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 18

Reid is designing an asset allocation for two defined benefit pension plan’s respectively operated by his clients, Joyce Manufacturing JM and Regale Corporation RC.. He begins by collect

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FinQuiz.com

CFA Level III Item-set - Question

Study Session 9 June 2018

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FinQuiz Item-set ID: 134472

Questions 1(134473) through 6(134478) relate to Reading 18

Mark Reid Case Scenario

Mark Reid is an asset advisor at SouthWest Asset Management (SWAM) Reid is designing an asset allocation for two defined benefit pension plan’s respectively operated by his clients, Joyce Manufacturing (JM) and Regale Corporation (RC) He begins by collecting details on both pension plans in Exhibit 1 below:

Exhibit 1: Defined Benefit Pension Plans

As part of his analysis, Reid also summarizes the investment objectives of the pension funds as follows:

JM: To reduce surplus risk

RC: To minimize long-term future contributions, convert to an annuity plan, and maintain

portfolio volatility

Reid sits down with the RC’s chief financial officer to discuss the plan’s asset allocation His agenda is to focus on the following two items:

Item 1: Propose an allocation to alternative investments identical to JM This will be achieved by

liquidating a portion of the equity allocation and re-investing the proceeds in alternative investments

Item 2: Consider the impact of taxes on the asset allocation (Exhibit 1) by analyzing a

breakdown of pre-tax returns and standard deviations (Exhibit 2) and correlations

(Exhibit 3)

Exhibit 2: Pre-tax Returns and Standard Deviations of RC’s Asset Allocation

Return (%)

Pre-tax Standard Deviation (%)

Tax Rate (%)

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Exhibit 3:

Correlation Matrix for RC’s Asset Allocation

Based on his taxes and correlations analysis, Reid decides to place equities in a taxable account and makes the following two conclusions:

Conclusion 1: Although IG and HY bonds are less tax-efficient, the addition of these two bonds

will bring risk reduction benefits to a taxable account

Conclusion 2: While taxes serve to reduce the distribution of returns, the correlations between

any two asset classes are unaffected

Next, Reid proceeds to set rebalancing ranges for a modified version of JM’s current asset

allocation which are presented in Exhibit 1 These ranges consider a proposed strategic asset allocation (SAA) for the policy portfolio The relevant data are presented in Exhibit 4

Exhibit 4:

Rebalancing Ranges for a Modified Version of JM’s Policy Portfolio

(%)

Modified Current Allocation (%)

Pre-tax Rebalancing Range

Alternative investments

During Reid’s meeting with JM, the asset advisor discusses the results of his findings and the rebalancing ranges for the three asset classes Reid makes the following comments concerning the rebalancing range for alternative investments:

Statement: “In response to a recent above average performance of alternative investments

securities, the rebalancing range has been widened to facilitate an overweighting of the asset class to a higher policy limit.”

Lewis Strong, Reid’s subordinate, reviews the asset allocation pointing out that the advisor has failed to consider the asset class’ past record of extreme volatility

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FinQuiz Question ID: 134473

1 Considering the asset allocation presented in Exhibit 1 and each client’s objectives, which of

the following statements is most likely correct? The asset allocation for:

A JM carries a higher liquidity risk

B RC carries a higher contribution risk

C RC will result in a lower pension cost

2 In context of the meeting between Reid and the chief investment officer, which of the

following asset allocation constraints has Item 1 failed to consider?

A Liquidity

B Asset size

C Time horizon

3 With respect to his analysis of the impact of taxes on the asset allocation, Reid is most likely

correct regarding:

A Conclusion 1 only

B Conclusion 2 only

C both of the conclusions

4 Using the data in Exhibit 2, the impact of taxes is lowest on the volatility of:

A equities

B IG bonds

C HY bonds

5 Using the tax rates in Exhibits 2 and a 25% tax rate for alternative investments, which asset class presented in Exhibit 4 requires rebalancing?

A Bonds

B Equities

C Alternative investments

6 In light of Lewis’ observation and Reid’s statements concerning the rebalancing range for alternative investments, which of the following behavioral biases is the advisor subject to?

A Availability

B Illusion of control

C Representativeness

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