2018 CFA® EXAM REVIEW W IL E Y Wiley Study Guide for 2018 Level III CFA Exam Review Complete Set Thousands of candidates from more than 100 countries have relied on these Study Guides to pass the CFA® Exam Covering every Learning Outcome Statement (LOS) on the exam, these review materials are an invaluable tool for anyone who wants a deep-dive review of all the concepts, formulas, and topics required to pass Wiley study materials are produced by expert CFA charterholders, CFA Institute members, and investment professionals from around the globe For more information, contact us at info @efficientleaming.com Wiley Study Guide for 2018 Level III CFA Exam Review Wi l ey Copyright © 2018 by John Wiley & Sons, Inc All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, 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materials should be used in conjunction with the original readings as set forth by CFA Institute in the 2017 CFA Level III Curriculum The information contained in this book covers topics contained in the readings referenced by CFA Institute and is believed to be accurate However, their accuracy cannot be guaranteed ISBN 978-1-119-43611-9 (ePub) ISBN 978-1-119-43610-2 (ePDF) Contents About the Authors xi Wiley Study Guide for 2018 Level III CFA Exam Volume 1: Ethical and Professional Standards & Behavioral Finance Study Session 1: Code of Ethics and Standards of Professional Conduct Reading 1: Code of Ethics and Standards of Professional Conduct Lesson 1: Code of Ethics and Standards of Professional Conduct Reading 2: Guidance for Standards l-VII Lesson 1: Standard I: Professionalism Lesson 2: Standard II: Integrity of Capital Markets Lesson 3: Standard III: Duties to Clients Lesson 4: Standard IV: Duties to Employers Lesson 5: Standard V: Investment Analysis, Recommendations, and Actions Lesson 6: Standard VI: Conflicts of Interest Lesson 7: Standard VII: Responsibilities as a CFA Institute Member or CFA Candidate 3 9 36 46 70 84 97 107 Study Session 2: Ethical and Professional Standards in Practice Reading 3: Application of the Code and Standards Lesson 1: Ethical and Professional Standards in Practice, Part 1: The Consultant Lesson 2: Ethical and Professional Standards in Practice, Part 2: Pearl Investment Management 119 119 Reading 4: Asset Manager Code of Professional Conduct Lesson 1: Asset Manager Code of Professional Conduct 121 121 120 Study Session 3: Behavioral Finance Reading 5: The Behavioral Finance Perspective Lesson 1: Behavioral versus Traditional Perspectives Lesson 2: Decision Making Lesson 3: Perspectives on Market Behavior and Portfolio Construction 131 131 136 140 Reading 6: The Behavioral Biases of Individuals Lesson 1: Cognitive Biases Lesson 2: Emotional Biases Lesson 3: Investment Policy and Asset Allocation 147 148 154 159 ©2018 Wiley © CONTENTS Reading 7: Behavioral Finance and Investment Processes Lesson 1:The Uses and Limitations of Classifying Investors into Types Lesson 2: How Behavioral Factors Affect Advisor-Client Relations Lesson 3: How Behavioral Factors Affect Portfolio Construction Lesson 4: Behavioral Finance and Analyst Forecasts Lesson 5: How Behavioral Factors Affect Committee Decision Making Lesson 6: How Behavioral Finance Influences Market Behavior 165 165 168 169 172 178 179 Wiley Study Guide for 2018 Level III CFA Exam Volume 2: Private Wealth Management & Institutional Investors Study Session 4: Private Wealth Management (1) Reading 8: Managing Individual Investor Portfolios Lesson 1: Investor Characteristics: Situational and Psychological Profiling Lesson 2: Individual IPS: Return Objective Calculation Lesson 3: Individual IPS: Risk Objective Lesson 4: Individual IPS: The Five Constraints Lesson 5: A Complete Individual IPS Lesson 6: Asset Allocation Concepts: The Process of Elimination Lesson 7: Monte Carlo Simulation and Personal Retirement Planning 3 10 18 20 Reading 9: Taxes and Private Wealth Management in a Global Context Lesson 1: Overview of Global Income Tax Structures Lesson 2: After-Tax Accumulations and Returns forTaxable Accounts Lesson 3: Types of Investment Accounts and Taxes and Investment Risk Lesson 4: Implications for Wealth Management 21 21 23 31 34 Reading 10: Domestic Estate Planning: Some Basic Concepts Lesson 1: Basic Estate Planning Concepts Lesson 2: Core Capital and Excess Capital Lesson 3: Transferring Excess Capital Lesson 4: Estate Planning Tools Lesson 5: Cross-Border Estate Planning 39 39 42 46 51 53 Study Session 5: Private Wealth Management (2) © Reading 11: Concentrated Single-Asset Positions Lesson 1: Concentrated Single-Asset Positions: Overview and Investment Risks Lesson 2: General Principles of Managing Concentrated Single-Asset Positions Lesson 3: Managing the Risk of Concentrated Single-Stock Positions Lesson 4: Managing the Risk of Private Business Equity Lesson 5: Managing the Risk of Investment in Real Estate 59 59 60 66 71 74 Reading 12: Risk Management for Individuals Lesson 1: Human Capital and Financial Capital Lesson 2: Seven Financial Stages of Life Lesson 3: A Framework for Individual Risk Management Lesson 4: Life Insurance Lesson 5: Other Types of Insurance Lesson 6: Annuities Lesson 7: Implementation of Risk Management for Individuals 77 77 78 80 83 88 91 95 ©2018 Wiley CONTENTS Study Session 6: Portfilio Management for Institutional Investors Reading 13: Managing Institutional Investor Portfolios Lesson 1: Institutional IPS: Defined Benefit (DB) Pension Plans Lesson 2: Institutional IPS: Foundations Lesson 3: Institutional IPS: Endowments Lesson 4: Institutional IPS: Life Insurance and Non-Life Insurance Companies (Property and Casualty) Lesson 5: Institutional IPS: Banks 103 103 111 115 117 120 Wiley Study Guide for 2018 Level III CFA Exam Volume 3: Economic Analysis, Asset Allocation, Equity & Fixed Income Portfolio Management Study Session 7: Applications of Economic Analysis to Portfolio Management Reading 14: Capital Market Expectations Lesson 1: Organizing the Task: Framework and Challenges Lesson 2: Tools for Formulating Capital Market Expectations,Part 1: Formal Tools Lesson 3: Tools for Formulating Capital Market Expectations,Part 2: Survey and Panel Methods and Judgment Lesson 4: Economic Analysis, Part 1: Introduction and Business Cycle Analysis Lesson 5: Economic Analysis, Part 2: Economic