CFA 2018 level 3 gostudy individual IPS (r8)

Rather than knowing the steps or constraints by rote you will be asked to: solve for a client’s expected return, identify their ability and/or willingness to take risk on a scale from l

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Guided Notes for CFA® Level 3 – 2016

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Contents

Private Wealth Management (1) - Study Session 4 4

Managing Individual Investor Portfolios (Reading 8) 4

Overview of the Investment Policy Statement (IPS) 4

Classifying Investors 5

Constructing the IPS 8

Return 9

The Five Constraints 11

Strategic Asset Allocation (SAA) 14

Private Wealth Management (1) - Study Session 4

We now (mostly) shift away from the theoretical underpinnings of behavioral finance and the detailed evaluation of individual biases Our task now is to put what we’ve just learned into a practical context in terms of the specific actionable steps an investment manager should take when constructing an Investment Policy Statement (IPS)

The IPS is a document that identifies the needs, goals, and risk tolerance of an investor as well

as any constraints under which the portfolio must operate The final goal as an investment

manager is to build an IPS that is consistent with a client’s beliefs, attitude, and life stage From there we can determine a strategic asset allocation (SAA) that meets their required return while staying within the risk and constraint parameters of a given investor Thus the IPS unifies

traditional finance’s prescriptive approach to asset allocation with an acknowledgement of an investor’s individual quirks and situation

In practice, this section will appear as a major stand-alone question in the morning section of the exam (usually the first problem, accounting for 18+ points) Rather than knowing the steps

or constraints by rote you will be asked to: solve for a client’s expected return, identify their ability and/or willingness to take risk (on a scale from low to very high), and pick out their key constraints from a long passage

While the CFAI reading presents the IPS in the context of a case study the best way to really see how this material is tested is via the practice problems found in the morning CFAI practice exams Each exam has at least 1 lengthy problem on managing an individual’s portfolio If you

do 8-9 of them in preparation you are virtually guaranteed to do well on this pivotal and often

feared morning section (and hopefully get faster at it too) It is shocking how many Candidates

wait until the last month to look at past morning exams Don’t make this rookie mistake

Managing Individual Investor Portfolios (Reading 8)

The IPS guides the entire advisor/client relationship by setting clear objectives and constraints on the portfolio Constructing an IPS, especially for the purposes of the L3 exam, is a very codified process It has clearly defined steps and you can expect that each step will be tested The good news is that this means it is very clear exactly what you need to know to get most of the morning points here For studying purposes as well, the precision of the exam lets us condense well over

a hundred of pages of reading into just a few pages Seriously!

Overview of the Investment Policy Statement (IPS)

The IPS is a living document that defines the client/advisor relationship and sets clear objectives and constraints on the portfolio in order to develop a strategic asset allocation (SAA) that is unique to each investor The IPS should be reviewed annually or changed whenever a major change in circumstances could affect risk-return objectives or portfolio constraints.1

On the exam, the IPS section is most focused on identifying the expected return and risk and then discussing the five constraints an investor faces: time, taxes, liquidity, legal, and unique The

1 Examples of such changes include: change in income, divorce, marriage, change in tax laws, severe portfolio underperformance, a major liquidity need etc

best way to remember this is with RR-TTLLU In the morning section of the exam expect

questions asking you to decide on an investor’s risk tolerance, solve for return, and ID and talk about each constraint, all based on information presented in a passage

Why create an IPS?

The world of individual investors is “heterogeneous, burdened by taxes, and less well suited to

the simplifying assumptions of modern portfolio theory.”2 We create an IPS to help guide an investment manager through this complexity and because we expect it to be useful for both

clients and advisors:

Client Benefits Advisor Benefits

 Creating an IPS is an educational process

 Prioritizes clients objectives & constraints

 Makes it easier to add new managers

 Provides a long term plan that is understandable/can

provide discipline through market cycles but has

flexibility

 Builds knowledge of clients

 IDs clients objectives & constraints

 Provides guidance/support for decisions and a formal framework for resolving disputes

Relevant Behavioral Finance Concepts

The IPS is about creating a document to help optimize a portfolio using traditional finance

concepts while also building in elements of behavioral finance to account for a client’s

personality, age, and wealth

To briefly summarize the traditional vs behavioral distinction one more time:

We can think of behavioral modifications as pesky, annoying deviations from the optimal

efficient state that need to be accounted for, and the IPS as the document that captures these deviations by creating a profile for each investor’s unique situation

This is most important when thinking through an investor’s ability & willingness to take risk In fact most of this reading is centered on teaching us how to identify an investor’s risk

tolerance (willingness) and ability to take on risk according to their constraints and actual

situation Expect this to be tested on the exam

Classifying Investors

There are a variety of different methods of categorizing investors, many of which we’ve already covered In this reading, however, we touch on a few more frameworks and tie them more

closely to being able to answer likely exam questions such as:

 What is the risk tolerance of this investor? (Above-average, average, below-average)

 What is the willingness of this investor to take risk (above average, average, below

average)

2 CFA Institute, Managing Individual Investor Portfolios, 2015

Classifying Investors by Personality Type

When it comes to classifying investors by personality type (usually from answers to a

questionnaire) this reading introduces four main classifications

Cautious Investors: Prefer safe investments with low volatility Loss averse Not a

decision-maker, but nevertheless are often resistant to professional advice Often have an inability to pull trigger causing them to lose opportunities due to over-analysis or fear of taking action Exhibit low portfolio turnover Signs of a cautious investor could include previous life situations (lost a lot of money in the markets) or their financial situation

Methodical Investors: Are diligent researchers that rely on hard facts They are thus

unemotional and constantly looking for new information They tend to be conservative investors

due to their disciplined approach

Individualistic Investors: Do their own research and very confident They make their own

decisions and will take the time/make the effort to reconcile different data

Spontaneous Investors: Adjust their portfolio a lot in reaction to new developments and often

chase fads This over-management causes high trading costs and the highest turnover of any personality type They usually lack experience but still doubt professional advice and are more concerned with missing a trend than a portfolio’s overall level of risk

Graphically we can plot these types against their risk aversion and method of decision-making:

Situational Profiling - Source of Wealth, Stage of Life & Risk Tolerance

We can also profile investors by their stage of life or economic circumstances On the exam, you will likely see passages that hint at an investor’s stage of life, wealth, and method by which they

accumulated that wealth Each should give you valuable clues to both their willingness and

ability to take risk

Active (entrepreneurial) sources of wealth usually indicate above-average risk tolerance whereas passive (inheritors) display below average risk tolerance The presumption is that “self-made” investors have greater familiarity with risk-taking and a higher degree of confidence that they can recover from setbacks.3 To identify more passive lower-risk investors look for information that they’ve inherited wealth, received a large one-time payment, or steadily accumulated wealth during a period of secure employment

perception of one’s wealth the higher the risk tolerance Take two fifty year olds with the same

amount of assets as an example If one of them has 15 years of living expenses saved, or can

expect an inheritance, they might have a higher level of wealth than the other 50 year old whose

assets only cover 2 years of expenses On the exam you may need to make this determination based on how easily (or not) a portfolio’s returns can support an investor’s desired lifestyle In addition, if an investor is greatly concerned with succession/estate planning this is usually a sign that the portfolio is considered “large.”

Stage of Life: One’s stage in life is also vital to establishing a client’s risk tolerance The key

concept here is that the longer your investment time horizon the greater your ability to recover from downturns and thus the higher your risk tolerance all else equal There are four main stages

of life that follow one’s life progression from young to old (note we cover these stages in more depth when talking about human capital vs financial capital)

The Four Stages of Life

Foundation: Accumulation phase Long time horizon: Greatest ability to take risk from a time

perspective but this may be offset by having little accumulated wealth

Accumulation: Period of maximum saving & accumulation Strong ability to take risk from both

a time and asset perspective, but there may also be greater financial demands than previously

Maintenance: Retirement phase Can still be long time horizon, however, declining ability to

take risk given less income and thus less ability to replace lost principal/capital Emphasis shifts

to preserving wealth and purchasing power which can involve shifting assets to lower-volatility

investments On the exam this means usually means solving for an E(r) that keeps portfolio at

the same level of purchasing power

3 As we cover later, the degree or willingness to assume risk for these self-made investors often depends on how much control they feel they have over the situation

Distribution: Can be during the maintenance phase or also post-death for any bequests the

clients wanted to make and for which had excess assets over what they require For clients with substantial wealth this is where proper estate planning becomes critical

Constructing the IPS

IPS questions are GUARANTEED to be on the CFA Exam While you will not need to “create”

an IPS from scratch it is helpful to know the basic steps in the process of actually creating one The exam questions will often follow this structure in their flow and order

As a bonus, understanding the structure of the IPS also gives you insight into how the entire L3 curriculum and exam are structured In other words, the hyperlinks for each numbered step below point to major readings or even entire study sessions

The Formal IPS Process

1 Determine the Investor’s Objectives

a Return Requirements (return objective, and required return to meet those objectives)

b Risk Tolerance

2 Determine the Investor’s Constraints

a Time Horizon

b Taxes

c Liquidity needs

d Legal/Regulatory

e Unique considerations

3 ID the appropriate investment strategy ( SAA )

a Must meet the investor’s objectives

b Must fall within the investor’s constraints

c Is appropriate given the manager’s capital market expectations (i.e is realistic)

4 Carry out the Asset Allocation process

5 Execute portfolio trades

6 Evaluate portfolio performance at regular intervals

7 Rebalance the portfolio as needed

For the morning exam question this boils back down to RR-TTLLU We break each one down next, but lead with a high level summary checklist of how each will actually be tested:

RRTTLLU

 Risk - Above average, average, or below average tolerance based on details in passage

 Return - Calculation based on investor goals, may be pre or post tax

 Time - Multi-stage time horizons, positive relationship with risk, determines n in return calculation

 Taxes - May factor into return calculation, watch out for any long term holdings with substantial capital gains

 Liquidity - How much cash do you need within a 1 year period, inverse relationship to

risk

 Legal - Less important for individuals, state they may need to consult legal professionals

 Unique – A catch-all bucket for non-standard constraints

Return

The return section is divided into two parts

 The return objective, which is a statement of the investor’s objectives

 The required return, which is a calculation designed to figure out the return needed to meet

the client’s objectives On the exam when solving for return you will be using your financial

calculator in a straightforward PV/FV calculation There are, however, a few things to keep

in mind about return calculations:

a Calculate the return consistent with Capital Market Expectations (achievable)

b The return is governed by client constraints ID their risks before talking about their

expected return

c The return may be defined as either or both the required return or the desired return

d The return may be pre or post tax and it may be defined in nominal or real terms The return requirement is usually framed as the return required to meet all essential objectives such as living expenses, child education, and bequests etc It could also be framed as a desire to maintain a portfolio’s real purchasing power (keeping up with inflation) over a period of time while also meeting certain spending requirements Basically, FV =PV(1+r)^N (but accounting for yearly cash flows in or out)

Note that required return is distinct from desired return, which could include things like taking a

large vacation or wanting to buy a yacht Finally, if an investor’s return objective cannot be met without violating their risk parameters the individual may have to modify their behavior (e.g retire later) or accept a slightly more risk than they may be comfortable with (if they have

sufficient ability)

Solving for required return

When solving for required return take close account of nominal vs real and pre-tax vs post tax

so that you solve for the right rate of return (I/R) On the exam you will use your financial

calculator and follow these steps in order to perform the necessary calculation:

 List the client objectives

 Quantify their current assets This is their PV

 Calculate the time horizon This is n

 Calculate what they will need on an annual basis This is their PMT This is sometimes a

predictable annual payment (like a mortgage) or the sum of their total living expenses (accounting for time value) NET of their income (so total inflow or outflow) Make sure you also apply nominal/real and pre/post tax to these inputs if needed

 Calculate their FV This is often equal to the PV adjusted for inflation over the time

horizon

 Calculate the % return needed

What it boils down to for the exam itself is that you will need to read a passage about an

investor, and from that passage pick out the right values for Time (N=), their Base Assets (PV=), the amount they spend per year to meet expenses net of income (PMT (can be positive or

negative)), and then do a quick calculation for the amount they need at the end of the period (FV=?) Finally you can then you solve for expected return (I/Y)

Although you have to work to pick out the relevant information from a long passage this

calculation is pretty straightforward BUT the exam makers will try to make it trickier by

adding in tax and inflation considerations Keep the following keys in mind:

 Are you solving for after tax or before tax returns?

 If you are solving for nominal return (most likely) are you including expected inflation?

 Have you adjusted the PV (current investable assets) to account for any immediate cash inflows/outflows?

 Have you adjusted next year’s required cash flows (CF) for inflation if needed? Are you using the correct (+/-) signs when adjusting for cash in and out?

 Do you have the correct FV, either adjusted for future value, or correctly specified as the given terminal value?

 Have you adjusted the PV to account for any immediate cash flows in or out?

If you keep these points in mind, do ample sample problems from past exams, and show your

work on the day of the exam then you should get most of these points Half the battle here is

not getting bogged down in bad time management

Risk

Think about risk as defining the return you can expect and strive for given a person’s financial situation and psychological profile Here we define the main factors influencing one’s

willingness and ability to take risk and then provide a comprehensive list of factors that might be mentioned in a passage to help you identify where on the spectrum of risk they fall

Risk depends on both your willingness to take risk and your ability to take risk Willingness and ability are different Think of ability as a quantitative assessment of how much they can afford to lose relative to their goals Willingness on the other hand is a more subjective assessment of an

investor’s mental attitude towards investing If there is a conflict between the two always go

for the most conservative option

Main Factors affecting ability to take risk:

a Measure of Wealth: > Wealth, > Ability to take Risk Also subjective, partly depends

on investor’s perception of their wealth relative to needs

b Time Horizon/Stage of Life: The longer your time horizon (the younger you are) the

greater your ability to take risk

c Importance of Goals: Critical goals (like meeting essential spending needs) indicates a

lower ability to take risk whereas things like luxury spending

d Ability to withstand portfolio losses: The larger the shortfall an investor can tolerate

before jeopardizing their goals the greater their ability to take risk Note that the

relativity of goals can also equate to degrees of flexibility (bigger or smaller ranges for your asset allocation)