2019 Level III Mock Exam PM The afternoon session of the 2019 Level III Chartered Financial Analyst Mock ® Examination has 60 questions To best simulate the exam day experience, candidates are advised to allocate an average of 18 minutes per item set (vignette and multiple choice questions) for a total of 180 minutes (3 hours) for this session of the exam Questions Topic Minutes 1–6 Ethical and Professional Standards 18 7–12 Behavioral Finance 18 13–18 Private Wealth 18 19–24 Economics 18 25–30 Asset Allocation 18 31–36 Fixed Income 18 37–42 Fixed Income 18 43–48 Equity 18 49–54 Alternative Investments 18 55–60 Global Investment Performance Standards Total: 18 180 By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to currently registered CFA candidates Candidates may view and print the exam for personal exam preparation only The following activities are strictly prohibited and may result in disciplinary and/or legal action: accessing or permitting access by anyone other than currently-registered CFA candidates; copying, posting to any website, emailing, distributing and/or reprinting the mock exam for any purpose © 2018 CFA Institute All rights reserved 2019 Level III Mock Exam PM 2019 LEVEL III MOCK EXAM PM Athena Investment Services Case Scenario Caitlyn Wilson, CFA, recently started her own asset management company, Athena Investment Services The board of directors of Athena adopted both the CFA Institute Code of Ethics and Standards of Practice (Code and Standards) and the CFA Institute Asset Manager Code of Professional Conduct (Asset Manager Code) to institutionalize ethical behavior within the firm The board also implemented half-yearly staff performance reviews, including an assessment of each manager’s ability to ensure their department’s compliance with the both the Code and Standards and the Asset Manager Code Six months into the first financial year, Wilson meets with all of the managers to assess each department’s compliance Wilson asks the compliance officer, Mark Zefferman, CFA, to make an opening statement to set the right tone for the meeting Zefferman states, “At a minimum, we are responsible for implementing procedures addressing the general principles embedded in the six components of the Asset Manager Code As stated below, we must: Statement Statement Statement Act with skill, competence, and diligence while exhibiting independence and objectivity when giving investment advice, Put our clients’ interests above the firm’s when appropriate and act in a professional and ethical manner at all times, and Communicate with our clients in a timely and non- misleading manner and obey all rules governing capital markets.” Zefferman adds, “With regard to the last statement, please be aware that we must implement the new anti-money-laundering regulations introduced by our local regulator, effective the first quarter of next year I have analyzed the new regulations and have found that all of the local requirements are part of regulations recently introduced in Europe, where only a few of our clients reside When we start taking on new clients based in Singapore in the second half of next year, we will also need to follow that country’s anti- money-laundering regulations The local anti-money-laundering legislation appears to be embedded in the Singapore regulations as well.” Wilson continues, “I would like each of you to explain how the implementation of the Asset Manager Code within your department is being supervised Let us start with Shenal Mehta, our client service manager.” Mehta states, “With respect to the Asset Manager Code relating to client services, we have ensured that we enforce the following policies: All disclosures are accurate and complete, and our calculations are shown, no matter how complicated We also ensure that the client sees some sort of communication from us when they request it and that the marketing material sent to clients is checked by the compliance department for accuracy and completeness.” 2019 Level III Mock Exam PM Anders Peterson, CFA, chief investment officer, states, “In addition to what Mehta has said, I have the following comments: Comment Comment Comment On occasion, we are able to acquire securities we expect will be particularly strong performers, such as oversubscribed initial public offerings In order to ensure that all clients are treated fairly, each client portfolio is given the same number of shares Any communication with clients is kept confidential and is only accessible by authorized personnel A gift and entertainment policy is in place to help ensure our managers and analysts keep their independence and objectivity.” Richard Gilchrist, head of portfolio administration, then adds, “Our portfolio policies call for all assets to be valued at fair market prices using third-party pricing services When a security price is not available from the service, a committee whose members have experience in valuing illiquid assets uses the hierarchy dictated by Global Investment Performance Standards (GIPS) to determine values.” Wilson concludes the meeting by mentioning that Athena must even more to ensure its clients continue to have faith in Athena’s ability to protect and grow their assets She recommends they disclose their risk management practices, which identify, measure, and manage the various risk aspects of the business to clients and the regulator She adds, “In addition, we need to create a business continuity plan covering data backup and recovery, alternate trading systems if the primary system fails, and methods to communicate to employees, critical vendors, and suppliers in case of an emergency that could disrupt normal business functions.” Which of Zefferman’s opening statements is inconsistent with the Asset Manager Code of Professional Conduct? A Statement B Statement C Statement C is correct Zefferman states that the firm is responsible for putting clients’ interests above the firm’s when appropriate The General Principles of Conduct embedded in the six components of the Asset Manager Code state that managers have the responsibility of acting for the benefit of clients The code does not stipulate that this responsibility is applicable only when appropriate A is incorrect because the principles reflected in the statement are correct B is incorrect because the principles reflected in the statement are correct Asset Manager Code of Professional Conduct LOS b General Principles of Conduct Which of the following anti-money-laundering laws must Athena currently comply with to be consistent with the CFA Institute Standards of Professional Conduct? A Local B Singaporean 2019 Level III Mock Exam PM C European C is correct Zefferman, as a CFA charterholder, will be responsible for ensuring that Athena complies with the stricter anti-money-laundering laws of Europe, where some of its clients reside, as per Standard I(A)–Knowledge of the Law Europe’s new laws, which encompass and exceed the local anti-money-laundering regulations, are already in place; therefore, these are the regulations that must be currently followed A is incorrect because Zefferman will be responsible for implementing the more strict laws of Europe that are currently in place B is incorrect because Zefferman will be responsible for implementing the more strict laws of Europe that are currently in place Guidance for Standards I–VII LOS b Standard I(A)–Knowledge of the Law Which of Mehta’s client service policies is consistent with the Asset Manager Code of Professional