L3 mock sample exam CFA level III guideline answers 2001

LOS: The candidate should be able to “Determination of Portfolio Policies: Institutional Investors” Study Session 10 a contrast a defined-benefit and a defined-contribution plan from th

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LEVEL III, QUESTION 1

Topic: Portfolio Management

Minutes: 28

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, 2ndedition, John L Maginn and Donald L Tuttle, eds (Warren, Gorham & Lamont, 1990)

2 “Pension Investing and Corporate Risk Management,” Robert A Haugen, Managing

Institutional Assets, Frank J Fabozzi, ed (Harper Collins, 1990)

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

4 Question 13, including Guideline Answer, 1996 CFA Level III Examination (AIMR)

Purpose:

To test the candidate’s: 1) understanding of the investment policy implications for a pension plan when the pension plan is underfunded, and 2) ability to develop an appropriate investment policy statement and asset allocation for a pension plan

LOS: The candidate should be able to

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

a) contrast a defined-benefit and a defined-contribution plan from the perspective of both the employee and employer;

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

“Pension Investing and Corporate Risk Management” (Study Session 10)

a) appraise the investment policy implications, especially for risk management, of the

relationship between the financial condition of a corporate pension fund and the corporation itself;

b) evaluate the potential effects of a corporate pension fund investment policy on plan surplus, the corporation’s valuation, and the corporation’s constituents;

c) appraise the pension fund investment policy when risk is considered from the perspective of the (1) asset value, (2) plan surplus, or (3) financial position of the corporation

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;

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Question 13, including Guideline Answer (Study Session 10)

b) criticize 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 an

Justify with one reason

Return

Because the Plan is currently underfunded, the primary objective should be to make the pension fund financially stronger The risk inherent in attempting to maximize total returns would be inappropriate

Risk Tolerance IPS Y

Because of the fund’s underfunded status, the Plan has a limited risk tolerance; should the fund have a substantial loss, payments to beneficiaries could be jeopardized

Although going concern pension plans usually have a long time horizon, the Acme plan has a shorter time horizon because of the reduced retirement age and the relatively high median age of the workforce

Because of the early retirement feature starting next month and the age of the workforce (which indicates an increasing number of retirees in the near future), the Plan needs a moderate level of liquidity to fund monthly benefit payments

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B The current portfolio is the most appropriate choice for the pension plan’s asset allocation The current portfolio offers:

i an expected return that exceeds the Plan’s return requirement;

ii an expected standard deviation that only slightly exceeds the Plan’s target; and

iii a level of liquidity that should be sufficient for future needs

The higher expected return will help the Plan’s underfunded status somewhat, and the change

in the fund’s risk profile will be minimal if any The portfolio has significant allocations to U.K bonds (42 percent) and large-cap equities (13 percent), in addition to cash (5 percent) The availability of these highly liquid assets should be sufficient, particularly in view of the stable income flows from these investments, to fund monthly benefit payments when the early retirement feature takes effect next month

The Graham portfolio offers:

i an expected return that is slightly below the Plan’s requirement;

ii an expected standard deviation that is substantially below the Plan’s target; and

iii a level of liquidity that should be more than sufficient for future needs

The portfolio’s expected return is unacceptable given the Plan’s underfunded status

The Michael portfolio offers:

i an expected return that is substantially above the Plan’s requirement;

ii an expected standard deviation that far exceeds the Plan’s target; and

iii a level of liquidity that should be sufficient for future needs

The portfolio’s level of risk is unacceptable given the Plan’s underfunded status

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Minutes: 9

1 “Developing a Recommendation for a Global Portfolio,” Charles I Clough, Jr., Improving the Investment Decision Process—Better Use of Economic Inputs in Securities Analysis and Portfolio Management (AIMR, 1992)

2 “Economic Forecasts and the Asset Allocation Decision,” Abbey Joseph Cohen, Economic Analysis for Investment Professionals (AIMR, 1997)

3 “The Importance of the Investment Policy Statement” (AIMR, 1999)

