2020 Mock Exam - LIII [PDF]

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CFA® Society Boston Level III 2020 Practice Exam Morning Session

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The following list contains the command words used on the Morning Session of the CFA Society Boston Level III 2020 Practice Exam. Candidates may want to refer to this list as they formulate their answers. Calculate:

To find (the value of something) by using mathematics.

Classify:

To assign to categories or groups.

Compare:

To note the similarities and differences of two or more things.

Contrast:

To state the differences between.

Describe:

To portray in words.

Determine:

To decide; to ascertain.

Discuss:

To examine critically and in detail.

Explain:

To make clear the meaning of.

Identify:

To recognize and correctly name.

Justify:

To show to be valid or appropriate in a particular context.

Recommend: To offer as being appropriate or good. Select:

To choose as being the best or most suitable.

State:

To express in words the probability of an event in terms odds for or against the event; to provide.

Support:

To provide corroboration for each response with one reason.

2

The morning session of the CFA Society Boston Level III 2020 Practice Exam has 8 questions. For grading purposes, the maximum point value for each question is equal to the number of minutes allocated to that question. Question 1 2 3 4 5 6 7 8

Topic Minutes Portfolio Management – Behavioral 16 Portfolio Management – Derivatives and 12 Currency Management Portfolio Management – Trading, Performance 12 Evaluation, and Manager Selection Portfolio Management – Equity 28 Portfolio Management – Individual 30 Portfolio Management – Alternative Investments 18 Portfolio Management – Fixed Income 34 Portfolio Management – Institutional 30 Total 180

3

QUESTION 1 HAS A TOTAL OF FOUR PARTS (A, B, C, D) FOR A TOTAL OF 16 MINUTES. Alexander James, CFA, is the head of asset management at AJ Investments, where he has worked for eight years. James is meeting with Samuel and Nikita Erving and their son, Louis, to discuss their personal investment strategies. All of the Erving family members have been clients of AJ Investments for the last ten years. Samuel Erving is 59 years of age and has been a manager at a blue-chip technology firm for 30 years. He has consistently invested in the company’s stock and employee stock options. Samuel has accumulated a portfolio of $1.8 million, of which 80% is invested in his firm. Samuel recognizes that he has no investment experience and considers himself to be a low to medium risk taker. He relies on AJ Investments for advice and actively follows leads from research reports and friends. A.

Identify the behavioral investment type (BIT) that most likely describes Samuel. 3 minutes (Answer 1-A on page 6)

James recommends to Samuel that he reduce his exposure to his employer in the portfolio. The current stock price of the employer’s stock is $98. Samuel is reluctant to sell and believes that the share price will rebound towards its 52-week high of $160. After deciding to hold the stock, Samuel observes that the quarterly sales of his firm have declined from the previous quarter. He believes that this decline in sales is temporary because of the stock’s past success and reaffirms his belief in his employer’s stock. B.

Identify two behavioral biases exhibited by Samuel. State how he can overcome these biases with one recommendation for each. 5 minutes (Answer 1-B on page 7)

Nikita Erving is a 49-year-old entrepreneur who attributes most of her success to the textile firm she founded 15 years ago. Nikita recently sold the firm for $4 million, which is currently invested in a diverse mix of stocks and bonds. Her total income is generated by the $4 million portfolio. Nikita states that her objectives are 1) not losing capital, and 2) that her portfolio generate enough income to cover all of her routine expenses. She also expresses an interest to hold various buckets of investments, where each bucket is dedicated to generating monthly, quarterly and annual income. C.

Identify the behavioral bias exhibited by Nikita and describe briefly one consequence of the bias. 3 minutes (Answer 1-C on page 8)

4

Louis Erving is 34 years old, single and a medical doctor. Louis indicates he has a low risk tolerance on his existing $2.5 million portfolio composed exclusively of health care stocks, most of which have realized a decline in value since their initial purchase. Because his earnings as a physician cover his current expenses, he views the health care portfolio as providing the capital for the purchase of a luxury home and a high-end vacation property. He also reiterates his interest to preserve wealth without taking significant risk. James makes the recommendation to sell the health care stocks and to diversify into a broader market exposure. Louis declines this recommendation and states that he wants to hold on to the health care positions for another year in anticipation of future price increases. He does not wish to sell at a loss. Further, he would not want to miss out on any subsequent recovery if he were to sell as James recommends. Louis recently inherited real estate investments from his grandfather totaling $2 million. Louis indicates his desire to sell the real estate properties and to redeploy his portfolio into stocks and bonds for his retirement. Louis is determined to sell his properties above their current market valuation of $2.5 million. D.

Identify Louis’s behavioral investor type. Identify three emotional biases or cognitive errors exhibited by him to support your choice. 5 minutes (Answer 1-D on page 9)

5

Answer Question 1-A on this page

Identify the behavioral investment type (BIT) that most likely describes Samuel.

Friendly Follower Biases mostly cognitive -Availability -Framing -Regret Aversion

6

Answer Question 1-B on this page

Identify two behavioral biases exhibited by Samuel. State how he can overcome these biases with one recommendation for each. Behavioral Bias Recommendation 1.

2.

7

Answer Question 1-C on this page

Identify the behavioral bias exhibited by Nikita and describe briefly one consequence of the bias. Behavioral Bias Consequence

8

Answer Question 1-D on this page

Identify Louis’s behavioral investor type. Identify three emotional biases or cognitive errors exhibited by him to support your choice. Behavioral Investor Type

1.

2.

3.

9

QUESTION 2 HAS A TOTAL OF THREE PARTS (A, B, C) FOR A TOTAL OF 12 MINUTES. Jake Piesz, CFA, and Carol Chlapowski, CFA Level II candidate, are senior analysts at Ankit Capital Management (Ankit), a US investment firm that provides multiple investment services for its clients. Piesz is in charge of managing client portfolios. Chlapowski is in charge of hedging portfolio risk using derivative instruments. Piesz and Chlapowski are meeting with Ankit Gehlot, CFA, the head of investment services, to discuss recent developments in client portfolios. Kai Dong, a US client at Ankit, is a high net worth individual with investments in Switzerland, the UK and Germany. Exhibit 1 provides the details of Dong’s international portfolio. Dong’s IPS gives Ankit discretion in managing currency risk in the portfolio. Gehlot requests that Piesz calculate the overall return on Dong’s portfolio and evaluate the effects of exchange rate fluctuations.

