Mock exam a afternoon session (with solutions)

2018 Level III Mock Exam PM The afternoon session of the 2018 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 Private Wealth 18 13–18 Private Wealth 18 19–24 Economics 18 25–30 Asset Allocation 18 31–36 Fixed Income 18 37–42 Equity 18 43–48 Alternative Investments 18 49–54 Derivatives 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 © 2017 CFA Institute All rights reserved 2018 Level III Mock Exam PM 2018 LEVEL III MOCK EXAM PM CleanTech Research Fund Case Scenario Kim Tang, CFA, is a consultant reviewing a hedge fund, CleanTech Research Fund CleanTech invests in high-­risk and volatile “clean technology” companies CleanTech has adopted the CFA Institute Code of Ethics and Standards of Professional Conduct Tang examines the various forms of advertising used by CleanTech to attract new clients In one of its advertising messages, CleanTech states, “We have a very experienced research team and are proud they are all CFA’s Several of our managers serve as volunteers for CFA Institute CFA Institute recognizes their expertise, and as a result, you can rely on our team for superior performance results.” In reviewing CleanTech’s marketing brochure, Tang reads the following statements: Statement The share prices of companies in the clean technology sector have increased recently because of the growing awareness of climate change issues and the rising cost of energy There are many risks in this sector, some of which include new technology that is unproven Also, the addition or removal of government incentives can make markets dysfunctional Nevertheless, it is our opinion that returns in this area will continue to be above average for several years In fact, our proprietary investment analytics software has determined that investments in green transportation companies are likely to double in value in the next six months based on a multiple factor regression analysis Key risks associated with analytics software include the fact that they rely on historical data and that a set of unknown factors could interfere with the anticipated results We will earn a 200% return over the next year on one of our solar power company investments based on sales projections we prepared, assuming that last year’s generous tax incentives stay in place Statement The CleanTech fund invests in publicly traded and highly liquid companies and is recommended only for investors who are able to assume a high level of risk Last month, we invested in EnergyAlgae, a “green energy” company that partnered with a global energy firm early last year to create oil from algae EnergyAlgae’s market capitalization quadrupled shortly after the partnership was formed Recently, EnergyAlgae also patented a waste plastic-­to-­oil process that produces oil at less than $30 a barrel One of the founders of CleanTech is on the board of EnergyAlgae, and information he gave us on the company’s patent process led us to purchase additional stock in EnergyAlgae before the patent became widely publicized with the release of the company’s semiannual financial report.* (*Information supporting the statements made in this communication is available upon request.) When Tang asks CleanTech’s founders for supporting documents related to their investment in EnergyAlgae, she is told that this information is based on third-­party research from Slar Brokerage (Slar), who maintains all necessary records Tang completes a due diligence exercise on this research and learns that Slar has used sound assumptions and rigor in its analysis of EnergyAlgae In particular, Tang learned that Slar used, at a minimum, the following attributes to form the basis of 2018 Level III Mock Exam PM the recommendation: the company’s past three years of operational history, current stage of the industry’s business cycle, an annual research update, a historical financial analysis, and a one-year earnings forecast Tang also learns that the founders of CleanTech are majority shareholders of Slar, which underwrote the public offering of EnergyAlgae Additionally, CleanTech’s analysts inform Tang that they did not need to look at the quality of Slar’s research because one of their former colleagues recently left CleanTech and established the research department at the brokerage firm In researching EnergyAlgae, Tang finds that potential customers and suppliers of EnergyAlgae are highly skeptical of the claims made regarding the company’s respective products She also contacts several energy companies and is unable to locate anyone who has even heard of EnergyAlgae When Tang reviews CleanTech’s trading activity in EnergyAlgae shares, she finds that CleanTech liquidated its position in EnergyAlgae soon after CleanTech’s portfolio managers presented positive views on EnergyAlgae in a number of media interviews In addition, many of CleanTech’s employees also sold their shares in EnergyAlgae immediately after CleanTech sold its shares of the company The share price of EnergyAlgae dropped dramatically after the stock sales made by CleanTech and its employees CleanTech’s advertising is least likely in violation of the CFA Institute Standards of Professional Conduct with respect to: A expected performance results B managers’ volunteer activities C use of the CFA designation B is correct Disclosure of the managers’ involvement with CFA Institute is not a violation of Standard VII(A)–Conduct as Members and Candidates in the CFA Program, because it does not reveal any confidential information But the CFA designation must always be used as an adjective In this situation, the designation has not been used as an adjective, thus the statement is in violation of Standard VII(B)–Reference to CFA Institute, the CFA Designation, and the CFA Program (i.e., the statement should read “the entire research team is made up of CFA charterholders,” rather than “they are all CFA’s”) Members must not exaggerate the meaning or implications of membership in CFA Institute or holding the CFA designation, which Tang does, violating Standard VII(B) A is incorrect because members must not exaggerate the meaning or implications of membership in CFA Institute or holding the CFA designation Statements that overstate the competency of an individual or imply that superior performance can be expected from someone with the CFA designation are not allowed under the Standard C is incorrect because the CFA designation must always be used as an adjective, i.e., “the entire research team is made up of CFA charterholders.” Guidance for Standards I–VII LOS a Standard VII(A)–Conduct as Members and Candidates in the CFA Program; Standard VII(B)–Reference to CFA Institute, the CFA Designation, and the CFA Program In Statement 1, CleanTech management most likely violated the CFA Institute Standards of Professional Conduct with regard to their comments on: A investment analytics software B clean technology sector returns C solar power company investment 2018 Level III Mock Exam PM C is correct The performance return claim is a violation of Standard V(B)–Communication with Clients and Prospective Clients, which requires opinion to be separated from fact In addition, Standard I(C)–Misrepresentation prohibits members and candidates from guaranteeing clients any specific return on volatile investments In the case of complex analyses, such as proprietary investment analytics software used by CleanTech, analysts must clearly separate fact from statistical conjecture and should identify the known limitations of an