Conduct? A Types of disclosures B Communication timing C Marketing material reviews C is correct Section D, Risk Management, Compliance, and Support, of the Asset Manager Code states that portfolio information provided to clients should be reviewed by an independent third party The compliance department would be considered an independent third party because compliance is not involved with compiling or presenting the information to clients According to Section F, Disclosures, disclosures should be truthful, accurate, complete, and understandable It is unlikely that clients would easily understand complicated calculations Section F, Disclosures, also calls for communications with clients to be on an ongoing and timely basis Communication with clients only when they ask for it would not be consistent with the Asset Manager Code It is recommended that communication be at least on a quarterly basis A is incorrect because according to Section F, Disclosures, disclosures should be truthful, accurate, complete, and understandable It is unlikely that clients would easily understand complicated calculations B is incorrect because Section F, Disclosures, calls for communications with clients to be on an ongoing and timely basis Annual communication would not be considered timely Asset Manager Code of Professional Conduct LOS c Section A, Loyalty to Clients; Section D, Risk Management, Compliance, and Support; Section F, Disclosures Which of Peterson’s comments is inconsistent with the Asset Manager Code of Professional Conduct? A Comment B Comment C Comment 2019 Level III Mock Exam PM A is correct Section B(6)(b), Investment Process and Actions, requires clients to be treated equitably, not equally Clients have different investment objectives and risk tolerances, so treating clients equally would be inconsistent with the Asset Manager Code B is incorrect because the policy is consistent with the Asset Manager Code C is incorrect because the policy is consistent with the Asset Manager Code Asset Manager Code of Professional Conduct LOS c Section A, Loyalty to Clients; Section B, Investment Process and Actions Are Gilchrist’s comments regarding portfolio valuation consistent with the Asset Manager Code of Professional Conduct? A Yes B No, with regard to third-party pricing services C No, with regard to the process used to price illiquid securities A is correct Section E, Performance and Valuation, of the Asset Manager Code calls for the use of fair market values sourced by third parties when available, and when such third-party prices are not available, the code calls for the use of “good faith” methods to determine fair value Athena’s policy appears consistent with this requirement In terms of client reporting, monthly valuation reports would be consistent with the call for timely reporting B is incorrect because Gilchrist’s valuation methodology using fair value and third- party valuers is consistent with the Asset Manager Code C is incorrect because Gilchrist’s monthly valuation reports to clients would be considered consistent with the Asset Manager Code Asset Manager Code of Professional Conduct LOS c Section E, Performance and Valuation; Section F, Disclosures Are Wilson’s closing remarks consistent with recommended practices and procedures designed to prevent violations of the Asset Manager Code of Professional Conduct? A No, with regard to the business continuity plan B No, with regard to disclosure of the firm’s risk management process C Yes A is correct At a minimum, Section D, Risk Management, Compliance, and Support, of the Asset Manager Code recommends that a business continuity plan include plans for contacting and communicating with clients during a period of extended disruption Wilson’s continuity plan includes no such strategy Wilson’s recommendation for disclosing the firm’s risk management process to both clients and regulators goes beyond the code recommendation, which is to disclose the risk management process only to clients 2019 Level III Mock Exam PM B is incorrect because Wilson’s recommendation for disclosing the firm’s risk management process goes beyond the Code recommendations to disclose the risk management process to just clients, not to regulators Wilson recommends they disclose to both C is incorrect because Wilson’s recommendation regarding the business continuity plan did not include the recommended action of having a plan to contact and communicate with clients during a period of extended disruption Asset Manager Code of Professional Conduct LOS d Section D, Risk Management, Compliance, and Support; Appendix 6, Recommendations and Guidance Emerald Private Bank Case Scenario Laura Davidson is a financial advisory partner with Emerald Private Bank (Emerald) Emerald is based in Dublin, Ireland, and manages money on behalf of high-net-worth individual investors, foundations, and endowments Davidson works in Emerald’s private wealth group (PWG) This group is tasked with meeting clients, developing financial plans, and implementing recommendations from Emerald’s investment committee The PWG meets weekly to review new client relationships and to discuss the most appropriate approach for working with each client Emerald believes there are significant benefits to incorporating behavioral finance as part of their client assessment process and has recently made changes to this effect During preparation for the weekly PWG meeting, Davidson reviews the financial holdings of three new clients along with their risk assessment questionnaires Her observations are summarized in Exhibit 1 Exhibit 1 Client Assessment Highlights Client Assessment Notes Kyra Conner Conner is a mid-level executive at a publicly traded technology company Approximately 80 percent of her defined-contribution plan is invested in her own company’s stock Conner focuses on short-term performance and is not comfortable with change Her assessment indicates she is not comfortable taking excessive risks Michael Donnelly Donnelly recently sold a large publishing firm that he founded 20 years ago Although he has substantial assets, he spends at a rate that does not appear to be sustainable He has a very high risk tolerance and enjoys chasing high-risk investments recommended by friends He is strong willed and questions the benefits of portfolio diversification Alan O’Driscoll O’Driscoll is a retired biotechnology executive His investment portfolio is comprised of a variety of mutual funds and stocks he has acquired over the years based on recommendations from friends and colleagues He tends to be drawn to the latest, popular investment themes He is indicated as a moderate risk taker During the meeting, fellow adviser Liam Roche makes the following observation based on the information in Exhibit 1: “Mr Donnelly should respond favorably to education focused on how the investment program affects financial security, retirement planning, and future generations However, Ms Connor and Mr O'Driscoll will respond better to education on portfolio metrics, such as the Sharpe Ratio.” 