4 “Determination of Portfolio Policies: Institutional Investors,” Ch 4, Keith P Ambachtsheer, John L Maginn, and Jay Vawter, Managing Investment Portfolios: A Dynamic Process, 2ndedition, John L Maginn and Donald L Tuttle, eds (Warren, Gorham & Lamont, 1990)

5 “Pension Investing and Corporate Risk Management,” Robert A Haugen, Managing

Institutional Assets, Frank J Fabozzi, ed (Harper Collins, 1990)

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

Purpose:

To test the candidate’s understanding of the relationship between economic changes and

investment strategy, the investment policy statement, and asset allocation

“Developing a Recommendation for a Global Portfolio” (Study Session 4)

a) explain the effects of macroeconomic factors—money and credit conditions, demographic trends, unit labor costs, trade and capital flows, and government policies—on expected returns and risks of the bond and stock markets in the United States and other countries; b) recommend and justify an investment portfolio based on expected changes in

macroeconomic factors

“Economic Forecasts and the Asset Allocation Decision” (Study Session 4)

b) contrast consumer and business behavior in an environment of high inflation expectations with behavior in an environment of low inflation expectations;

c) discuss the relationship between equity price-to-earnings (P/E) multiples and inflation and between dividend yields and inflation;

d) relate structural changes in the economy to sector performance;

f) relate funds flows in international securities markets to economic activity and capital market returns

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

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

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

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Cases in Portfolio Management (Study Session 10)

a) appraise the investment policy implications, especially for risk management, of the

relationship between the financial condition of a corporate pension fund and the corporation itself;

b) evaluate the potential effects of a corporate pension fund investment policy on plan surplus, the corporation’s valuation, and the corporation’s constituents;

c) appraise the pension fund investment policy when risk is considered from the perspective of the (1) asset value, (2) plan surplus, or (3) financial position of the corporation

“Pension Investing and Corporate Risk Management” (Study Session 10)

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

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

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

institutional investor

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Guideline Answer:

Action

State whether each recommended action is Correct or Incorrect (Circle One)

Justify with one reason

The Investment Policy Statement also considers a client’s return requirement This return requirement may change over the long term if the inflation outlook has changed over the long term A change in outlook for inflation over a short period, such as in this question, would not necessitate a change in the return portion or any other aspect of the Investment Policy

international equities

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Minutes: 10

Reading Reference:

Emerging Stock Markets: Risk, Return, and Performance, Christopher B Barry, John W Peavy

III, and Mauricio Rodriguez (Research Foundation of the ICFA, 1997)

A “Introduction”

B “Historical Performance of Emerging Equity Markets,” Ch 1

C “Portfolio Construction Using Emerging Markets,” Ch 2

Purpose:

To test the candidate’s understanding of the investment opportunities and risks of emerging markets and of the potential diversification benefits of investing in emerging markets

“Introduction” (Study Session 5)

b) describe the characteristics of an emerging market

“Historical Performance of Emerging Equity Markets” (Study Session 5)

c) discuss the risks involved in investing in emerging markets

“Portfolio Construction Using Emerging Markets” (Study Session 5)

a) appraise the impact of adding emerging market equities on portfolio risk for a global equity investor;

b) discuss the variations of various correlations over time between different emerging markets and between emerging and international developed markets

A Rose should pursue Strategy #1, the 100 percent domestic market strategy (his current portfolio) The correlation of the domestic market with both the international emerging market and the international developed market is high (0.80 and 0.84, respectively), thus limiting any diversification benefits In addition, the domestic market has the highest expected return (22.9 percent) by a substantial margin Also, the standard deviations of the three markets are not expected to be significantly different (17.4 percent, 17.3 percent, and 17.1 percent) and therefore should not affect his decision Accordingly, if Rose believes Scenario I is most likely, all funds would remain invested in the domestic market, and none invested internationally, because no (or little) diversification, return, or volatility benefit is expected to be derived from investing in either the international developed market or the international emerging market

