CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 r08 managing individual investor portfolios summary

Return Objective Year Type Comment 2016 Multi Period Minimum annual after-tax return required by X to be able to retire in 10 years.. 2013 Single Period Calculate nominal after-tax re

Level III

Managing Individual Investor Portfolios

Summary

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Key Concepts

Questions based on this reading test us on key components of the IPS

• Return Objective

• Risk

• Constraints

Asset Allocation

Monte Carlo Simulations

Return Objective

Year Type Comment

2016 Multi Period Minimum annual after-tax return required by X to be able to retire in 10 years

2015 Multi Period Pre-tax gift that will allow X to meet his goals

2014 Multi Period Determine whether return is sufficient to meet retirement goals

2013 Single Period Calculate nominal after-tax required rate of return

2013 Multi Period Determine which portfolio is appropriate using short-fall risk approach

2012 Multi Period Calculate required nominal annual rate of return

2011 Single Period Calculate after-tax nominal rate of return

2010 Multi Period Calculate annual pre-tax nominal rate of return

2009 Single Period Calculate pre-tax nominal rate of return

2008 Single Period Calculate after-tax nominal rate of return

2008 Multi Period Calculate after-tax nominal rate of return

2007 Multi Period Calculate nominal pre-tax return while maintaining purchasing power

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Problem Solving Tips

Single-Period Questions

Three parts:

1 Cash needed

2 Investable assets

3 Return (*)

* If investor wants to maintain purchasing power of investable assets then add inflation rate

Multi-Period Questions

1 Periodic cash flow (**)

2 Investable assets (initial portfolio amount)

3 Final portfolio amount (based on retirement needs)

4 Rate

** If savings go to a tax-deferred account then we should calculate the pre-tax income needed to meet spending needs

Return Objective (1)

Client A is 30 years old and plans to retire when he is 60

Pretax annual compensation is 200,000 The tax rate is 30%

Annual expenditure is 100,000

Savings go to a tax deferred account (TDA)

Annual savings are expected to remain the same

Current value of TDA portfolio is 1,000,000

On retirement your client will need 3,500,000 on a pre-tax basis

What is the required rate of return?

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Return Objective (1) Solution

Your client is 30 years old and plans to retire when he is 60

Pretax annual compensation is 200,000 The tax rate is

30%

Annual expenditure is 100,000

Savings go to a tax deferred account (TDA)

Annual savings are expected to remain the same

Current value of TDA portfolio is 1,000,000

On retirement your client will need 3,500,000

What is the required rate of return?

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Common mistakes:

1 Calculating savings as 200,000 (1 – 0.3) – 100,000 = 60,000

2 Not properly recognizing the +/- convention

Pre-tax income needed

= 100,000 / (1 – 0.30) = 142,857

N = 30, PV = 1,000,000, PMT = 57,143,

FV = -3,500,000 CPT I/Y = 1.23%

Return Objective (2)

Client B has just retired

Net investable assets = 2,000,000

Value of home = 600,000 (all paid)

After-tax pension = 40,000 (flat)

Current-year living expenses = 150,000

Living expenses will increase with inflation

Inflation = 2%

Client wants to maintain real value of investable assets

What is the required after-tax nominal rate of return

for the first year?

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Return Objective (2) Solution

Your client has just retired

Net investable assets = 2,000,000

Value of home = 600,000 (all paid)

After-tax pension = 40,000 (flat)

Current-year living expenses = 150,000

Living expenses will increase with inflation

Inflation = 2%

Client wants to maintain real value of investable assets

What is the required after-tax nominal rate of return

for the first year?

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Step 1: Determine year 1 cash flow

Living expenses: 150,000 x 1.02 = 153,000 Less 40,000 pension = 113,000

Step 2: Investable assets

2,000,000

Step 3: Calculate required return

Real rate = 113,000 / 2,000,000 = 5.65% Nominal rate ≈ 5.65 + 2.00 = 7.65%

Common mistakes:

1 Forgetting to increase living expenses to account for inflation

2 Not subtracting pension

3 Not adding inflation at the end

Return Objective (3)

Client C has just sold his business for 8,000,000 and has retired

The costs basis of the business is 0 Taxes are due on the gain

from sale of business at 20% Net proceeds from the sale of

business will be added to his investment portfolio next week

This investment portfolio is taxable and has a current market

value of 2,000,000 Client C wants to grow the investment

portfolio over time to maintain its after-tax purchasing power

He will receive payments of 100,000 per year from a trust fund

established by his parents The first payment is due next week

These payments are not indexed to inflation and will be taxed as

ordinary income at 25% Investment income is also taxed at 25%

Living expenses for last year were 400,000 and are expected to

grow at the inflation rate of 2%

Client C owns his home worth 3,000,000 His mortgage debt is

2,000,000 He wants to pay off this debt immediately

Determine the nominal after-tax required rate of return for the

coming year What is the nominal before-tax rate?