2019 Level III Mock Exam PM Amanda Kelly is an investment strategist and a member of Emerald’s investment committee Kelly sits in on the PWG meeting to provide an update on the firm's investment themes and positioning Emerald has developed a multifactor macro model to forecast such variables as GDP growth and interest rate movements At the meeting, Kelly provides detailed information about the macro model, including many statistics on how the factors have performed using both in-sample and out-of-sample backtesting The model appears to have had a good track record of predicting changes in the macro environment over time As part of her investment update, Kelly notes that the macro model predicts that interest rates in Europe are going to revert to their historical averages over the next three years and that this move will start within the next six to nine months Davidson asks Kelly if recent unprecedented monetary policy actions by the Bank of England and European Central Bank have affected the reliability of the model Kelly responds that because the macro model incorporates more than 100 different variables, central bank policies are accurately accounted for Later that day, Kelly attends Emerald’s weekly investment committee meeting Kelly brings up Davidson's concerns regarding how central bank activity may affect the accuracy of their macro model Emerald's chief investment officer (C IO), wh o chairs the meeting, dismisses Davidson's concerns as uninformed The r est o f t he committee members agree The C IO t hen s uggests u pdating t heir s tock s election model to incorporate a price momentum factor Kelly states that she is concerned that momentum will not be effective across all sectors The CIO counters that because a number of behavioral biases support the persistence of price momentum, they would be foolish not to incorporate this factor After a brief discussion, the other committee members agree with the CIO, and momentum is added to the stock selection model Following the meeting, Kelly is frustrated and writes an email to the CIO with suggestions she believes will improve the dynamics of the investment committee in the future Her recommendations include the following: Spending more time analyzing prior committee decisions Structuring the committee to ensure a higher level of common skills and experiences Requesting stated opinions from members prior to any formal committee discussion Benefits of the recent changes to Emerald’s client assessment process least likely include: A improving Emerald’s client retention metrics B reducing portfolio risk C closer adherence to client expectations B is correct Incorporating behavioral finance does not have a direct impact on portfolio risk In some cases, this approach will help encourage a reduction in portfolio risk, but it may also help other clients to take on more risk as appropriate Investing as the client expects and improvements to client retention metrics are both benefits of incorporating behavioral finance A is incorrect Improving the advisory practice is a likely benefit of incorporating behavioral finance 2019 Level III Mock Exam PM C is incorrect Investing as the client expects is a likely benefit of incorporating behavioral finance Behavioral Finance and Investment Processes LOS b Section Roche’s observation regarding client education is least likely accurate for which client? A Kyra Conner B Alan O’Driscoll C Michael Donnelly A is correct Both Conner and Donnelly are exhibiting emotional biases When advising emotionally biased investors, advisers should focus on explaining how the investment program being created affects such issues as financial security, retirement, or future generations rather than focusing on quantitative details The recommendation for Conner would be more suited for a cognitively biased investor O’Driscoll is a cognitively biased investor (friendly follower) As such, focusing on such metrics as the Sharpe Ratio would be appropriate for this client B is incorrect O’Driscoll is a cognitive investor, so focusing on metrics such as the Sharpe ratio would be appropriate for this client C is incorrect Donnelly is an emotional investor, and this approach is appropriate Behavioral Finance and Investment Processes LOS b Section Which behavioral investor type most likely describes Michael Donnelly? A Independent individualist B Friendly follower C Active accumulator C is correct Donnelly is entrepreneurial and created his own wealth He lacks spending controls, does not believe in the benefits of portfolio diversification, has a high risk tolerance, and prefers high-risk investments recommended by friends These are all attributes of an active accumulator A is incorrect Independent individualists have a medium to high risk tolerance whereas Donnelly has a very high risk tolerance While some of the traits are similar, active accumulator more closely describes this client B is incorrect Friendly followers have a low to medium risk tolerance whereas Donnelly has a very high risk tolerance Behavioral Finance and Investment Processes LOS a Section 10 In Kelly’s response to Davidson, she is most likely exhibiting: 2019 Level III Mock Exam PM A gambler’s fallacy B self-attribution bias C illusion of control bias C is correct The illusion of control bias can be encouraged by complex models The illusion of control can lead to analysts being overly confident when forecasting complex patterns, such as future interest rate movements B is incorrect With self-attribution bias, analysts take personal credit for successes and attribute failures to external factors outside of their control There is no evidence that Kelly is suffering from this bias A is incorrect The gambler’s fallacy is a misunderstanding of probabilities in which analysts wrongly project reversal to a long-term mean This bias is caused by a faulty understanding of random events and expecting patterns to repeat While Kelly is expecting rates to increase to historical averages, she is basing this on output from the macro-model Behavioral Finance and Investment Processes LOS e Section 11 Which of the following biases least likely provides behavioral support for the factor being added to the stock selection model? A Framing B Hindsight C Availability A is correct Framing bias is a type of cognitive error in which a person answers a question differently based on the way in which it is asked This behavior is unlikely to explain the persistence of momentum Regret is a type of hindsight bias that can result in investors purchasing securities after a significant run-up in price because of a fear of not participating This bias could explain momentum With availability bias, also referred to as the recency effect, the tendency to recall recent events more vividly can result in investors extrapolating recent price gains into the future This bias could also explain momentum B is incorrect Regret is a type of hindsight bias that can result in investors purchasing securities after a significant run-up in price due to fear of not participating This could explain momentum C is incorrect With availability bias, also referred to as the recency effect, the tendency to recall recent events more vividly can result in investors extrapolating recent price gains into the future This could explain momentum Behavioral Finance and Investment Processes LOS g Section and 12 Which of Kelly’s recommendations is least likely to be effective? A Recommendation B Recommendation C Recommendation 10 2019 Level III Mock Exam PM A is correct It is recommended that investment committees be composed of people with differing skills and experiences, not similar as Kelly has suggested Decision makers are most likely to learn to control harmful behavioral biases when they have repeated attempts at decision making and there is good quality feedback on prior outcomes The investment committee chair should actively encourage alternative opinions so that all perspectives are