Professional Documents
Culture Documents
Reading References:
1. “Managing Institutional Investor Portfolios,” Charles R. Tschampion, Laurence B. Siegel,
Dean J. Takahashi, and John L. Maginn, Managing Investment Portfolios: A Dynamic
Process, 3rd edition (AIMR, forthcoming)
Purpose:
To test the candidate’s ability to create an appropriate investment policy statement for a life
insurance company.
Guideline Answer:
A. i. The return requirement for the bond portfolio is at least 7.5 percent (6 percent crediting
rate plus 1.5 percent marketing and administrative expenses). This level of return is
needed to cover both the cost of interest-sensitive products and associated marketing and
administrative expenses.
ii. The return requirement for the common stock portfolio is a total return equal to or greater
than the total return of the designated benchmark, the Wilshire 5000 Total Market Index.
Factors specific to
determining the risk Specific evidence for each factor that should be reflected in
objectives of a life Rightland Life’s risk objectives:
insurance company are:
1. Valuation concerns For the surplus, there are risks associated with the decline in the
stock market. Surplus as a percentage of assets has declined from
25 percent in 2000 to 17 percent in 2002. This could potentially
lead to a capital adequacy problem if asset prices erode further.
For the bond portfolio, there are similar risks associated with the
substantial widening of corporate bond spreads that has occurred
even though interest rates in general have declined during the
past two years.
2. Reinvestment risk Returns will suffer if interest rates continue to trend downward
and coupon and principal payments are reinvested at lower rates.
3. Credit risk The bond portfolio is too heavily invested (31 percent vs. an
industry average weighting of 17 percent) in lower-rated (BBB)
securities, resulting in excess credit risk.
4. Cash Flow Volatility Although cash flow volatility is a relevant factor in general, there
is no specific evidence that it should be reflected in Rightland’s
risk objectives.
2. Time Horizon Although life insurance companies generally have long time
horizons, Rightland has a somewhat shorter time horizon, evidenced
by the portfolio’s liability duration of five shown in Exhibit 1-1. The
average maturity of the bond portfolio of ten years may (or may not)
produce a portfolio duration that roughly matches the portfolio
duration of five. The time horizon of the company would be
somewhat longer when the investment of the surplus is considered.
3. Tax Considerations Although Rightland is subject to income, capital gains, and other
taxes, investment income on surplus is taxed whereas investment
income on the policyholders’ share of investment income is not
taxed. Tax considerations are a factor in determining the investment
mix that provides the most favorable after-tax returns.
5. Unique Circumstances Rightland may not hold tobacco or alcohol stocks in its common
stock portfolio.
Reading References:
1. “Managing Institutional Investor Portfolios,” Charles R. Tschampion, Laurence B. Siegel,
Dean J. Takahashi, and John L. Maginn, Managing Investment Portfolios: A Dynamic
Process, 3rd edition (AIMR, forthcoming)
Purpose:
To test the candidate’s understanding of differences in the investment policy statements of life
and non-life insurance companies.
Reading References:
1. “Managing Institutional Investor Portfolios,” Charles R. Tschampion, Laurence B. Siegel,
Dean J. Takahashi, and John L. Maginn, Managing Investment Portfolios: A Dynamic
Process, 3rd edition (AIMR, forthcoming)
Purpose:
To test the candidate’s ability to critique an asset allocation for a nonlife insurance company.
Guideline Answer:
A. The shortcoming with respect to the critical goal of asset/liability management is that the
bond portfolio duration (5.2) is mismatched in relation to the estimated duration of liabilities
(1.8).
B. The asset allocation is not appropriate with respect to the liquidity needs of the automobile
insurance division.
The current allocation to cash equivalents of two percent is insufficient to meet the liquidity
demands of a casualty business with low liability duration (1.8) and potentially erratic cash
flows.
Reading References:
3. Emerging Stock Markets: Risk, Return, and Performance, Christopher B. Barry, John W.
Peavy III, and Mauricio Rodriguez (Research Foundation of the ICFA, 1997)
A. “Introduction”
B. “Historical Performance of Emerging Equity Markets,” Ch. 1
C. “Portfolio Construction Using Emerging Markets,” Ch. 2
Purpose:
To test the candidate’s ability to interpret the effects of adding an asset class (e.g., emerging
markets) to an existing asset allocation.