Growth Trends, Exogenous Shocks, and International Interactions Lesson 6: Economic Analysis, Part 3: Economic Forecasting Lesson 7: Economic Analysis, Part 4: Asset Class Returns andForeign Exchange Forecasting 3 27 30 33 Reading 15: Equity Market Valuation Lesson 1: Estimating a Justified P/E Ratio and Top-Down and Bottom-Up Forecasting Lesson 2: Relative Value Models 39 39 46 13 19 Study Session 8: Asset Allocation and Related Decisions in Portfolio Management (1) Reading 16: Introduction to Asset Allocation Lesson 1: Asset Allocation in the Portfolio Construction Process Lesson 2: The Economic Balance Sheet and Asset Allocation Lesson 3: Approaches to Asset Allocation Lesson 4: Strategic Asset Allocation Lesson 5: Implementation Choices Lesson 6: Strategic Considerations for Rebalancing 53 53 54 55 57 64 65 Reading 17: Principles of Asset Allocation Lesson 1: The Traditional Mean-Variance Optimization (MVO) Approach Lesson 2: Monte Carlo Simulation and Risk Budgeting Lesson 3: Factor-Based Asset Allocation Lesson 4: Liability-Relative Asset Allocation Lesson 5: Goal-Based Asset Allocation, Heuristics, Other Approaches to Asset Allocation, and Portfolio Rebalancing 67 67 70 71 72 75 Study Session 9: Asset Allocation and Related Decisions in Portfolio Management (2) Reading 18: Asset Allocation with Real-World Constraints Lesson 1: Constraints in Asset Allocation Lesson 2: Asset Allocation for the Taxable Investor ©2018 Wiley 81 81 84 CONTENTS Lesson 3: Altering or Deviating from the Policy Portfolio Lesson 4: Behavioral Biases in Asset Allocation 85 87 Reading 19: Currency Management: An Introduction Lesson 1: Review of Foreign Exchange Concepts Lesson 2: Currency Risk and Portfolio Return and Risk Lesson 3: Currency Management: Strategic Decisions Lesson 4: Currency Management: Tactical Decisions Lesson 5: Tools of Currency Management Lesson 6: Currency Management for Emerging Market Currencies 89 89 95 98 101 104 112 Reading 20: Market Indexes and Benchmarks Lesson 1: Distinguishing between a Benchmark and a Market Index and Benchmark Uses and Types Lesson 2: Market Index Uses and Types Lesson 3: Index Weighting Schemes: Advantages and Disadvantages 113 113 117 119 Study Session 10: Fixed-Income Portfolio Management (1) Reading 21: Introduction to Fixed-Income Portfolio Management Lesson 1: Roles of Fixed Income Securities in Portfolios Lesson 2: Fixed Income Mandates Lesson 3: Bond Market Liquidity Lesson 4: Components of Fixed Income Return Lesson 5: Leverage Lesson 6: Fixed Income Portfolio Taxation 127 127 129 133 135 137 140 Reading 22: Liability-Driven and Index-Based Strategies Lesson 1: Liability-driven Investing Lesson 2: Managing Single and Multiple Liabilities Lesson 3: Risks in Managing a Liability Structure Lesson 4: Liability Bond Indexes Lesson 5: Alternative Passive Bond Investing Lesson 6: Liability Benchmarks Lesson 7: Laddered Bond Portfolios 143 143 144 147 148 148 149 149 Study Session 11: Fixed-Income Portfolio Management (2) Reading 23: Yield Curve Strategies Lesson 1: Foundational Concepts for Yield Curve Management Lesson 2: Yield Curve Strategies Lesson 3: Formulating a Portfolio Postioning Strategy for a Given Market View Lesson 4: A Framework for Evaluating Yield Curve Trades 153 153 155 161 167 Reading 24: Fixed-Income Active Management: Credit Strategies Lesson 1: Investment-Grade and High-Yield Corporate Bond Portfolios Lesson 2: Credit Spreads Lesson 3: Credit Strategy Approaches Lesson 4: Liquidity Risk and Tail Risk in Credit Portfolios Lesson 5: International Credit Portfolios Lesson 6: Structured Financial Instruments 169 169 172 175 185 189 191 ©2018 Wiley OVERVIEW OF THE GLOBAL INVESTMENT PERFORMANCE STANDARDS LOS 34m: Evaluate the relative merits of high/low, range, interquartile range, and equal-weighted or asset-weighted standard deviation as measures of the internal dispersion of portfolio returns within a composite for annual periods Vol 6, pp 251-257 Dispersion of portfolio returns within a composite allows investors the opportunity to determine how well the investment manager implements the composite strategy across different portfolios Acceptable measures include but are not limited to high/low range (i.e., difference between high and low value), and equal-weighted or asset-weighted standard deviation Equal-weighted standard deviation for a composite uses a familiar calculation where r, is the return for a portfolio, rc is the return for the composite, and n is the number of portfolios in the composite This measure answers the question of dispersion of returns for clients: Asset-weighted standard deviation answers the question of dispersion of return for the average dollar invested, where rCavv is the asset-weighted average return for the composite, and Wj is the portfolio’s percentage of assets in the composite based on beginning-ofperiod value Vq : Note that either n or n -1 in the denominator can be theoretically supported, although the above formulas are used To determine returns above or below a particular percentage, apply the number of standard deviations representing the appropriate percentage to the standard deviation for the composite (similar to hypothesis testing) Although the GIPS standards not specifically require a particular method, nor they recommend one, they provide the foregoing as examples Additionally, some firms may prefer to present the interquartile range (i.e., the difference between returns in the third and first quartiles) Stated differently, the interquartile range describes the range spanning the middle 50% of portfolio returns and excludes relatively high and low 25 percent returns (i.e., outliers) ©2018 Wiley OVERVIEW OFTHE GLOBAL INVESTMENT PERFORMANCE STANDARDS By defining the yth percentile of a descending order series as the point above which y percent of n observations fall, the observations at percentile breaks for the interquartile range are calculated by substituting 25 and 75 for y: Next, it will usually be necessary to interpolate the return between two portfolios around the interquartile cutoff For example, L 25 for a composite with 16 portfolios is 0.25 x (16 + 1) = 4.25 The interquartile return will begin at the return of portfolio less 25% of the distance between the return for portfolios and This can be represented