analysis, which has been done A is incorrect because the investment software has determined investment returns on green transportation companies based on a multiple factor regression analysis, so there is diligence and reasonable basis for the opinion as required by Standard V(A)–Diligence and Reasonable Basis In addition, disclosure of key risks associated with such software has been provided B is incorrect because Standard V(B)–Communication with Clients and Prospective Clients, which requires a balanced discussion of how this investment would perform should tax incentives change or be eliminated completely, has been addressed Guidance for Standards I–VII LOS a Standard V(B)–Communication with Clients and Prospective Clients; Standard I(C)–Misrepresentation In Statement 2, CleanTech most likely violated which of the following Standards of Professional Conduct? A Material Nonpublic Information B Suitability C Misrepresentation A is correct Standard II(A)–Material Nonpublic Information has been violated by the board member who shared material nonpublic information with the hedge fund and by the fund because it acted on the information Standard III(C)–Suitability does not appear to have been violated because the fund is characterized as a high-­risk investment, and it is clearly stated that EnergyAlgae is also a high-­risk investment CleanTech’s statement that the hedge fund benefited from the increase in share value for EnergyAlgae last year is a violation of Standard I(C)–Misrepresentation because the fund had only recently invested in the stock, so it did not benefit from the large move in the stock’s price B is incorrect because Standard III(C)–Suitability does not appear to have been violated because the fund is characterized as a high-­risk investment and it is clearly stated that EnergyAlgae is also a high-­risk investment C is incorrect because CleanTech’s statement that the hedge fund benefited from the increase in share value for EnergyAlgae last year is a violation of Standard  I(C)– Misrepresentation because the fund had only just recently invested in the stock, so it did not benefit from the large move in the stock’s price Guidance for Standards I–VII LOS a Standard II(A)–Material Nonpublic Information; Standard I(C)–Misrepresentation To be in compliance with the CFA Institute Standards of Professional Conduct, CleanTech should most likely question the validity of Slar’s research on EnergyAlgae for deficiencies in which of the following areas? A Operational analysis 2018 Level III Mock Exam PM B Earnings projections C Annual research update C is correct A reasonable and diligent effort was not made when the analysis on EnergyAlgae was updated on only an annual basis because the information on the company could change materially in such a high-­risk industry, a violation of Standard V(A)– Diligence and Reasonable Basis In addition, when the company reports financial results on a semiannual basis, an annual update to a research report would not be timely A and B are incorrect because the earnings projections along with the operational analysis are components of a reasonable and diligent effort Third-­party research may be relied upon only when a reasonable and diligent effort has been made to determine the research is sound, which in this case appears to have been performed Guidance for Standards I–VII LOS b Standard V(A)–Diligence and Reasonable Basis 5 Tang’s most appropriate course of action concerning the relationship between CleanTech and Slar is to recommend that CleanTech: A communicate relevant information to all clients B explain the ownership structure to all clients C sever the relationship immediately A is correct According to Standard  I(B)–Independence and Objectivity, full and fair disclosure of all matters that could reasonably be expected to impair independence and objectivity must be made to all clients In this case, the controlling position in the broker held by the founders of CleanTech, as well as the fact that Slar has underwritten two stocks the hedge fund holds and whose recommendations the fund relied on to make these investments, must be disclosed to all clients so they are better able to judge motives and possible biases for themselves C is incorrect because the controlling position in the broker as well as the fact that this firm has underwritten two stocks the hedge fund holds and whose recommendations the fund relied upon to make these investments must be disclosed to all clients so they may be better able to judge motives and possible biases for themselves according to Standard VI(A)–Disclosure of Conflicts; however, there is no requirement the position be eliminated B is incorrect because all clients should be made aware of the ownership structure along with other relevant information as required by Standard V(B)–Communication with Clients and Prospective Clients, and there should not be selective disclosure of just one piece of relevant information concerning the arrangement Guidance for Standards I–VII LOS b Standard I(B)–Independence and Objectivity The EnergyAlgae trades are least likely to have violated the CFA Institute Standards of Professional Conduct with regard to: A the adverse and skeptical opinions of EnergyAlgae products 2018 Level III Mock Exam PM B the order in which the shares were traded C share price distortion because of positive media presentations B is correct The hedge fund had priority in trading the stock ahead of employees The hedge fund is effectively the client But it does not alleviate the stock price manipulation that was engaged in by the fund and its employees, a violation of Standard II(B)–Market Manipulation In addition, there does not appear to be an adequate basis for recommending the stock (i.e., negative information on the company’s products from potential customers and suppliers), a violation of Standard V(A)–Diligence and Reasonable Basis A is incorrect because there does not appear to be an adequate basis for recommending the two stocks in violation of Standard V(A)–Diligence and Reasonable Basis C is incorrect because both the hedge fund and its employees have engaged in practices that distort prices in violation of Standard II(B)–Market Manipulation This appears to be a classic “pump and dump” fraud where worthless stock is promoted to the public and once it reaches a certain price level the insiders who helped boost the share price sell off their shares, leaving other investors holding stock that has little or no value Guidance for Standards I–VII LOS a Standard II(B)–Market Manipulation, Standard V(A)–Diligence and Reasonable Basis Connor McClelland Case Scenario Conner McClelland is a private client financial consultant with US-­based Edmonstone Wealth Management LLC McClelland has been engaged by Bradley and Reagan Graham to develop a personal wealth management plan Prior to meeting with McClelland, the Grahams filled out a personal profile questionnaire that will be used in developing their wealth management plan Using information from the questionnaire, McClelland prepares Exhibit 1 Exhibit 1  Graham Family: Personal and Financial Information Occupations and Family Structure ■ Bradley is a 50-­year-­old electrical engineer at a major utility company His annual income of $175,000 is projected to increase 3% per year He has a defined-­contribution pension plan and expects to retire at age 65 ■ Reagan is a 48-­year-­old pharmacist with a pharmaceutical company Her annual income of $132,000 is projected to increase 