covered Asking for individual views prior to discussion can help mitigate the impact of group thinking B is incorrect Individuals may moderate their own views in a committee setting to fit with consensus The chair should actively encourage alternate opinions so that all perspectives are covered Asking for individual views prior to discussion can help mitigate the impact of group thinking C is incorrect It is recommended that investment committees are comprised of people with differing skills and backgrounds, not similar as Kelly has suggested Behavioral Finance and Investment Processes LOS f Section 8.6 Geri Buylak Case Scenario Geri Buylak, a financial advisor, is preparing for a meeting with Kasey McLoughlin, the recent widow of, Bryn McLoughlin, a resident of the country of Weshvia From her files of the McLoughlin family, Buylak notes the following which she thinks might be relevant in the meeting: ■ Kasey was Bryn’s second wife ■ Bryn has been the sole provider for his grandson Paulo for the past 20 years; Paulo was orphaned at the age of three and initially lived with Bryn and his first wife Mainly as a result of the stress arising from the disabilities and medical problems that Paulo developed, Bryn’s first marriage ended in divorce within one year Two years later, it was determined that Paulo would be better off living in a private care facility in the sunny warm climate of Izlandia where he continues to live today ■ To insure that Paolo’s future needs would be met, shortly after the child was orphaned, Bryn purchased a €3 million life insurance policy on his own life for a one-time premium of €500,000 At the same time, Bryn’s father bought a similar, but smaller policy on his own life Ownership of both policies was transferred to a discretionary irrevocable trust with Paolo as the primary beneficiary and the University of Izlandia as the remainderman ■ Buylak was appointed as the investment advisor for the trust ■ Bryn and Kasey were married two years after Bryn’s divorce Buylak had been faxed a copy of Bryn’s will and in combination with other information she had available made the following notes: ■ Two years ago, Bryn disposed of his very successful construction company and invested the proceeds in two overseas distribution centers The first property is located in the country of Landlochen and at the time of his death it was jointly owned with Kasey with the right of survivorship For the second of these properties Bryn’s will named Paolo as the beneficiary of the property – the property is located in Izlandia where he resides 34 2019 Level III Mock Exam PM 38 Is Akamu most likely correct with regard to how he alters convexity in his portfolios? A Yes B No, he is incorrect regarding buying MBSs C No, he is incorrect regarding selling options A is correct Akamu can sell convexity by selling a call on the bonds he owns or selling a put on bonds he would like to own The option premium received would augment the yield of the portfolio The selling lowers convexity in the portfolio, which is acceptable if he expects future volatility to be lower than that reflected in current option prices Buying MBSs also provides an option-writing opportunity, in this case selling a prepayment option to homeowners B is incorrect because buying MBSs is a way to sell convexity C is incorrect because selling options is a way to sell convexity Yield Curve Strategies LOS b Section 3.1.3 39 Which combination of securities in Exhibit 1 would Akamu most likely use to implement his butterfly trade? A Short Securities A and C and long Security B B Long Security D and short Securities A and E C Long Securities A and C and short Security B C is correct Akamu has a view that the yield curve will flatten, so an overweight to the long end would benefit the most He wants to establish a butterfly trade to protect the portfolio from parallel shifts The butterfly trade consists of a long (short) barbell and a short (long) bullet In this case, the best trade is a long barbell and a short bullet Akamu uses the US Treasury two-year futures contract for the front end of the barbell and a long- duration receive-fixed swap to complete the barbell He would short the intermediate pay-fixed swap in an equal money duration amount to offset the long position A is incorrect because this is the reverse of the correct trade This is short a barbell and long a bullet B is incorrect because a receiver swaption is a long intermediate position, rather than short Security A should be long, and E is a bearish not bullish position in the long end Yield Curve Strategies LOS c, d Section 4.3.2 40 Given the yield curve shift and other data in Exhibit 2, which portfolio would most likely outperform the benchmark? A Portfolio A B Portfolio B C Portfolio C 2019 Level III Mock Exam PM 35 A is correct All three portfolios have the same total duration but varying partial durations The PVBP overweights/underweights would determine how each performs relative to the benchmark Portfolio A is overweight the 10 partial PVBP and, given that this is where yields are expected to fall, would benefit relative to the benchmark It is also underweight short and long maturities where rates are expected to rise Portfolio B is a barbell and would fare the worst versus the benchmark Portfolio C is positioned for a flattening of the yield curve particularly in the long end, where most of the rise is expected The change in portfolio value is calculated as follows: Predicted change = Portfolio par amount × Partial PVBP × (–Curve shift) Actual changes are provided below to more precisely illustrate actual changes year year 10 year 20 year 30 year Benchmark (413.10) (137.52) (127.20) (96.96) 126.60 12.78 (190.80) Portfolio A (354.42) (136.08) (114.60) (98.40) 153.00 12.66 (171.00) Portfolio B (449.10) (148.32) (124.20) (107.52) 113.40 11.94 (194.40) Portfolio C (427.50) (136.08) (126.00) 12.06 (207.00) Total year (96.48) 126.00 B is incorrect because Portfolio B is underweight 10/20s where rates decline C is incorrect because Portfolio C is equal weight 10/20s where rates rally and overweight 30s where rates sell off Yield Curve Strategies LOS e Section 4.3 41 What mix of bonds from Exhibit 3 would Akamu most likely swap into to profit from his view? He would buy: A 39% of year and 61% of 30 year B 66% of year and 34% of 30 year C 50% of year and 50% of 30 year A is correct Given that Akamu is uncertain regarding the direction of interest rates—that is, they could rise or fall—the best strategy is to increase the portfolio’s convexity while maintaining the same duration to meet client guidelines The proportion of bonds to sell and buy is given by: 6.80 = (Duration of 2-year note × Weight of 2-year note) + (Duration of 30-year bond × Weight of 30-year bond) = 1.87x + 9.92(1 – x) x = 38.76% Allocate 39% of the sale proceeds to the 2-year note and 61% to the 30-year note The convexity for the trade improves from 62 to 107 while keeping duration the same B is incorrect because it solves for convexity rather than duration 36 2019 Level III Mock Exam PM C is incorrect because it equal weights the securities, falling short of the duration target as well as the convexity offered by the combination in A Yield Curve Strategies LOS f Section 4.2 42 The expected return for the horizon on the German bund trade Akamu asks Kalani to evaluate is closest to: A 1.99% B 3.39% C 3.64% B is correct The horizon return is equal to the yield income plus the roll-down return, which when combined equals the