FinQuiz.com CFA Level III Mock Exam June, 2017 Revision Copyright © 2010-2017 FinQuiz.com All rights reserved Copying, reproduction or redistribution of this material is strictly prohibited info@finquiz.com CFA Level III Mock Exam – Solutions (PM) FinQuiz.com – 5th Mock Exam 2017 (PM Session) Questions Topic Minutes 1-6 Ethical and Professional Standards 18 7-12 Ethical and Professional Standards 18 13-18 Economic Analysis 18 19-24 Equity Investments 18 25-30 Fixed-Income Portfolio Management 18 31-36 Fixed-Income Portfolio Management 18 37-42 Alternative Investments 18 43-48 Performance & Evaluation 18 49-54 Derivatives 18 55-60 Global Investment Performance Standards 18 Total FinQuiz.com © 2017 - All rights reserved 180 CFA Level III Mock Exam – Solutions (PM) Questions to relate to Ethical and Professional Standards Sun Davidson, CFA, Case Scenario Sun Davidson, CFA, is a sell side energy research analyst Davidson maintains an equity investment blog which is actively followed by over 5,000 investors spread across numerous countries The investors are from various financial backgrounds with differing risk appetites In the current year, Davidson decides to change the layout of the blog Instead of placing announcements concerning investment recommendations at the bottom of the screen, as has been the case since she started the blog, recommendations can now be accessed by clicking on a highlighted (in bold) ‘Recommendations’ tab located at the top left of the screen Davidson does not feel it is necessary to make any announcement with respect to the change For her next entry, Davidson will be preparing an investment recommendation on Energy Fund, a hedge fund which undertakes long and short positions in equity securities from the energy sector Due to her limited expertise with the alternative asset class, Davidson seeks the advice of Earl Ramos, a leading hedge fund manager at Carlton, a hedge fund management firm During their initial meeting, Ramos informs Davidson that, with the knowledge of his employer, he is invested in the Energy Fund (EF) and maintains a working relationship with the fund’s manager from whom he has learnt that the fund will be expanding to include highly risky energy stocks issued in less developed countries Upon Ramos’s advice, Davison issues a buy recommendation but does not disclose Ramos’s holding in EF or his relationship with the fund manager Pleased with their professional relationship, Davidson invites Ramos to become a regular contributor to the blog which he accepts Ramos’s compensation will be in the form of commission generated for the recommendations he issues However, he will not be paid by Davidson Ramos informs his supervisor of the offer after acceptance and has decided to contribute to the blog during the weekends so as not to disrupt his routine work activities FinQuiz.com © 2017 - All rights reserved CFA Level III Mock Exam – Solutions (PM) The same evening, both professionals attend an investment conference at which Ramos collides into Wilson Clark Clark maintains an investment in the Carlton hedge fund along with his brother, Ridley Wilson praises Ramos for his exemplary performance results achieved during the current year on both their holdings Wilson invites Ramos to vacation with him in Morocco Upon the conclusion of their conversation, Ramos shares the details of the offer with Davidson stating, “I manage the hedge fund investments of the Clark brothers and both are equally pleased with my performance This calls for a celebration.” By changing the layout of the blog Davidson is in violation of the CFA Institute Standards of Professional Conduct with respect to: A loyalty to clients B diligence and reasonable basis C communication with clients and prospects Correct Answer: C Reference: CFA Level III, Volume 1, Study Session 1, Reading 2, LOS a C is correct Davidson is in violation of Standard V (B) Communication with Clients and Prospective Clients by failing to disclose the change in layout to investors following the blog Communicating the change in the location of the recommendation section is crucial Moreover it is not sufficient to highlight the tab in bold and assume investors will readily be able to locate it Davidson should have made an announcement on his blog and by not doing so she has violated this standard which requires members and candidates to promptly disclose any changes which materially affect investment processes A is incorrect There is no evidence which indicates that Davidson has placed her personal interests before those of investors or otherwise acted in a manner inconsistent with the interests of investors B is incorrect The standard relating to diligence and reasonable basis has not been violated FinQuiz.com © 2017 - All rights reserved