CFA CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA level 3 finquiz item set questions, study session 7, reading 17

Exhibit 1: Paulus Manufacturing’s Defined Benefit Pension Plan Details participants million Current sponsor contributions None After collecting details, Gill designs a strategic asset a

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CFA Level III Item-set - Question

Study Session 8 June 2018

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FinQuiz Item-set ID: 134419

Questions 1(134420) through 6(134425) relate to Reading 17

Paulus Manufacturing Case Scenario

Paulus Manufacturing is a manufacturer of doors and panels The company has a base of 4,000 employees which are covered by a defined benefit pension plan Stephanie Gill is the plan’s chief investment officer Gill summarizes details concerning the pension plan in Exhibit 1

Exhibit 1: Paulus Manufacturing’s Defined Benefit Pension Plan Details

participants

million

Current sponsor contributions

None

After collecting details, Gill designs a strategic asset allocation for the policy portfolio She refrains from determining the allocation using Markowitz’s mean variance optimization (MVO) because she feels the approach fails to consider an investor’s risk tolerance, rebalancing costs and taxes as well as leads to poorly diversified portfolios She compares the asset-only and liability-relative approaches for deriving allocations

Next, Gill considers the inclusion of private equity in the allocation She recognizes that the lack

of accurate indexes for illiquid asset classes such as private equity makes it difficult to make capital market projections, which are essential in deriving expected returns and volatilities

estimates for the asset classes in an allocation As a consequence, Gill decides to employ a

private equity fund for fulfilling the strategic asset allocation

After considerable deliberation, Gill concludes that a liability-relative approach will more

comprehensively address the manufacturer’s funding objectives compared to an asset-only approach She bases her selection of the most suitable liability-relative approach on rebalancing costs and taxes

Gill proceeds to compare the possibility of employing a factor-based with an asset-class based optimization in a liability-relative asset allocation framework She identifies economic changes and inflation as the most important factors to influence the plan’s liabilities Exhibit 2 illustrates the strategic asset allocation with rebalancing corridors designed by her for the plan Gill intends

to rebalance the allocation using the percent-range rebalancing approach

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Exhibit 2: Strategic Asset Allocation for Paulus Manufacturing’s Defined Benefit Pension Plan

Gill explains the factor-based optimization approach to Paulus Manufacturing’s board stating,

“The approach is only appropriate in an integrated liability-relative asset allocation framework as the latter is sophisticated enough to link factor exposures to asset and liability returns.”

FinQuiz Question ID: 134420

1 Considering the reasons identified by Gill, which of the following least likely justifies why

Markowitz’s MVO approach is unsuitable for determining the policy portfolio’s asset

allocation?

A Leads to poorly diversified allocations

B Does not consider an investor’s risk tolerance

C Does not consider the impact of rebalancing costs and taxes

2 A drawback of using an investment vehicle to represent private equity is that:

A the strategy is costly to implement

B there is a lack of availability of investment vehicles

C there is high correlation between the vehicle and the asset class it is intended to represent

3 Using the data in Exhibit 1 and considering Gill’s rebalancing concerns which

liability-relative approach will be most suitable for the pension plan?

A Surplus optimization

B Hedging/return seeking portfolio

C Integrated asset-liability approach

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4 Which of the following reasons accurately identifies why the allocation in Exhibit 2 is

inappropriate?

A Poor diversification

B 25-year Treasury bonds are not positively correlated with the risk factors

C An underfunded plan requires a higher growth component to reduce sponsor concerns for funding future liabilities

5 Based on Gill’s comments concerning factor-based allocation, she is most likely:

A correct

B incorrect, a factor-based approach can be implemented with any liability-relative asset allocation approach

C incorrect, the integration approach makes asset allocation decisions independently of liabilities which is inconsistent with the fundamentals of factor-based allocation

6 Using the data in Exhibit 2 and considering transaction costs, will a simultaneous increase in correlation between domestic equities with the rest of the portfolio and volatility require an adjustment to the asset class’s corridor width?

A No

B Yes, the width should be increased

C Yes, the width should be decreased

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