Country Germany UK Switzerland A.

Exhibit 1 Kai Dong’s Portfolio Details Percentage of Foreign Asset Overall Portfolio February 1, 2019 Return 45% USD/EUR = 1.10 3.6% 25% USD/GBP = 1.30 4.1% 30% CHF/USD = 0.96 -2.7%

February 1, 2020 USD/EUR = 1.14 USD/GBP = 1.27 CHF/USD = 1.01

Calculate the overall domestic (USD) currency returns on Dong’s portfolio using the information in Exhibit 1. 4 minutes (Answer 2-A on page 12)

Gehlot then turns his attention to Dong’s Swiss Franc (CHF) exposures, which have depreciated approximately 5% against the USD. He requests that Chlapowski recommend ways to hedge the CHF exposure at a minimal hedging cost. Chlapowski explains the usage of option contracts in Dong’s portfolio and presents the details in Exhibit 2. Exhibit 2 Option Prices for USD/CHF on February 1, 2020 USD/CHF Strike Put Option Price Call Option Price 0.99 $0.17 $0.08 0.98 $0.15 $0.10 0.97 $0.11 $0.16 0.96 $0.09 $0.18 0.95 $0.07 $0.21

10

B.

Calculate the cost of implementing a put spread using USD/CHF strike prices 0.98 and 0.95 shown in Exhibit 2. 4 minutes (Answer 2-B on page 13)

Gehlot asks Chlapowski to provide input regarding foreign exchange management. Chlapowski presents spot and forward rates in Exhibit 3. She also states: Statement 1: A positive roll yield could be created in Dong’s portfolio by selling a USD/EUR forward contract. Statement 2: A positive roll yield could be created in Dong’s portfolio by selling a CHF/USD forward contract.

Currency Pair USD/EUR USD/GBP CHF/USD C.

Exhibit 3 Spot and Forward Rates Spot Rates Six-Month Forward Rates USD/EUR = 1.14 USD/EUR = 1.20 USD/GBP = 1.27 USD/GBP = 1.31 CHF/USD = 1.01 CHF/USD = 1.05

Identify which of Chlapowski’s statements is most likely to be correct based on the information provided in Exhibit 3. Calculate the forward premium or discount for each statement. 4 minutes (Answer 2-C on page 14)

11

Answer Question 2-A on this page

Calculate the overall domestic (USD) currency returns on Dong’s portfolio using the information in Exhibit 1.

12

Answer Question 2-B on this page

Calculate the cost of implementing a put spread using USD/CHF strike prices 0.98 and 0.95 shown in Exhibit 2.

13

Answer Question 2-C on this page

Identify which of Chlapowski’s statements is most likely to be correct based on the information provided in Exhibit 3. (circle your response) Statement 1

Correct

Incorrect

Statement 2

Correct

Incorrect

Calculate the forward premium or discount for each statement. Statement 1

Statement 2

14

QUESTION 3 HAS A TOTAL OF FOUR PARTS (A, B, C, D) FOR A TOTAL OF 12 MINUTES. Steve Beckman manages the Global Equity Fund (Fund) at NavalMemes Asset Management. Beckman uses a top-down investment approach that utilizes technical analyses and econometric models to forecast country and sector return expectations. Beckman does not take idiosyncratic risks, and he hedges the aggregate market risk of the Fund. The Fund seeks a target rate of return (minimum acceptable return) of T-bill return plus 4%. A.

Recommend the risk attribution approach best suited in evaluating the Fund. 1 minute (Answer 3-A on page 17)

Bill Weiss, the head of manager research at Harvard Analytics, is engaged in a performance evaluation of the Fund. Weiss turns his attention to analyzing performance. Weiss considers both returns-based and holdings-based attribution methods. B.

Contrast the two attribution methods by describing the most appropriate use of each method. Identify one drawback of each attribution method. 3 minutes (Answer 3-B on page 18)

In preparation for the attribution analysis, Weiss collects the country weights and returns for the Fund and the benchmark for the last year. He proceeds to evaluate the impact of allocation and selection decisions as detailed in Exhibit 1. Exhibit 1

France Germany China United States Japan Total C.

Fund Benchmark Fund Benchmark Weight Weight Return Return Allocation Selection Interaction 25.00% 20.00% 10.80% 8.00% –0.20% 0.56% 0.14% 15.00% 20.00% 16.50% 13.70% –0.09% 0.56% –0.14% 35.00% 25.00% 8.40% 6.00% –0.60% 0.60% 0.24% 18.00% 30.00% 21.10% 20.00% –0.96% 0.33% –0.13% 7.00% 5.00% 1.30% 3.20% ? ? ? 100.00% 100.00% 12.00% 12.00% ? ? ?

Calculate the allocation, selection and interaction effects for both Japan and the Fund. Discuss briefly the allocation and selection effects for each of the individual countries and for the overall Fund. 6 minutes (Answer 3-C on page 19)

15

D.

Calculate the Sortino ratio of the Fund given the information provided below. • The average Fund return over the measurement period is 12%. • The T-bill rate is constant at 4%. • The average standard deviation of returns is 14%. • The average target semi-standard deviation is 8%. 2 minutes (Answer 3-D on page 20)

16

Answer Question 3-A on this page

Recommend the risk attribution approach best suited in evaluating the Fund.

17

Answer Question 3-B on this page

Contrast the two attribution methods by describing the most appropriate use of each method. Returns-based attribution

Holdings-based attribution

Identify one drawback of each attribution method. Attribution Method Drawback Returns-based

Holdings-based

18

Answer Question 3-C on this page

Calculate the allocation, selection and interaction effects for both Japan and the Fund. Allocation Effect Selection Effect Interaction Effect Japan

Total Fund

Discuss briefly the allocation and selection effects for each of the individual countries and for the overall Fund. France

Germany

China

United States

Japan

Total Fund

19

Answer Question 3-D on this page

Calculate the Sortino ratio of the Fund given the information provided.