CFA Level III Mock Exam – Solutions (PM) By issuing the purchase recommendation, Davidson is in violation of the CFA Institute Standards of Professional Conduct because she has failed to: A conduct a suitability analysis B disclose that she has employed the expertise of Ramos C disclose her reliance on material nonpublic information Correct Answer: B Reference: CFA Level III, Volume 1, Study Session 1, Reading 2, LOS a B is correct Prior to engaging Ramos, Davidson generated investment recommendations using her skills and expertise Therefore, employing the services of Ramos to help her make the hedge fund investment recommendation is a material change to her investment process and one which will require disclosure according the standard concerning Communication with Clients and Prospective Clients [Standard V (B)] A is incorrect The investor base following the blog is characterized by a variety of risk appetites Therefore, it is highly unlikely that the highly risky hedge fund investment will be inappropriate for all investors C is incorrect Davidson has violated the CFA Institute Standards of Professional Conduct by relying on material nonpublic information Information regarding a proposed change in fund mandate is material information and basing a recommendation on it constitutes a violation That being said, disclosure of a violation is not a solution to the wronged action In order to avoid violation of the CFA Institute Standards of Professional Conduct, Davidson is required to disclose to investors: A Ramos’s investment in the EF only B Ramos’s relationship with the manager of the EF only C Both Ramos’s investment in and relationship with the manager of the EF Correct Answer: C Reference: CFA Level III, Volume 1, Study Session 1, Reading 2, LOS b FinQuiz.com © 2017 - All rights reserved CFA Level III Mock Exam – Solutions (PM) According to the Standard VI (A) Disclosure of Conflicts members and candidates are required to disclose all actual and potential conflicts of interest which can impair their objectivity or interfere with their respective duties to their clients and employers Ramos’s relationship with the hedge fund manager has given him access to material nonpublic information Therefore his relationship with the manager indicates the existence of actual and potential conflict of interests which mandate disclosure Furthermore, Ramos’s investment in the hedge fund which he recommends for investment represents a source of potential conflict of interest requiring disclosure Investors may view his recommendation as an attempt to improve the value of his investment By accepting Davidson’s offer to contribute to the blog, is Ramos in violation? A No, he will not be disrupting the activities of his employer B Yes, he should have sought permission prior to acceptance C Yes, he has not disclosed the commission income which he will earn Correct Answer: B Reference: CFA Level III, Volume 1, Study Session 1, Reading 2, LOS a B is correct Standard V (A) Employer Loyalty requires members and candidates to abstain from competitive activity that could conflict with the interests of their employer The standard does not preclude members and candidates from entering into an independence practice agreement for compensation while still employed, prior approval must be sought Therefore, even if his participation in blog as hedge fund analyst will not interfere with his duties at Carlton, Ramos is in violation by not seeking prior permission C is incorrect Although Ramos is required to disclose details of the offer to his employer, he must seek approval prior to acceptance and by not doing so, he is in violation Ramos’s best course of action with respect to Clark’s offer is to: A decline the offer B disclose the offer to his employer only C disclose the offer to his clients and employer FinQuiz.com © 2017 - All rights reserved CFA Level III Mock Exam – Solutions (PM) Correct Answer: B Reference: CFA Level III, Volume 1, Study Session 1, Reading 2, LOS b According to Standard I (B) Independence and Objectivity, members and candidates may accept gifts and benefits from their employer as long as they either notify employers prior to or after accepting the gift, whichever is possible However, the standards not mandate disclosure to clients With respect to the statement made to Davidson at the investment conference, is Ramos in violation of the CFA Institute Standards of Professional Conduct? A No B Yes, by mentioning that he manages Ridley’s portfolio only C Yes, by mentioning that he manages the investment portfolios of the Clark brothers Correct Answer: A Reference: CFA Level III, Volume 1, Study Session 1, Reading 2, LOS a Standard III (E) Preservation of Client Confidentiality requires members and candidates to