L3 mock sample exam CFA level III guideline answers 2002

Sharpe Purpose: To test the candidate’s ability to formulate an investment policy statement and recommend an asset allocation for an endowment fund.. LOS: The candidate should be able t

LEVEL III, QUESTION 1

Topic: Portfolio Management

Minutes: 26

Reading References:

1 “Determination of Portfolio Policies: Institutional Investors,” Ch 4, Keith P Ambachtsheer,

John L Maginn, and Jay Vawter, Managing Investment Portfolios: A Dynamic Process, 2nd

edition, John L Maginn and Donald L Tuttle, eds (Warren, Gorham & Lamont, 1990)

2 Cases in Portfolio Management, John W Peavy III and Katrina F Sherrerd (AIMR, 1990)

A “Mid-South Trucking Company”: Case p 26, Guideline Answers p 75

B “Universal Products Inc.”: Case p 39, Guideline Answers p 90

C “Good Samaritan Hospital (A)”: Case p 45, Guideline Answers p 101

D “Good Samaritan Hospital (B)”: Case p 49, Guideline Answers p 103

E “Good Samaritan Hospital (C)”: Case p 50, Guideline Answers p 106

3 Question 13, including Guideline Answer, 1996 CFA Level III Examination (AIMR), 2002 CFA Level III Candidate Readings

4 Managing Investment Portfolios: A Dynamic Process, 2nd edition, John L Maginn and

Donald L Tuttle, eds (Warren, Gorham & Lamont, 1990)

A “Asset Allocation,” Ch 7, pp 7-1 through 7-27, William F Sharpe

Purpose:

To test the candidate’s ability to formulate an investment policy statement and recommend an asset allocation for an endowment fund

LOS: The candidate should be able to

“Determination of Portfolio Policies: Institutional Investors” (Study Session 10)

b) appraise and contrast the factors that affect the investment policies of pension funds,

endowment funds, insurance companies, and commercial banks

c) differentiate among the return objectives, risk tolerances, constraints, regulatory

environment, and unique circumstances of endowment funds, pension funds, insurance companies, and commercial banks

Cases in Portfolio Management (Study Session 10)

a) formulate the overall portfolio management process leading to an investment policy

statement and an asset allocation decision for an institutional investor, including developing objectives and constraints and analyzing capital market expectations

b) compare and contrast the investment objectives and constraints of institutional investors in different economic circumstances

c) create a formal investment policy statement for an institutional investor

d) recommend and justify an asset allocation that would be appropriate for an institutional investor

Question 13, including Guideline Answer, 1996 (Study Session 10)

a) formulate the overall portfolio management process leading to an investment policy

statement and an asset allocation decision for an institutional investor, including developing objectives and constraints and analyzing capital market expectations

b) critique an existing investment policy statement and its associated asset allocation

c) create a formal investment policy statement for an institutional investor

d) recommend and justify a general asset allocation that would be appropriate for a particular institutional investor

“Asset Allocation” (Study Session 11)

b) discuss the major steps in asset allocation

c) formulate the basic elements of the strategic asset allocation process

Guideline Answer:

A

Prepare the components of an appropriate investment policy statement for the Jarvis

University endowment fund as of June 1, 2002

Ability: Average Risk

• Endowment funds are long-term in nature, having infinite lives This long time horizon

by itself would allow for above-average risk

• However, creative tension exists between the JU endowment’s demand for high current income to meet immediate spending requirements and the need for long-term growth to meet future requirements This need for a spending rate (exceeds 5 percent) and the university’s heavy dependence on those funds allow for only average risk

Willingness: Above Average Risk

• University leaders and endowment directors have set a spending rate in excess of 5 percent To achieve their 7 percent real rate of return, the fund must be invested in above-average risk securities Thus the 7 percent spending rate indicates a willingness to take above-average risk

CONSTRAINTS

1 Time Horizon

A two-stage time horizon is needed The first stage recognizes short-term liquidity

constraints ($200 million library payment in eight months) The second stage is an infinite time horizon (endowment funds are established to provide permanent support)