3% per year She has a defined-­contribution pension plan and expects to retire at age 65 Prior to joining the pharmaceutical company, Reagan had a 20-­year career in the US Navy, retiring at the rank of commander ■ The family has two children, ages 10 and Financial Information Checking account $27,000 Taxable investment account 625,000 Residence 525,000 Residential mortgage 285,000 Outstanding balance on a $100,000 home equity line of credit 38,000 Bradley’s defined-­contribution plan (vested; normal retirement age for the plan is 65) 796,000 Cash value of Bradley’s life insurance ($250,000 death benefit) 67,000 2018 Level III Mock Exam PM Exhibit 1  (Continued) Financial Information Estimated present value of Bradley’s future earnings 2,150,000 Reagan’s defined-­contribution plan (vested; normal retirement age for the plan is 65) 160,000 Present value of Reagan’s military pension (vested; inflation indexed; survivor benefit) 1,320,000 Cash value of Reagan’s life insurance ($250,000 death benefit) 52,000 Estimated present value of Reagan’s future earnings 1,790,000 Estimated present value of the Grahams’ future consumption 3,700,000 Aspirational and Other Goals ■■ Cost of four years of university for the two children, with an estimated present value of $350,000 ■■ Purchase of a vacation home in the next five years, with an estimated present value of $325,000 ■■ Donations to charitable organizations during the next 15 years, with an estimated present value of $400,000 At their initial meeting, Bradley tells McClelland that he recently attended a financial planning seminar conducted by his employer’s human resources department One of the presenters discussed the importance of preparing and understanding the components of an economic balance sheet compared with a traditional balance sheet Bradley was confused by a few of the presenter’s comments and asks McClelland for further clarification The presenter’s comments were as follows: ■■ Real estate can be described as a personal asset, an investment asset, and a mixed asset ■■ Financial capital consists of tangible and intangible assets, including both the vested and unvested portions of an employer pension plan ■■ The value of human capital relative to overall economic wealth is typically higher for an individual in mid-­career with an established earnings record than for an individual in the early stages of his career As McClelland reviews insurance coverage with the Grahams, he explains that there are various ways to manage risk “It depends on the frequency of a risk occurring and the severity of the potential loss For example, consider the following two risks: ■■ An earthquake: This risk seldom occurs but would result in a large financial loss; ■■ Dental cavities: This risk arises frequently, resulting in small financial losses.” McClelland determines that both Bradley’s and Reagan’s life insurance coverage is inadequate Bradley is particularly concerned about the inadequacy of his life insurance and asks McClelland to calculate how much additional insurance he should purchase to cover him until he retires in exactly 15 years and begins to receive his employer pension McClelland prefers to use the human life value method to determine the appropriate level of life insurance coverage Exhibit  contains additional personal and financial information about Bradley 2018 Level III Mock Exam PM Exhibit 2  Bradley Graham: Additional Personal and Financial Information Current annual income; salary and expenses expected to increase 3% per year $175,000 Income and payroll taxes (percentage of annual income) 30% Employer contribution to defined-­contribution plan (percentage of annual income) 5% Annual family expenses attributable to Bradley 20,000 Estimated tax rate on income earned on insurance proceeds 20% Applicable discount rate 4% The Grahams mention that a primary concern is the ability to manage the risks to both their financial and human capital so that they can achieve their financial goals of maintaining a comfortable lifestyle while having sufficient assets to purchase a vacation home, pay for their children’s university education, and fund charitable donations Bradley mentions that he and Reagan have some concern about possibly outliving their assets and that he understands annuities can help protect against this risk He is interested in an annuity that will provide income for as long as one of them is alive The Grahams have average risk tolerance and expect they will be able to adjust their spending in retirement if necessary Using the data in Exhibit 1, the Grahams’ net wealth (in thousands) is closest to: A $2,174 B $2,414 C $2,795 B is correct The Grahams’ net wealth is their total assets less their total liabilities ($7,512 – $5,098 = $2,414), as calculated in the following economic balance sheet Economic Balance Sheet of Bradley and Reagan Graham ($ thousands) Assets Liabilities Financial Capital Debts  Checking account $27 Residential mortgage  Taxable investment account 625 Home equity line of credit – outstanding balance 38  Residence 525  Cash value of life insurance (combined Bradley and Reagan) 119 University education for children 350 Vacation home 325 Human capital (combined Bradley and Reagan) 3,940 Lifetime consumption (present value) Planned donations Employer pensions (combined Bradley and Reagan) 956 Military pension (Reagan) 1,320 Total Liabilities $285 3,700 400 $5,098 2018 Level III Mock Exam PM (Continued) Assets Total Assets Liabilities Net Wealth $7,512 Total Liabilities and Net Wealth $2,414 $7,512 A is incorrect Human capital was not included in assets and lifetime consumption was not included in liabilities: [(7,512 – 3,940) – (5,098 – 3,700)] = 3,572 – 1,398 = 2,174 C is incorrect The death benefit rather than the cash value of life insurance was included in the calculation of assets: (7,512 + 250 + 250 – 119) – 5,098 = 7,893 – 5,098 = 2,795 Risk Management for Individuals LOS d Section 3.3 Which of the presenter’s comments regarding economic and traditional balance sheets is most accurate? A The comment about human capital B The comment about financial capital C The comment about real estate C is correct Personal assets are consumed, whereas investment assets are held for the potential to increase in value and fund future consumption Some assets, such as real estate, can be described as “mixed assets” because they can act as both personal assets (shelter) and investment assets (to help fund retirement) B is incorrect Financial capital includes the tangible and intangible assets (outside of human capital) owned by an individual or household Financial capital would include the vested portion but not the unvested portion of an employer pension plan A is incorrect The economic wealth of an individual changes throughout their lifetime, as the underlying assets that make up that wealth The total economic wealth of younger individuals is typically dominated by the value of their human capital because younger individuals have not had as much time to save and accumulate financial wealth As individuals grow older, they are likely to save some of their earnings and will accumulate financial capital Risk Management for Individuals LOS a, b Sections 2.2 and 3.3.2 Which of the following risk management techniques is most appropriate for the second risk exposure example provided by McClelland? A Risk retention B Risk reduction C Risk transfer 10 2018 Level III Mock Exam PM B is correct A risk with the loss characteristics of high frequency