rolling yield, plus the FX return In this case, Coupon Sell price − Market price + ± FX gain/loss Market price Market price 2.50 101.40 − 100.25 − 0.25 = 3.39 + 100.25 100.25 A is incorrect because it uses EUR100 rather than EUR101.40 as the selling price in one year C is incorrect because it does not subtract the FX loss Yield Curve Strategies LOS g Section Allfunz Consulting Case Scenario Allfunz Consulting Partners provides advice to primarily long-term investors in regard to active investment strategies and managing active risk Reed Leeter, a senior consultant, is discussing active strategies with a client, Peter Clickman Leeter makes the following statements about quantitative strategies: Manager experience and discretion in identifying new trends in the market are important components of any quantitative strategy Loss aversion bias is more prominent with quantitative strategies than with fundamental strategies Generally, quantitative methods rely on information coefficients between firm returns and model factors Leeter tells Clickman about the interesting investment process of the XTZZ Fund Leeter states that many times, government-reported data are revised three to six months after the data are initially reported These revisions then become incorporated into the historical data, with the revised value replacing the originally reported value When the revision is incorporated, the data are referred to as “clean data.” XTZZ applies its 2019 Level III Mock Exam PM analysis in a manner in which the originally reported data exist as a lagged factor until the revised data become available This approach differentiates XTZZ from funds that use only the “clean” data, which ignore the initially reported data values Next, Leeter describes the investment approach of the Kopernicus Fund Kopernicus makes extensive use of market data to support its primary focus—pairs trading between industry peers Statistical techniques identify two securities that have been highly correlated with each other in the past If the price relationship between a pair diverges, Kopernicus expects mean reversion over a few days or weeks and places long–short positions accordingly to take advantage of the divergence Leeter then uses a firm-generated brochure (Exhibit 1) to inform Clickman about some other potential funds that may interest him Exhibit 1 Funds in Brochure Firm Description Altitude Funds Uses the 12-month forward price-to-earnings ratio (P/E) over the forecasted earnings per share (EPS) to select stocks Pioneer Funds Compares a company P/E with an industry average P/E in order to invest in firms that are under-priced Regulas Funds Invests in a combination of global equity securities from 5–10 different countries Portfolio weights are adjusted to take advantage of companies that appear to have the best near- term growth prospects Leeter states that although Altitude Funds and Pioneer Funds both use P/Es in their strategies, both funds incorporate a growth strategy Clickman asks Leeter how Regulas Funds determines its equity selections Leeter says that Regulas uses monthly data from non-traditional, but measurable, sources to determine the influence of customer and government attitudes toward a firm and its products Leeter also notes that Regulas compares its performance relative to an equity benchmark customized to its strategy and that the factors tend to be more volatile than traditional market factors He also states that the fund does tend to suffer in performance when exchange rates are volatile Clickman then asks Leeter how he should determine the style of the funds he is considering Leeter responds, “The best way to determine the style of the funds is to perform a returns-based analysis by regressing the past returns on the funds against the past returns on a number of style indexes to determine which styles are most prevalent within each fund Unfortunately, this method tends to not be as easy to perform as holdings-based analysis However, returns-based analysis allows for a deeper level of analysis relative to holdings-based analysis.” 43 Which of Leeter’s statements concerning the quantitative approach to active management is most accurate? A Statement B Statement C Statement 37 38 2019 Level III Mock Exam PM C is correct Leeter’s third statement is most accurate Generally, quantitative methods use past data to identify systematic factors that can be overweighted or underweighted in a portfolio based on an information coefficient A is incorrect Leeter’s first statement is not accurate Manager discretion has a minimal role in quantitative approaches B is incorrect Leeter’s second statement is not accurate Loss aversion is more symptomatic of fundamental approaches rather than quantitative approaches Active Equity Investing: Strategies LOS h, a Sections 2, 5.1.3.1 44 XTZZ’s approach to analyzing government-reported data most likely reduces: A look-ahead bias B survivorship bias C model overfitting A is correct XTZZ’s approach prevents the use of “revised” government data that are not known when the data are initially reported By not incorporating revised government data until they are actually revealed, XTZZ reduces look-ahead bias B is incorrect Survivorship bias occurs when analysis on past data ignores firms that have ceased to exist at some point during the analysis period C is incorrect Model overfitting occurs when the model fits the past data by finding a pre-conceived relationship (i.e., making the model specifications biased toward the pre-conceived relationship) or when the model is biased toward patterns that are specific only to the past data Active Equity Investing: Strategies LOS h Section 5.2.1 45 Which risk management method is the Kopernicus Fund most likely to use to offset the primary risk of its strategy? A Proper identification of the pairs B Frequent use of stop-loss order rules C Extensive analysis of the limit order book B is correct The biggest risk in pairs trading is that the observed price divergence is not temporary and could be due to structural reasons Frequent use of stop-loss rules, which are set to exit trades when a loss limit is reached, addresses this risk A is incorrect Although proper identification of the pairs to be used is critical to the success of this statistical arbitrage strategy, the selection process alone does nothing to address the risk that changes in fundamentals between the companies in the pair may occur, thereby extending (or eliminating) price convergence 2019 Level III Mock Exam PM C is incorrect Using the limit order book to identify pairs pricing anomalies implies a very short time frame—as brief as a few milliseconds—and focuses on high-frequency trading Kopernicus lets trades play out for days or weeks; therefore, using the limit order book will not help it Active Equity Investing: Strategies LOS f Section 3.5.1 46 Using Exhibit 1, Leeter’s statement about Altitude Funds and Pioneer Funds is most likely: A correct B incorrect in regard to Altitude Funds C incorrect in regard to Pioneer Funds C is correct The statement is incorrect in regard to Pioneer Funds but is correct in regard to Altitude Funds Pioneer Funds uses a relative value strategy (i.e., seeks under-priced securities relative to an industry value benchmark) that has no aspects of a growth strategy Altitude Funds uses a hybrid of value strategies (use of P/E) and growth strategies (use of forward EPS) known as GARP (growth at a reasonable price) A is incorrect The statement is incorrect