L3 mock sample exam CFA level III guideline answers 2003

LOS: The candidate should be able to “Managing Institutional Investor Portfolios” Study Session 10 h create a formal investment policy statement for a foundation, an endowment, and an i

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LEVEL III, QUESTION 1

Topic: Portfolio Management - Institutional

Minutes: 20

Reading References:

1 “Managing Institutional Investor Portfolios,” Charles R Tschampion, Laurence B Siegel,

Dean J Takahashi, and John L Maginn, Managing Investment Portfolios: A Dynamic

Process, 3rd edition (AIMR, forthcoming)

Purpose:

To test the candidate’s ability to create an appropriate investment policy statement for a life insurance company

LOS: The candidate should be able to

“Managing Institutional Investor Portfolios” (Study Session 10)

h) create a formal investment policy statement for a foundation, an endowment, and an

insurance company;

j) differentiate among the return objectives, risk tolerances, liquidity requirements, time

horizon, tax considerations, regulatory environment, and unique circumstances of defined benefit plans, foundations, endowments, and life and nonlife insurance companies

Guideline Answer:

A i The return requirement for the bond portfolio is at least 7.5 percent (6 percent crediting

rate plus 1.5 percent marketing and administrative expenses) This level of return is

needed to cover both the cost of interest-sensitive products and associated marketing and administrative expenses

ii The return requirement for the common stock portfolio is a total return equal to or greater than the total return of the designated benchmark, the Wilshire 5000 Total Market Index

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B

Factors specific to

determining the risk

objectives of a life

insurance company are:

Specific evidence for each factor that should be reflected in Rightland Life’s risk objectives:

1 Valuation concerns For the surplus, there are risks associated with the decline in the

stock market Surplus as a percentage of assets has declined from

25 percent in 2000 to 17 percent in 2002 This could potentially lead to a capital adequacy problem if asset prices erode further For the bond portfolio, there are similar risks associated with the substantial widening of corporate bond spreads that has occurred even though interest rates in general have declined during the past two years

2 Reinvestment risk Returns will suffer if interest rates continue to trend downward

and coupon and principal payments are reinvested at lower rates

3 Credit risk The bond portfolio is too heavily invested (31 percent vs an

industry average weighting of 17 percent) in lower-rated (BBB) securities, resulting in excess credit risk

4 Cash Flow Volatility Although cash flow volatility is a relevant factor in general, there

is no specific evidence that it should be reflected in Rightland’s risk objectives

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C

Prepare the constraints section of an appropriate investment policy statement for

Rightland Life

1 Liquidity Requirements In the absence of evidence suggesting adverse cash flow volatility,

Rightland needs minimal liquidity

2 Time Horizon Although life insurance companies generally have long time

horizons, Rightland has a somewhat shorter time horizon, evidenced

by the portfolio’s liability duration of five shown in Exhibit 1-1 The average maturity of the bond portfolio of ten years may (or may not) produce a portfolio duration that roughly matches the portfolio duration of five The time horizon of the company would be somewhat longer when the investment of the surplus is considered

3 Tax Considerations Although Rightland is subject to income, capital gains, and other

taxes, investment income on surplus is taxed whereas investment income on the policyholders’ share of investment income is not taxed Tax considerations are a factor in determining the investment mix that provides the most favorable after-tax returns

4 Regulatory/Legal

Considerations

Rightland’s operations must conform to the insurance code of the state where Rightland is domiciled That state limits common stock holdings of life insurance companies to 20 percent of total assets and limits non-domestic investments to five percent of total assets Rightland needs to set aside an asset valuation reserve to limit the impact of valuation and credit-related losses on the surplus

Rightland must also adhere to the prudent person rule

5 Unique Circumstances Rightland may not hold tobacco or alcohol stocks in its common

stock portfolio

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Minutes: 9

Purpose:

To test the candidate’s understanding of differences in the investment policy statements of life and non-life insurance companies

i) appraise and contrast the factors that affect the investment policies of defined benefit plans, foundations, endowments, and life and non-life insurance companies

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Anget’s three questions

Determine whether Rightland Life or Southaw P&C is the more appropriate response to

each of Anget’s three questions (circle one for each question)

Justify each of your responses

by providing one

characteristic of the appropriate company

Which subsidiary has

greater ability to take risk?