20

QUESTION 4 HAS A TOTAL OF FOUR PARTS (A, B, C, D) FOR A TOTAL OF 28 MINUTES. Richard Rizzitano is the new CIO of Big Time Management Company, an investment company established by Big Time University (BTU) to manage the university’s endowment. Today, Rizzitano is meeting with Anthony Swanson, the founder of Americana Capital. Americana is a US large-cap equity manager with $1 billion in assets under management (AUM). Swanson manages the firm’s Legends Fund, one of the best performers in its category over the last ten years. BTU’s endowment has committed $25 million to the Legends Fund, and Rizzitano wants to learn more about Swanson’s investment philosophy and strategy. The meeting begins with Rizzitano asking Swanson to explain his investment philosophy and portfolio construction process. Swanson tells Rizzitano he believes strongly that only highquality companies outperform the benchmark over a long horizon. As such, Swanson’s process involves screening the S&P 500 to identify the seventy-five highest-quality companies in the index. This includes research activities such as reviewing historical SEC filings, meeting with company management and interviewing key constituents. To calculate a company’s intrinsic value, Swanson then develops a financial model and projects five years of free cash flow for all seventy-five companies. The intrinsic value is compared to the current market price for each company. The forty names trading at the largest discount to their fair value are then included in the portfolio. A.

Classify Swanson’s approach to portfolio construction. Justify your response with two supporting reasons. 7 minutes (Answer 4-A on page 23)

After explaining his investment philosophy and portfolio construction process, Swanson is asked about the Legends Fund’s active share. Swanson explains that the active share of the fund is typically very high and is currently at 90%. One of the reasons the active share is high is due to Swanson’s large relative bets on different sectors. Twelve of the fund’s thirty-five holdings are in the technology sector, whereas not a single financial sector name is held in the portfolio. Swanson also notes that Legends’s active risk is also quite high, and comments that not much can be done to lower it, as active risk is based on the correlations and variances of different securities. B.

Identify two changes Swanson could make to lower active risk. Support each of your proposed changes. 7 minutes (Answer 4-B on page 24)

After answering a few additional questions, Swanson provides Rizzitano with a one-page document comparing the Legends Fund to the Kingston Fund. The information in this document is displayed in Exhibit 1. Swanson notes that the Kingston Fund is the Legends Fund’s closest competitor and employs a very similar investment philosophy focused on quality. Swanson tells Rizzitano that the document demonstrates that the Legends Fund has a much more efficient portfolio structure than the Kingston Fund. 21

Exhibit 1 Fund Comparison (January 2014 – December 2019) # of Securities Active risk (annualized) Active share (average) Volatility (annualized) Maximum drawdown Total return (annualized) Management fee Factor Risk Contribution Market Size Value Momentum Quality Unexplained Total C.

Legends Fund 40 4.9% 0.88 14.1% 22.7% 11.3% 75 basis points

Kingston Fund 120 4.7% 0.38 14.2% 21.2% 7.9% 75 basis points

99.5% 1.3% 7.7% –0.4% –12.2% 4.1% 100.0%

83.2% 7.2% –2.2% –0.2% –0.2% 12.2% 100.0%

Identify two fund characteristics in Exhibit 1 that support Swanson’s comment regarding the Legends Fund’s relatively efficient portfolio structure. 7 minutes (Answer 4-C on page 25)

Before the meeting ends, Swanson mentions that Americana is launching a new market-neutral fund. This fund will take full advantage of the stock-picking expertise of Americana’s research team by expressing negative views through short positions. Swanson’s comments to Rizzitano on this topic are captured in Statement 1. Statement 1: I suggest taking $5 million of the $25 million that the BTU endowment has invested in the Legends Fund and investing the proceeds in this new marketneutral fund. Doing so would allow the BTU endowment to reduce its total equity portfolio market risk (i.e., beta), increase the portfolio’s diversification across other non-market risk factors and reduce the portfolio’s tracking error. Rizzitano tells Swanson that he will consider the suggestion. D.

State whether Swanson’s justification in Statement 1 is correct. Explain your reason briefly. 7 minutes (Answer 4-D on page 26)

22

Answer Question 4-A on this page

Classify Swanson’s approach to portfolio construction. Justify your response with two supporting reasons. Approach Reason 1

Reason 2

23

Answer Question 4-B on this page

Identify two changes Swanson could make to lower active risk. Support each of your proposed changes. Change 1 Support

Change 2

Support

24

Answer Question 4-C on this page

Identify two fund characteristics in Exhibit 1 that support Swanson’s comment regarding the Legends Fund’s relatively efficient portfolio structure. Characteristic 1

Characteristic 2

25

Answer Question 4-D on this page

State whether Swanson’s justification in Statement 1 is correct. Explain your reason briefly. (circle your answer) Correct

Incorrect

Explain briefly

26

QUESTION 5 HAS SIX PARTS (A, B, C, D, E, F) FOR A TOTAL OF 30 MINUTES. Kathleen Cheng, CFA, is the personal investment advisor and financial consultant to Louis, Charles and Edmund Bray, brothers who founded the publicly traded retail chain Three Brothers Auto Parts Stores (Three Brothers), headquartered in New Cumberland, Pennsylvania. The company began operations in the mid-1980s and has grown rapidly over the years. It now has over 2,000 stores nationwide. As the three principal shareholders, the brothers have done well financially. At present, however, the firm is at a critical junction. Louis, the middle brother, is planning to retire next month and relinquish all his duties and responsibilities. Louis, aged 65, is a widower in excellent health and has an adult daughter who is successful and financially independent in her own right. He plans to remain in his current home and intends to be active in community and charitable activities throughout his retirement years. Louis has no debts and no extraordinary charitable or testamentary intentions. He will receive a pension from Three Brothers in addition to social security benefits and his own retirement plan withdrawals. He has an adequate emergency fund to meet unexpected liabilities. He is taxed at a flat 30% rate on all earned and investment income (interest, dividends and capital gains). This tax rate is expected to remain constant throughout his remaining life. In anticipation of his imminent retirement, Louis is reviewing his insurance coverage to determine possible savings opportunities by reducing these costs. His current insurance coverage and costs are shown in Exhibit 1. All premiums are paid entirely by Louis. Exhibit 1 Insurance Coverage and Costs of Louis Bray Insurance Coverage Annual Cost Disability insurance 60% of compensation $5,500 Life insurance $2 million (annual renewable $26,500 term) Property & casualty (primary residence) 100% replacement with $3,500 $300,000 liability Property & casualty (vacation home) 100% replacement with $2,500 $300,000 liability Property & casualty (autos) Actual cash value* of asset $2,000 with $300,000 liability Property & casualty (boat) Actual cash value* of asset $2,000 with $300,000 liability Excess liability (“umbrella”) $2 million in addition to $2,000 other liability coverages Total $44,000 * Property coverage limited to fair market value of the underlying asset at time of loss

27

Determine Louis’s likely insurance cost savings in his first year of retirement.