Guideline Answer:
Determine whether
each of Houston’s
four comments is If incorrect, give one reason why
Houston’s four comments
correct or incorrect the comment is incorrect
(circle one for each
comment)
1. “For an investor holding There have been periods of strong
only developed market performance despite weak currencies.
equities, the existence of Correct It is also possible that an appreciating
stable emerging market currency could enhance performance.
currencies is one of several
pre-conditions necessary for Incorrect
that investor to realize strong
emerging market
performance.”
2003 Level III Guideline Answers
Morning Session - Page 7
2. “Local currency
depreciation against the dollar
has been a frequent
Correct
occurrence for U.S. investors
in emerging markets. U.S.
investors have consistently
seen large percentages of their Incorrect
returns erased by currency
depreciation. This is true even
for long-term investors.”
Reading References:
1. Quantitative Methods for Investment Analysis, Richard A. DeFusco, Dennis W. McLeavey,
Jerald E. Pinto, and David E. Runkle (AIMR, 2001)
A. “Multiple Regression and Issues in Regression Analysis,” Ch. 9
Purpose:
To test the candidate’s ability to interpret and analyze the results of a multiple regression model.
Guideline Answer:
A. Houston’s conclusion is incorrect.
The F-statistic is not the appropriate statistic to judge the significance of individual
independent variables in a multiple regression. The F-statistic measures the joint significance
of all independent variables in a multiple regression; a significant F-statistic indicates that at
least one of the independent variables is significant, but the F-statistic cannot be used to
judge the significance of individual independent variables. The t-statistic should be used to
determine the significance of the individual independent variables in a multiple regression
model.
The adjusted R-Squared corrects for the loss of degrees of freedom resulting from the
addition of independent variables, and does not automatically increase when insignificant
independent variables are added to a regression model.
Based on the adjusted R-Squared (the preferred measure), the explanatory power of
Houston’s regression has not increased.
The action that Houston should take is to experiment with excluding different independent
variables to determine the source of the multicollinearity and then remove the variable(s)
causing the multicollinearity from the model.
D. The new variables that should be added to Houston’s regression model to test for a month-of-
year effect are dummy variables.
There would be 11 dummy variables, one for each month of the year with one arbitrary
month omitted. Each monthly dummy variable will take a value of one in the specified
month, and zero in all other months.
E.
Reading References:
1. “Alternative Measures of Risk,” Roger G. Clarke, Investment Management, Peter L.
Bernstein and Aswath Damodaran, eds. (Wiley, 1998)
Purpose:
To test the candidate’s understanding of, and ability to calculate and interpret, various measures
of risk.
Indicate whether
each of Houston’s
Houston’s three three statements is If incorrect, give one reason why the
statements correct or incorrect statement is incorrect
(circle one for each
statement)
1. “Probability of shortfall Houston’s statement is incorrect
is a useful risk measure because the probability of shortfall
because it shows the Correct does not indicate the potential
manager’s potential for magnitude for losses. The probability
large losses.” of shortfall gives the probability that
Incorrect the undesirable event or return will
occur (the chance that returns from the
portfolio may fall below a chosen
reference point), but does not give any
information about how severe the
undesirable event will be.
2. “If financial market
returns are normally
distributed, standard Correct
deviation is the most
appropriate measure of total
risk.” Incorrect
where
βp = portfolio beta
βm = market beta
σm = market standard deviation
σrp = portfolio residual standard deviation
__________________________
TE = √ [(0.80 – 1.00)2 × 15.02] + 11.52
TE = 11.9%
C.
Indicate whether
each of Houston’s
two conclusions is If incorrect, give one reason why the
Houston’s two conclusions correct or incorrect conclusion is incorrect
(circle one for each
conclusion)
1. If Chariton Partners has a Portfolio beta in absolute terms does not
larger tracking error than determine tracking error, and a higher
Mendon Advisors, that is Correct portfolio beta does not, in and of itself,
because Chariton’s portfolio signify higher tracking error. What
has a higher beta. matters in the calculation of tracking
Incorrect error is the difference between the
portfolio beta and the beta of the market
portfolio. In that regard, Chariton’s beta
of 1.1 is actually closer to the market
beta of 1.0 than is Mendon’s beta of 0.8.