2 Liquidity

Generally, endowment funds have long time horizons and little liquidity is needed in excess

of annual distribution requirements However, the JU endowment requires liquidity for the upcoming library payment in addition to the current year’s contribution to the operating budget Liquidity needs for the next year are:

Library Payment +$200 million

Operating Budget Contribution +$126 million

Annual Portfolio Income –$ 29 million*

B

Asset

Determine the most

appropriate revised allocation percentage

for each asset as of

June 1, 2002

Justify each revised allocation

percentage

with one reason

U.S Money Market

Fund

15 (14-17) % Liquidity needs for the next year are:

Library payment +$200 million Operating budget

contribution +$126 million Annual portfolio

income –$ 29 million* Total +$297 million Total liquidity of at least $297 million is required (14.85 percent of current endowment assets) Additional allocations (more than 2 percent above the suggested

15 percent) would be overly conservative This cushion should be sufficient for any transaction needs (i.e., mismatch of cash inflows/outflows)

*Annual portfolio income = (.04 × $40 million) + (.05 × $60 million) + (.01 ×

$300 million) + (.001 × $400 million) + (.03 × $700 million) = $29 million Intermediate Global

Bond Fund

20 (15-25) % To achieve a 10 percent portfolio return,

the fund needs to take above average risk (e.g., 20 percent in Global Bond Fund and

30 percent in Global Equity Fund) An allocation below 15 percent would involve taking unnecessary risk that would put the safety and preservation of the endowment fund in jeopardy An allocation in the 21-25 percent range could still be tolerated because the slight reduction in portfolio expected return

Global Equity Fund 30 (25-35) % To achieve a 10 percent portfolio return,

the fund needs to take above average risk (e.g., 30 percent in Global Equity Fund and 20 percent in Global Bond Fund) An allocation above 35 percent would

involve taking unnecessary risk that would put the safety and preservation of the endowment fund in jeopardy An allocation in the 25-29 percent range could still be tolerated, as the slight reduction in portfolio expected return would be partially compensated by the reduction in portfolio risk An allocation below 25 percent would not satisfy the endowment fund return requirements Bertocchi Oil and Gas

Common Stock

15% There is a single issuer concentration risk

associated with the current allocation, and

a 25 percent reduction ($100 million), which is the maximum reduction allowed

by the donor, is required ($400 million –

$100 million = $300 million remaining)

Total 100%

The suggested allocations (point estimates) would allow the JU endowment fund to meet the 10

percent return requirement, calculated as follows:

Asset Suggested

Allocation

Expected Return Weighted Return

The allowable allocation ranges, taken in proper combination, would also be consistent with the

10 percent return requirement

LEVEL III, QUESTION 2

Topic: Portfolio Management

Minutes: 11

Reading References:

“Dynamic Strategies for Asset Allocation,” Andre Perold and William Sharpe, Financial

Analysts Journal (AIMR, January/February 1988), 2002 CFA Level III Candidate Readings

Purpose:

To test the candidate’s understanding of the dynamic strategies available to rebalance a portfolio

in the context of changes in general market conditions, investor return objectives and risk

tolerance, and the transaction costs associated with rebalancing

LOS: The candidate should be able to

“Dynamic Strategies for Asset Allocation” (Study Session 11)

a) contrast the risk-return tradeoffs of the alternative dynamic portfolio rebalancing strategies b) appraise the appropriateness of the alternative rebalancing strategies under various sets of investor risk tolerances and asset return expectations

c) appraise the impact of rebalancing strategies on the return and risk of a portfolio

Guideline Answer:

A i Buy-and-hold strategy The buy-and-hold strategy maintains an exposure to equities that

is linearly related to the value of equities in general The strategy involves buying, then holding, an initial mix (equities/bills) No matter what happens to relative values, no rebalancing is required; hence this is sometimes termed the “do nothing” strategy The investor sets a floor below which s/he does not wish portfolio value to fall An amount equal to the value of that floor is invested in some non-fluctuating asset (i.e., Treasury bills, money market funds) The payoff diagram for a buy-and-hold strategy is a straight line, so the value of the portfolio rises (falls) as equity values rise (fall), with a slope equal to the equity proportion in the initial mix The value of the portfolio will never fall below the specified floor, and the portfolio has unlimited upside potential Increasing equity prices favor a buy and hold strategy; the greater the equity proportion in the initial mix, the better (worse) the strategy will perform when equities outperform

(underperform) bills

The strategy is particularly appropriate for an investor whose risk tolerance above the specified floor varies with wealth, but drops to zero at or below that floor After the initial portfolio transaction, transaction costs are not an issue The strategy is tax efficient for taxable investors

ii Constant-mix strategy The constant-mix strategy maintains an exposure to equities that

is a constant percentage of total wealth Periodic rebalancing to return to the desired mix requires the purchase (sale) of equities as they decline (rise) in value This strategy,

which generates a concave payoff diagram, offers relatively little downside protection and performs relatively poorly in up markets The strategy performs best in a relatively flat (but oscillating or volatile) market and capitalizes on market reversals The constant-mix strategy performs particularly well in a time period when equity values oscillate greatly, but end close to their beginning levels; greater volatility around the beginning values accentuates the positive performance

The constant-mix strategy is particularly appropriate for an investor whose risk tolerance varies proportionately with wealth; such an investor will hold equities at all levels of wealth This strategy requires some rule to determine when rebalancing takes place; typical approaches avoid transaction costs until either the value of a portion of the, or of the entire, portfolio has changed by a given percentage At this point, transaction costs are incurred to rebalance Taxes can be material for taxable investors

iii Constant-proportion strategy The constant-proportion strategy maintains an exposure to

equities that is a constant multiple of a “cushion” specified by the investor The investor sets a floor below which s/he does not wish assets to fall, and the value of that floor is invested in some non-fluctuating asset (i.e., Treasury bills, money market funds) Under normal market conditions the value of the portfolio will not fall below this specified floor The investor then selects a multiplier to be used The initial commitment to equities equals the multiplier times the “cushion” (the difference between the value of the total assets to be invested and the value of the floor) [e.g., $ in equities = multiplier × (assets – floor)] As equity values rise (fall), the constant-proportion strategy requires the investor

to purchase (sell) additional equities Thus following this strategy (via the formula

indicated above) keeps equities at a constant multiple of the cushion (assets – floor) and generates a convex payoff diagram The constant-proportion strategy tends to give good downside protection and performs best in directional, especially up, markets; the strategy does poorly in flat but oscillating markets and is especially hurt by sharp market

reversals

The strategy is particularly appropriate for an investor who has zero tolerance for risk below the stated floor but whose risk tolerance increases quickly as equity values move above the stated floor This strategy requires some rule to determine when rebalancing takes place; typical approaches avoid transaction costs until either the value of a portion

of the, or of the entire, portfolio has changed by a given percentage At this point

transaction costs are incurred to rebalance Taxes can be material for taxable investors

B The constant-proportion strategy is the most appropriate rebalancing strategy for the JU endowment fund, taking into account the major circumstances described: the endowment’s increased risk tolerance, the outlook for a bull market in growth assets over the next five years, the expectation of lower than normal volatility, and the endowment’s desire to limit

downside risk

• The constant-proportion strategy is consistent with higher risk tolerance, because the strategy calls for purchasing more equities as equities increase in value; higher risk tolerance is reflected in the resulting increased allocation to equities over time

• The constant-proportion strategy will do well in an advancing equities market; by buying equities as their values rise, each marginal purchase has a high payoff

• The constant-proportion strategy would do poorly in a higher volatility environment for equities, because the strategy would sell on weakness but buy on strength, only to

experience reversals; conversely, the strategy does much better in the face of lower volatility

• The constant-proportion strategy provides good downside protection, because the strategy sells on weakness and reduces exposure to equities as a given floor is approached