preserve the confidentiality of the information communicated to them by their clients However, information concerning client names is not considered confidential information and its communication does not constitute a violation FinQuiz.com © 2017 - All rights reserved CFA Level III Mock Exam – Solutions (PM) Questions to 12 relate to Ethical and Professional Standards Riverside Asset Management Case Scenario Riverside Asset Management (RAM) is a privately owned, small-scaled investment advisory firm The firm’s client base exclusively includes institutional clients Roger Marquez, the firm’s compliance officer, has made necessary modifications to RAM’s policies and procedures to ensure they are consistent with the Asset Manager Code Once he is reasonably satisfied with RAM’s level of compliance, Marquez sends an investment letter to clients and prospective clients which includes the compliance statement, “RAM claims compliance with the CFA Institute Asset Manager Code of Professional Conduct This claim has not been verified by the CFA Institute.” Thomas Nash manages RAM’s global equity fund which in benchmarked to the MSCI global equity index Nash employs a passive mandate for the global equity allocation of Aero Inc’s defined benefit pension plan’s portfolio, which is consistent with the client’s funding objectives In the current year, the sponsor reports a surplus following a profitable financial year Nash decides to modify his investment strategy and employ a semi-active approach which will allow him to increase the portfolio’s opportunity to earn higher returns He intends to inform the sponsor of the change in their next quarterly meeting Victoria Reed is a junior portfolio manager reporting to Nash Reed is managing the investment portfolio of the Legend Foundation As instructed by the foundation’s chief executive, Reed allocates 1,000 of Hower Inc’s shares to the portfolio which has undertaken an IPO Reed simultaneously purchases 2,000 shares for her personal investment portfolio She discloses the amount and quantity of her purchase in a quarterly trade confirmation and an annual statement of personal holdings which she will email to Marquez on the respective dates Marquez is soon to retire and has been asked by RAM’s chief investment officer to nominate a successor Marquez evaluates two candidates one of whom is his brother who is well-informed on the Code’s compliance policies and procedures The second candidate is an investment manager who overlooks RAM’s emerging market equity fund FinQuiz.com © 2017 - All rights reserved CFA Level III Mock Exam – Solutions (PM) Several of the fund’s clients have requested an allocation to commodities However, RAM lacks expertise and has selected Fairhole Associates, a commodity trading specialist to manage the allocation Upon making the allocation, a letter is sent to clients which states, “RAM has appointed Fairhole Associates to manage commodity investments Fairhole Associates retains liability for the performance of these investments.” At the end of the performance year, Nash prepares a performance presentation for the global equity fund Although the fund has been in operation for the past eight years, he decides to present the annual performance for the recent most five years as they represent its most successful years He presents gross- and net-of-fees returns and provides a breakdown of fees charged as management fees, incentive fees and commission His disclosure purposely omits a contingent fee component which he deems as too complex for the understanding of clients Is RAM’s claim of compliance statement consistent with the Asset Manager Code? A No B Yes, the CFA Institute cannot verify actual compliance with the Code C Yes, the CFA Institute can only verify the Manager’s claim of compliance Correct Answer: B Reference: CFA Level III, Volume 1, Study Session 2, Reading 4, LOS a RAM’s claim of compliance is consistent with the Asset Manager Code The CFA Institute does not verify either the Manager’s claim of compliance or actual compliance with the Code By modifying his strategy, is Nash in violation of the Asset Manager Code? A No B Yes, he has not undertaken a suitability analysis C Yes, he has not made disclose to clients prior to the change Correct Answer: C FinQuiz.com © 2017 - All rights reserved CFA Level III Mock Exam – Solutions (PM) Reference: CFA Level III, Volume 1, Study Session 2, Reading 4, LOS b C is correct Nash is in violation of the Asset Manager Code because he has not provided disclosure to clients prior to converting to a semi-active fund mandate Managers are required to provide this information well in advance of the change so that clients should be given enough time to consider the change and take any actions as necessary B is incorrect A