A.

2 minutes (Answer 5-A on page 31) A substantial portion of Louis’s wealth is comprised of Three Brothers stock, with a tax basis of effectively zero. Cheng advises Louis to mitigate this risk, especially as market volatility is rising, and he agrees. Louis has no emotional attachment to the stock and no aversion to selling it. His two brothers are not interested in purchasing his interest in the company. Cheng lists a number of potential strategies for Louis that address the management of risks associated with a concentrated stock position in an individual’s portfolio. She notes that active and liquid markets exist on exchanges and OTC for all Three Brothers related derivative products. Cheng warns Louis, however, that the removal of all market risk in any of the strategies will be treated as a constructive sale by the Internal Revenue Service with immediate capital gains tax due. The strategies Cheng lists are: • • • • • • • •

Outright sale Shorting against the box Establishing a collar Entering into a total return equity swap Buying a put Establishing a prepaid variable forward Using options to effect a forward conversion Selling the stock forward

In response, Louis identifies his preferences and conditions regarding the disposition of the Three Brothers stock. • He does not want to borrow or incur debt in any way. • He seeks the lowest cost solution. • He does not want to incur any tax liability this year. • He does not want to be exposed to uncertainty in the tax treatment of the sale. • He wants to retain the stock at least until the next Three Brothers shareholder meeting in six months in order to vote his shares on a restructuring proposal before the board. B.

Identify two strategies Louis might consider with regard to his concentrated position in Three Brothers shares. Justify each of your selections with three reasons. 6 minutes (Answer 5-B on page 32)

28

Louis asks Cheng to explain how some of his investments are performing. Three of his accounts are shown in Exhibit 2. All three derive their returns from current income (i.e., no net unrealized capital gains or losses). After five years, Louis plans to liquidate the three accounts and purchase an annuity with the proceeds.

Account Tax-exempt Taxable Tax-deferred C.

Exhibit 2 Selected Accounts of Louis Bray Current Value/Tax Basis Nominal Return $1 million 6% $1 million 10% $1 million 9%

Standard Deviation 10% 13% 12%

Identify which of the accounts will have the smallest and the largest after-tax return and which accounts exhibit the lowest and highest risk over the next five years. 6 minutes (Answer 5-C on page 33)

D.

Identify the relative advantages and disadvantages for Louis of fixed and variable annuities by citing two advantages and two disadvantages for each type of annuity. 6 minutes (Answer 5-D on page 34)

Charles Bray is 75 years old, a widower with no offspring, and is in poor health. As part of a recent estate planning exercise following his retirement from Three Brothers, Charles liquidated nearly all of his assets, including his home, taxable accounts and retirement accounts. He purchased a series of inflation-indexed life annuities and a lifetime residency contract at an assisted living facility. These actions, coupled with a comprehensive health insurance plan, have resulted in all of Charles’s future living, spending and health care costs being covered. When he was liquidating his assets, Charles only retained a single balanced fund in the amount of $3 million in a tax-exempt account. This is his only remaining financial asset. As he no longer has any future expenses, Charles would like to use this fund to benefit his deceased wife’s favorite niece. Because of previous gifting, Charles has no tax credits or allowances available to shelter either future gifts or bequests from taxation. The tax rate that would apply to both gifts and bequests would be a flat 50% and the tax would be due immediately, payable by Charles or by his estate. The niece is in the same income tax bracket as Charles and the fund would earn the same rate of return whether held by Charles or the niece. Charles asks Cheng whether he should gift the balanced fund to the niece now or leave it to her, including any interim reinvested appreciation, at his death. He wishes for her to receive the maximum possible economic benefit. 29

E.

Determine whether Charles should gift or bequeath the assets to the niece and determine the financial advantage of the strategy chosen. [Note: No generation-skipping transfer tax would apply in this case.] 4 minutes (Answer 5-E on page 35)

Edmund Bray is the CFO of Three Brothers and the chair of the investment committee overseeing the company’s defined benefit pension plan. Cheng has repeatedly and strongly recommended the development of investment policy statements for Edmund and the pension plan, but none exist currently. Before proceeding in this matter, Edmund would like to obtain some general background information from Cheng regarding the similarities and differences between the two IPSs Cheng recommends. F.

Contrast and compare, in general terms, the likely objectives and constraints sections of Edmund’s IPS versus those of the Three Brothers pension plan. 6 minutes (Answer 5-F on page 36)

30

Answer Question 5-A on this page

Determine Louis’s likely insurance cost savings in his first year of retirement.

31

Answer Question 5-B on this page

Identify two strategies Louis might consider with regard to his concentrated position in Three Brothers shares. Justify each of your selections with three reasons. Strategy Reasons 1. 1.

2.

3.

2.

1.

2.

3.

32

Answer Question 5-C on this page

Identify which of the accounts will have the smallest and the largest after-tax return and which accounts exhibit the lowest and highest risk over the next five years. (circle your answers) Smallest return Largest return Taxable

Taxable

Tax exempt

Tax exempt

Tax deferred

Tax deferred

Lowest risk

Highest risk Taxable

Taxable

Tax exempt

Tax exempt

Tax deferred

Tax deferred

33

Answer Question 5-D on this page

Identify the relative advantages and disadvantages for Louis of fixed and variable annuities by citing two advantages and two disadvantages for each type of annuity. Advantage Disadvantage Fixed Annuity 1. 1.

Variable Annuity

2.

2.

1.

1.

2.

2.