In summary, given that JU receives little other funding support, the endowment fund must produce the maximum return for a specified level of risk Given that the level of acceptable risk is generally higher, although with a very specific downside floor, the market outlook suggests that the constant-proportion strategy is the endowment fund’s best rebalancing strategy

LEVEL III, QUESTION 3

Topic: Portfolio Management

Minutes: 22

Reading Reference:

1 “Evaluation of Portfolio Performance,” Ch 24 (omit pp 658-664), Modern Portfolio Theory and Investment Analysis, 5th edition, Edwin Elton and Martin Gruber (John Wiley & Sons,

1995), 2002 CFA Level III Candidate Readings

2 “Evaluation of Portfolio Performance,” Ch 27, Investment Analysis and Portfolio

Performance, 5th Edition, Frank K Reilly and Keith C Brown (Dryden, 1997), 2002 CFA Level III Candidate Readings

Purpose:

To test the candidate’s understanding of: 1) the different approaches to performance

measurement and attribution, and 2) the Sharpe, Treynor, and Jensen measures of performance

LOS: The candidate should be able to

“Evaluation of Portfolio Performance” (Study Session 16)

b) compare and contrast the Sharpe ratio, the Treynor measure, and Jensen’s alpha

c) calculate the Sharpe ratio and the Treynor measure

d) appraise investment manager performance using the Sharpe ratio, the Treynor measure, and Jensen’s alpha

e) evaluate a manager’s performance after that performance has been attributed to

diversification effect, market timing effect, and other sources of return

“Evaluation of Portfolio Performance” (Study Session 16)

a) prepare a performance attribution analysis for a portfolio and determine whether value was added through allocation effects (market timing or sector rotation) and /or selection effects

Guideline Answer:

A i Sharpe ratio = (portfolio return – risk-free rate) / standard deviation

Sharpe ratio: Williamson Capital = (22.1% – 5.0%) / 16.8% = 1.02

Sharpe ratio: Joyner Asset Management = (24.2% – 5.0%) / 20.2% = 0.95

ii Treynor measure =(portfolio return – risk-free rate) / portfolio beta

Treynor measure: Williamson Capital = (22.1% – 5.0%) / 1.2 = 14.25

Treynor measure: Joyner Asset Management = (24.2% – 5.0%) / 0.8 = 24.00

B

Calculate the following five components of investment performance for

Joyner Asset Management

i

Overall performance

iii

Selectivity

= overall performance – risk

iv

Diversification

= (risk-free rate + (std dev of the portfolio / std dev of the market) × (market return – risk-free rate)) – (risk-free rate + (portfolio beta × (market return – risk-free rate)))

v Net Selectivity

= selectivity – diversification

W 22.1% –

5.0% =

17.10%

(18.9% – 5.0%) × 1.2

= 16.68%

17.10% – 16.68% = 0.42%

(5.0% + (16.8% / 13.8%) × (18.9% – 5.0%)) – (5.0% + (1.2 × (18.9% – 5.0%))) =

= 11.12%

19.20% – 11.12% = 8.08%

(5.0% + (20.2% / 13.8%) × (18.9% – 5.0%)) – (5.0% + (0.8 × (18.9% – 5.0%))) =

9.23%

8.08% – 9.23%

=

−1.15%

C i The Sharpe ratio versus the Treynor measure The difference in the ranking of

Williamson and Joyner results directly from the difference in diversification of the

portfolios Joyner has a higher Treynor measure (24.00) and lower Sharpe ratio (0.95) than Williamson (14.25 and 1.02), so Joyner must be less diversified than Williamson; the Treynor measure indicates that Joyner has a higher return per unit of systematic risk than Williamson, while the Sharpe ratio indicates that Joyner has a lower return per unit

of total risk than Williamson

ii Overall performance versus net selectivity Overall performance is the portfolio’s return

net of the risk-free rate and is therefore a return measure that does not consider risk Because Joyner’s average annual rate of return is higher than Williamson’s, its overall performance is also higher Net selectivity, however, is a return measure that has been

adjusted both for systematic risk and for unsystematic risk To compute net selectivity, diversification is subtracted from selectivity Because the diversification term is much higher for Joyner than for Williamson (the difference is 8.99% = 9.23% – 0.24%), to achieve the same net selectivity as Williamson, Joyner would need commensurately higher selectivity, which Joyner did not achieve (the difference is 7.66% = 8.08% – 0.42%) The diversification measure indicates how much return would be required for the amount of non-systematic risk a manager is taking if non-systematic risk received the same return as systematic risk