of occurrence and low severity of loss, such as dental cavities, is best managed through risk reduction—for example, through proper dental hygiene A risk with the loss characteristics of low frequency of occurrence and high severity of loss, such as an earthquake that destroys your home, is best managed through risk transfer A risk with the loss characteristics of low frequency of occurrence and low severity of loss is best managed through risk retention, such as not purchasing an extended warranty on an infrequently used and relatively inexpensive item A is incorrect A risk with the loss characteristics of low frequency of occurrence and low severity of loss would be best managed through risk retention, such as not purchasing an extended warranty on an infrequently used and relatively inexpensive item C is incorrect A risk with the loss characteristics of low frequency of occurrence and high severity of loss, such as an earthquake that destroys your home, would be best managed through risk transfer Risk Management for Individuals LOS j Section 5.1 10 Based on the data in Exhibits and and using the human life value method for determining life insurance needs, the additional amount of life insurance that Bradley should purchase is closest to: A $1,701,345 B $1,547,862 C $1,951,345 A is correct The additional amount of life insurance Bradley should purchase using the human life value method is calculated as follows The calculations assume (1) Bradley works for exactly 15 years and (2) his family needs the proceeds of the life insurance immediately upon his death Calculate the pretax income needed to be replaced Bradley’s annual income (before taxes) $175,000 Less: income and payroll taxes at 30% ($175,000 × 30%) = 52,500 Annual income (after taxes) 122,500 Less: family expenses attributable to Bradley 20,000 Net annual income after expenses attributable to Bradley 102,500 Plus: non-­taxable employer contribution to defined-­contribution retirement plan ($175,000 × 5%) = 8,750 Net after-­tax income needed to be replaced for Bradley 111,250 Amount of pretax income needed to replace the net after-­tax income: [($111,250/(1 – 0.20)] = ($111,250/0.80) = $139,063 Adjust the discount rate to account for the projected growth rate of earnings and expenses Discount rate: 4% Projected annual salary and expense increase for Bradley: 3% 2018 Level III Mock Exam PM Risk 3: Misjudging whether a stock’s undervaluation will correct within the investor’s investment horizon Smith concludes by telling Morris that she is impressed by MCAM’s track record in adding alpha in the US stock market However, she believes that the European equity markets are likely to outperform the US equity markets over the next five years She asks whether MCAM can structure a portfolio to capture both opportunities Morris offers to combine his long–short active equity strategy with a EURO STOXX 50 Index strategy 37 Based on Exhibit 1, the approach that is least likely efficient with respect to delivering active returns for a given level of tracking risk is: A semi-­active derivatives B semi-­active equity C active equity C is correct The active equity strategy has the lowest information ratio and is thus least efficient in delivering active returns Information ratio = Active return (Portfolio – Benchmark)/Tracking risk The information ratio is 0.5%, which is the lowest of the three B is incorrect because its information ratio is 0.6 A is incorrect because its information ratio is 0.7 Equity Portfolio Management LOS b Section 38 McKeen’s response to Smith’s question about MCAM’s active equity style is least likely correct with respect to: A Reason B Reason C Reason C is correct A market-­neutral strategy is constructed to have an overall zero beta and thus show a pattern of returns expected to be uncorrelated with equity market returns B is incorrect The statement is correct A is incorrect The statement is correct Equity Portfolio Management LOS m Section 5.3.1 39 Smith’s Comment and Comment 2, respectively, are most likely consistent with an investment style that is: A active; active B semi-­active; active C active; semi-­active 33 34 2018 Level III Mock Exam PM C is correct Comment describes the characteristics of an active approach, and Comment describes the characteristics of a semi-­active approach A is incorrect because Comment describes a semi-­active approach B is incorrect because Comment describes an active approach, and Comment describes a semi-­active approach Equity Portfolio Management LOS c Section 40 Based on Exhibits and 3, what can Smith most likely determine about MCAM’s investment style over time? MCAM's style has: A drifted from growth to value B drifted from value to growth C not drifted A is correct The active equity strategy was not value oriented because the returns-­based style analysis indicates a growth orientation given a 0.65 coefficient of determination with respect to growth returns The current holdings, however, depict a value orientation when compared with the manager’s normal benchmark given the differences in dividend yield and P/E MCAM’s style has drifted over time from growth to value B is incorrect because the two methodologies show a drift from growth to value C is incorrect because the two methodologies show a shift Equity Portfolio Management LOS c Section 5.1.4 41 Which of the risks Morris identifies with respect to MCAM’s active equity strategy is least likely applicable to a growth-­oriented investor? A Risk B Risk C Risk A is correct The main risk for a value-­oriented investor rather than a growth-­oriented investor is misinterpreting a stock’s cheapness within the investor’s time horizon B is incorrect because earnings per share growth is most applicable to a growth-­ oriented investor C is incorrect because earnings multiple contraction is most applicable to a growth-­ oriented investor Equity Portfolio Management LOS h Sections 5.1.1, 5.1.2 2018 Level III Mock Exam PM 42 The type of portfolio that Morris recommends to Smith to take advantage of both US and European equity market opportunities is most likely a(n): A completeness fund B core–satellite C alpha and beta separation C is correct Alpha and beta separation involve combining an index strategy with a market-­neutral active strategy in order to earn a desired beta + alpha outcome Smith’s objective is to realize returns from the European market (beta) + MCAM’s active return (alpha) In this case, by using the EURO STOXX 50 index strategy, MCAM is able to offer both strategies combined into an alpha and beta separation strategy for Smith A is incorrect because a completeness fund, when added to active managers’ positions, establishes an overall portfolio with approximately the same risk exposures as the investor’s overall equity benchmark B is incorrect because a core–satellite constitutes of a core holding plus a number of active managers to represent a ring of satellites around this core This is not the same as alpha and beta separation because each of the core and satellite holdings are producing both beta and alpha Equity Portfolio Management LOS t Section 7.3 Faith Wanja Case Scenario Faith Wanja is an asset consultant to many large Kenyan pension funds In response to numerous client inquiries about alternative investment products now being offered in the market to pension funds, she decides to hold a seminar for her clients She believes it is important for her clients to understand the pros and cons of adding alternate investments to their