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B Rose should pursue Strategy #3, the 50 percent domestic market and 50 percent international emerging market strategy The correlation of the domestic market with the international emerging market (0.33) is low compared to the correlation between the domestic market and the international developed market (0.80) Thus, under Scenario II, the international emerging market is expected to provide significant diversification benefits to domestic market

exposure, thereby improving the expected risk-reward profile of the overall portfolio The international developed market is not expected to provide meaningful diversification benefits

to either the international emerging or domestic markets because of its relatively high

correlation with each market (0.66 and 0.80, respectively) All three markets have similar expected returns (8.7 percent, 8.4 percent, and 8.4 percent) and similar expected standard deviations (14.3 percent, 14.1 percent, and 14.0 percent) Therefore, neither return nor

volatility is a useful discriminator in Scenario II

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Minutes: 18

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)

2 “Evaluating Portfolio Performance,” Ch 14, pp 14-23 through 14-47, Peter Dietz and

Jeannette Kirschman, Managing Investment Portfolios: A Dynamic Process, 2nd edition, John Maginn and Donald Tuttle, eds (Warren, Gorham & Lamont, 1990)

3 “Benchmark Portfolios and the Manager/Plan Sponsor Relationship,” Jeffery V Bailey,

Thomas M Richards, and David E Tierney, Current Topics in Investment Management,

Frank Fabozzi and T Dessa Fabozzi, eds (Harper Collins, 1990)

4 “Are Manager Universes Acceptable Performance Benchmarks?,” Jeffery V Bailey, The Journal of Portfolio Management (Institutional Investor, Spring 1992)

5 “Measuring and Evaluating Performance,” Frank J Fabozzi, Ch 9, Fixed Income Readings for the Chartered Financial Analyst Program: Level III Readings, Frank J Fabozzi, ed

(Frank J Fabozzi Associates, 2000)

Purpose:

To test the candidate’s understanding of: 1) the advantages and disadvantages of different

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

“Evaluation of Portfolio Performance” (Study Session 16)

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

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

“Evaluating Portfolio Performance” (Study Session 16)

b) appraise the advantages and limitations of using manager universes, benchmark indexes, normal portfolios, and attribution analysis to evaluate investment manager performance; d) critique the use of publicly available indexes (e.g S&P 500) as benchmarks

“Benchmark Portfolios and the Manager/Plan Sponsor Relationship” (Study Session 16)

b) explain the steps in constructing an effective benchmark portfolio and identify the resources needed to construct and maintain the benchmark;

c) evaluate the advantages and disadvantages, compared with alternative approaches, of using a custom benchmark portfolio to evaluate performance

“Are Manager Universes Acceptable Performance Benchmarks?” (Study Session 16)

a) evaluate the validity and appropriateness of using manager universes for evaluating a

manager’s performance;

b) explain the basis for constructing valid benchmarks;

c) explain the conceptual shortcomings of manager universes, including how survivor bias potentially affects performance measurement results

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“Measuring and Evaluating Performance” (Study Session 16)

d) explain the steps involved in constructing a normal portfolio;

e) discuss the use of a normal portfolio as a portfolio benchmark;

f) contrast the use of a normal portfolio as a portfolio benchmark with the use of a market index

A

Benchmark Explain two different weaknesses of using each of the

benchmarks to measure the performance of a portfolio

Market index • A market index may exhibit survivorship bias; firms that have

gone out of business are removed from the index resulting in a performance measure that overstates the actual performance had the failed firms been included

• A market index may exhibit double counting that arises because

of companies owning other companies and both being represented in the index

• It is often difficult to exactly and continually replicate the holdings in the market index without incurring substantial trading costs

• The chosen index may not be an appropriate proxy for the management style of the managers

• The chosen index may not represent the entire universe of securities (e.g., S&P 500 Index represents 65-70 percent of U.S equity market capitalization)

• The chosen index may have a large capitalization bias (e.g., S&P

500 has a large capitalization bias)

• The chosen index may not be investable There may be securities in the index that cannot be held in the portfolio

Benchmark

normal portfolio • This is the most difficult performance measurement method to

develop and calculate

• The normal portfolio must be continually updated, requiring substantial resources

• Consultants and clients are concerned that managers who are involved in developing and calculating their benchmark portfolio may produce an easily-beaten normal portfolio, making their performance appear better than it actually is

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Median of the

manager universe • It can be difficult to identify a universe of managers appropriate

for the investment style of the plan’s managers

• Selection of a manager universe for comparison involves some, perhaps much, subjective judgment

