candidate Readings Purpose: To test the candidate's ability to define the types of hedge funds, evaluate general approaches to investment employed by hedge funds, identify segments of the hedge fund universe, and analyze the risks associated with hedge funds LOS: The candidate should be able to “The Reality of Hedge Funds” (Study Session 8) a) contrast the classic and current definition of a hedge fund c) contrast the different segments of the hedge fund universe in terms of investment strategy, use of leverage, and risk control d) analyze the risks inherent in hedge funds 2002 Level III Guideline Answers Morning Session - Page 29 Guideline Answer: A Arnold’s statements Classic hedge funds tend to use long and short positions in publicly traded securities, with the primary goal of being market-neutral This strategy allows such funds to focus on stock selection Like classic hedge funds, current hedge funds are privately organized, pooled investment vehicles that use leverage Unlike classic hedge funds, current hedge funds also take positions in derivatives on publicly traded securities Indicate one inaccuracy in each of Arnold’s statements Very few classic hedge funds seek to be market-neutral Both classic and current hedge funds use derivative securities Macro funds use forward Because of the low correlations between the currencies and and futures contracts to take indexes in which macro funds trade, these funds tend to use investment positions in relatively low levels of leverage currency, bond, and/or equity markets Because the currencies and indexes in which macro funds trade are closely correlated, these funds are able to use very high levels of leverage Hedge fund managers often Errors in analyzing data or recording positions lead to use complicated computer operational risk “Greeks” risk, associated with delta, models to manage their gamma, and vega, arises from the use of options portfolios Errors in analyzing data or recording positions can lead to delta, gamma, and vega risks 2002 Level III Guideline Answers Morning Session - Page 30 B • Arnold’s conclusion about liquidity risk is correct If a fund needs to trade a large position quickly, the trade is likely to affect prices if that trade is a large portion of the outstanding shares available to be traded Arnold could find that a particular fund’s trades affect market pricing and result in purchase or sale prices that are less favorable than those that might be achieved in a larger, more liquid market • Arnold’s conclusion about “herd” risk is correct Many hedge fund managers know one another personally Additionally, because many use common styles, they seek to profit from similar opportunities When the time comes to trade a position, many fund managers may attempt to trade at the same time, exacerbating liquidity risk Arnold may find that prices are adversely affected by the activities of numerous other fund managers seeking to employ similar strategies in the same trading windows • Arnold’s conclusion about redemption risk is incorrect Hedge funds usually allow infrequent redemptions at certain times of the year, such as quarterly At these times, when an entire period’s redemptions must be funded at the same time, managers may be forced to unwind positions at less than desirable prices 2002 Level III Guideline Answers Morning Session - Page 31 LEVEL III, QUESTION Topic: Minutes: Asset Valuation 18 Reading References: Alternative Investing (AIMR, 1998), 2002 CFA Level III Candidate Readings A “Controlled Risk Strategies,” Bruce I Jacobs B “Market Neutral: Engineering Return and Risk,” David Steyn Purpose: To test the candidate's ability to compare and contrast long-only and long-short strategies across various characteristics LOS: The candidate should be able to: “Controlled Risk Strategies” (Study Session 8) a) differentiate the sources of value added using a long-only strategy versus a long-short strategy b) discuss the rationale for pricing inefficiencies on the short side d) discuss how to equitize a long-short strategy f) contrast long-only strategies and long-short strategies in the following areas: trading costs, management fees, risk levels, and implementation of long and short positions “Market Neutral: Engineering Return and Risk” (Study Session 8) a) contrast the sources of risk using a long-only strategy versus a long-short strategy c) appraise and critique the long-short strategies in international equity markets 2002 Level III Guideline Answers Morning Session - Page 32 Guideline Answer: Is the long or the short side of a longshort strategy more likely to allow a manager to profit from security mispricings, and why? Formulate one correct response to each of Arnold’s questions The manager is more likely to profit on the short side, because when short selling is restricted, market prices are not efficient, and some securities will be overpriced What is the manager’s value-added or payoff from a market-neutral strategy, and what are the components of the payoff? The long-short payoff is the long-short spread; the components are alpha from long portfolio + alpha from short portfolio + interest on proceeds from short sales How a long-only strategy and a long-short strategy differ with regard to the importance of benchmark holdings if the investor is particularly concerned about the residual risk of each strategy? To reduce residual risk, the long-only manager must eventually force the portfolio to conform to benchmark index capitalization weightings The benchmark effectively imposes inherent restrictions on the long-only manager Longshort managers not need to hold benchmark index stocks to control residual risk, or put another way, they not hold certain stocks merely to match benchmark weightings The balance of long and short positions effectively eliminates the benchmark as a constraint in security selection and weighting How might a manager equitize a long-short strategy without disturbing current portfolio holdings? A market-neutral strategy can be equitized by adding exposure to market risk and market return back to a long-short portfolio This strategy is achieved by purchasing stock index futures equal to the amount of the initial investment How risk levels differ between long-only and long-short management in terms of maximum potential losses? The maximum loss from a long-only strategy is the price paid for the security The maximum loss from a long-short strategy is theoretically unbounded on the short position When implementing international long-short strategies, are correlations between strategy returns or country market returns more important to consider, and why? Correlations between strategy returns are more important Low correlations across long-short pairs are responsible for the majority of the diversification achieved Further marginal diversification is achieved by applying the strategy internationally Arnold’s questions 2002 Level III Guideline Answers Morning Session - Page 33 ... Case p 18, Guideline Answers p 62 Questions and 2, including Guideline Answers, 1995 CFA Level III Examination (AIMR), 2002 CFA Level III Candidate Readings Question 1, including Guideline Answer,... prices 2002 Level III Guideline Answers Morning Session - Page 31 LEVEL III, QUESTION Topic: Minutes: Asset Valuation 18 Reading References: Alternative Investing (AIMR, 1998), 2002 CFA Level III. .. Answer, 1998 CFA Level III Examination (AIMR), 2002 CFA Level III Candidate Readings “Global Investment Performance Standards,” including Appendix A (AIMR, 1999), 2002 CFA Level III Candidate Readings