existing portfolios, which are made up of public equity, fixed-­income securities, and direct real estate investments To start off the seminar, Wanja discusses the general characteristics of real estate investment trusts (REITs), private equity, and hedge funds She makes the following statements: Statement Hedge funds have tended to be more heavily regulated than other pooled investments because of their perceived higher risk profiles Statement Successful private equity investments, unlike public equity investments, rely heavily on a portfolio manager’s business skills rather than his or her portfolio management skills Statement REITs act as cash flow conduits for underlying real estate assets Wanja discusses the possible benefits of adding REIT investments to her clients’ portfolios that currently only hold equities and fixed-­income securities She indicates to the seminar participants that two existing private property investment companies (Batian and Lenana) are converting to a REIT structure and will soon be listed on the local securities exchange In Exhibit 1, Wanja shows the audience the projected impact on her clients’ portfolios, as reflected in a client composite, by adding one of the two REITs to a portfolio that had a 50/50 allocation to equities and fixed income 35 36 2018 Level III Mock Exam PM Exhibit 1  Forecast Data for Portfolio Returns Client Composite with Traditional 50/50 Equity/ Bond (%) Client Composite with Batian REIT 45/45/10 Equity/ Bond/REIT (%) Client Composite with Lenana REIT 45/45/10 Equity/ Bond/REIT (%) Expected return 15.5 18.3 20.6 Standard deviation of returns 9.8 12.5 18.4 Measure The next topic Wanja discusses is private equity investments She lists the attributes of private equity and the possible benefits of adding private equity to a pension fund as follows: Private equity has low correlations with public equity, so it can greatly contribute to a portfolio’s ability to diversify risks The asset class’s low liquidity generally implies a smaller allocation Small pension funds should invest in a fund-­of-­funds structure to help increase diversification without increasing expenses She tells the audience that private equity management fees are often based on a percentage of the value of the limited partners’ committed funds and tend to stay the same throughout the life of the investment In addition, managers typically receive carried interest of about 20%, which is paid before any limited partner distribution of profits But limited partners sometimes require a clawback provision that mandates if they not achieve the preferred return over the full life of the investment, the manager is required to forfeit carried interest previously earned After Wanja finishes her presentation, she opens the floor to questions An audience member tells Wanja she recently met an investment adviser for high-­net-­worth individuals who stated that she has a tougher job advising high-­net-­worth clients than someone managing funds for institutional investors She asks, “Is this true? I would have thought the level of responsibility would be very similar for both types of clients.” Wanja responds, “Investment advisers have a fiduciary duty to both individual clients and institutional clients, so it is vital to discuss the issue of suitability with both types of client But advisers working with high-­net-­worth clients must recognize that they are more prone to panicking and changing strategies when there are large losses than institutional investors.” Wanja ends the seminar by stating that pension fund managers should consider investing in distressed securities if approved by the pension regulator She states, “Because government security yields remain low, pension funds will need to chase yield, and distressed securities can add value to a portfolio because Sharpe ratios of distressed securities tend to be understated.” She further explains her recommendation by saying, “Credit risk assessments are also often similar across distressed companies because they have similar cash flow problems, so due diligence costs are not very high I should also point out that market risk is not as important as liquidity risk for distressed securities.” 43 Which of Wanja’s statements regarding the new asset classes available in the Kenyan market is least likely correct? A Statement B Statement 2018 Level III Mock Exam PM C Statement C is correct Hedge funds have tended to be less regulated, not more regulated, than other types of pooled investments Internationally, hedge funds have adopted structures that permit them to be loosely regulated and to avoid certain reporting and other requirements A is incorrect because Statement about private equity is incorrect Successful investment in private equity relies heavily on the portfolio manager’s skills as a businessperson rather than his portfolio management skills B is incorrect because Statement about REITs is incorrect REITs act as cash flow conduits for underlying real estate assets Alternative Investments Portfolio Management LOS d Section 44 Based only on the information in Exhibit 1 and a risk-­free rate of 8%, should Wanja most likely recommend a 10% REIT exposure to her clients’ existing portfolios? A Yes, the Batian REIT B No C Yes, the Lenana REIT A is correct On the basis of the data given, the Sharpe ratio for the portfolio that includes the Batian REITs is greater [(18.3 – 8.0)/12.5  = 0.82] than for the other two portfolios Therefore, Wanja should recommend to her clients that they modify their current strategic asset allocation to include the Batian REIT B is incorrect On the basis of the data given, the Sharpe ratio for the portfolio that includes the Batian REITs is greater [(18.3 – 8.0)/12.5 = 0.82] than the portfolio without any REIT exposure [(15.5 – 8.0)/9.8 = 0.77] Therefore, Wanja should recommend to her clients that they modify their current strategic asset allocation to include the Batian REIT C is incorrect On the basis of the data given, the Sharpe ratio for the portfolio including the Lenana REITs is less [(20.6 – 8.0)/18.4 = 0.68] than the portfolio including the Batian REIT Therefore, Wanja should recommend to her clients that they modify their current strategic asset allocation to include the Batian REIT Alternative Investments Portfolio Management LOS f Section 3.3.2 45 When discussing the possible benefits of adding private equity to a pension fund, Wanja is most likely correct regarding the: A relationship between liquidity and size of the exposure B ability to diversify portfolio risks C use of a fund-­of-­funds structure 37 38 2018 Level III Mock Exam PM A is correct Private equity investments, both direct and through private equity funds, are highly illiquid Capital is typically restricted from exiting the fund for to 10 years As a result, private equity allocations are typically 5% or less B is incorrect Private equity returns have moderately high average correlations with publicly traded share returns in that all types of businesses have some exposure to economic and industry conditions Private equity probably can only play a moderate role as a risk diversifier C is incorrect Although a private equity fund-­of-­funds is likely a better diversification strategy for small funds given that institutional partnership commitments are typically not less than US$5 million, they add a second layer of management fees Alternative Investments Portfolio Management LOS l Section 4.3.2 46 Wanja’s explanation of a private equity fund