34

Answer Question 5-E on this page

Determine whether Charles should gift or bequeath the assets to the niece and determine the financial advantage of the strategy chosen. [Note: No generation-skipping transfer tax would apply in this case.] (circle your answer) Gift

Bequeath

Financial Advantage

35

Answer Question 5-F on this page

Contrast and compare, in general terms, the likely objectives and constraints sections of Edmund’s IPS versus those of the Three Brothers pension plan. Edmund’s IPS Pension Plan IPS Objectives Return

Risk

Constraints Liquidity

Time Horizon

Tax

Legal/Regulatory

36

QUESTION 6 HAS A TOTAL OF FOUR PARTS (A, B, C, D) FOR A TOTAL OF 18 MINUTES. William Gary, CFA, is meeting with his client, Ross Franco, to discuss the addition of hedge fund exposure to Franco’s portfolio. Franco has been reading recently about the benefits of alternative investments and is considering adding these to his portfolio. Franco is especially interested in Alpha Fund, a hedge fund that creates and uses complex quantitative strategies with the goal of eliminating any impact of general market movements. Franco admits that, while he has a vague understanding of what different hedge fund strategies entail, he would like Gary to explain the market-neutral concept in more detail. Gary begins by discussing the strengths and weaknesses of a market-neutral strategy and when its implementation is most appropriate. Gary uses a hypothetical example of a pairs trade to demonstrate how an investor could create a market-neutral strategy. Gary bases his example on two stocks: DTY and GHT. These stocks are peers in a competitive industry, and have a high historical correlation and similar historical betas. Recently, the performance of these two stocks has deviated considerably. Share prices of DTY have risen sharply and are considered by most analysts to be overvalued. Share prices of GHT have also risen, but are considered fairly valued. Gary describes how a strategy combining these two stocks could be protected from general market movement. Franco is happy with the pairs trade explanation and asks Gary about the proposed allocation of alternative investments to his portfolio. Gary recommends an allocation to hedge funds of 15%. To demonstrate how the addition of hedge fund exposure would impact Franco’s portfolio, Gary presents Franco with the information in Exhibit 1. The table shows how Franco’s current portfolio metrics would change with a 15% allocation to the three different hedge funds.

Current Adding Fund 1 Adding Fund 2 Adding Fund 3

Mean Return (%) 8.56 8.88 8.04 9.42

Exhibit 1 Standard Deviation (%) 10.67 9.28 9.85 10.54

Sharpe Ratio 0.61 0.74 0.61 0.70

Sortino Ratio 1.18 1.25 1.33 1.30

Max Drawdown (%) 18.11 25.26 12.54 17.74

Franco tells Gary to move forward with the fund he thinks would provide the best performance with the current portfolio. A.

Identify three potential benefits of investing with Alpha Fund over a typical long- short strategy fund. 6 minutes (Answer 6-A on page 39)

37

B.

Identify two risks of the example equity market neutral strategy Gary described. 2 minutes (Answer 6-B on page 40)

C.

Describe the steps to a pairs trade for the two stocks Gary mentions. 4 minutes (Answer 6-C on page 41)

D.

Identify which of the funds is the most suitable addition to the portfolio. Justify your choice with two reasons. 6 minutes (Answer 6-D on page 42)

38

Answer Question 6-A on this page

Identify three potential benefits of investing with Alpha Fund over a typical long-short strategy fund. Benefit 1

Benefit 2

Benefit 3

39

Answer Question 6-B on this page

Identify two risks of the example equity market neutral strategy Gary described. Risk 1

Risk 2

40

Answer Question 6-C on this page

Describe the steps to a pairs trade for the two stocks Gary mentions.

41

Answer Question 6-D on this page

Identify which of the funds is the most suitable addition to the portfolio. Justify your choice with two reasons. Most suitable addition (circle your answer) Reason 1 Fund 1

Fund 2

Reason 2

Fund 3

42

QUESTION 7 HAS A TOTAL OF 6 PARTS (A, B, C, D, E, F) FOR A TOTAL OF 34 MINUTES. Connor Markey, CFA, is an institutional salesperson at Limax Securities, a global investment bank. Markey’s clients include pension funds, insurance companies, mutual funds, commercial banks and hedge funds. His clients rely on him for advice regarding asset allocation, risk management and portfolio construction. Markey is preparing for a presentation to the board of directors at NorthWake Insurance. NorthWake has traditionally used a duration matching approach to investing, but is considering instituting a cash flow matching strategy. Markey has been asked to analyze the different types of immunization strategies. Markey knows from experience that NorthWake prefers to keep their investment strategies simple. Markey recommends that NorthWake institute a cash flow matching strategy. A.

Justify Markey’s recommendation for a cash flow matching strategy by listing two key features of the strategy that align with the client’s preference for simplicity. 4 minutes (Answer 7-A on page 46)

Markey is also planning to propose a leverage strategy to NorthWake. Potential components of the strategy are listed in Exhibit 1. Exhibit 1 Duration 7-year corporate bond 6.9 10-year US government bond 9.1 30-year Treasury note futures 17 Repurchase agreement 0.25

Rate 4.00% 4.50% 5.00% 2.00%

NorthWake’s existing portfolio has a market value of $100 million with a duration of 7. The proposed target duration for the portfolio is 9. B.

i.

Calculate the market value of 7-year corporate bonds that need to be purchased to achieve the target duration.

ii.

Determine the rebate rate that will be received by purchasing the 10-year bond and financing it with the repurchase agreement. 8 minutes (Answer 7-B on page 47)

43

NorthWake has expressed interest in strategies that benefit from a stable yield curve. By mandate, NorthWake cannot invest in non-local currency instruments. NorthWake also has a bias towards income over price appreciation, and prefers to not use derivatives. Dan Robbins, CFA, an analyst at NorthWake, believes the yield curve will flatten significantly, and that, as a result, the investment strategy should shift from a barbell to a bullet approach. C.

i.

Identify a strategy that would be consistent with NorthWake’s preferences and restrictions.

ii.

Determine if Robbins’s recommendation for a bullet portfolio restructure is appropriate. 4 minutes (Answer 7-C on page 48)

Markey is preparing to visit Hannan Capital, a hedge fund client. Markey has summarized in Exhibit 2 the key statistics of two bonds Hannan has purchased recently.

Maturity (years) Coupon Yield Current price Expected price in one year D.

Exhibit 2 Bond 1 1 2.00% 2.25% 98.76 100.00

i.

Calculate the yield income for Bond 1.

ii.

Calculate the roll down return for Bond 2.