in regard to Pioneer Funds but is correct in regard to Altitude Funds Pioneer Funds uses a relative value strategy (i.e., seeks under-priced securities relative to an industry value benchmark) that has no aspects of a growth strategy B is incorrect The statement is incorrect in regard to Pioneer Funds but is correct in regard to Altitude Funds Altitude Funds uses a hybrid of value strategies (use of P/E) and growth strategies (use of forward EPS) known as GARP (growth at a reasonable price) Active Equity Investing: Strategies LOS b Sections 3.1.1 and 3.1.2 47 Using Exhibit 1 and the equity selection process of Regulas Funds, the strategy will most likely benefit from: A a portfolio overlay B a new benchmark C using annual rebalancing A is correct Regulas Funds will benefit from a portfolio overlay of derivative securities to eliminate exchange rate risk B is incorrect Regulas uses a custom benchmark that is already appropriate for its strategy C is incorrect Annual rebalancing is too infrequent given the volatile nature of the factors used by Regulas Active Equity Investing: Strategies LOS d Sections 3.2.4 and 3.3 39 40 2019 Level III Mock Exam PM 48 Leeter’s reply to Clickman concerning determining the style of funds is most accurate in regard to the: A description of a returns-based analysis B applicability of returns-based analysis versus holding-based analysis C comparison of depth of analysis between returns-based analysis versus holdings-based analysis A is correct Leeter’s reply is correct in regard to the description of returns-based analysis Regressing a fund’s past returns against the past returns from a number of style indexes is a returns-based style analysis B is incorrect Leeter’s reply is incorrect in regard to the applicability of returns-based analysis versus holdings-based analysis Returns-based analysis is easier to implement than holdings-based analysis because data are more readily available C is incorrect Leeter’s reply is incorrect in regard to the comparison of depth analysis between the two methods Holdings-based analysis allows for a deeper level of analysis when compared with returns-based analysis because holdings-based analysis uses the actual portfolio holdings The analysis is more accurate and generates more information for making style allocation decisions Active Equity Investing: Strategies LOS i Sections 6.1.2 and 6.2 Kootenay Foundation Case Scenario Caitlan Bohmer is the lead portfolio manager for the Kootenay Foundation, located in British Columbia, Canada The foundation’s mission is to provide ongoing support for research on and implementation of sustainable agriculture and land management practices in southwestern Canada The foundation’s investment portfolio of approximately CAD861 million has targeted allocations of 60% to equities, 30% to fixed income, and 10% to real estate for the past decade All investments have been in low-cost index funds that hold long-only positions in publicly traded securities With the approval of the foundation’s investment advisory board, Bohmer has recently revised the portfolio’s target structure to include allocations of 5% to private equity and 5% to hedge funds, along with reduced target allocations of 55% to publicly traded equities and 25% to fixed income The target allocation for real estate will remain at 10% The three goals driving this change in target allocations are as follows: Goal 1: Higher expected portfolio return Goal 2: Reduced overall risk through better diversification Goal 3: Increased current income from interest and dividends rather than capital gains In order to implement the new investments in private equity and hedge funds, Bohmer has hired Andre Gorges, an independent consultant with expertise in these areas During their first meeting, Gorges explains to Bohmer, “Although different terms may be used, private equity funds and hedge funds have similar fee structures You will be charged a fixed management fee, likely 1%–2%, and fund managers will receive an incentive fee that is typically 10%–20% of any positive returns earned by the fund; 2019 Level III Mock Exam PM however, the incentive fee may be based only on returns in excess of a minimum or hurdle rate of return Hedge funds often include a clawback provision that requires managers to return incentive fees if the fund loses value in future years.” Bohmer tells Gorges she is curious about the differences between venture and buyout funds Gorges replies, “Buyout funds invest in established companies that produce and sell goods and services in established markets, whereas venture funds invest in new companies that produce more innovative products in less developed markets This means p ortfolio companies in buyout f unds are able to produce p ositive c ash flow sooner than those in venture funds, which is a benefit However, buyout funds can add to their risk profile through their use of leverage, whereas venture funds not use leverage Because the companies they invest in are younger and have simpler business structures, it is easier for venture funds to value their portfolio companies than it is for buyout funds.” The discussion moves from private equity to hedge funds and managed futures Bohmer asks Gorges to compare managed futures programs and hedge funds Gorges replies, “There are many similarities, and managed futures are sometimes classified as a type of hedge fund Like hedge funds, managed futures are absolute return strategies designed to produce positive returns regardless of market conditions However, unlike hedge funds, managed futures are available to investors only as separately managed accounts, whereas hedge funds are generally structured as limited partnerships.” Bohmer tells Gorges she is not sure how to go about selecting specific hedge funds in which to invest Gorges mentions that, despite the fees, it might be useful for Kootenay to invest in a fund of funds because of the benefits they provide to investors as compared to investing in individual hedge funds Bohmer tells Gorges, “In my review of hedge fund performance measurement for the last two decades, I’ve read of results that seem almost too good to be true However, I know from that review that there are a number of potential problems with the ways in which that performance has been measured There are three issues that concern me about hedge fund index performance: Issue 1: Fund returns are often subject to stale price bias Issue 2: Historical fund ‘performance’ is presented by applying the fund’s strategy during a period of time prior to when actual investments were made by the fund manager Issue 3: Indexes include only those funds that survived long enough to meet the requirements for inclusion in the index, rather than all funds available to investors during the time period examined.” 