manager’s fees is least likely correct with regards to: A management fees B clawback provisions C carried interest A is correct Although management fees are typically based on the percentage of the value of limited partners’ committed funds, management fees often scale down in the later years of a partnership to reflect a lower workload as the fund becomes fully invested Consequently, the manager is not actively involved in identifying potential investment companies B is incorrect because her explanation regarding clawback provisions is correct C is incorrect because her explanation regarding carried interest is correct Alternative Investments Portfolio Management LOS k Section 4.1.1 47 Is Wanja most likely correct when she explains the differences between managing high-­net-­worth client funds and institutional funds? A No, in regard to decision risk B Yes C No, in regard to communication with clients B is correct Wanja is correct in that advisers have a fiduciary duty to both types of clients, so advisers must determine and communicate issues of suitability with all types of clients She is also correct in stating that high-­net-­worth individuals are more prone or sensitive to losses at any given point in their investment time horizon, reflecting a higher level of decision risk than institutional investors 2018 Level III Mock Exam PM A is incorrect Wanja is correct in that advisors have a fiduciary duty to both types of clients so advisors must determine and communicate issues of suitability with all types of clients She is also correct in stating that high-­net-­worth individuals are more prone or sensitive to losses at any given point in their investment time horizon, reflecting a higher level of decision risk than institutional investors C is incorrect Wanja is correct in that advisors have a fiduciary duty to both types of clients so advisors must determine and communicate issues of suitability with all types of clients She is also correct in stating that high-­net-­worth individuals are more prone or sensitive to losses at any given point in their investment time horizon, reflecting a higher level of decision risk than institutional investors Alternative Investments Portfolio Management LOS c Section 48 Which of the distressed security characteristics described by Wanja is most likely correct? A Sharpe ratio B Due diligence costs C Market risk C is correct Market risk is correct For distressed securities, uncertainty regarding the economy, interest rates, and the state of equity markets are not as important as liquidity risks A is incorrect because the Sharpe ratio for distressed securities is often overstated, not understated, due to stale valuations B is incorrect because due diligence costs are likely to be costly because investing in distressed securities is complex and requires legal, operational, and financial analysis and each distress situation requires a unique approach and solution Alternative Investments Portfolio Management LOS t Section 8.3.2 Omega Analytics Case Scenario Omega Analytics provides risk management consulting services for institutional and individual clients Rachel Osborne, CFA, is an investment adviser for Omega who works with the firm’s larger accounts She is considering derivative strategies for four separate clients: HMM Foundation, Bob Valentine, Bedford Trust, and Kung Chen HMM Foundation owns 30,000 shares of NASDAQ 100 Index Tracking Stock (QQQQ), which has a current price of $30 per share Osborne believes there is substantial risk of downside price movement in the index over the next six months She recommends HMM use a six-­month collar for the entire position of 30,000 shares as protection against the QQQQ price falling below $27 HMM would maintain the collar strategy until expiration of the put and call options Exhibit 1 provides data on current QQQQ puts and calls expiring in six months 39 40 2018 Level III Mock Exam PM Exhibit 1  QQQQ Puts and Calls Expiring in Six Months Option Type Exercise Price ($) Option Premium ($) Call 35 0.80 Put 27 0.95 Another client, Bob Valentine, believes the prices of large-­capitalization stocks will rise slightly, and he wants to profit from this movement using a bull spread strategy Osborne recommends that Valentine use 1/100 Dow Jones Industrial Average (DJX) options expiring in two months The current price of DJX is $91 Exhibit 2 provides current option information for two DJX call options expiring in two months Exhibit 2  DJX Call Options Expiring in Two Months Option Premium ($) Delta 88 4.40 0.75 94 1.00 0.30 Exercise Price ($) Valentine decides to use 100 contracts per position Each contract is equal to 100 shares The Bedford Trust is focused on long-­term growth and invests only in equities The trust has an equity portfolio with a market value of $60 million, of which $20 million is allocated to WTO stock Its trustees are considering a temporary decrease in the allocation to WTO stock in order to diversify into small-­capitalization US stocks Osborne recommends the Russell 2000 Index as an appropriate small-­capitalization index and recommends that Bedford Trust enter into an equity swap on $20 million of WTO stock with the Russell 2000 Kung Chen expects the tracking stock on the SPDR Dow Jones Industrial Average ETF (DIA) to trade within a narrow range around its current price over the near term On the basis of this expectation, he believes a profitable trading opportunity is to initiate a butterfly spread strategy using call options on DIA Osborne suggests using three one-­month call options on the DJIA Chen initiates a butterfly spread using a total of 200 long contracts and 200 short contracts Exhibit 3 illustrates current DJIA call options expiring in one month Exhibit 3  DJIA Call Options Expiring in One Month Exercise Price ($) Option Premium ($) 88 4.20 92 2.00 96 0.50 49 If HMM enters into the collar recommended by Osborne, and the market value of QQQQ is $33 when the options expire, the change in the profit of the collar would be closest to: 2018 Level III Mock Exam PM A $94,500 B $85,500 C $90,000 B is correct The profit per collar = ST + max(0,X1 – ST) – max(0,ST – X2) – S0 – (p0 – c0), where: S0, ST = price of underlying at time and time T X1 = exercise price of put X2 = exercise price of call p0 = price of put at time c0 = price of call at time Profit = 33 + – – 30 – 0.15 = 2.85 Total profit = $2.85 × 30,000 = $85,500 A is incorrect because the net premium was added rather than subtracted C is incorrect because it ignores the initial cost of the options Risk Management Applications of Option Strategies LOS b Section 2.4.1 50 If HMM enters into the collar recommended by Osborne, the maximum profit of the collar at option expiration would be closest to: A $154,500 B $150,000 C $145,500 C is correct The maximum profit on the collar occurs when the short call expires at the money (i.e., QQQQ = $35) Max profit per collar = ST + max(0,X1 – ST) – max(0,ST – X2) – S0 – (p0 – c0) Max profit per collar = 35 + – – 30 – 0.15 = $4.85 Total max profit = 4.85 × 30,000 = $145,500 A is incorrect because it adds the initial cost of the options rather than subtracts B is incorrect because it ignores the initial cost of the options Risk Management Applications of Option Strategies LOS b Section 2.4.1 51 At expiration of the DJX call options, the maximum potential profit from the bull spread strategy recommended for Valentine is closest to: A $60,000 B $6,000 C $26,000 41 42 2018 Level III Mock Exam PM C is correct A bull spread