mathematically using rA for the return portfolio above the bound (i.e., portfolio in this case), rB for the portfolio below the bound (i.e., portfolio in this case), and Ly - nALy where nALy is the ordinal number of the portfolio above the bound: Interquartile range, however, will be unfamiliar to many investors and may merit additional disclosures such as: “Internal dispersion of portfolio returns for this composite has been presented for each annual period as the interquartile spread, calculated as the difference between returns at the 25th and 75th percentile.” Example 6-1 According to the GIPS, which of the following measures of internal dispersion is most appropriate for a composite whose returns are not normally distributed and prone to outliers? A Range B Interquartile range C Standard deviation Solution: B While standard deviation is the most commonly recognized measure of dispersion, it is not appropriate when the composite returns are not normally distributed The range would be affected by outliers, making it inappropriate for this composite The interquartile range measures the spread of the middle 50 percent of returns (capturing the median value at its center), which is not dependent on the returns being normally distributed nor is it heavily influenced by outliers ©2018 Wiley OVERVIEW OF THE GLOBAL INVESTMENT PERFORMANCE STANDARDS While the GIPS standards not require any particular measure of internal dispersion for portfolios in an annual period, it does require that firms present the three-year annualized ex p o s t standard deviation of monthly returns for the composite and the benchmark beginning January 1, 2011 This provides investors with some way to compare standardized measures of a strategy’s risk as implemented by various firms In composites where standard deviation will not meaningfully represent risk (e.g., strategies using derivatives or other cases with non-normal return distributions), firms must present an appropriate risk measure for the composite and the benchmark Firms must present only compliant performance after January 1, 2000, but may fink previous non-compliant periods with appropriate disclosures of the non-compliance and the periods involved Firms must not annualize partial annual period results, which would be similar to forecasting results for the remainder of the annual period Firms must present the percentage of composite assets represented by carve-outs, but only for periods beginning January 1, 2006 and prior to January 1, 2011 While all fee-paying discretionary accounts must be included in at least one composite, firms must not include any non-discretionary account in a composite Firms may, however, include non-fee paying accounts in a composite with relevant disclosures as to the end-ofperiod percentage of such assets This addresses the issue of management fees waived for a charitable organization, an employee, or for proprietary accounts Firms must also disclose the end-of-period percentage of composite assets in bundled-fee portfolios, if the composite includes any LOS 341: Explain the conditions under which the performance of a past firm or affiliation must be linked to or used to represent the historical performance of a new or acquiring firm Vol 6, pg 255 Firms must link performance of a past firm or affiliation to represent performance for the new or acquiring firm on a composite-specific basis if the following conditions are all met: • • • All investment decision-makers from the past firm or affiliation are employed by the new or acquiring firm; The decision-making process remains independent and in place at the new or acquiring firm; and The new or acquiring firm can support the reported performance with appropriate documentation Recommendations Although investors actually receive returns net of all expenses and fees, the GIPS standards recommend that firms present g ro ss-o f-fee returns (i.e., returns reduced for trading costs but not for investment management and administrative fees) Doing so allows investors to compare management’s strategy against an appropriate benchmark without deductions for potentially negotiable in vestm en t m a n a g em en t fe e s and potentially uncontrollable a d m in istra tive fe e s (i.e., all fees other than trading costs and investment management fees, including accounting, auditing, consulting, custody, etc.) ©2018 Wiley OVERVIEW OFTHE GLOBAL INVESTMENT PERFORMANCE STANDARDS Further, the GIPS standards recommend that firms present net-of-fee returns without deducting administrative expenses Therefore, the returns would ideally be represented as: Portfolio returns Less: Trading costs Gross-of-fee returns Less: Management fees Net-of-fee returns Less: Administrative expenses Client returns The required presentation of annual returns should also be supplemented with cumulative returns for the composite and benchmark, calculated using geometric Unking of historical returns In addition to the asset-weighted annual returns which must be presented, the GIPS standards recommend also presenting equal-weighted mean and median returns This will be especially useful to clients if the internal dispersion of portfolio returns for the composite is calculated on an equal-weighted basis (e.g., the standard deviation calculation) Presentations should also be updated at least quarterly, with presentation of returns for quarterly and/or monthly time periods While returns for partial annual periods must not be annuahzed, annualized composite and benchmark returns should be presented for periods longer than one year based on a geometric mean calculation: In addition to the required presentation of annuahzed three-year ex post standard deviation for composite and benchmark returns, the GIPS standards also recommend: • • • Same presentation for earlier annual periods; Annualized composite and benchmark total returns and three-year ex post standard deviation should be presented together; and Firms should present relevant composite-level ex post risk measures Recommendations also include compliance with GIPS requirements for all periods rather than as required for the period beginning January 1, 2000 Prior to that, firms may present non-compliant data with appropriate disclosures Further, firms should present more than 10 years of historical data, if apphcable