CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 r08 managing individual investor portfolios summary

Level III Managing Individual Investor Portfolios Summary Key Concepts Questions based on this reading test us on key components of the IPS • Return Objective • Risk • Constraints Asset Allocation Monte Carlo Simulations www.ift.world Return Objective Year 2016 Type Multi Period Comment Minimum annual after-tax return required by X to be able to retire in 10 years 2015 Multi Period Pre-tax gift that will allow X to meet his goals 2014 Multi Period Determine whether return is sufficient to meet retirement goals 2013 Single Period Calculate nominal after-tax required rate of return 2013 Multi Period Determine which portfolio is appropriate using short-fall risk approach 2012 Multi Period Calculate required nominal annual rate of return 2011 Single Period Calculate after-tax nominal rate of return 2010 2009 2008 2008 2007 Multi Period Single Period Single Period Multi Period Multi Period Calculate annual pre-tax nominal rate of return Calculate pre-tax nominal rate of return Calculate after-tax nominal rate of return Calculate after-tax nominal rate of return Calculate nominal pre-tax return while maintaining purchasing power www.ift.world Problem Solving Tips Single-Period Questions Three parts: Cash needed Investable assets Return (*) * If investor wants to maintain purchasing power of investable assets then add inflation rate Multi-Period Questions Periodic cash flow (**) Investable assets (initial portfolio amount) Final portfolio amount (based on retirement needs) Rate ** If savings go to a tax-deferred account then we should calculate the pre-tax income needed to meet spending needs www.ift.world Return Objective (1) Client A is 30 years old and plans to retire when he is 60 Pretax annual compensation is 200,000 The tax rate is 30% Annual expenditure is 100,000 Savings go to a tax deferred account (TDA) Annual savings are expected to remain the same Current value of TDA portfolio is 1,000,000 On retirement your client will need 3,500,000 on a pre-tax basis What is the required rate of return? www.ift.world Return Objective (1) Solution Your client is 30 years old and plans to retire when he is 60 Pretax annual compensation is 200,000 The tax rate is 30% Annual expenditure is 100,000 Savings go to a tax deferred account (TDA) Annual savings are expected to remain the same Current value of TDA portfolio is 1,000,000 On retirement your client will need 3,500,000 What is the required rate of return? Common mistakes: Calculating savings as 200,000 (1 – 0.3) – 100,000 = 60,000 Not properly recognizing the +/- convention www.ift.world Pre-tax income needed = 100,000 / (1 – 0.30) = 142,857 N = 30, PV = 1,000,000, PMT = 57,143, FV = -3,500,000 CPT I/Y = 1.23% Return Objective (2) Client B has just retired Net investable assets = 2,000,000 Value of home = 600,000 (all paid) After-tax pension = 40,000 (flat) Current-year living expenses = 150,000 Living expenses will increase with inflation Inflation = 2% Client wants to maintain real value of investable assets What is the required after-tax nominal rate of return for the first year? www.ift.world Return Objective (2) Solution Your client has just retired Net investable assets = 2,000,000 Value of home = 600,000 (all paid) After-tax pension = 40,000 (flat) Current-year living expenses = 150,000 Living expenses will increase with inflation Inflation = 2% Client wants to maintain real value of investable assets What is the required after-tax nominal rate of return for the first year? Common mistakes: Forgetting to increase living expenses to account for inflation Not subtracting pension Not adding inflation at the end www.ift.world Step 1: Determine year cash flow Living expenses: 150,000 x 1.02 = 153,000 Less 40,000 pension = 113,000 Step 2: Investable assets 2,000,000 Step 3: Calculate required return Real rate = 113,000 / 2,000,000 = 5.65% Nominal rate ≈ 5.65 + 2.00 = 7.65% Return Objective (3) Client C has just sold his business for 8,000,000 and has retired The costs basis of the business is Taxes are due on the gain from sale of business at 20% Net proceeds from the sale of business will be added to his investment portfolio next week This investment portfolio is taxable and has a current market value of 2,000,000 Client C wants to grow the investment portfolio over time to maintain its after-tax purchasing power He will receive payments of 100,000 per year from a trust fund established by his parents The first payment is due next week These payments are not indexed to inflation and will be taxed as ordinary income at 25% Investment income is also taxed at 25% Living expenses for last year were 400,000 and are expected to grow at the inflation rate of 2% Client C owns his home worth 3,000,000 His mortgage debt is 2,000,000 He wants to pay off this debt immediately Determine the nominal after-tax required rate of return for the coming year What is the nominal before-tax