combines a long call at a lower exercise price (X1 = 88) and a short call at a higher exercise price (X2 = 94) The cost of X1 is c1 = $4.40, and the benefit from X2 is c2 = $1.00 The maximum profit per contract = (X2 – X1 – c1 + c2) × 100  = ($94 – $88 – $4.40 + $1.00) × 100  = 2.60 × 100  = $260 The maximum profit for 100 contracts is $260 × 100 = $26,000 B is incorrect because it looks only at the terminal value of the option, not their initial costs C is incorrect because it ignores the option premium, i.e., ($94 – $88) × 100 = $6,000 Risk Management Applications of Option Strategies LOS b Section 2.3.1 52 If the price of DJX is $91, the delta of Valentine’s bull spread just before contract expiration, will most likely be in the range of: A 0.00 to 0.20 B 0.40 to 0.60 C 0.80 to 1.00 C is correct If the price of DJX = $91, then the long call (exercise price = $88) will be in the money and its delta would be close to 1.0 The short call (exercise price = $94) will be out of the money and (very close to expiration) its delta would be close to 0.0 The overall delta is then very close to 1.0 A is incorrect If the price of DJX = $91, then the long call (exercise price = $88) will be in the money and its delta would be close to 1.0 The short call (exercise price = $94) will be out of the money and (very close to expiration) its delta would be close to 0.0 The overall delta is then very close to 1.0 B is incorrect If the price of DJX = $91, then the long call (exercise price = $88) will be in the money and its delta would be close to 1.0 The short call (exercise price = $94) will be out of the money and (very close to expiration) its delta would be close to 0.0 The overall delta is then very close to 1.0 Risk Management Applications of Option Strategies LOS e, f Section 2.3.1 53 If Bedford Trust implements Osborne’s recommendation regarding WTO, it will least likely experience a cash outflow if the returns on WTO stock and the Russell 2000 Index are: A WTO Return: Positive and Russell 2000 Return: Negative B WTO Return: Negative and Russell 2000 Return: Positive C WTO Return: Zero and Russell 2000 Return: Negative 2018 Level III Mock Exam PM B is correct Bedford has entered into a swap that pays the return on the WTO stock and receives the return on the Russell 2000 If it pays a negative return on the WTO stock, it will receive a cash inflow; receiving a positive return on Russell 2000 Index is also a positive cash inflow A is incorrect Bedford would pay the counterparty on both the WTO and Russell 2000 Index return resulting in only a cash outflow C is incorrect Bedford would pay the counterparty nothing for the WTO return, but would pay for the Russell 2000 Index return Risk Management Applications of Swap Strategies LOS g Section 4.1 54 If Chen creates a butterfly spread using the three one-­month call options suggested by Osborne, the maximum potential loss at expiration is closest to: A $7,000 B $3,000 C $27,000 A is correct A butterfly spread involves call options with three different exercise prices— the investor goes long one call each at the lowest and highest exercise prices and short two calls at the middle exercise price In this case, Chen is long 100 calls at X1 = 88 (c1 = 4.20), short 200 calls at X2 = 92 (c2 = 2.00), and long 100 calls at X3 = 96 (c3 = 0.50) Maximum loss per contract = c1 – 2c2 + c3  = [$4.20 – (2 × $2.00) + $0.50] × 100  = $0.70 × 100  = $70 To find the maximum loss at expiration for Chen’s spread strategy, multiply the per contract payoff by 100, or $70 × 100 = $7,000 B is incorrect C is incorrect Risk Management Applications of Option Strategies LOS b Section 2.3.3 Katherine Ng Case Scenario Katherine Ng, a Global Investment Performance Standards (GIPS) specialist, has been hired as a consultant to assist Rune Managers in becoming a GIPS-­compliant firm Rune is a global asset manager with several divisions around the world that invest in both stock and bond strategies James Arnott, a performance specialist at Rune, is responsible for the project In their first meeting, Ng and Arnott discuss the GIPS standards and the steps Rune will need to take to become compliant Ng recommends starting with the definition of the firm She tells Arnott that how the firm is defined will affect the compliance process and that the standards recommend the firm be defined as broadly as possible Arnott replies that Rune management 43 44 2018 Level III Mock Exam PM has been discussing the firm definition, and they want the definition to include all Rune divisions except the European division, Rune Europe Rune Europe has its own strategies and management team that are distinct from the rest of Rune Ng replies that the Rune Europe division should be included in the definition of the firm because the division markets itself as part of Rune Managers Ng then asks about Rune’s policies for the inclusion of portfolios in composites Arnott responds that Rune has the following policies for all composites: Policy All new accounts funded with cash or securities on or before the 10th day of the month are added to the composite at the beginning of the following month Those funded after the 10th day of the month are added at the beginning of the 2nd month after funding, or at the beginning of the calendar month after the proceeds are substantially invested in the appropriate strategy Policy All portfolios are deemed “non-­discretionary” on the date the notice of termination of the management relationship is received and removed from the composite at the end of the month of notification The discussion then moves on to a new composite that Rune is constructing Arnott tells Ng that the marketing department has decided to target domestic Swiss investors and would like to carve out the Swiss portion of international and global accounts for the period of January 2006 through January 2011 and allocate cash to each carved-­out segment to create a Swiss franc (CHF) composite Ng responds that this new composite will comply with the standards, but Rune must disclose the percentage of composite assets that are carve-­outs for each annual period end, as well as the policy used to allocate cash to the carved-­out segments Arnott interjects that the marketing department is looking forward to claiming GIPs compliance in advertisements He is meeting with the marketing department and asks Ng what they need to be aware of regarding the Standards in advertising Ng responds that there are several requirements in the GIPS Advertising Guidelines; specifically, the following must be disclosed in the advertisements: the firm description, composite and benchmark descriptions, and the number of accounts in the composite Arnott and Ng then move on to discuss one of Rune's GIPS-­compliant performance presentations, provided in Exhibit 1 Exhibit 1  Rune Mid-­Capitalization Value Equity Composite (Benchmark: Russell Midcap Value Index) Year Composite Gross Return (%) Composite Net Return (%) Benchmark Return (%) 2006 11.2 10.69 2007 18.92 2008 0.07 2009 –33.75 2010 2011 Composite 3-­Year Std Dev (%) Number of Portfolios Internal Dispersion (%) Composite % of Firm Assets 12.65 15 0.09 7.1 18.68 20.22 19 0.06 7.2 –0.17 –1.42 22 0.46 6.8 –33.95 –38.44 23 0.25 5.5 31.44 31 34.21 26 0.95 5.9 22.09 21.73 24.75 25 0.21 6.9 22.83 Rune Managers claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards Rune Managers has not been independently verified Notes: Rune Managers is an investment manager registered with the US SEC Rune Managers has