Bond 2 4 5.00% 4.50% 102.22 103.39

4 minutes (Answer 7-D on page 49) Hannan recently established a new global relative value fixed income credit strategy, buying bonds in developed markets, such as the US, as well as in emerging markets where the government bond and swap markets are not as well developed or well regarded. While the portfolio manager, Ana Edwards, CFA, has extensive experience with corporate bonds, the new trader, Mike Gramin, is less experienced. Gramin has asked Edwards if she thinks it is appropriate to use the I-spread and G-spread to measure the credit risk in all of their holdings. Edwards replied that there may not be appropriate benchmarks in all cases. Gramin also asked under what circumstances OAS may be preferable to the Z-spread as a spread measure. E.

i.

Justify Edwards’s reply to Gramin regarding the use of benchmarks in assessing credit risk. 44

ii.

Explain the circumstances under which OAS would be a more appropriate spread measure than the Z-spread. 4 minutes (Answer 7-E on page 50)

Hannan also has a very successful lineup of equity strategies. Hannan’s CEO would like to leverage the capabilities of the equity research group, which specializes in the identification of overlooked companies with promising earnings and cash flow potential in the energy sector. The CEO believes that this top-down approach will contribute greatly to the future success of the fixed income strategies. Hannan has also been discussing appropriate benchmarks for its new credit strategies. Markey has been asked to prepare a report on the trends and characteristics of the investment-grade, high-yield and ABS markets. Key factors of interest to Hannan are interest rate, credit and liquidity risks. To manage those risks, Markey has identified three key quantitative metrics that he believes will be useful: 1) portfolio effective duration, 2) OAS, and 3) average daily trading volume. Markey has compiled data on a bond for further analysis in the meeting. This information is summarized in Exhibit 3. Exhibit 3 Bond Data

Bond yield Spread duration Target horizon Current credit spread Expected credit spread at target horizon Annualized expected probability of default Expected loss severity F.

4% 6.25 9 months 2.00% 1.50% 0.50% 70%

i.

State whether the CEO’s statement regarding the equity research group’s topdown approach is reasonable. Justify briefly your response.

ii.

Identify the key quantitative metric mentioned by Markey that is most likely to be effective in managing liquidity risk.

iii.

Calculate the excess return over the target horizon. (Assume constant spread duration and no defaults.)

iv.

Calculate the expected annual credit loss. 10 minutes (Answer 7-F on page 51)

45

Answer Question 7-A on this page

Justify Markey’s recommendation for a cash flow matching strategy by listing two key features of the strategy that align with the client’s preference for simplicity. Feature 1

Feature 2

46

Answer Question 7-B on this page

i. Calculate the market value of 7-year corporate bonds that need to be purchased to achieve the target duration.

ii. Determine the rebate rate that will be received by purchasing the 10-year bond and financing it with the repurchase agreement.

47

Answer Question 7-C on this page

i. Identify a strategy that would be consistent with NorthWake’s preferences and restrictions.

ii. Determine if Robbins’s recommendation for a bullet portfolio restructure is appropriate.

48

Answer Question 7-D on this page

i. Calculate the yield income for Bond 1.

ii. Calculate the roll down return for Bond 2.

49

Answer Question 7-E on this page

i. Justify Edwards’s reply to Gramin regarding the use of benchmarks in assessing credit risk.

ii. Explain the circumstances under which OAS would be a more appropriate spread measure than the Z-spread.

50

Answer Question 7-F on this page

i. State whether the CEO’s statement regarding the equity research group’s top- down approach is reasonable. Justify briefly your response.

ii. Identify the key quantitative metric mentioned by Markey that is most likely to be effective in managing liquidity risk.

iii. Calculate the excess return over the target horizon. (Assume constant spread duration and no defaults.)

iv. Calculate the expected annual credit loss.

51

QUESTION 8 HAS SEVEN PARTS (A, B, C, D, E, F, G) FOR A TOTAL OF 30 MINUTES. R-Cubed is a private foundation dedicated to the advancement of resource recycling and environmental solutions. Although the foundation is headquartered in Cambridge, Massachusetts, its headquarters’ staff is minimal. Most of its employees are located in its offices in Tokyo, Japan, and Dublin, Ireland. R-Cubed maintains two separate and distinct retirement plans for its workers: a traditional defined benefit pension plan for its Japanese staff and a defined contribution plan for its American and Irish staffs. A summary of high-level characteristics for each plan are provided in Exhibit 1. The defined benefit pension plan is frozen, with no new participants permitted to join. R-Cubed has shifted all future hiring to its Dublin office.

Benefit formula Early retirement option Lump-sum option Inflation-adjusted benefit New participants permitted Plan assets (USD equivalent) Currency hedging permitted

Exhibit 1 Defined Benefit Pension Yes No 96% Age 60 Years of service and average final compensation Yes Yes Yes No 220 million No

Participant Characteristics Primary enrollment # Participants Active lives Retired lives/Beneficiaries Average service Average participant age

Japanese staff 340 120 220 24 years 52 years

Plan Characteristics R-Cubed contributions Employee contributions Current funding status Benefits available

Defined Contribution Yes Optional NA Age 65 NA Yes Yes No Yes 180 million Yes American/Irish staff 470 360 110 13 years 31 years

R-Cubed contributes 7% of compensation to the accounts of new participants in the defined contribution plan, increasing its contribution to 11% of compensation for employees who have been with the company for at least five years. Employees are permitted to contribute up to 16% of their compensation to the plan on a voluntary basis. A.

Contrast the time horizon and liquidity constraints of the R-Cubed pension and defined contribution plans. 3 minutes (Answer 8-A on page 56) 52

B.

Contrast the return and risk objectives of the R-Cubed pension and defined contribution plans. 3 minutes (Answer 8-B on page 57)

Elizabeth Donovan, CFA, is the chief investment officer of R-Cubed and a member of both retirement plan boards. She is considering four possible new asset allocations for the defined benefit plan. Asset Class JPY cash Non-JPY cash JPY bonds Non-JPY bonds JPY equities USD equities EUR equities EM* equities Gold bullion Global real estate Total * Emerging markets C.

Allocation A 5% 10 30 15 10 10 5 0 5 15 100%

Allocation B 10% 0 45 5 20 5 5 0 0 10 100%

Allocation C 0% 10 5 25 15 10 0 15 10 10 100%

Allocation D 15% 0 15 15 10 10 10 10 10 5 100%

Select the asset allocation most appropriate for the defined benefit pension plan. Justify each of the asset allocations not selected by citing two reasons in support of your rejection. 8 minutes (Answer 8-C on page 58)

The R-Cubed Foundation has a USD2.4 billion portfolio invested in quality, liquid, publicly traded securities (Exhibit 2). Donovan is concerned about the liquidity risk exposures of the foundation, which may hamper its timely grant-making and advocacy initiatives. She is also aware that R-Cubed may have been missing out on capturing illiquidity premiums with its existing asset allocation.