Reading References:
2. “Evaluating Portfolio Performance,” Ch. 14, pp. 14-23 through 14-47, Peter Dietz and
Jeannette Kirschman, Managing Investment Portfolios: A Dynamic Process, 2nd edition, John
L. Maginn and Donald L. Tuttle, eds. (Warren, Gorham & Lamont, 1990)
3. “Measuring and Evaluating Performance,” Frank J. Fabozzi, Ch. 9, pp. 271−278 and
281−299, Fixed Income Readings for the Chartered Financial Analyst Program, Frank J.
Fabozzi, ed. (Frank J. Fabozzi Associates, 2000)
Purpose:
To test the candidate’s ability to measure and evaluate portfolio performance.
LOS: The candidate should be able to
“Evaluating Portfolio Performance” (Study Session 16)
b) appraise the advantages and limitations of using manager universes, benchmark indexes,
normal portfolios, and attribution analysis to evaluate investment manager performance;
d) critique the use of publicly available indexes (e.g., S&P 500) as benchmarks;
f) judge a portfolio manager’s performance relative to a market index or benchmark, especially
considering the effect of returns resulting from exposure to various industry sectors and the
specific investment objectives of the portfolio.
“Measuring and Evaluating Performance” (Study Session 16)
e) explain the decomposition of both a domestic and a global fixed-income portfolio’s return
into factors;
f) interpret a return attribution for both a domestic and a global fixed-income portfolio and for
the relevant benchmark;
g) evaluate, based on a return attribution, the consistency of an investment manager’s
performance versus the manager’s stated investment style.
ii. Very little of Broughton’s performance results can be attributed to identifying individual
issues that are mispriced.
The performance contribution for Bond Selectivity—the most direct measure of success
in security selection—was only 0.12. Nearly all of Broughton’s positive performance—
1.37 percent of the total 1.66 percent—was a result of the Interest Rate Effect, an effect
that is not related to successfully identifying mispriced securities.
Reading References:
1. GIPS Handbook, Edition 1, CFA Candidate Version, pp. 1−116 and 146−148 (AIMR, 2002)
2. “Global Investment Performance Standards – Level III Workbook” (AIMR, 2002)
Purpose:
To test the candidate’s understanding of GIPS and ability to modify a performance report to
make the report GIPS-compliant.
2. “To show performance The GIPS Standards allow firms to link non-GIPS compliant
returns since our inception, performance to their five-year compliant history, but firms must
Matthews Advisors has disclose which periods are not in compliance and the reasons the
linked non-GIPS compliant performance does not comply with GIPS Standards. To be in
performance to our five compliance, Matthews must disclose which periods are
years of GIPS compliant noncompliant and the reasons why the noncompliant periods were
returns.” not in compliance.
4. “Matthews Advisors If Matthews uses swaps, which are derivative instruments, the
uses swap instruments to firm must also disclose information sufficient to identify the risks
enhance returns in fixed of the derivative instruments. To be in compliance, Matthews
income portfolios under must specifically include a description of the: 1) use, 2) frequency,
management.” and 3) characteristics of the instruments.
Reading References:
1. Managing Investment Portfolios: A Dynamic Process, 3rd edition (AIMR, forthcoming)
A. “The Portfolio Management Process and the Investment Policy Statement,” John L.
Maginn, Donald L. Tuttle, Dennis W. McLeavey, and Jerald E. Pinto
B. “Managing Individual Investor Portfolios,” James W. Bronson, Matthew H. Scanlan, and
Jan R. Squires
Purpose:
To test the candidate’s ability to prepare an investment policy statement for an individual
investor.
1. Risk Tolerance
Ability. The Trust has average ability to assume risk, largely because the total return
requirement is a relatively modest 6.71 percent (see calculation below). Compared to
portfolio assets, before-tax expenses plus inflation equals 3.71 percent + 2 percent = 5.71
percent, which is an achievable level given the size of the portfolio. The Petrie
Enterprises stock, however, represents 12 percent of the portfolio. If the value of the
portfolio were to drop significantly, it would be more difficult for the portfolio to meet its
return requirements. Because the portfolio is the only source of support for Bavier, the
Trust’s ability to assume risk is lower than it might otherwise be.