LEVEL III, QUESTION 4

Topic: Portfolio Management

Minutes: 16

Reading References:

1 “How Should Plan Sponsors Approach AIMR Performance Presentation Standards (PPS)? –

Learning from the Kentucky Retirement System Example,” Chris Tobe, The Journal of Performance Measurement (The Spaulding Group, Winter 1998/1999), 2002 CFA Level III Candidate Readings

2 Question 5, including Guideline Answer, 1998 CFA Level III Examination (AIMR), 2002 CFA Level III Candidate Readings

3 “Global Investment Performance Standards,” including Appendix A (AIMR, 1999), 2002 CFA Level III Candidate Readings

Purpose:

To test the candidate’s: a) understanding of the Global Investment Performance Standards, and b) ability to determine whether performance reports are in compliance with these standards

LOS: The candidate should be able to

“How Should Plan Sponsors Approach AIMR Performance Presentation Standards (PPS)? –Learning from the Kentucky Retirement System Example” (Study Session 17)

a) identify the violations of the AIMR-PPS standards

b) recommend changes to the performance presentations that would bring the presentations into compliance with the AIMR-PPS standards

Question 5, including Guideline Answer, 1998 (Study Session 17)

criticize a performance presentation that is not in compliance with the AIMR-PPS standards

“Global Investment Performance Standards” (Study Session 17)

c) explain the requirements and recommendations of GIPS standards with respect to input data, calculation methodology, composite construction, disclosures, and presentation and reporting d) explain the minimum procedures that must be followed to verify that an investment entity is GIPS compliant

• A firm must use the compliance statement as specified in the GIPS There are no

provisions for partial compliance If a firm does not meet all the GIPS requirements, then the firm is not in compliance with GIPS Bristol’s use of the “except for” compliance statement is a violation of GIPS

• The column titled “Composite Dispersion (%)” is incomplete; it should be accompanied

by a footnote describing the measure of dispersion being used

• The column titled “Benchmark Return (%)” is incomplete; it should be accompanied by a

footnote describing the composition of the benchmark

• GIPS states that accrual accounting must be used for fixed-income securities and all other assets that accrue interest income; Bristol states that it uses cash basis accounting for the

recognition of interest income

B Omissions that prevent the Bristol Capital Management performance report from being GIPS compliant:

• The availability of a complete list and description of all of Bristol’s composites is not disclosed as is required

• Although Bristol does disclose the use of derivatives, the firm has omitted the required description of the extent of use, frequency, and characteristics of the instruments that must also be disclosed in sufficient detail to identify the risks

• If the firm has included non-fee paying accounts in its composite, the percentage of the composite represented by these accounts must be disclosed

• The composite creation date must be disclosed

• Because the composite represents a global investment strategy, the presentation should include information about the treatment of withholding tax on dividends, interest income, and capital gains

• Because the composite is a global strategy, managed against a specific benchmark, the presentation should include information about the percentage of the composite invested

in countries/regions not included in the benchmark

• Because the composite is a global strategy, managed against a specific benchmark, exchange rates presumably are a major performance factor; any known inconsistencies between the chosen source of exchange rates and the exchange rates of the benchmark must be described and presented

LEVEL III, QUESTION 5

Topic: Portfolio Management

Minutes: 36

Reading References:

1 “The Importance of the Investment Policy Statement” (AIMR, 1999), 2002 CFA Level III Candidate Readings

2 “Individual Investors,” Ch 3, Ronald W Kaiser, Managing Investment Portfolios: A