49 Which of the three goals is the new allocation to private equity most likely able to meet? A Goal B Goal C Goal A is correct Private equity funds, both venture and buyout, require long-term investments and not provide returns of capital or earnings to investors for many years, so adding private equity does not provide increased current income from interest and dividends relative to debt and equity index funds Further, the returns to private equity have relatively high correlations with publicly traded equity; therefore, diversification benefits for a portfolio with a high allocation to equity are likely to be modest Private 41 42 2019 Level III Mock Exam PM equity is best able to improve portfolio returns, as a reward for taking on illiquidity and higher risk relative to seasoned public equity or fixed income and for making a longer- term commitment of capital B is incorrect because private equity has moderately high correlations with publicly traded equity, especially publicly traded micro-cap shares, so the diversification benefits for a portfolio with a high equity allocation are likely to be modest C is incorrect because private equity makes long investments in equity securities, and the Kootenay portfolio already has a substantial exposure to long equity Alternative Investments Portfolio Management LOS a, l Section 4.3 50 Is Gorges most likely correct in his comments regarding fee structures? A Yes B No, he is incorrect regarding hurdle rates C No, he is incorrect regarding clawback provisions C is correct Gorges is incorrect regarding clawback provisions These are sometimes included in private equity funds, and they require managers to return incentive fees earned from profitable investments that are sold earlier in the life of the fund if later investments are sold at a loss Hedge fund managers are not required to return incentive fees if their funds lose value in futures years; however, they may be subject to a high-water mark provision that provides incentive fees only when a fund’s value is higher than its maximum previous value Both private equity funds and hedge funds sometimes have hurdle rates that award incentive fees only for returns that exceed the hurdle rate of return A is incorrect because Gorges is incorrect regarding clawback provisions, which apply to private equity funds, not hedge funds B is incorrect because Gorges is correct regarding hurdle rates, which can be applied to private equity funds and hedge funds Alternative Investments Portfolio Management LOS k, p Section 4.1 51 In his comparison of buyout and venture private equity investments, Gorges is least likely correct regarding the: A use of leverage B timing of cash flows C valuation of portfolio companies C is correct Gorges is incorrect regarding the valuation of portfolio companies Because buyout funds invest in established companies operating in establish industry sectors, it is easier to value them than the holdings of venture funds A is incorrect because Gorges is correct that buyout funds typically use leverage, which increases their risk, whereas venture funds not 2019 Level III Mock Exam PM B is incorrect because Gorges is correct that buyout funds typically experience positive cash flows earlier than venture funds This occurs because buyout funds invest in established companies that are already producing and selling goods and services Alternative Investments Portfolio Management LOS i Section 4.3 52 Is Gorges most likely correct in his comments about managed futures? A Yes B No, he is incorrect regarding absolute return strategies C No, he is incorrect regarding the use of limited partnerships C is correct It is true that managed futures programs, like most hedge funds, are designed to produce positive returns regardless of market conditions (e.g., absolute return strategies); however, it is incorrect that managed futures programs are available to investors only as separately managed accounts, because limited partnerships are available as private commodity pools run by commodity pool operators (CPOs) A is incorrect because Gorges is incorrect in his assertion that managed futures are available only through separately managed accounts B is incorrect because Gorges is correct that managed futures are designed as absolute return strategies Alternative Investments Portfolio Management LOS s Section 53 Which of the potential benefits of a fund of funds is least likely to apply in Kootenay’s situation? A Selection skill B Diversification C Access to closed funds B is correct Among the potential benefits of a fund of funds relative to investment in individual hedge funds are (1) the skill at selecting fund managers provided by the fund-of-funds manager; (2) the diversification provided by the fund-of-funds investment in multiple hedge funds, which may be difficult for a portfolio to achieve given its size, its allocation to hedge funds, and the minimum investment required by individual hedge funds; and (3) access to closed funds that the fund of funds already has a stake in Kootenay’s investment in hedge funds will be approximately CAD43 million, which is sufficient to create diversification by investing in six to eight separate funds without needing to incur the additional fees charged by a fund of funds In contrast, there is some indication that Bohmer lacks expertise in selecting hedge fund managers, so that would be a valuable benefit provided by the fund-of-funds manager Further, access to desirable closed funds can be achieved only by investing in the fund of funds that already holds a position A is incorrect because the fund-of-funds manager’s ability to select superior hedge fund managers would be valuable to the Kootenay portfolio given Bohmer’s lack of experience 43 44 2019 Level III Mock Exam PM C is incorrect because the fund of funds’ access to desirable closed hedge funds would be valuable to the Kootenay portfolio Alternative Investments Portfolio Management LOS q Section 6.5 54 Of the problems with hedge fund indexes Bohmer describes, she is least likely correct regarding: A Issue B Issue C Issue A is correct Although private equity valuations often rely on appraisals rather than market prices, most hedge fund strategies involve traded securities for which market prices are available Although prices can be somewhat stale in some markets, this is no more true for hedge funds than for other assets There is little evidence of stale price bias in hedge fund index returns B is incorrect because backfill bias—that is, applying returns that “would have been earned” by following a strategy before it was followed—is a substantial concern for hedge fund indexes The bias occurs because only strategies that would have worked historically are adopted C is incorrect because survivorship bias—including the returns of only those funds that survived long enough to meet requirements for inclusion—shifts returns upward by not including the returns of funds that failed quickly Alternative Investments Portfolio Management LOS r Section 6.2 Wryte Capital Management Case Scenario Bud Walter is the chief investment officer of Wryte Capital Management (WCM) He is meeting with T.M McGourn, a prospective client, to discuss Wryte’s investment performance as presented in Exhibit 1 and subsequent disclosure notes: Exhibit 1 Year Wryte Capital Management US Large-Cap Equity Composite Gross Return (%) Benchmark Internal Return Dispersion (%) (%) Number of Portfolios Composite Assets ($ Firm Assets millions) ($ millions) 2007 15 15 5.2 20 100 175 2008 22 20 6.1 40 200 275 2009 –20 –25 5.7 30 150 200 2019 Level III Mock Exam PM 45 Exhibit 1 (Continued) Year Gross Return (%) Benchmark Internal Return Dispersion (%) (%) Number of Portfolios Composite Assets ($ Firm Assets millions) ($ millions) 2010 11 10 5.2 45 225 300 2011 20 20 4.7 50 250 350 WCM has prepared this report in compliance with the Global Investment Performance Standards (GIPS) The US Large-Cap Equity Composite has been independently verified by a qualified third party to be GIPS compliant The verification report was issued only for the composite and not for WCM It states that during 2009, 2010, and 2011, WCM complied with all composite construction