LESSON 7: REAL ESTATE, PRIVATE EQUITY, AND WRAP FEE-SEPARATELY MANAGED ACCOUNTS The GIPS standards contain various exceptions to the general requirements and recommendations for real estate, private equity, and separately managed accounts with wrap fees Unless stated otherwise, the special GIPS provisions apply to periods beginning January 1, 2011 ©2018 Wiley OVERVIEW OF THE GLOBAL INVESTMENT PERFORMANCE STANDARDS Real Estate Provisions LOS 34n: Identify the types of investments that are subject to the GIPS standards for real estate and private equity Vol 6, pg 259 Real estate investments subject to the special provisions of GIPS include: • • • • Ownership of real property; Debt with equity participation; REIT and REOC private placement securities; and Commingled funds, property unit trusts, and insurance company separate accounts However, special real estate provisions not apply to publicly traded real estate securities (e.g., REITs), mortgage-backed securities, and real estate loans (if related only to a contractual interest rather than any participation in the underlying property dynamics) The general GIPS provisions also apply to private equity open-end and evergreen funds that allow continuing redemption and investment LOS 34o: Explain the provisions of the GIPS standards for real estate and private equity Vol 6, pp 259-265 Real estate must be valued using market value (defined in the 2005 edition of GIPS) prior to January 1, 2011 and in accordance with the GIPS valuation principles and definition of fa ir value for periods beginning January 1, 2011 Fair value will be defined in more detail in the valuation principles Real estate must be valued as follows: • • • Prior to January 1, 2008—At least once every 12 months; Beginning January 1, 2008 but prior to January 1, 2010—At least quarterly; and Beginning January 1, 2010—As of each quarter end or the last business day of each quarter Periodic valuations must be performed by an independently certified, designated, or licensed commercial property appraiser or valuer with no ties to the firm If no such certified appraiser or valuer is available in the local area, firms should ensure they use independent, well-qualified individuals with relevant experience The standards require third-party valuation as follows: • • Prior to January 1, 2012—Every 36 months; Beginning January 1, 2012—Every 12 months unless client agreements stipulate more or less frequently, but no less frequently than every 36 months Firms must present the percentage of composite assets as of annual period end subjected to external valuation Portfolio returns after subtracting actual transactions expenses must be calculated quarterly beginning January 1, 2006 Transactions expenses include actual trading expenses and any advisory, financial, investment banking, and legal fees related to buying/ ©2018 Wiley © OVERVIEW OFTHE GLOBAL INVESTMENT PERFORMANCE STANDARDS selling or recapitalizing/restructuring portfolio investments Gross-of-fee returns are portfolios after transactions expenses, while net-of-fee returns are gross-of-fee returns after investment management fees For periods after January 1, 2011, firms must separately calculate income returns and capital (i.e., component) returns using geometrically linked time-weighted returns Firms must calculate composite and component returns at least quarterly using asset-weighting individual portfolio returns Component returns can typically be divided into three types of strategies: • • • Core—Most of total return from income; Opportunistic—Most of total return from capital gains; and Value-added—Total return derived from both income and capital gains Firms may make compliant presentations by including gross-of-fee or net-of-fee total returns and component returns Firms should, however, present the same type of total return and component returns Further, firms should use the same method of calculating returns for all portfolios included in a composite Firms must disclose the method used to internally value property (e.g., using income capitalization rates computed from recent comparable sales or directly using a method of comparables) Firms must disclose material changes to valuation methodologies beginning January 1, 2011 Firms must not link GIPS-compliant performance with non-compliant performance beginning January 1, 2006 Firms must disclose periods of non-compliance prior to that date Firms must calculate and present a measure of internal dispersion that describes the high and low annual time-weighted return among the portfolios in a composite Recommendations include: • • • • Valuing investments for periods prior to January 1, 2012, using independent third-party appraisers at least annually, and preferably performing the third party valuation at the end of each annual period; Disclosing the accounting basis (i.e., U.S GAAP, IFRS, etc.) for portfolios and explaining the differences between valuations provided for performance reporting and financial reporting; Disclose for periods prior to January 1, 2011, material changes to valuation policies or methods; Presentation of both gross- and net-of-fee returns, percentage of total portfolio assets in a composite that are not real estate investments, and component returns for the benchmark, if available The GIPS standards also require that closed-end funds show not only time-weighted rates of return, but also internal rates of return since inception (SI-IRR) using quarterly or more frequent cash flows Similar calculations have been described elsewhere Returns using these quarterly calculations can then be annualized using the formula: aim 98 rQuarterly ©2018 Wiley OVERVIEW OF THE GLOBAL INVESTMENT PERFORMANCE STANDARDS The GIPS standards recommend that firms use daily cash flows to calculate SI-IRR, but must disclose the frequency of cash flows used in the return calculation In addition to composite definition described in the general provisions, closed end real estate funds must also describe the composite by vintage year and disclose how they have defined it The methods mentioned in the GIPS glossary for defining vintage year are the year of: • • First drawdown or capital call from investors; or First committed capital from investors is closed and legally binding Firms must present closed-end fund composite