rate? www.ift.world Return Objective (3) Solution Sold his business for 8,000,000 The costs basis of the business is Taxes are due on the gain from sale of business at 20% Investment portfolio is taxable and has a current market value of 2,000,000 Maintain its after-tax purchasing power He will receive payments of 100,000 per year These payments are not indexed to inflation and will be taxed as ordinary income at 25% Investment income is also taxed at 25% Living expenses for last year were 400,000 and are expected to grow at the inflation rate of 2% Client C owns his home worth 3,000,000 His mortgage debt is 2,000,000 He wants to pay off this debt immediately Determine the nominal after-tax required rate of return for the coming year What is the before tax return? Step 1: Determine year cash flow Living expenses: 400,000 x 1.02 Less after-tax income: 100,000 (1 – 0.25) Net cash needed in year 1: = 408,000 = (75,000) = 333,000 Step 2: Investable assets Net proceeds from sale: 8,000,000 x 0.8 Plus investment portfolio value Less mortgage debt Total investable assets = 6,400,000 = 2,000,000 = (2,000,000) = 6,400,000 Step 3: Calculate required return After-tax real rate = 333,000 / 6,400,000 Nominal after-tax rate ≈ 5.20 + 2.00 Nominal before-tax rate = 7.20/0.75 = 5.20% = 7.20% = 9.60% www.ift.world What factors impact ability to take risk? • Age • Employability and nature of income • Investment time horizon • Pension eligibility • Home ownership • Level of debt • Asset base relative to spending needs • Saving habits • Spending needs (liquidity requirements) and habits • Major cash inflows or outflows • Desire to leave an estate www.ift.world What factors impact willingness to take risk? • • • • Behavioral biases Attitude towards equity markets Planned retirement age Preference for conservative versus aggressive investing – Consider current fixed income / equity allocation • Attitude towards risky activities • Source of wealth – Through savings over time – Business Risk tolerance considers the ability and the willingness to take risk www.ift.world Liquidity When discussing a client’s liquidity constraint we should consider the investment portfolio’s ability to efficiently meet an investor’s anticipated and unanticipated demands for cash distributions A portfolio’s liquidity is impacted by transaction costs and price volatility Significant liquidity requirements limit ability to take risk Liquidity needs can be one-off or on-going Three primary types of liquidity requirements: Ongoing expenses • Net living expenses • Health care expenses Liquidity events • Fund children’s education • Create trust fund for children • Go on a world tour • Planned donation • Debt payments (pay off mortgage) Emergency/cash reserves www.ift.world Liquidity Scenarios Client X has an investment portfolio of 300,000 Her income is 90,000 per year, after-tax Her ongoing living expenses are 70,000 per year? Do the ongoing living expenses create a liquidity need from the portfolio? Client X wants to go on a world tour at the end of the year The estimated cost will be 40,000 She also wants to establish a cash reserve worth 50,000 Are these liquidity requirements? Client Y has just retired Her investment portfolio is worth 1,000,000 She does not have any pension income Her ongoing living expenses are estimated to be 70,000 per year Is this a liquidity requirement? www.ift.world Time Horizon 15 years or longer  long term years or shorter  short term Single stage vs multi stage time horizon Example of multi-stage time horizon: Stage 1: From now till when a major liquidity retirement is met Stage 2: After meeting liquidity retirement till retirement Stage 3: Retirement (Stage arises if client outlives savings) www.ift.world Asset Allocation and Monte Carlo Simulations Basic process of selecting appropriate strategic asset allocation: Determine which asset allocations meet return requirement Eliminate asset allocations that fail to meet risk objectives Eliminate asset allocations that fail to meet investor constraints Select allocation that is most rewarding for client Monte Carlo simulation has some advantages over deterministic approaches: More accurately portrays risk-return tradeoff Illustrates tradeoffs between short-term and long-term goals Provides more realistic modeling of taxes Better suited to assessing multi-period effects www.ift.world 16 ... www.ift.world Pre-tax income needed = 100,000 / (1 – 0 .30 ) = 142,857 N = 30 , PV = 1,000,000, PMT = 57,1 43, FV = -3, 500,000 CPT I/Y = 1. 23% Return Objective (2) Client B has just retired Net investable... Living expenses: 150,000 x 1.02 = 1 53, 000 Less 40,000 pension = 1 13, 000 Step 2: Investable assets 2,000,000 Step 3: Calculate required return Real rate = 1 13, 000 / 2,000,000 = 5.65% Nominal rate... investable assets = 6,400,000 = 2,000,000 = (2,000,000) = 6,400,000 Step 3: Calculate required return After-tax real rate = 33 3,000 / 6,400,000 Nominal after-tax rate ≈ 5.20 + 2.00 Nominal before-tax