requirements for the composite and that WCM policies are designed to calculate and present performance in compliance with GIPS standards Notes: The firm is defined as an independent investment manager that invests exclusively in US large-cap, US mid-cap, and US small-cap equity securities for US resident clients WCM’s policy for valuing portfolios and calculating performance is available upon request WCM’s calculation methodology is to use time-weighted rates of return Subperiod rates of return are geometrically linked Cash equivalent instruments are included in rate-of-return calculations Returns are calculated quarterly or when large external cash flows (as defined by WCM) take place The US Large-Cap Equity Composite includes all actual fee-paying portfolios Each portfolio contains positions in large-cap stocks, which are selected by WCM after an extensive independent analysis Non-discretionary portfolios are not included in any composite WCM does not include in any composite its large-cap model portfolio, which is used during the investment selection process The composite benchmark is the S&P 500 Index, which represents the size- weighted returns of the 500 largest (as measured by market capitalization) US- based publicly traded companies Gross-of-fees returns are presented before investment management fees but after trading expenses, which include custodial fees All clients pay an investment management flat fee of 75 basis points on the month-end account value plus a 10-basis-point performance fee whenever the composite return exceeds the benchmark return by 100 basis points Internal dispersion is the equal-weighted standard deviation of the annual gross returns of the five portfolios included in WCM’s US Large-Cap Equity Composite McGourn asks Walter why he uses standard deviation as the measure of internal dispersion and whether there are better dispersion measures Walter responds, “Standard deviation has the advantage of comparability across investment firms Other measures, such as the high/low range and the interquartile range, are skewed by outliers.” Finally, McGourn asks Walter about WCM’s investment valuation policies Walter states that WCM uses a valuation hierarchy based on items through as follows: 46 2019 Level III Mock Exam PM Item Observable quoted market prices for similar investments in active markets Item Quoted prices for similar investments in markets that are not active Item Market-based inputs other than quoted prices that are not observable for the investment Item When no quotes or other market inputs are available, estimates based on quantitative models and assumptions 55 Is WCM most likely correct in claiming compliance based on the verification report? A No, because of the level at which verification is claimed B Yes C No, because of the time frame for which verification is claimed A is correct For GIPS compliance, a single verification report must be issued with respect to the whole firm Verification cannot be carried out only on a composite and, accordingly, does not provide assurance about the investment performance of any specific composite The Standards stress that firms must not state or imply that a particular composite has been “verified.” B is incorrect C is incorrect The minimum initial period for which verification can be performed is one year, or from the firm’s inception date through the period-end if that timeframe is less than one year The standards recommend (but not require) that verification cover all periods for which the firm claims compliance Global Investment Performance Standards LOS s Section 56 WCM’s methodology for calculating performance, as disclosed in Note 1, is least likely consistent with GIPS standards for: A frequency of return calculations B external cash flows C geometrically linked returns A is correct WCM’s return calculation is not GIPS compliant GIPS standards require that returns be calculated on a monthly basis for periods beginning on or after January 2001 B is incorrect WCM’s calculation of returns when a large external cash flow takes place is GIPS compliant C is incorrect WCM is GIPS compliant GIPS require geometrically linking of subperiod returns which is done Global Investment Performance Standards LOS d Section 3.2 2019 Level III Mock Exam PM 57 Is WCM most likely compliant with GIPS standards required for composite construction as disclosed in Note 2? A Yes B No, because of how the large-cap model portfolio is treated C No, because of how non-discretionary portfolios are treated A is correct The composite consists of all actual fee-paying portfolios that are managed on a discretionary basis It is therefore in compliance with GIPS standards B is incorrect because WCM does comply with GIPS standards with respect to non- discretionary portfolios since their performance results are not included in any composite C is incorrect because WCM does comply with GIPS standards with respect to its utilization of the model portfolio since its performance results are not included in any composite Global Investment Performance Standards LOS f Section 2.1 58 With respect to gross-of-fees returns, Note is least likely compliant with GIPS required standards in its treatment of: A month-end account value B trading expenses C performance fees B is correct Only direct trading expenses should be deducted in calculating gross-of-fees returns Custodial fees cannot be considered a component of direct trading expenses A is incorrect because month-end account value may be used to calculate fees C is incorrect because performance fees are a component of the investment management fee and must not be considered part of the gross-of-fees return Global Investment Performance Standards LOS j Section 3.5 59 With respect to the relative merits of internal dispersion measures, Walter is least likely correct about: A standard deviation B interquartile range C high–low range B is correct Walter is correct about the high–low range, which is skewed by outliers He is also correct that the standard deviation allows for comparability across investment firms He is incorrect, however, about the interquartile range Because this measure includes only the middle 50% of portfolio returns, thus excluding extreme observations, it is not affected by outliers 47 48 2019 Level III Mock Exam PM A is incorrect C is incorrect Global Investment Performance Standards LOS m Section 3.12 60 Is Walter’s response to McGourn’s inquiry regarding WCM’s valuation hierarchy most likely correct? A No, Item from the valuation hierarchy should be excluded B Yes C No, the valuation hierarchy should be reordered as Item 2, Item 1, Item 3, and Item B is correct The valuation hierarchy presented by Walter is GIPS compliant A is incorrect The valuation hierarchy presented by Walter is GIPS compliant C is incorrect Number is part of the GIPS valuation hierarchy Global Investment Performance Standards LOS q Section ... Compliance, and Support; Appendix 6, Recommendations and Guidance Emerald Private Bank Case Scenario Laura Davidson is a financial advisory partner with Emerald Private Bank (Emerald) Emerald is based... the data are referred to as “clean data.” XTZZ applies its 2019 Level III Mock Exam PM analysis in a manner in which the originally reported data exist as a lagged factor until the revised data... the applicability of returns-based analysis versus holdings-based analysis Returns-based analysis is easier to implement than holdings-based analysis because data are more readily available