53

Asset Class Cash/cash equivalents Global government bonds Global corporate bonds US equities International equities Total Portfolio/Macro Statistics Nominal return (%) Real return (%) Standard deviation (σ) Beta (β) Sharpe ratio VaR at 5% Inflation (%) Risk-free rate (%) D.

Exhibit 2 Allocation (USD million) 60 520 380 1,020 420

Percent 2.5 21.7 15.8 42.5 17.5

2,400

100.0

6.9 4.4 12.7 1.02 0.35 USD 60 million 2.2 2.5

Notes

One day Long-term expectation Long-term expectation

Identify and describe briefly two tools Donovan might use for managing liquidity risk. 3 minutes (Answer 8-D on page 59)

E.

Identify two additional asset classes that would assist R-Cubed in capturing the illiquidity premiums Donovan has referenced. 2 minutes (Answer 8-E on page 60)

In her pursuit of illiquidity premiums, Donovan is aware of the uncertainty of risk and return estimates in her analysis. The availability, quality, reliability and frequency of pricing data, as well as infrequent trading, the use of leverage, and long investment horizons, combine to distort the raw data she has assembled. F.

Identify one drawback Donovan might encounter by using raw pricing data in her analysis and recommend an approach, technique or remedy to address this drawback. 2 minutes (Answer 8-F on page 61)

54

To capture illiquidity premiums, Donovan is considering three asset class additions (Exhibit 3) to the portfolio. She has, however, multiple concerns: • • •

Will the addition of the illiquid asset class improve the portfolio’s overall return and riskreturn efficiency? Will the risk character of the illiquid asset class violate R-Cubed’s asset class risk threshold of no more than a nominal 25% loss in any year at a 95% confidence level? Will R-Cubed be successful in incorporating a new asset class or strategy to capture illiquidity premiums, given that Donovan and her staff are unfamiliar with both the new asset classes and the strategy?

Exhibit 3 Characteristic Asset Class X Asset Class Y Nominal return (%) 7.4 7.8 Standard deviation (σ) 15.3 17.2 Sharpe ratio 0.32 0.31 Correlation (ρ) with existing portfolio 0.88 0.90 Capital required USD120 million USD180 million Implementation period* 3 years 2 years * Time period over which capital is committed G.

Asset Class Z 7.9 16.8 0.32 0.95 USD120 million 1 year

Select the asset class that best addresses Donovan’s illiquidity objective and concerns. Justify your selection with three reasons. 9 minutes (Answer 8-G on page 62)

55

Answer Question 8-A on this page

Contrast the time horizon and liquidity constraints of the R-Cubed pension and defined contribution plans. Pension Plan Defined Contribution Plan Time Horizon

Liquidity

56

Answer Question 8-B on this page

Contrast the return and risk objectives of the R-Cubed pension and defined contribution plans. Pension Plan Defined Contribution Plan Return Objective

Risk Objective

57

Answer Question 8-C on this page

Select the asset allocation most appropriate for the defined benefit pension plan. Justify each of the asset allocations not selected by citing two reasons in support of your rejection. (circle your answer) Reason 1 Allocation A

Allocation B

Reason 2 Reason 1 Reason 2

Allocation C

Reason 1 Reason 2

Allocation D

Reason 1 Reason 2

58

Answer Question 8-D on this page

Identify and describe briefly two tools Donovan might use for managing liquidity risk. 1.

2.

59

Answer Question 8-E on this page

Identify two additional asset classes that would assist R-Cubed in capturing the illiquidity premiums Donovan has referenced. Asset Class 1

Asset Class 2

60

Answer Question 8-F on this page

Identify one drawback Donovan might encounter by using raw pricing data in her analysis and recommend an approach, technique or remedy to address this drawback.

61

Answer Question 8-G on this page

Select the asset class that best addresses Donovan’s illiquidity objective and concerns. (circle your answer) Asset Class X

Asset Class Y

Asset Class Z

Justify your selection with three reasons. 1.

2.

3.

END OF MORNING SESSION.

62

CFA Society Boston CFA Level III – 2020 Practice Exam Afternoon MULTIPLE CHOICE RESPONSE FORM

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. 44.

A 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

B 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

C 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

45. 46. 47. 48. 49. 50. 51. 52. 53. 54. 55. 56. 57. 58. 59. 60.

A 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

B 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

C 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

CFA® Society Boston Level III 2020 Practice Exam Afternoon Session

CFA® is a licensed service mark owned by CFA Institute.

1

The afternoon session of the CFA Society Boston Level III 2020 Practice Exam has 13 item sets. The item set format consists of a vignette or a short case followed by four or six multiple choice questions based on the vignette. Each item set is allocated either 12 minutes or 18 minutes for a total of 180 minutes. Item Set 1 2 3 4 5 6 7 8 9 10 11 12 13

Topic Ethics Ethics Capital Market Expectations Asset Allocation Asset Allocation Derivatives and Currency Management Derivatives and Currency Management Fixed-Income Portfolio Management Fixed-Income Portfolio Management Equity Portfolio Management Alternative Investments for Portfolio Management Trading, Performance Evaluation, and Manager Selection Trading, Performance Evaluation, and Manager Selection Total

Questions Minutes 1–6 18 7–12 18 13–18 18 19–22 12 25–26 12 27–30 12 31–34 12 35–38 12 39–42 12 43–48 18 49–52 12 53–56 12 57–60 12 160