Willingness. The Trust has below average willingness to assume risk. The Trust
document requires that the account be invested so that shortfall risk (defined as expected
total return minus two standard deviations) is limited to a –10 percent return in any one
year. This limitation implies that the Trust will be unwilling to tolerate any substantial
volatility in portfolio returns. Bavier has a below average willingness to assume risk,
given her unfortunate prior experience of receiving poor financial advice and seeing her
inherited assets shrink. In addition, Bavier is relying on steady returns to meet her current
and future living expenses.
Overall risk tolerance. The Trust has below average risk tolerance and will continue to
have it for many years, especially while Bavier is alive.
2. Return Requirement
The return requirement reflects two major factors: the need to cover living expenses and
the need to protect the portfolio from the adverse effects of inflation. Specifically, the
Trust must generate a total before-tax return of at least 6.71 percent on an annual basis to
meet the return requirements.
The living expenses are estimated at $78,000 per year. However, because income and
capital gains are taxed at 30 percent, the Trust will need to generate $111,429 before tax
to meet the living expenses of Bavier and Campbell, which equals a 3.71 percent return
on the $3,000,000 portfolio. Adding inflation and growth results in the total return of
6.71%, as follows:
(($78,000 / (1 – 0.30)) / $3,000,000) + 2% inflation + 1% (minimum) for growth =
($111,429 / $3,000,000) + 2% inflation +1% (minimum) for growth =
3.71% + 2% + 1% = 6.71%
1. Liquidity Requirements
The Trust has minimal liquidity needs, at least until Campbell begins his university
education, but should maintain liquidity, in case of emergencies, of $83,571, which is
equal to nine months of the first year's estimated living expenses on a pre-tax basis (as
mandated by the Trust), or [($78,000 / 0.70) × (9 / 12)].
2. Time Horizon
Based on the assumption that Campbell lives longer than Bavier, the Trust faces a time
horizon comprising three stages:
• The first stage is years 1 through 6, when the living expenses of Bavier and Campbell
are expected to increase consistent with inflation.
• The second stage would be years 7 through 10, when Bavier’s expenses continue and
Campbell’s expenses increase with the cost of his university education.
• The third and probably final stage would extend from year 11 onward to Bavier’s
death or year 20, whichever is later. As long as Bavier is alive, her expenses will
continue. If Bavier dies, this third stage would last until year 20, when Campbell
turns 32. During this period between Bavier’s death and year 20, if it occurs,
Campbell would receive distributions from the Trust sufficient to cover essential
expenses in excess of his after-tax income.
3. Tax Considerations
The Trust will be subject to taxes; therefore after-tax returns of individual securities and
of the portfolio will be critical. Income and capital gains are both taxed at the 30 percent
rate. The Trust should evaluate assets and portfolio returns on an after-tax basis and
consider the possible attractiveness of tax-advantaged securities.
4. Regulatory/Legal Considerations
The Trustee will need to follow the Prudent Investor statutes. The Trust also has the usual
fiduciary responsibilities.
5. Unique Circumstances
The restriction on selling the Petrie Enterprises common stock is a material unique
circumstance.
Reading References:
1. Managing Investment Portfolios: A Dynamic Process, 3rd edition (AIMR, forthcoming)
B. “Managing Individual Investor Portfolios,” James W. Bronson, Matthew H. Scanlan, and
Jan R. Squires
Purpose:
To test the candidate’s: 1) understanding of the factors affecting the asset allocation for an
individual investor, and 2) ability to determine an appropriate asset allocation.
The following table summarizes the five alternative portfolios in the context of the Trust’s
objectives and constraints:
Alternative Portfolios
Trust Objectives and Constraints A B C D E
Minimum Return (pre tax) = 6.71% 6.89% 6.74% 6.52% 6.06% 7.23%
Downside risk no worse than –10% –9.71% –8.68% –8.20% –7.00% –10.35%
Minimum Cash Equivalents = 2.79% of assets 2.00% 4.00% 10.00% 2.00% 5.00%
Portfolio A fails to meet the minimum liquidity requirement and barely meets the downside risk
requirement while having greater downside risk exposure than Portfolio B.
Portfolios C and D fail to meet the minimum return requirement and Portfolio D fails to meet the
liquidity requirement.