performance net of fees for each annual period Beginning January 1, 2011, firms must present non-annualized net-of-fees SI-IRR for an initial period less than a complete annual period, as well as for periods through a composite’s final liquidation date Firms must also disclose the final liquidation date Although net-of-fee SI-IRR m u st be presented, firms may choose to also show gross-of-fee SI-IRR but must show it for all periods for which net-of-fee SI-IRR has been presented Benchmarks must not only reflect the composite strategy, objective, or mandate, but must have the same vintage year Firms must also present end-of-period annual SI-IRR for the benchmark At the end of each annual period, firms must present a composite’s: • • • • • • • C u m u la tive c o m m itte d ca p ita l (i.e., capital committed by investors to the investment vehicle); P a id -in ca p ita l (i.e., the amount of committed capital drawn down by the investment vehicle); D istrib u tio n s since inception; In ve stm e n t m u ltip le or TVPI (i.e., total value to capital paid in since inception, where total capital can be computed as end-of-period residual value of the fund plus since-inception distributions); R e a liza tio n m u ltip le or DPI (i.e., since-inception distributions to since-inception paid-in capital); U n rea lized m u ltip le or RVPI (i.e., residual value to since-inception paid-in capital); P IC m u ltip le (i.e., paid-in capital to committed capital) Private Equity Provisions Private equity investments subject to the special provisions of GIPS will typically be structured as a limited partnership, which has a general partner to select and manage investments and administer fund business, and limited partners who invest in the fund Private equity investments must be valued at least annually in accordance with the GIPS valuation principles and definition of f a i r value for periods beginning January 1, 2011 For prior periods, firms may use either the GIPS 2005 edition P riva te E q u ity V aluation P rin c ip le s or the 2010 edition G IP S va lu a tio n p rin c ip le s Firms must calculate annualized SI-IRR using daily-weighted cash flows for periods beginning January 1, 2011 and either daily or monthly for prior periods Firms must include distributions of stock as cash flows valued as of the date of distribution, and must disclose the period used for weighting for periods prior to January 1, 2011 ©2018 Wiley OVERVIEW OFTHE GLOBAL INVESTMENT PERFORMANCE STANDARDS Firms must calculate private equity returns gross-of-fee returns after deducting actual transactions expenses Net-of-fees returns exclude management fees and c a rrie d interest (i.e., the investment profits allocated to general partners) Net-of-fee returns for private equity fund-of-funds must deduct management fees and carried interest from the fundof-funds a n d each underlying fund Firms must disclose whether any expenses other than transaction fees have been deducted in calculating gross-of-fee returns, and whether any expenses other than transactions fees and management fees have been deducted in calculating net-of-fee returns Therefore, firms must disclose carried interest if any In addition to composite definition described in the general provisions, private equity funds must also describe the composite by vintage year and disclose how they have defined it Fund-of-funds must be included in a fund-of-funds composite described by general provisions and vintage year Mandatory disclosures for each composite include vintage year and method of determination, as well as final liquidation date, if applicable Firms must disclose valuation methods and, beginning January 1, 2011, firms must disclose significant changes to those valuation methods The GIPS standards recommend disclosing such significant changes for prior periods In addition to the G IP S V aluation P rin cip les, firms must disclose whether they use additional industry-specific valuation guidelines Firms must disclose periods of non-GIPS compliant SI-IRR presented for periods prior to January 1, 2006 Firms must not present non-compliant performance after that date Firms must disclose the method used to calculate a composite’s benchmark In P M E (p u b lic m a rk e t e q u iva len t ) benchmarks, firms apply the composite’s external cash flows to a hypothetical capital market index In other words, capital calls are assumed to buy the index while distributions are assumed to be sold from the index Firms must initially present at least five years of performance as required by the general provisions (or since inception if less than five years) and an additional year each annual period thereafter Firms must present gross- and net-of-fees SI-IRR for partial periods at composite initiation or liquidation beginning January 1, 2011 Beginning January 1, 2011, fund-of-funds composites defined only by their strategy objective, or mandate must present: • • Aggregated, gross-of-fee SI-IRR for underlying investments as of the most recent period end; and A benchmark that reflects the composite strategy and vintage year of the underlying investments The GIPS standards recommend but not require that the percentage of direct investments included in composites of fund-of-fund assets be presented for earlier periods The GIPS standards also recommend but not require that beginning January 1, 2011, fund-of-funds composites defined only by their vintage year present gross-of fees SI-IRR for underlying investments grouped by strategy, objective, or mandate This is in addition to the other performance measures Beginning January 1, 2011, fund of funds composites are also required to separately report the percentage of assets invested in direct investments and in fund vehicles The GIPS standards recommend reporting these percentages in earlier periods ©2018 Wiley OVERVIEW OF THE GLOBAL INVESTMENT PERFORMANCE STANDARDS For all private equity composites, firms must report for each annual period the cumulative committed capital, paid-in capital since inception, and distributions since inception Firms must also present the TVPI, DPI, PIC, and RVPI multiples defined earlier Recommendations for private equity investments also include: • • • Quarterly or more frequent valuation; SI-IRR calculation using daily external cash flows for