Which subsidiary has a

Rightland’s time horizon is longer because it has longer-term (duration) liabilities than Southaw (Southaw’s estimated duration of liabilities is three compared to Rightland’s duration of five)

Which subsidiary has

greater liquidity needs?

Rightland Life

Southaw has relatively unpredictable cash flows compared to the relative cash flow certainty of Rightland Southaw’s underwriting cycle would typically require the company to liquidate investments to fund periodic cash flow shortfalls

Rightland Life

Southaw P&C

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Minutes: 6

Purpose:

To test the candidate’s ability to critique an asset allocation for a nonlife insurance company

k) compare and contrast the asset/liability management needs of life and nonlife insurance companies;

l) 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

A The shortcoming with respect to the critical goal of asset/liability management is that the bond portfolio duration (5.2) is mismatched in relation to the estimated duration of liabilities (1.8)

The recommended changes in the asset allocation are to:

• decrease the allocations to longer duration assets such as U.S long-term government bonds, U.S investment grade corporate bonds, and U.S intermediate-term government bonds

• increase the allocation to shorter duration assets such as cash equivalents

B The asset allocation is not appropriate with respect to the liquidity needs of the automobile

insurance division

The current allocation to cash equivalents of two percent is insufficient to meet the liquidity demands of a casualty business with low liability duration (1.8) and potentially erratic cash flows

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Topic: Equity Valuation

Minutes: 8

3 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 ability to interpret the effects of adding an asset class (e.g., emerging markets) to an existing asset allocation

“Introduction” (Study Session 5)

c) discuss the potential benefits of investing in emerging markets

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

a) evaluate the historical performance of emerging equity markets;

b) discuss the importance of currency issues in emerging market investing;

c) discuss the risks involved in investing in emerging markets

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

a) appraise the impact on portfolio risk of adding emerging market stocks to a portfolio

containing securities from developed markets;

b) discuss the variations of various correlations over time among different emerging markets and between emerging and developed markets, and the implications for portfolio

correct or incorrect

(circle one for each

comment)

If incorrect, give one reason why

the comment is incorrect

1 “For an investor holding

only developed market

equities, the existence of

stable emerging market

currencies is one of several

pre-conditions necessary for

that investor to realize strong

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2 “Local currency

depreciation against the dollar

has been a frequent

occurrence for U.S investors

in emerging markets U.S

investors have consistently

seen large percentages of their

returns erased by currency

depreciation This is true even

for long-term investors.”

Incorrect

3 “Historically, the addition

of emerging market stocks to

a U.S equity portfolio such as

the S&P 500 has reduced

volatility, volatility has also

been reduced when emerging

market stocks are combined

with an international portfolio

such as the MSCI EAFE

Index.”

Incorrect

4 “Although correlations

among emerging markets can

change over the short term,

such correlations show

evidence of stability over the

long term Thus an emerging

markets portfolio that lies on

the efficient frontier in one

period tends to remain close

to the frontier in subsequent

Correct

Incorrect

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Topic: Quantitative Analysis

Minutes: 16

1 Quantitative Methods for Investment Analysis, Richard A DeFusco, Dennis W McLeavey,

Jerald E Pinto, and David E Runkle (AIMR, 2001)

A “Multiple Regression and Issues in Regression Analysis,” Ch 9

Purpose:

To test the candidate’s ability to interpret and analyze the results of a multiple regression model

“Multiple Regression and Issues in Regression Analysis” (Study Session 3)

b) determine whether each independent variable in a multiple regression is statistically

significant in explaining the dependent variable and interpret the coefficients;

c) formulate a null and an alternative hypothesis about the population value of a regression coefficient, calculate the value of the test statistic, determine whether the null hypothesis is rejected at a given level of significance, and interpret the result of the test;

h) define, calculate, and interpret the F-statistic and discuss how it is used in regression

analysis;

i) distinguish between and interpret the R2 and adjusted R2 in multiple regression;

k) formulate a multiple regression equation, using dummy variables to represent qualitative factors, and interpret the results;