Reading References:
1. Managing Investment Portfolios: A Dynamic Process, 3rd edition (AIMR, forthcoming)
B. “Managing Individual Investor Portfolios,” James W. Bronson, Matthew H. Scanlan, and
Jan R. Squires
2. “The Psychology of Risk,” Amos Tversky, Quantifying the Market Risk Premium
Phenomenon for Investment Decision Making (AIMR, 1990)
3. “Behavioral Risk: Anecdotes and Disturbing Evidence,” Arnold Wood, Investing Worldwide
VI (AIMR, 1996)
4. “Behavioral Finance: Past Battles and Future Engagements,” Meir Statman, Financial
Analysts Journal (AIMR, November/December 1999)
Purpose:
To test the candidate’s: 1) understanding of behavioral issues that affect an individual investor,
and 2) ability to modify an individual investor’s investment policy statement to reflect changed
circumstances.
Petrie stock provides a level of confidence and comfort for Bavier, because of the
circumstances in which she acquired the stock and her recent history with the returns and the
income from the stock. However, Bavier exhibits overconfidence in the stock given the needs
of the Trust and the brevity of the recent performance history. Maintaining a 15 percent
position in a single stock is inconsistent with the overall strategy of the Trust, and her level of
confidence should reflect the stock’s overall record, not just the past two years.
The behavioral finance principle of mental accounting is most consistent with Bavier’s
second statement.
Bavier has segregated the monies distributed from the Trust into two “accounts”—the returns
the Trust receives from the Petrie stock, and the remaining funds that the Trust receives for
her benefit. She is maintaining a separate set of mental accounts with regard to the total funds
distributed. Bavier’s “specific uses” should be viewed in the overall context of the spending
needs of the Trust and should consider the risk and return profile of the entire Trust.
C. i. The Bavier-Campbell Trust’s willingness to take risk is below average because of its
need to have a high probability of covering Bavier’s living expenses during the remainder
of her lifetime, which encompasses a short time horizon. The below average willingness
of Bavier (coupled with her short time horizon) dominates the above average willingness
of Campbell (coupled with his long time horizon).
ii. Campbell’s willingness to take risk is above average because of the relatively long time
horizon that results from his desire for the Trust to grow enough to cover his fixed
payments of $600,000 per year in years 11 through 15. His willingness is further
enhanced by the fact that the Trust assets themselves will be distributed to him upon
termination of the Trust. His willingness may be tempered somewhat by his desire to
have the entire amount of his obligation available when the first payment is due.
Reading References:
5. “The Reality of Hedge Funds,” pp. 26–35 (up to “Conclusions Drawn from the Data”),
Appendix B, and Appendix C, Dave Purcell and Paul Crowley, Journal of Investing
(Institutional Investor, Fall 1999)
6. Alternative Investing (AIMR, 1998)
A. “Controlled Risk Strategies,” Bruce I. Jacobs
7. “The Search for Alpha Continues−Do Fund of Hedge Funds Managers Add Value?”
Alexander M. Ineichen, pp. 26−61 and 73−80, UBS Warburg Global Alternative Investment
Strategies (September 2001)
Purpose:
To test the candidate’s understanding of hedge fund strategies and controlled risk strategies.
3. Risk-based leverage uses a measure of market risk (such as VAR) relative to a measure
of the resources available to absorb risk (such as cash or equity). Accounting-based
leverage is based on the traditional concept of measuring asset values relative to equity
capital.
B. The hedge fund investment strategies best characterized by each of the three strategy
components reviewed by Marco are:
1. Quantitative strategy
2. Arbitrage/relative value strategy
3. Quantitative strategy
Judge whether
each of Marco’s
five Conclusions If incorrect,
Marco’s five
is correct or give one Reason why the Conclusion is
Conclusions
incorrect incorrect
(circle one for
each Conclusion)
1. Investing in a fund of
hedge funds is likely to
increase the client’s Correct
portfolio diversification
and allow the client’s
portfolio to have
exposure to a wide Incorrect
variety of hedge funds
that may not otherwise be
available to the client.
Reading References:
1. Economic Analysis for Investment Professionals (AIMR, 1997)
B. “Economic Forecasts and the Asset Allocation Decision,” Abby Joseph Cohen
3. Improving the Investment Decision Process—Better Use of Economic Inputs in Securities
Analysis and Portfolio Management (AIMR, 1992)
B. “Developing a Recommendation for a Global Portfolio,” Charles I. Clough, Jr.
Purpose:
To test the candidate’s understanding of economic factors that affect sector and market risks and
returns.