semi-active fund mandate is appropriate in light of the surplus reported by the fund A fund surplus accompanied by improved financial performance translates will increase the plan’s risk tolerance With respect to the purchase of Hower Inc.’s shares, is Reed in violation of the Asset Manager Code? A No B Yes, she did not seek prior approval C Yes, she did not delay the purchase of shares Correct Answer: B Reference: CFA Level III, Volume 1, Study Session 2, Reading 4, LOS b B is correct Reed is in violation of the Asset Manager Code by not seeking approval prior to purchasing shares for his personal portfolio The Code requires Managers to require employees to receive approval prior to any personal investments in initial public offerings or private placements C is incorrect Reed is not in violation by purchasing shares for her account concurrently with those for Legend Foundation’s portfolio Reed has fulfilled the foundation’s request to purchase 1,000 shares and by purchasing 2,000 shares for her personal portfolio, her actions not adversely affect her client’s interests FinQuiz.com © 2017 - All rights reserved 10 CFA Level III Mock Exam – Solutions (PM) A limitation of VA’s portfolio benchmark being based on the specified returnsbased index is that tracking error will increase This is because an equal allocation to large-cap growth and large-cap value indexes does not fully replicate the performance of a portfolio with a market-oriented large-cap equity mandate Therefore, the risk exposure of the portfolio will not match that of its benchmark Options A and B are incorrect Benchmarks based on return-based indexes are unambiguous as they are investable 45 The most appropriate benchmark for VA’s EAFE segment is a: A style index B broad market index C custom security-based index Correct Answer: C Reference: CFA Level III, Volume 6, Study Session 17, Reading 31, LOS f & g C is correct It is highly unlikely that a benchmark covering EAFE marketoriented large-cap equities exists Therefore, to replicate the performance of these stocks, the most appropriate strategy would be to custom design a benchmark to reflect the manager’s unique weighting approach A is incorrect Style indexes are widely available indexes reflecting distinct investment styles such as 1) large-capitalization growth, 2) large-capitalization value, 3) small-capitalization growth, and 4) small-capitalization value Style indexes not exist for a market-oriented large-cap investment strategy B is incorrect Broad market indexes are unsuitable as benchmarks for the simple reason that the constituent securities will not reflect the portfolio’s investment mandate thus violating the appropriateness criterion FinQuiz.com © 2017 - All rights reserved 44 CFA Level III Mock Exam – Solutions (PM) 46 Based on the data in the Exhibit and considering each factor in isolation, Daniels will conclude that the benchmark is of low quality based on the fact that the: A the proportion of active positions is low B benchmark is not reflective of Spencer’s investment style C benchmark bears little resemblance to the opportunity set of Spencer’s investment process Correct Answer: A Reference: CFA Level III, Volume 6, Study Session 17, Reading 31, LOS i A is correct The active mandate of VA’s portfolio is long-only Based on this mandate, Spencer will be expected to hold positive active positions An overall negative average active position indicates that the benchmark poorly represents the manager’s investment approach B is incorrect Tracking error is defined as the volatility of A Given that the volatility of the account’s return versus the benchmark (σA = 9.5%) is lower relative to the account’s return versus the market index (σP – M = σE*= 18.7%), the benchmark is “good” as it reduces tracking error or noise in the performance evaluation process This will indicate that the benchmark is capturing important aspects of the manager’s investment style C is incorrect The chosen benchmark is of high quality based on benchmark coverage, which is a measure of the benchmark’s relationship, on a security level, with the opportunity set generated by the manager’s investment process 47 Using the correlation data in the Exhibit, Spencer will conclude that systematic bias in the benchmark relative to the account is: A minimal based on correlation coefficient of E and M (pE,M) B minimal based on correlation coefficient of A and B (pA,B) C significant based on correlation coefficient of E and M (pE,M) Correct Answer: C Reference: CFA Level III, Volume 6, Study Session 17, Reading 31, LOS i FinQuiz.com © 2017 - All rights reserved 45 CFA Level III Mock Exam – Solutions (PM) C is correct An account will demonstrate systematic bias when the correlation between A = (P – B) and S = (B – M) is