periods before January 1, 2011 ; and Disclosing and explaining differences between valuations provided for performance reporting and financial reporting Wrap Fee/Separately Managed Account (SMA) Provisions LOS 34p: Explain the provisions of the GIPS standards for wrap fee/ separately managed accounts Vol 6, pp 268-270 Separately managed accounts (SMAs) involve a portfolio of subaccounts, often managed by third-party sub-advisors The SMA sponsor charges a wrap fee that bundles together complex charges for trading, custody, investment management, and administration Thus, SMAs are often known as “wrap fee accounts.” The GIPS SMA provisions apply to presentations beginning January 1, 2006, but only when a sponsor stands between the client and an investment manager of a subaccount claiming GIPS compliance and not to other types of bundled fees The provisions only apply to model or overlay portfolios when the investment management firm for the overlay has discretionary management SMA provisions of GIPS require firms to include bundled-fee portfolios in at least one composite in accordance with their inclusion policies, or define separate composites to include/exclude SMA portfolios Alternatively, firms may redefine themselves into a separate division or firm that manages SMA portfolios SMA portfolios are subject to the same verification and reporting requirements as other portfolios with some exceptions An SMA sponsor will often rely on investment management firms to present GIPS compliant performance data to its prospects and clients An investment management firm’s compliant presentation must include composites that contain SMA portfolios, and must disclose the percentage of composite assets represented by bundled fee portfolios Although including non-SMA and SMA portfolios may increase the assets under management for a composite and increase the investment manager’s stature, including SMA portfolios that reduce performance by the entire bundled fee (rather than just transactions costs) also reduce the gross-of-fee and net of fee performance of the strategy presented to clients and could result in a competitive disadvantage To avoid this problem, subadvisors may either rely on sponsor data (a potentially dubious prospect) or maintain a separate set of accounting records for investment performance reporting (i.e., shadow accounting) on portfolios managed for an SMA Investment managers may wish to provide sponsor-specific composites (i.e., apply only to the sponsor’s clients) Firms must disclose the sponsor’s name and, if the presentation is designed to solicit new business and does not include performance net of bundled fees, must indicate that the presentation is only for the sponsor’s use However, sponsors must ©2018 Wiley OVERVIEW OFTHE GLOBAL INVESTMENT PERFORMANCE STANDARDS present composite performance to SMA prospects and clients net of the entire wrap fees applied If a composite currently contains but did not always contain SMA portfolios, firms must disclose periods when it did not contain SMA portfolios Firms may not link noncompliant results for periods after January 1, 2006 with compliant results, but may link pre-2006 non-compliant results with compliant periods after January 1, 2006 and may only present compliant performance for periods beginning with 2006 LESSON 8: VALUATION PRINCIPLES AND ADVERTISING GUIDELINES GIPS VALUATION PRINCIPLES LOS 34q: Explain the requirements and recommended valuation hierarchy of the GIPS Valuation Principles Vol , pp 270-273 Beginning January 1, 2011, the GIPS standards require firms to determine fair value for assets, defined as the amount exchanged in a current transaction between willing, unrelated parties acting in their own interests with knowledge and prudence If available, firms must use the objective, observable, unadjusted market price quoted on the measurement date in an active market If not available, firms must use their best estimate of market value, including any accrued income, and disclose use of subjective, unobservable inputs if material to composite performance Private equity, real estate, and private agreements among counterparties (e.g., swaps) are examples of assets for which market value may be problematic The valuation hierarchy involves: • • • • Objective, observable, unadjusted market price Quoted prices for identical or similar investments in markets that are not active (i.e., non-current prices, few transactions for the investment, or widely varying quotations among market makers) Observable market-based inputs for the investment other than quoted prices Subjective, unobservable inputs The GIPS standards require firms to document valuation policies, methods, and hierarchies, and recommend that firms develop hierarchies specific to assets in the composite Firms must make these valuation policies available to clients upon request Firms should also fist risk-adjusted cash flows and discount rates used Real Estate Firms are required to periodically subject assets to external valuation by third parties who adhere to the standard setting body governing their conduct Firms may not provide incentive compensation that could potentially inflate the appraiser’s estimate of value The GIPS standards further recommend that the external appraiser be rotated every three to five years, and that the value estimate be presented as a single value (rather than as a range of values) 102 ©2018 Wiley OVERVIEW OF THE GLOBAL INVESTMENT PERFORMANCE STANDARDS Private Equity In addition to previously mentioned requirements, appraisers must use the facts and circumstances of the investment to determine the most appropriate valuation method These considerations may include but may not be limited to: • • • Data quality and reliability used for each method; Comparability of firms and transactions; and Additional considerations unique to the valuation target GIPS ADVERTISING GUIDELINES LOS 34r: Determine whether advertisements comply with the GIPS Advertising Guidelines Vol 6, pp 273-275 Advertising includes written or electronic materials disseminated to one or more clients or prospective clients These guidelines not apply to presentations to individuals or multi-individual entities making a single investment decision (i.e., investment committees or boards of directors), nor they