• Comparison with a manager universe does not take into account the risk taken in the portfolio

• The median of a manager universe does not represent an

“investable” portfolio, meaning a portfolio manager may not be able to invest in the median manager portfolio

• Such a benchmark may be ambiguous The names and weights

of the securities constituting the benchmark are not clearly delineated

• The benchmark is not constructed prior to the start of an evaluation period; it is not specified in advance

• A manager universe may exhibit survivorship bias; managers that have gone out of business are removed from the universe resulting in a performance measure that overstates the actual performance had those managers been included

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B i The Sharpe ratio is calculated by dividing the portfolio risk premium, (i.e., actual

portfolio return minus risk-free return), by the portfolio standard deviation of return Sharpe Ratio = (Rp – Rf) / σp

Where: Rp = Actual portfolio return

Rf =Risk-free return

σp = Standard deviation of portfolio return

The Treynor measure is calculated by dividing the portfolio risk premium, (i.e., actual portfolio return minus risk-free return), by the portfolio beta

Treynor measure = (Rp – Rf) / βp

Where: βp = Portfolio beta

Jensen’s alpha is calculated by subtracting the market premium, adjusted for risk by the portfolio’s beta, from the actual portfolio’s excess return (risk premium) It can be described as the difference in return earned by the portfolio compared to the return implied by the Capital Asset Pricing Model or Security Market Line

αp = Rp – Rf – βp(Rm – Rf)

or αp = Rp – [Rf + βp(Rm – Rf)]

ii The Sharpe ratio assumes that the relevant risk is total risk and measures excess return per unit of total risk

The Treynor measure assumes that the relevant risk is systematic risk and measures

excess return per unit of systematic risk

Jensen’s alpha assumes that the relevant risk is systematic risk and measures excess return

at a given level of systematic risk

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4 “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)

6 “Global Investment Performance Standards,” including Appendix A (AIMR, 1999)

Purpose:

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

AIMR Performance Presentation Standards Handbook and “AIMR’s Performance Presentation

Standards” (Study Session 17)

b) describe and explain the requirements and recommendations of the AIMR-PPS standards with regard to composite construction and maintenance, performance presentation,

calculation of returns, and disclosures;

c) evaluate a sample performance presentation to determine whether the presentation complies with the AIMR-PPS standards;

d) recommend changes to a sample performance presentation that would bring the presentation into compliance with the AIMR-PPS standards

“Moosehead Investment Management” (Study Session 17)

a) evaluate a performance presentation to determine any violations of the AIMR-PPS standards and AIMR Standards of Professional Conduct;

c) revise a performance presentation so that it complies with the AIMR-PPS standards

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

(PPS)?-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

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

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“Global Investment Performance Standards” (Study Session 17)

c) describe and explain the requirements and recommendations of GIPS with regard to input data, calculation methodology, composite construction, disclosures, and presentation and reporting;

d) describe and explain the minimum procedures that must be followed to verify that an investment entity is GIPS compliant

A

Note

State whether each note meets requirements (Circle One)

Explain why each note does or does not meet requirements

Yes The firm is required to disclose the minimum

asset level, below which portfolios are not included in a composite Composites must also include new portfolios on a timely and consistent basis

No The firm is required to disclose that composites are asset-weighted using beginning of period

weightings or another method that reflects both beginning market values and cash flows

3 The year 1995 is

not in compliance

For any performance presented for periods prior

to January 1, 2000, that does not comply with GIPS (1995 in this question), the firm is required

to disclose the period of noncompliance and how

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X

No This restriction makes the portfolio nondiscretionary It would not be included in the discretionary composite None

Y Yes The original amount under management is shown in the

composite The additional £12.5 million of overlay assets would be shown in a separate overlay assets category

£50 million

Z Yes Performance must be shown on a leveraged basis, using £10 million as the base In addition, performance must be

shown in supplemental information on an all-cash basis, using £13 million as the base

£10 million

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“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

based on its experience

with investors, has

standard policy

statements in five

categories You would

be better served to adopt

one of these standard

policy statements instead

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