statistically different from zero or when there is not a statistically significant positive correlation between S and E The correlation between S and E is negative Therefore, even though Spencer’s investment style is in favor relative to the market (as B – M is positive), Daniels should expect either the benchmark or portfolio or neither of the two to outperform the market index This will introduce systemic biases in the benchmark relative to the portfolio and reduce benchmark quality 48 Regarding hedge fund performance evaluation, Smith is most accurate regarding her conclusions with respect to: A only B and only C all three options Correct Answer: C Reference: CFA Level III, Volume 6, Study Session 17, Reading 31, LOS j FinQuiz.com © 2017 - All rights reserved 46 CFA Level III Mock Exam – Solutions (PM) C is incorrect Spencer is accurate with respect to her conclusions concerning all three options Her conclusion concerning Option is accurate as the net assets of long-short positions may start out as positive, due to various margins and administrative requirements, but may approach zero as net asset values get smaller The account’s return may, in turn, become nonsensically extreme (either positive or negative infinity) Her conclusion concerning Option is accurate because, although the technique is similar to manager universes, hedge funds are not required to report their performance results and therefore report their performance on a less frequent basis in comparison to other asset classes This low frequency of reporting will, in turn, reduce the measurability of the technique identified in Option as the Sharpe ratio cannot be calculated on a regular basis for the hedge funds under analysis Furthermore, most hedge funds incorporate a high degree of skewness complicating performance evaluation using Sharpe ratios Her conclusion concerning Option is accurate One issue with custom securitybased benchmarks is that they are not composed of published indexes and therefore a lack of transparency may be a valid concern FinQuiz.com © 2017 - All rights reserved 47 CFA Level III Mock Exam – Solutions (PM) Question 49 to 54 relate to Derivatives Gus Weaver Case Scenario Gus Weaver holds a $30 million portfolio invested in Arc Limited’s shares of a stock which is indexed to the DJIA 30 Weaver would like to reduce his exposure to the shares in anticipation of a profit squeeze which is forecasted to decrease Arc’s share price over the course of the coming months Weaver asks his portfolio manager, Eric Cox, to devise a suitable strategy which does not involve liquidating his holding Cox designs two alternative strategies using DJIA 30 equity index futures contracts and options, respectively The strategies he has devised include: Strategy 1: Synthetically reducing the exposure using 1-month DJIA 30 equity index futures Strategy 2: Employing equity call and/or put options written on the Arc Limited stock Cox explains to Weaver that should Strategy be implemented, the position will need to be rolled over each month until protection is no longer desired He collects details with respect to the instruments used for the strategy (Exhibit 1) Exhibit 1: Details Concerning Strategy Current market price per share $51.50 Futures price 1,860.50 Multiplier 25.00 Index dividend yield 0.50% One- month risk-free rate 2.30% After studying the strategy, Weaver asks Cox how an alternative strategy involving the liquidation of portfolio holdings and subsequent investment of the proceeds in a risk-free asset would compare to Strategy in terms of relative liquidity, transaction costs, and success in reducing portfolio beta to zero FinQuiz.com © 2017 - All rights reserved 48 CFA Level III Mock Exam – Solutions (PM) Next, Cox proceeds to explore Strategy He collects details relevant to three one-month put options (Exhibit 2) written on the Arc Limited stock He expects the stock to be worth $51.80 at option expiration The designed strategy will greatly depend on whether Weaver would like to: i ii maximize loss protection or retain upside potential but hedge losses Option Exercise price ($) Option price ($) Exhibit 2: One-Month Put-Option Prices 49.70 51.00 1.10 1.70 54.30 2.40 Cox believes that a protective put strategy will be most suitable if Weaver decides to maximize loss protection and selects the 54.30 put to achieve this purpose Cox concludes his analysis by exploring the most suitable option structure should Weaver choose to retain upside potential Cox strongly believes that market volatility will remain low over the next three months and intends to incorporate this projection in his selection decision 49 The number of futures contracts required to be sold and the effective amount of money needed to be invested in risk-free bonds to