apply to advertisements that not mention the GIPS standards In order to claim compliance with the GIPS standards, firms must either include a compliant performance presentation in advertising, or comply with the GIPS Advertising Guidelines (referred to as “the Guidelines” in this section) Following the Guidelines does not exempt the firm from other areas of compliance, or from presenting a compliant presentation, but allows it to reduce the advertising space required All advertising claiming GIPS compliance must include a definition of the firm, and instructions for obtaining a list of composite descriptions and a compliant presentation for the composite Compliant advertising that includes performance information must additionally include: • • • • The composite description; Indication of presentation gross- or net-of-fees; Currency used to express returns; and One of the following sets of total returns: o One-, three-, and five-year annualized composite returns through the most recent period; o Period-to-date composite returns in addition to the annualized returns above, for the same time period as the compliant presentation; or o Period-to-date composite returns in addition to five years of annual returns, for the same time period as the compliant presentation Whichever alternative performance is presented, returns for less than one year must not be annualized and period end dates must be provided Return since inception must be provided for composites in existence less than five years For example, under the first option, annualized returns for a composite in existence four years would be provided for one, three, and four years Advertising performance requires firms to disclose, if material, the nature and extent of derivatives, leverage, and short positions with a description sufficient to identify risks ©2018 Wiley 103 OVERVIEW OFTHE GLOBAL INVESTMENT PERFORMANCE STANDARDS Other GIPS compliant information may be presented as long as it does not receive greater prominence in the advertising than the required information Advertisements must include the same benchmark provided in the compliant presentation, and must be presented for the same periods as composite performance Firms must disclose why no benchmark is presented LESSON 9: VERIFICATION AND OTHER ISSUES Verification LOS 34s: Discuss the purpose, scope, and process of verification Vol 6, pp 275-280 Verification is the process of a third-party assessment of a firm’s compliance with the GIPS standards for constructing composites and calculating and presenting composite performance While verification cannot insure the accuracy of any particular composite presentation, it can provide additional confidence in the firm’s claim of compliance with the GIPS standards The GIPS standards recommend but not require verification If undertaken, verification must be performed by an independent third party A firm must not state that it has been verified unless the verifier has issued a verification report indicating that it has met the GIPS requirements for constructing composites and calculating and presenting composite performance Verifiers In performing verification, verifiers may rely on the verifier’s own work, the work of other verifiers, or on the work of qualified, independent third parties The principal verifier must, however, document the competency, objectivity, qualifications, and reputation of the third party Reports A verification report attests to firmwide compliance; a verification report cannot be issued for some subset of the firm’s composites Therefore, the GIPS standards prohibit firms from claiming that a particular composite has been verified However, firms may choose to have a detailed examination performed for a specific composite and can state that composite has been examined if they receive an examination report for the composite The verification report must indicate that required verification procedures have been followed A verifier finding fault with the firm’s composite descriptions, method of calculating and presenting performance, or data gathering and retention, must provide a statement denying a verification report Scope GIPS standards recommend that a firm undergo verification of all periods for which it claims compliance The minimum period is one year or since inception, if less than one year ©2018 Wiley OVERVIEW OF THE GLOBAL INVESTMENT PERFORMANCE STANDARDS Verifiers may use sampling as the basis for firmwide verification with the sample size dependent on: • • • • • • • Assets under management; Number and type of composites; Number of portfolios in composites; The method of calculating performance; Use of third-party software to construct and maintain composites and calculate performance; Use of external performance measurement services; and Internal control structure Verification Procedures Verifiers must be satisfied that the firm meets fundamental requirements In order to accomplish that, verifiers must understand the requirements and the firm, as well as complete the procedures for verification Pre-Verification Verifiers must understand the GIPS standards and updates, interpretations and clarifications, Guidance Statements, and Questions & Answers published by CFA Institute and the GIPS Executive Committee Verifiers must understand applicable laws and regulations and differences between these and the GIPS standards Next, verifiers must learn about firm operations and how the firm complies with GIPS requirements and implements recommendations Verifiers must understand the firm’s GIPS-related procedures and compliance policies, especially with regard to performance calculations, and ensure they are documented Verification Verifiers must determine that the firm has met fundamental requirements of the GIPS standards: • • • • • • • • • Consistent previous and current firm definition; Consistent application of policies and procedures to ensure existence and ownership of client assets; Appropriate calculation and disclosure of total firm assets; Composites are appropriately defined and maintained; Policies for creating and maintaining composites have been consistently applied; The firm’s list of composite descriptions is complete; All fee-paying, discretionary portfolios have been included in at least one composite and portfolios have not been