divisions in Europe, Asia, and the United States that invest in various equity and bond strategies 2018 Level III Mock Exam PM Exhibit 1  (Continued) The Rune Mid-­Capitalization Equity Composite includes all institutional portfolios that invest in mid-­capitalization US equities, with the goal of providing long-­term capital growth and steady income from dividends by investing in low price-­to-­earnings, undervalued securities A complete list and description of Rune Managers’ composites, as well as policies for valuing portfolios and preparing compliant presentations, are available upon request The composite was created on 30 November 2005 Leverage, derivatives, and short positions are not used by this strategy Performance is expressed in US dollars The returns include the reinvestment of all income Gross-­of-­fees returns are presented before management and custodial fees but after all trading expenses Net-­of-­fees returns are calculated by deducting the actual fees of the accounts from the gross composite return The management fee schedule is as follows: 0.80% on the first $10 million, 0.55% on the next $40 million, 0.40% on assets greater than $50 million This presentation is not required to conform to any laws or regulations that conflict with the GIPS standards Internal dispersion is calculated using the asset-­weighted standard deviation of annual gross returns of those portfolios that were included in the composite for the entire year 10 The three-­year annualized standard deviation measures the variability of the composite and the benchmark returns during the preceding 36-­month period The standard deviation is not presented for 2006 through 2010 because monthly composite and benchmark returns were not available, and it is not required for periods prior to 2011 55 In their discussion of the Rune Europe division, which of the following is most likely correct? A Ng’s analysis, because of how the division markets itself B Arnott’s analysis, because of how the strategies are run C Arnott’s analysis, because of how the division is managed A is correct Ng is correct Because Rune Europe is using the Rune Managers name and marketing materials, the division is not being held out to clients or potential clients as a distinct business entity, so it should be included in the definition of the firm B is incorrect because although Rune Europe has a distinct strategy, it is not held out as a distinct business entity and so should be included in the definition of the firm C is incorrect because although Rune Europe has a distinct management team, it is not held out as a distinct business entity and so should be included in the definition of the firm Global Investment Performance Standards LOS b Section 3.1 56 Which policy on the inclusion of portfolios in composites is most likely compliant with the GIPS standards? A Policy B Policy C Policy and Policy 45 46 2018 Level III Mock Exam PM A is correct The policy on account inclusion is compliant with the standards B is incorrect A firm must include a terminated portfolio in the historical performance of the appropriate composite up to the last full measurement period that the portfolio was under management Portfolios should be removed at the start of the period of notification C is incorrect, policy is not compliant with GIPS standards Global Investment Performance Standards LOS h Section 3.9 57 In the discussion of carve-­outs, Ng is least likely correct in her statement regarding the: A disclosure of the cash allocation policy B compliance of the composite C disclosure of the percentage of composite assets B is correct For periods after January 2010, carve-­outs must include their own cash balance in order to be included in a composite, so a cash allocation policy for periods after January 2010 would not be GIPS compliant A is incorrect because the firm is required to disclose the cash allocation policy for periods prior to January 2010 C is incorrect because the compliant presentation is required to present the percentage of the composite that is composed of carve-­outs as of each annual period end for periods beginning on or after January 2006 and ending before January 2011 Global Investment Performance Standards LOS i Section 3.10 58 In the discussion of the GIPS Advertising Guidelines, Ng is most likely correct in her statement regarding the disclosure of: A composite description B number of accounts in the composite C firm description C is correct The firm description must always be presented in GIPS compliant advertisements The number of accounts in the composite need not be disclosed in advertisements, and only advertisements that include performance information must disclose the composite and benchmark descriptions A is incorrect because only advertisements that include performance must disclose the composite and benchmark descriptions 2018 Level III Mock Exam PM B is incorrect because the number of accounts in the composite is not required to be disclosed in advertisements Global Investment Performance Standards LOS r Section 59 Regarding the disclosures contained in the notes to Exhibit 1, the notes most likely required are: A 1, and B 2, and C 6, and C is correct The currency used to express performance, whether any fees other than trading expenses are deducted from gross-­of-­fees returns, whether any fees other than trading expenses and management fees are deducted from net-­of-­fees returns, the fee schedule, and a measure of internal dispersion are all required disclosures for compliance with the GIPS standards A is incorrect because firms must only disclose the presence, use, and extent of leverage, derivatives, and short positions if it is material; no negative statement is required B is incorrect because firms must only disclose if the presentation conforms to laws or regulations that conflict with the requirements of the GIPS standards; no negative statement is required Global Investment Performance Standards LOS j, k Sections 3.11, 3.12, and 3.13 60 Regarding Exhibit 1, which item is least likely an error in the presentation? A Composite percentage of firm assets B Note C Three-­year standard deviation A is correct The annualized three-­year ex post standard deviation of monthly returns must be presented for both the composite and the benchmark for each annual period after January 2011 Firms are required to disclose that policies for valuing portfolios, calculating returns, and preparing compliant presentations are available upon request B is incorrect because the disclosures in note #3 are required for compliance with the GIPS standards C is incorrect because either the percentage of the firm’s total assets represented by the composite or the amount of total firm assets at the end of each period is required to be presented for compliance with the GIPS standards Global Investment Performance Standards LOS u Sections 3.11, 3.12, and 3.13 47 ... contains additional personal and financial information about Bradley 8 2018 Level III Mock Exam PM Exhibit 2  Bradley Graham: Additional Personal and Financial Information Current annual income; salary... deductibles Health factors also typically have an impact on life, disability, and long-­term care insurance premiums Health risks also have implications for human capital and financial capital For example,... paying capital gains until the assets are sold many years later is an example of a tax deferral strategy B is incorrect Strategy is a tax avoidance strategy because no taxes are paid on tax exempt