implement Strategy is, respectively, closest to: A B C number of futures contracts to be sold: 645 646 646 effective investment in risk-free bonds: $29,998,096.00 $29,990,190.99 $29,999,940.12 Correct Answer: B Reference: CFA Level III, Volume 5, Study Session 15, Reading 26, LOS c FinQuiz.com © 2017 - All rights reserved 49 CFA Level III Mock Exam – Solutions (PM) Because Weaver wants to effectively liquidate his Arc Limited holding, futures contracts will need to be sold on the DJIA 30 index The number of contracts required to be sold (Nf) is approximately equal to 646 V (1 + r ) $30,000,000(1.023) − Nf = = qf ($25 × 1,860.50) T 12 = −646.21 Selling 646 futures contracts is equivalent to selling contracts on stock worth 646(1,860.50 × $25) = $29,990,190.99 (1.023)1 12 And is equivalent of investing $29,990,190.99 in risk-free bonds 50 In order to establish an effective hedge using Strategy 1, Cox must ensure that relative to the index beta, portfolio beta is: A lower B higher C identical Correct Answer: C Reference: CFA Level III, Volume 5, Study Session 15, Reading 26, LOS c Since the index underlying the futures contract is to be used to represent the performance of the Arc Limited stock holding, it is essential that the betas of the two are identical; this will enable Cox to implement a precise hedge Furthermore, this will enable the futures price and stock price to have the same sensitivity to market movements thereby resulting in an effective hedge 51 Cox’s most appropriate response to Weaver’s query concerning the comparison of Strategy to a liquidation of and reinvestment of portfolio proceeds in the context of liquidity and success of eliminating beta exposure is that: A neither of the two strategies will guarantee a zero beta exposure B strategy will be more effective in guaranteeing a zero beta exposure C investing the liquidation proceeds in risk-free securities is the more liquid alternative FinQuiz.com © 2017 - All rights reserved 50 CFA Level III Mock Exam – Solutions (PM) Correct Answer: A Reference: CFA Level III, Volume 5, Study Session 15, Reading 26, LOS c A is correct Neither of the two strategies can guarantee that beta will be reduced to zero C is incorrect Executing transaction in derivatives is generally a more liquid alternative compared to buying risk-free assets from liquidation proceeds 52 Using the data in Exhibit and assuming the share price expectation is realized, the value of the protective put strategy, on a per share basis, is closest to: A $0.00 B $51.90 C $54.30 Correct Answer: C Reference: CFA Level III, Volume 5, Study Session 15, Reading 27, LOS a Value at expiration = VT = ST + max(0, X – ST) = $51.80 + max(0, $54.30 – $51.80) = $54.30 53 Using the data in Exhibits and 2, the breakeven price per share on the proposed protective put strategy is closest to: A $49.10 B $51.90 C $53.90 Correct Answer: C Reference: CFA Level III, Volume 5, Study Session 15, Reading 27, LOS a Breakeven = ST* = S0 + p0 = $51.50 + $2.40 = $53.90 FinQuiz.com © 2017 - All rights reserved 51 CFA Level III Mock Exam – Solutions (PM) 54 Which of the following strategies is most suitable for maximizing upside potential on the Arc stock position? A Straddle B Long position in a butterfly spread C Bear spread using put options and Correct Answer: C Reference: CFA Level III, Volume 5, Study Session 15, Reading 26, LOS b Given that Cox is highly certain that volatility will be lower than expected, he should consider going either long the butterfly spread, which involves selling put option and buying put options and 3, or a bear spread using put options and C is correct The maximum profit on a bear spread using put options and is higher relative to the maximum profit of a butterfly spread A bear spread using put options and will generate a maximum profit of $2.60 Maximum profit on bear spread = X3 – X2 – p3 + p2 = $54.30 – $51.00 – $2.40 + $1.70 = $2.60 B is incorrect The maximum profit on a long butterfly spread position is lower relative to the specified bear spread position Maximum profit = X2 – X1 – (p1 – 2p2 + p3) = $51.00 – $49.70 – [$1.10 – 2($1.70) + $2.40] = $1.20 A is incorrect A straddle strategy is inappropriate given Cox’s low volatility expectations The straddle strategy benefits from high volatility expectations FinQuiz.com © 2017 - All rights reserved 52 CFA Level III Mock Exam – Solutions (PM) Questions 55 to 60 relate to Global Investment Performance Standards Walk Associates Case Scenario Walk Associates (WA) is a firm providing brokerage and asset management services The firm is seeking to present its financial statements in compliance with the requirements and recommendations of the Global Investment Performance Standards (GIPS) Clarence Long is WA’s senior compliance officer who