excluded from the appropriate composite; The firm has consistently applied its definition of discretion; and Composite benchmarks reflect the strategy, objective, or mandate For a sample of portfolios, verifiers must: • • Determine consistent firm treatment for data related to accounting treatment and classification of portfolio flows (e.g., external cash flows, income, fees, and taxes); Ensure appropriate valuation methodologies for investments; ©2018 Wiley 105 OVERVIEW OFTHE GLOBAL INVESTMENT PERFORMANCE STANDARDS • • • Recalculate rates of return, taking into account proper recognition of fees and expenses; Validate the discretionary status of portfolios; and Determine whether they have been appropriately included in at least one composite, including appropriate movement among composites (if applicable) For a sample of composites, verifiers must: • • • • Validate applicability of and calculations for composite and benchmark dispersion and risk; Validate applicability of the benchmark as a comparison for the composite; Sample custom benchmark data to ensure correct calculation and compliance with the required benchmark disclosure; and Ensure that they include all required information and disclosures Verifiers must document their judgments and conclusions regarding compliance Toward that end, verifiers must obtain a representation letter from the firm assuring consistent application of the firm’s policies and procedures during the examination period The letter must also contain other representations made to the verifier during the verification process AFTER-TAX RETURN CALCULATION CHALLENGES LOS 34t: Discuss challenges related to the calculation of after-tax returns Vol 6, pp 280-283 The GIPS standards not require firms to present after-tax returns for composites However, many firms manage investment portfolios for and market tax-aware strategies to individuals and institutions subject to taxation The GIPS Executive Committee has opted to remove its Guidance Statement for country-specific tax issues in favor of transferring responsibility to GIPS country sponsors Effective January 1, 2011, compliant presentations will include after-tax performance as supplemental information subject to the Guidance Statement on the Use of Supplemental Information Methods Pre-Liquidation Method A pre-liquidation calculation recognizes taxes actually incurred or accrued during the period, but does not consider the liability or benefit embedded in unrealized gains or losses Not all potential gains will be realized by the portfolio because they may be offset with losses However, the investment manager has no idea precisely what the ex ante net effect will be Therefore, the pre-liquidation method completely disregards prospective capital gains and losses Mark-to-Liquidation Method Mark-to-liquidation assumes taxes on unrealized gains are payable at the end of the report period This method not only ignores future changes in valuation that may increase or 106 ©2018 Wiley OVERVIEW OF THE GLOBAL INVESTMENT PERFORMANCE STANDARDS decrease tax liability, but also ignores the additional future gains that may accrue to the as yet untaxed gain Estimated Liquidation Method This method estimates the timing and amount of taxable liquidations over some extended period This requires a method of estimating future returns and tax outcomes No universally accepted method has been developed Tax Rate Challenges Different tax rates apply to different types of securities and return periods In addition, client tax rates vary based on income, wealth, or other factors specific to the tax code to which they are subject Benchmarks After-tax benchmarks should have all the attributes of pre-tax benchmarks and, in addition, reflect client tax liability However, the rates used for various types of income or gain cannot adequately reflect every possible client tax situation Although some benchmark providers have published benchmarks net of dividend withholding tax, little attention has been paid to other types of tax In addition to considering dividends, interest, and price changes, firms would have to develop simplifying assumptions that could reflect the provider’s rules for constmcting and rebalancing the index, turnover of securities that generates tax liability, stock splits, and other corporate actions Mutual funds and ETFs benchmarked to capital indexes are imperfect because of their fees and deviation from benchmark External cash flows and investment manager transactions affect mutual fund tax liability ETFs may be somewhat better suited, however, because they not experience turnover or reflect other investor actions Non-Discretionary Tax Events Managers may have to liquidate securities to satisfy customer withdrawal requests While using time-weighted returns minimizes the impact of these non-discretionary external cash flows, they generate taxes that will impact after-tax return Managers who could otherwise time discretionary trading to consider tax liabilities must have a method of adjusting for non-discretionary tax events, such as simply removing non-discretionary capital gains by adding back tax on hypothetical realized gains However, that method introduces the potential incentive for managers to liquidate assets with the greatest embedded capital gain This can be solved by adding back gains tax hypothesized from selling a proportionate share of all securities in the portfolio Non-discretionary tax loss harvesting will tend to improve after-tax returns Firms should disclose net harvested tax losses Until other methods are developed, portfolio tax efficiency measures presented with performance can assist tax paying clients in selecting investments ©2018 Wiley ... Securities 197 197 198 204 2 15 218 222 2 23 Wiley Study Guide for 2018 Level III CFA Exam Volume 4: Alternative Investments, Risk Management, & Derivatives Study Session 13: Alternative Investments... 978-1-119- 436 11-9 (ePub) ISBN 978-1-119- 436 10-2 (ePDF) Contents About the Authors xi Wiley Study Guide for 2018 Level III CFA Exam Volume 1: Ethical and Professional Standards & Behavioral Finance Study. .. Influences Market Behavior 1 65 1 65 168 169 172 178 179 Wiley Study Guide for 2018 Level III CFA Exam Volume 2: Private Wealth Management & Institutional Investors Study Session 4: Private Wealth