CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank 08 equity questions(1)

EQUITY QUESTION 1 IS COMPOSED OF FOUR PARTS A, B, C, D FOR A TOTAL OF 13 MINUTES Randy Rhodes is a wealthy, self-employed chiropractor who made his money opening a number of offices in

EQUITY

QUESTION 1 IS COMPOSED OF FOUR PARTS (A, B, C, D) FOR A TOTAL OF 13 MINUTES

Randy Rhodes is a wealthy, self-employed chiropractor who made his money opening a number

of offices in a large Midwestern city His work keeps him very busy with little time to review his investments Rhodes has always enjoyed reading about the markets, but acknowledges that he does not have time to track them as much as he would like He plans to keep working for another

10 years and has approximately $10 million in investable assets

Rhodes is unhappy with his current advisor because his portfolio has underperformed its

benchmark Rhodes is considering a new financial advisor, Tim Walcker, CFA Previously, the core of the portfolio was equally invested in the components of the S&P 100, a cap weighted index with quarterly rebalancing Despite holding all 100 stocks in the S&P 100, this investment has lagged the benchmark for the last three years See exhibits A and B for the portfolio's and the S&P 100's performances, respectively

Exhibit A

Rhodes Portfolio Equal-Weighted S&P 100 Fund

Exhibit B

S&P 100 Value-Weighted Index

Rhodes strongly believes in an active approach, but he has a tendency to be influenced by news articles he's recently read He is willing to accept down years in the markets, yet does not want to lag the index by a wide margin On more than one occasion, he’s said that he would prefer a portfolio of municipal bonds because he is attracted to their tax advantages

A Given Rhodes' objectives, identify which type of management (active, passive, or

semi-active) is the most appropriate, justifying your response using two reasons from the case

(3 minutes)

2

B Explain two reasons the previous manager likely underperformed the value-weighted S&P

100 index Do not discuss the investment manager’s fee

(4 minutes)

Rhodes is interested in adding two other investments to his portfolio The first is a portfolio comprised of 75 publicly traded U.S companies with the highest net sales, which he read about

in a financial publication According to the article, these companies are well diversified because they derive profits from around the world and have a low risk of bankruptcy because of their size

The second is a value-weighted index, called the Key Three, containing the three stocks as seen

in exhibit C The index company has announced that it will be changing the method of

calculating the index to be free float adjusted from its current value weighting scheme

Exhibit C

The Key Three Index

Market Capitalization (Billions) Float

C Regarding the portfolio made up of the top 75 publicly traded companies in the United States

ranked by sales, identify the best way to mimic this portfolio by using either optimization, full

replication, or stratified sampling and explain why

(3 minutes)

D When the Key Three index changes to being float-adjusted, which stock in the index will see

its weight in the index increase the most? No calculations necessary

(3 minutes)

4

QUESTION 2 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 10 MINUTES

Jim Harper is on the board of trustees for an endowment of a small liberal arts college Harper and the board have strong convictions that equity markets are generally efficient They do want

to hire a manager to actively manage a smaller portion of the equities in the endowment with the rest being indexed Harper is responsible for finding and meeting with potential investment managers and reporting his recommendations back to the rest of the board

Michael Peters, CFA, has made it into the final group of managers being considered for the job based on his ability to outperform the broader market index Peters’ expertise is in investing in stocks with high projected growth rates in earnings He often utilizes larger cap stocks and off index investing His five year performance results are shown below:

Short-Term Treasuries 4.4%

A Calculate Peters’ true active return and interpret based on those results whether or not Peters should be hired Show your calculations

(3 minutes)

Harper and the board want to spread the rest of the endowment’s equity portfolio across

numerous indices, including the S&P 500, the Russell 2000, and an international index They also want to allocate some funds to publicly traded companies that donate to charitable causes They have located a Charitable Index that represents this strategy The index invests in 500 companies based on criteria that are available with various delays It follows quarterly

rebalancing rules, but it is not investable In spite of this, Harper and the board feel strongly about adding this index to their portfolio because the charitable focus aligns with the beliefs of the college

B Identify the best way the endowment can invest in the Charitable Index by using either

futures, a separate account, or an equity return swap Justify your response with one reason

for each method that was not chosen

(4 minutes)

C Determine the best way the Charitable Index return can be replicated by using either full

replication, an equal weighting scheme, or stratified sampling Justify your response with

two reasons

(3 minutes)

6

QUESTION 3 HAS FIVE PARTS (A, B, C, D, E) FOR A TOTAL OF 17 MINUTES

Joyce Brown is a performance analyst with West Coast Consultants (WCC) WCC advises institutional portfolios on a range of investment management issues She is preparing for the annual review meeting with Durham Energy (DE) DE has a large pension fund and employs multiple outside managers and strategies

Brown is reviewing the returns- and holdings-based analysis reports for the equity manager who manages the largest portion of the pension fund’s equity allocation Both reports are as of the calendar quarter just ended

Returns Based Analysis (Trailing 60 Months)

(regression coefficient):

Unexplained –0.01

Total 1.00

Holdings Based Analysis (Quarter End)

Category: Weighting:

Total 1.00

A Determine the fund’s most recent allocation to cash equivalents

(3 minutes)

B Explain whether the fund has likely experienced style drift, and support your conclusion

with two facts based directly on the reports

(4 minutes)

C Explain two adverse consequences of style drift for DE

(4 minutes)

Brown is also reviewing the investment strategies used for the total pension fund portfolio DE has historically focused on long-only strategies but is looking for ways to increase return They are considering a $100 million allocation to a short extension strategy (the SE approach) For SE,

$100 million would be allocated to a new manager who will utilize a 130/30 strategy One of the

DE Investment Committee members asked Brown if they could achieve the same economic results with a “combination approach” by allocating the new funds to one of their existing long-only managers, then retaining a new manager who is a short sale overlay specialist

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D Quantify how the “combination approach” would be structured

(3 minutes)

E Explain which approach (SE or combination) Brown will recommend as most likely more

efficient

(3 minutes)