will be overseeing the conversion process Long evaluates the performance presentation of WA’s large-cap equity composite whose equity holdings are benchmarked to the Russell 3000 index (Exhibit 1) The composite commenced on January 1, 2010 The presentation has been prepared by a senior equity fund manager and includes note disclosures During his evaluation of the presentation, Long identifies numerous inconsistencies which require rectification Exhibit 1: Large-Cap Equity Composite Performance Presentation and Note Disclosures Composite Benchmark Value of Value of Gross-ofGross-ofTotal NonComposite Cash Fees Fees Firm Holdings Discretionary Downside Returns Returns Assets Assets Deviation ($ Year (%) (%) ($ Millions) ($ millions) (%) Millions) 2010 8.9 7.8 2.5 0.1 0.1 - 4.5% 2011 9.1 9.0 2.8 0.2 0.1 - 8.8% 2012 9.5 9.5 3.4 0.1 0.3 - 2.2% 2013 9.0 9.8 3.0 0.3 0.2 - 7.1% 2014 8.9 9.8 3.1 0.3 0.4 - 12.0 Note 1: Gross-of-fees returns represent a return net of an all-in-fee comprising advisory, custody and administrative fees The portion of advisory fees including actual trading expenses has been omitted from return calculations as these expenses are highly variable and an estimate for trading expenses cannot otherwise be derived with a reasonable degree of accuracy Note 2: Total firm assets include discretionary fee- and non-fee paying portfolios FinQuiz.com © 2017 - All rights reserved 53 CFA Level III Mock Exam – Solutions (PM) Note 3: Cash holdings represent investments in Treasury bills which are being managed by a client-designated external fixed-income specialist firm Returns from cash holdings have been included in portfolio return calculations Note 4: The firm routinely employs option strategies such as protective put and bear spreads to provide downside protection on its equity holdings Note 5: Due to the existence of embedded options for hedging purposes, the firm has elected to present downside deviation as an additional risk measure to standard deviation, which assumes normal distribution and is thus inappropriate for evaluating the performance of a skewed return distribution Note 6: Non-discretionary portfolios include those managed with an active mandate but are prohibited by portfolio holders from participating in small-cap equities Long would like to evaluate how composite portfolio returns are calculated and thus breaks down the performance of one portfolio in terms of cash flow activity and market values for the 1st quarter of 2015 (Exhibit 2) Exhibit 2: Portfolio Valuation and External Cash Flow Activity (January 1st 2015 to March 31st 2015) Market Value Market value Large External Including Cash Portfolio Date ($) Cash Flows ($) Flows ($) January 2015 242,000 31 January 2015 250,000 25 February 2015 275,000 - 2,000 273,000 28 February 2015 282,000 16 March 2015 262,000 +12,000 274,000 31 March 2015 295,000 FinQuiz.com © 2017 - All rights reserved 54 CFA Level III Mock Exam – Solutions (PM) 55 WA’s fee presentation policy presented in Note is inconsistent with the requirements of the GIPS standards and requires modification Which of the following statements represents an appropriate adjustment? A Trading expenses should be included even if they cannot be estimated with accuracy B Administrative fees must be excluded as they are generally not within the control of a firm C The portion of advisory fees including actual trading expenses must represent the sole deduction from gross-of-fees returns Correct Answer: C Reference: CFA Level III, Volume 6, Study Session 18, Reading 32, LOS d & k C is correct For actual trading expenses which cannot be broken out of bundled fees, the gross-of-fees returns must be reduced by the entire amount of bundled fees or that portion which includes actual trading expenses The use of estimated trading expenses is prohibited (I.2.A.5.a-b) Given that the portion of advisory fees including trading expenses has been identified, only that portion should have been deducted from the gross-of-fees returns A is incorrect The use of estimated trading expenses is prohibited B is incorrect The GIPS standards recommend the exclusion of administrative expenses because they are generally not within the control of the firm However, this is a recommendation and not a requirement (I.5.B.1.a) 56 Are Note and Note consistent with the requirements and recommendations of the GIPS standards? A B C Note 2? Consistent Inconsistent Inconsistent Note 3? Inconsistent Consistent Inconsistent FinQuiz.com © 2017 - All rights reserved 55 CFA Level III Mock Exam – Solutions (PM) Correct Answer: B Reference: CFA Level III, Volume 6, Study Session 18, Reading 32, LOS b & d Note is inconsistent with the GIPS standards which require firms to include discretionary, non-discretionary, fee-paying and