l) discuss the types of heteroskedasticity and the effects of conditional heteroskedasticity on statistical inference;

m) discuss the effects of serial correlation on statistical inference;

n) explain how to test and correct for heteroskedasticity and serial correlation;

p) discuss the causes and effects of multicollinearity in regression analysis

A Houston’s conclusion is incorrect

The F-statistic is not the appropriate statistic to judge the significance of individual

independent variables in a multiple regression The F-statistic measures the joint significance

of all independent variables in a multiple regression; a significant F-statistic indicates that at least one of the independent variables is significant, but the F-statistic cannot be used to judge the significance of individual independent variables The t-statistic should be used to

determine the significance of the individual independent variables in a multiple regression model

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B The R-Squared will generally increase when independent variables are added to the

regression model, whether or not the additional variables materially increase the model’s explanatory power (i.e., are significant)

The adjusted R-Squaredcorrects for the loss of degrees of freedom resulting from the

addition of independent variables, and does not automatically increase when insignificant independent variables are added to a regression model

Based on the adjusted R-Squared (the preferred measure), the explanatory power of

Houston’s regression has not increased

C Multicollinearity is the most likely cause of the result observed by Houston

The action that Houston should take is to experiment with excluding different independent variables to determine the source of the multicollinearity and then remove the variable(s) causing the multicollinearity from the model

D The new variables that should be added to Houston’s regression model to test for a

month-of-year effect are dummy variables

There would be 11 dummy variables, one for each month of the year with one arbitrary month omitted Each monthly dummy variable will take a value of one in the specified month, and zero in all other months

E

Two problems

Identify the evidence that would

most directly suggest the presence of each of the two

problems in a regression model

Recommend one method for correcting each

Newey-West methods)

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Topic: Risk Management

Minutes: 18

1 “Alternative Measures of Risk,” Roger G Clarke, Investment Management, Peter L

Bernstein and Aswath Damodaran, eds (Wiley, 1998)

Purpose:

To test the candidate’s understanding of, and ability to calculate and interpret, various measures

of risk

“Alternative Measures of Risk” (Study Session 15)

d) describe the circumstances in which variance or standard deviation may fail to capture selected dimensions of risk;

e) calculate and interpret the beta for a stock or a portfolio;

h) calculate the tracking error of a stock and a stock portfolio relative to a market index; j) describe how changes in security characteristics and market parameters affect the tracking error of a stock or bond portfolio;

k) contrast tracking error, beta, and standard deviation as measures of risk;

l) appraise and evaluate the probability of shortfall, expected shortfall, and relative

semivariance as risk measures

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statement)

If incorrect, give one reason why the

statement is incorrect

1 “Probability of shortfall

is a useful risk measure

because it shows the

manager’s potential for

large losses.”

Correct

Houston’s statement is incorrect because the probability of shortfall does not indicate the potential magnitude for losses The probability

of shortfall gives the probability that the undesirable event or return will occur (the chance that returns from the portfolio may fall below a chosen reference point), but does not give any information about how severe the

undesirable event will be

2 “If financial market

returns are normally

distributed, standard

deviation is the most

appropriate measure of total

3 “Expected shortfall is not

a desirable risk measure

because it penalizes

performance above the

benchmark index’s return.”

Correct

Houston’s statement is incorrect because expected shortfall does not address returns over the benchmark return and so does not penalize performance above the benchmark return Expected shortfall incorporates the probability of shortfall and the magnitude of the potential shortfall if

it does occur In so doing, expected shortfall only measures the difference between the actual return and the benchmark over the range of returns

when there is a shortfall

Incorrect

Correct

Incorrect

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B The tracking error (TE) for Mendon Advisors is 11.9%

The TE is calculated using the following formula:

σm = market standard deviation

σrp = portfolio residual standard deviation

conclusion)