Dynamic Process, 2nd edition, John L Maginn and Donald L Tuttle, eds (Warren, Gorham

& Lamont, 1990)

3 “Tax Considerations in Investing,” Ch 8, Robert H Jeffrey, The Portable MBA in

Investment, Peter L Bernstein, ed (John Wiley & Sons, 1995), 2002 CFA Level III

Candidate Readings

4 Cases in Portfolio Management, John W Peavy III and Katrina F Sherrerd (AIMR, 1990)

a “Introduction”

b “The Allen Family (A)”: Case p 15, Guideline Answers p 58

c “The Allen Family (B)”: Case p 18, Guideline Answers p 62

5 Questions 1 and 2, including Guideline Answers, 1995 CFA Level III Examination (AIMR),

2002 CFA Level III Candidate Readings

6 Question 1, including Guideline Answer, 1996 CFA Level III Examination (AIMR), 2002 CFA Level III Candidate Readings

Purpose:

To test the candidate’s ability to: 1) critique an individual investor’s existing investment policy statement and asset allocation, and 2) recommend a new investment policy statement and asset allocation that reflects the investor’s objectives, constraints, and circumstances

LOS: The candidate should be able to

“The Importance of the Investment Policy Statement” (Study Session 9)

a) explain the principal contents of a typical written investment policy statement and discuss their implications for portfolio management

b) explain the importance of an investment policy statement

“Individual Investors” (Study Session 9)

c) analyze the objectives and constraints of an individual investor and use this information to formulate an appropriate investment policy by taking into consideration the investor’s

psychological characteristics, position in the life cycle, long-term goals, liquidity constraints, and any special circumstances such as taxes, gifts, and estate planning

“Tax Considerations in Investing” (Study Session 9)

a) explain the importance of taxation for investment policy and discuss taxes as an investment expense

b) differentiate between capital gains and dividends and compare the taxation of each

c) analyze the impact of turnover on after-tax portfolio returns

e) discuss the benefits of deferring capital gains taxes

h) discuss the advantages and disadvantages of realizing losses

Cases in Portfolio Management (Study Session 9)

d) recommend and justify an asset allocation that would be appropriate for an individual

investor

Questions 1 and 2, including Guideline Answers, 1995 (Study Session 9)

a) prepare an investment policy statement that clearly states the investment objectives and

constraints for an individual investor

b) justify all recommendations and statements included in an investment policy statement

c) criticize an investment policy statement and identify key investment constraints and

objectives not included in the statement

d) recommend and justify an asset allocation

Question 1, including Guideline Answer, 1996 (Study Session 9)

a) prepare and justify a well-organized investment policy statement

b) recommend and justify an asset allocation and clearly state any assumptions made in

preparing the recommendation, especially with respect to the risk tolerance of the client

c) criticize an investment policy statement and judge whether the policy statement will meet the stated goals of the client

Guideline Answer:

A Return Requirement

New objective A total return objective of 7 percent before tax is sufficient to meet Claire

Pierce’s educational, housing, and retirement goals.* If the portfolio earns total return of 7

percent annually, the value at retirement ($3.93 million) should be adequate to meet ongoing spending needs then ($180,000 after tax = $257,143 before tax = 6.6 percent spending rate) and fund all Pierce’s extraordinary needs (college and homebuilding costs) in the meantime The million dollar gifts to her children represent unrealistic goals that she should be

encouraged to modify or drop

*The following calculations are not required, but provide the basis for the statement that a

return of 7 percent before tax is sufficient to generate a retirement portfolio that will support the desired retirement spending level (at a reasonable retirement spending rate)

Current portfolio (gross) $2,200,000 Calculations: Less college cost (daughter) $25,714 before tax $18,000 after tax / 0.7

Less college cost (son) $130,000 before tax $91,000 after tax / 0.7

Less housing cost $535,714 before tax $375,000 after tax / 0.7 Current portfolio (net) $1,508,572

After-tax return = Before-tax return (1–T) = 7.00% (0.7) = 4.90%