non-fee paying portfolios for which a firm has investment management responsibility as part of total firm assets (I.0.A.13) WA manages non-discretionary portfolios, as evidenced in Exhibit and Note 6; therefore the firm is required to present its non-discretionary portfolios as part total firm assets Note is consistent with the GIPS standards Cash and cash equivalents must be included in total return calculations even if the cash is not actually invested by the same group or person By including returns on cash holding in portfolio return calculations, the firm has complied with the GIPS standards 57 Note is inconsistent with the requirements and recommendations of the GIPS standards with respect to WA’s use of derivatives instruments Which of the following has been omitted by the disclosure and represents a violation? A presence B characteristics C frequency of use Correct Answer: B Reference: CFA Level III, Volume 6, Study Session 18, Reading 32, LOS j Note is inconsistent with the GIPS standards as it fails to address the characteristics of the hedging strategies and instruments used to provide downside protection For instance, the protective put strategy provides downside protection while the bear spread strategy can be used to make money based on movements in the prices of the underlying stock By indicating the presence of option strategies as well as managing the frequency, being ‘frequently’, with which the underlying derivatives instruments are being used WA is in compliance with the GIPS standards in this regard FinQuiz.com © 2017 - All rights reserved 56 CFA Level III Mock Exam – Solutions (PM) 58 Is the firm’s decision to include downside deviation as a measure of internal dispersion appropriate (Note 5)? A Yes B No, the firm may only present standard deviation as a measure of risk C No, the GIPS glossary does not define downside deviation as a measure of risk Correct Answer: A Reference: CFA Level III, Volume 6, Study Session 18, Reading 32, LOS m A is correct When standard deviation is not an appropriate risk measure, as is the case with the large-cap equity composite whose returns distribution is skewed due to the presence of embedded options, the standards require firms to present an additional three-year ex post measure of risk for the composite and benchmark; that is, in addition to standard deviation WA has identified this measure as downside deviation which is appropriate B is incorrect See above C is correct Although the GIPS glossary does not specifically identify downside deviation as a risk measure, this does not mean that the use of this measure is inappropriate 59 Has the firm appropriately classified its non-discretionary portfolios (Note 6)? A Yes B No, the restriction does not impede the investment process C No, client restrictions on the portfolio manager not render a portfolio as non-discretionary Correct Answer: A Reference: CFA Level III, Volume 6, Study Session 18, Reading 32, LOS f FinQuiz.com © 2017 - All rights reserved 57 CFA Level III Mock Exam – Solutions (PM) By precluding a manager with an active mandate from investing in small-cap stocks, which represent a potential source of active returns, the flexibility of the investment manager is reduced as the constraint will restrict the manager’s freedom in making investment decisions to achieve portfolio objectives and executing his or her strategy in line with the mandate 60 Using the data in Exhibit 2, calculate the rate of return for the portfolio for the 1st quarter of 2015 using revaluing the large cash flow methodology A 6.21% B 16.32% C 17.42% Correct Answer: C Reference: CFA Level III, Volume 6, Study Session 18, Reading 32, LOS e The true time-weighted return (rtwr) will be calculated for each period and geometrically be linked to produce an overall portfolio return for the 1st quarter 2015 r31 Jan = r1-24 Feb = r25-28 Feb = r1-15 March = r16-31 March = 250, 000 − 242, 000 = 0.0331 242, 000 275, 000 − 250, 000 = 0.100 250, 000 282, 000 − 273, 000 = 0.0330 273, 000 262, 000 − 282, 000 = −0.0709 282, 000 295, 000 − 274, 000 = 0.0766 274, 000 1st Quarter 2016 rtwr = [(1+ 0.0331) (1 + 0.100) (1 + 0.033) (1 - 0.0709) (1+ 0.0766)] – = 17.42% FinQuiz.com © 2017 - All rights reserved 58 ...CFA Level III Mock Exam – Solutions (PM) FinQuiz. com – 5th Mock Exam 2017 (PM Session) Questions Topic Minutes 1-6 Ethical and Professional... Performance & Evaluation 18 49-54 Derivatives 18 55-60 Global Investment Performance Standards 18 Total FinQuiz. com © 2017 - All rights reserved 180 CFA Level III Mock Exam – Solutions (PM) Questions... to contribute to the blog during the weekends so as not to disrupt his routine work activities FinQuiz. com © 2017 - All rights reserved CFA Level III Mock Exam – Solutions (PM) The same evening,