If incorrect, give one reason why the

conclusion is incorrect

1 If Chariton Partners has a

larger tracking error than

Mendon Advisors, that is

because Chariton’s portfolio

has a higher beta

Correct

Portfolio beta in absolute terms does not determine tracking error, and a higher portfolio beta does not, in and of itself, signify higher tracking error What matters in the calculation of tracking error is the difference between the portfolio beta and the beta of the market portfolio In that regard, Chariton’s beta

of 1.1 is actually closer to the market beta of 1.0 than is Mendon’s beta of 0.8

2. If Chariton Partners has a

larger tracking error than

Mendon Advisors, that is

because Chariton’s portfolio

has a lower Sharpe ratio

Correct

The portfolio Sharpe ratio is not an input

in calculating or determining tracking error Instead, the tracking error calculation uses portfolio residual standard deviation

Incorrect

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Topic: Portfolio Performance Measurement

Minutes: 9

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

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

3 “Measuring and Evaluating Performance,” Frank J Fabozzi, Ch 9, pp 271−278 and

281−299, Fixed Income Readings for the Chartered Financial Analyst Program, Frank J

Fabozzi, ed (Frank J Fabozzi Associates, 2000)

Purpose:

To test the candidate’s ability to measure and evaluate portfolio performance

“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;

f) judge a portfolio manager’s performance relative to a market index or benchmark, especially considering the effect of returns resulting from exposure to various industry sectors and the specific investment objectives of the portfolio

“Measuring and Evaluating Performance” (Study Session 16)

e) explain the decomposition of both a domestic and a global fixed-income portfolio’s return into factors;

f) interpret a return attribution for both a domestic and a global fixed-income portfolio and for the relevant benchmark;

g) evaluate, based on a return attribution, the consistency of an investment manager’s

performance versus the manager’s stated investment style

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A i Very little of Broughton’s performance results can be attributed to relying on active

interest rate management decisions

The performance contribution for Interest Rate Management Effect—the primary

indicator of effective active interest rate management decisions—was only 0.16,

indicating Broughton’s lack of success at anticipating interest rate changes and

incorporating those changes in the portfolio allocation Nearly all of Broughton’s positive performance—1.37 percent of the total 1.66 percent—was a result of the Interest Rate Effect, a totally passive effect that is not related to active manager decisions

ii Very little of Broughton’s performance results can be attributed to identifying individual issues that are mispriced

The performance contribution for Bond Selectivity—the most direct measure of success

in security selection—was only 0.12 Nearly all of Broughton’s positive performance—1.37 percent of the total 1.66 percent—was a result of the Interest Rate Effect, an effect that is not related to successfully identifying mispriced securities

B A substantial portion of Matthews’ performance results can be attributed to identifying

undervalued sectors The performance contribution for Sector/Quality was 1.15 percent, which represented a large proportion of Matthews’ overall return of 1.61 percent

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Topic: Portfolio Performance Standards

Minutes: 12

1 GIPS Handbook, Edition 1, CFA Candidate Version, pp 1−116 and 146−148 (AIMR, 2002)

2 “Global Investment Performance Standards – Level III Workbook” (AIMR, 2002)

Purpose:

To test the candidate’s understanding of GIPS and ability to modify a performance report to make the report GIPS-compliant

“GIPS Handbook” and “Global Investment Performance Standards − Level III Workbook” (Study Session 17)

e) describe the minimum historic performance record requirement and the proper treatment of non-complaint performance record;

g) discuss the requirements and recommendations of the GIPS standards with respect to input data, including supporting information, portfolio valuation, and accounting methods;

h) discuss the requirements and recommendations of the GIPS standards with respect to

calculation methodology, including return calculations, composite weightings, cash returns, expenses, and minimum asset levels;

i) discuss the requirements and recommendations of the GIPS standards with respect to

composite construction, including inclusion of all portfolios, composite definitions,

terminated portfolios, switching portfolios, carve-out single asset classes, and simulated or model portfolios;

j) discuss the requirements and recommendations of the GIPS standards with respect to

disclosures, including the definition of firm, firm assets, list of composites, valuation

methodology, asset level requirements, currency used, the use of leverage or derivatives, management fees, accounting methods, benchmark discussions, fees, conformation to local laws or regulations, compliance periods, and cash allocation methods;

k) discuss the requirements and recommendations of the GIPS standards with respect to

presentation and reporting, including time frame of performance records, annual returns, composite and firm assets, dispersion measures, compliance statement, creation dates, non-compliant performance linking, annualization, portability of records, carve-out asset classes, and benchmarks

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