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Return Objective (3) Solution

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Step 1: Determine year 1 cash flow

Living expenses: 400,000 x 1.02 = 408,000 Less after-tax income: 100,000 (1 – 0.25) = (75,000) Net cash needed in year 1: = 333,000

Step 2: Investable assets

Net proceeds from sale: 8,000,000 x 0.8 = 6,400,000 Plus investment portfolio value = 2,000,000 Less mortgage debt = (2,000,000) Total investable assets = 6,400,000

Step 3: Calculate required return

After-tax real rate = 333,000 / 6,400,000 = 5.20%

Nominal after-tax rate ≈ 5.20 + 2.00 = 7.20%

Nominal before-tax rate = 7.20/0.75 = 9.60%

Sold his business for 8,000,000

The costs basis of the business is 0

Taxes are due on the gain from sale of business at 20%

Investment portfolio is taxable and has a current market

value of 2,000,000

Maintain its after-tax purchasing power

He will receive payments of 100,000 per year

These payments are not indexed to inflation and will be

taxed as ordinary income at 25% Investment income is

also taxed at 25%

Living expenses for last year were 400,000 and are

expected to grow at the inflation rate of 2%

Client C owns his home worth 3,000,000 His mortgage

debt is 2,000,000 He wants to pay off this debt

immediately

Determine the nominal after-tax required rate of return

for the coming year What is the before tax return?

What factors impact ability to take risk?

• Age

• Employability and nature of income

• Investment time horizon

• Pension eligibility

• Home ownership

• Level of debt

• Asset base relative to spending needs

• Saving habits

• Spending needs (liquidity requirements) and habits

• Major cash inflows or outflows

• Desire to leave an estate

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What factors impact willingness to take risk?

• Behavioral biases

• Attitude towards equity markets

• Planned retirement age

• Preference for conservative versus aggressive investing

– Consider current fixed income / equity allocation

• Attitude towards risky activities

• Source of wealth

– Through savings over time

– Business

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Risk tolerance considers the ability and the willingness to take risk

Liquidity

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Liquidity needs can be one-off or on-going Three

primary types of liquidity requirements:

1 Ongoing expenses

• Net living expenses

• Health care expenses

2 Liquidity events

• Fund children’s education

• Create trust fund for children

• Go on a world tour

• Planned donation

• Debt payments (pay off mortgage)

3 Emergency/cash reserves

When discussing a client’s liquidity constraint we should consider the investment portfolio’s ability to efficiently meet an investor’s anticipated and unanticipated demands for cash distributions A portfolio’s liquidity is

impacted by transaction costs and price volatility Significant liquidity requirements limit ability to take risk

Liquidity Scenarios

Client X has an investment portfolio of 300,000 Her income is 90,000 per year, after-tax Her ongoing living expenses are 70,000 per year? Do the ongoing living expenses create a liquidity need from the portfolio?

Client X wants to go on a world tour at the end of the year The estimated cost will be 40,000 She also wants to establish a cash reserve worth 50,000 Are these liquidity requirements?

Client Y has just retired Her investment portfolio is worth 1,000,000 She does not have any pension income Her ongoing living expenses are estimated to be 70,000 per year Is this a liquidity

requirement?

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Time Horizon

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15 years or longer  long term 3 years or shorter  short term Single stage vs multi stage time horizon

Example of multi-stage time horizon:

Stage 1: From now till when a major liquidity retirement is met

Stage 2: After meeting liquidity retirement till retirement

Stage 3: Retirement

(Stage 4 arises if client outlives savings)

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Basic process of selecting appropriate strategic asset allocation:

1 Determine which asset allocations meet return requirement

2 Eliminate asset allocations that fail to meet risk objectives

3 Eliminate asset allocations that fail to meet investor constraints

4 Select allocation that is most rewarding for client

Monte Carlo simulation has some advantages over deterministic approaches:

1 More accurately portrays risk-return tradeoff

2 Illustrates tradeoffs between short-term and long-term goals

3 Provides more realistic modeling of taxes

4 Better suited to assessing multi-period effects

Asset Allocation and Monte Carlo Simulations