180

2

ITEM SET 1: ETHICS Questions 1 through 6 are allocated 18 minutes. Ruth McDougal, CFA, is a vice president of research with Cratter Finance, which covers the healthcare and medical device industry and specializes in research and valuation services. McDougal has been a health care industry analyst for fifteen years, closely following the emerging biotechnology field for the last three years. One of the companies McDougal follows, Randolph Enterprises, has developed a new treatment for a brain disorder associated with memory loss. The treatment has been in late-stage clinical trials for the last year. The majority of analysts who follow Randolph Enterprises believe that the new treatment, which uses a proprietary drug, will be successful. This consensus has caused the stock price of Randolph Enterprises to trade at a historical high. McDougal conducts her own independent analysis of Randolph Enterprises and agrees with the prevailing sentiment, resulting in a strong buy recommendation on the company. McDougal attended an all-expenses paid seminar sponsored by the Institute on Aging as a guest of Randolph Enterprises. At the seminar, McDougal noted that the CEO of Turkell-Young, a public company and a major competitor of Randolph, was in attendance. While McDougal was familiar with Turkell-Young, it was not one of the firms that she actively covered. The seminar provided valuable insight and information on the biotechnology industry and focused on the new research that Turkell-Young was co-sponsoring with the Institute on Aging. McDougal was introduced to Jay Turkell, the CEO of Turkell-Young, Turkell mentioned that when he was the CEO of a different firm, he engaged Cratter Finance as an advisor on some merger and acquisition work. Turkell also noted that he was aggressively seeking acquisitions, something that had not been reported in the press. Furthermore, Turkell made the following statement to McDougal: Statement 1: Turkell-Young would pay McDougal a referral fee for any recommendations she made that resulted in an acquisition for Turkell-Young. At a seminar gathering, McDougal overheard some industry experts at another table mention that the results of the late-stage clinical trial for Randolph Enterprises, although not yet public, were disappointing. McDougal knew that if this news became public, Randolph Enterprises’ stock price would fall, and Randolph Enterprises would then become a potential acquisition target for Turkell-Young. When McDougal returns to the office, she completes a research report on Randolph Enterprises that summarized the information she gathered at the seminar. She recommends that investors sell Randolph Enterprises shares and supports her conclusion with her opinion that too much value has been attributed to the outcome of the clinical trial for the new proprietary drug. She does not attribute her conclusion to any source, but in general represents that it is the result of her own fundamental analysis.

3

McDougal concurrently initiates coverage on Turkell-Young, issues a buy recommendation and comments in her report that Turkell-Young’s prominence in the biotechnology field could make the firm a successful industry consolidator through acquisitions. She circulates the Randolph Enterprises report internally for review but immediately releases the Turkell-Young report. Upon reading the Randolph Enterprises draft report, two portfolio managers cancel their buy orders on Randolph Enterprises on behalf of important Cratter Finance clients. Later, McDougal’s report on Randolph Enterprises is released to Cratter Finance’s clients. The following day, it is publicly reported that Randolph Enterprises’ late-stage clinical trial is not meeting expectations. McDougal’s report is picked up in the press. The CEO of TurkellYoung calls McDougal and congratulates her on her work. Turkell asks if Turkell-Young could engage Cratter Finance for a special assignment to do a more in-depth analysis on Randolph Enterprises. Turkell says he is trying to assess the potential synergies Turkell-Young might have with Randolph Enterprises. Turkell executes an engagement letter with McDougal, who says she will complete the analysis in the next few weeks. Turkell-Young’s engagement letter with Cratter Finance stipulates that if Turkell-Young acquires Randolph Enterprises based on McDougal’s analysis, a referral fee will be paid directly to McDougal. McDougal is concerned about revealing the referral fee that she could receive from TurkellYoung to her supervisor. Cratter Finance might assume that her recent buy recommendation on Turkell-Young was biased. McDougal decides to remain silent about the arrangement with Turkell-Young. McDougal justifies her actions as she does not want her colleagues to doubt her independence and objectivity. 1.

Did McDougal violate CFA Institute Standards when she changed her recommendation on Randolph Enterprises from a buy to a sell based on the conversations she heard at the seminar? A. B. C.

2.

Yes, since she did not have a reasonable basis for her recommendation. Yes, because she did not disclose that some of the analysis was opinion. No.

To comply with CFA Institute Standards, when invited to attend the all-expenses paid seminar as a guest of Randolph Enterprises, McDougal should have: A. B. C.

declined the offer and written an objective research report. accepted the offer and written an objective research report. dropped coverage of the company.

4

3.

To comply with CFA Institute Standards, McDougal’s responsibility regarding Turkell’s offer in Statement 1 is to: A. B. C.

4.

The portfolio managers who traded Randolph Enterprises based on the content of McDougal’s report most likely violated which Standards? A. B. C.

5.

Fair Dealing. Fair Dealing and Priority of Transactions. Fair Dealing, Priority of Transactions and Diligence and Reasonable Basis.

The purpose of Standard VI(C) Referral Fees is to help the client: A. B. C.

6.

receive permission from the CFA Institute before she accepts the assignment. turn down the assignment due to her conflict of interest. review the proposal with her employer and receive the employer’s permission before accepting the referral fee arrangement.

evaluate the transparency of the compliance system. assess any conflicts of interest the fees may cause and evaluate the transparency of the compliance system. assess any conflicts of interest the fees may cause and evaluate the full cost of the services.

A member of the CFA Institute found to be in serious violation of the Code and Standards and sanctioned by the CFA Institute can be penalized by: A. B. C.

a monetary fine. a monetary fine and/or private censure. private censure and/or suspension.

5

ITEM SET 2: ETHICS Questions 7 through 12 are allocated 18 minutes. Rejie Ariusu recently passed Level II of the CFA exam. Ariusu’s elation at passing the exam is tempered by the current uncertain economic environment. His firm, Scrimm Capital, is an asset manager for several closed-end, pooled investment funds for institutional investors. Ariusu works in the real estate investment division, identifying real estate investment opportunities that are presented to Scrimm Capital’s real estate investment committee for approval. Other groups within the firm include a high-yield loan group and a small-cap equity growth fund. Scrimm Capital was founded in 2010. All three funds were established and started trading in that year. Ariusu joined the firm in 2013. Scrimm Capital encourages a culture of cooperation and rewards employees who help the firm prosper. Lahi Tami is the supervisor of the real estate investment group. Tami championed the adoption of the Global Investment Performance Standards (GIPS) for the real estate group, which promotes its adherence to GIPS in its marketing materials. Ariusu made the following statement to Tami: Statement 1: Scrimm Capital cannot claim compliance with GIPS standards for only certain asset classes that fall within the definition of the firm. Tami replied: Statement 2: The real estate investment group claims GIPS compliance because it is a distinct business entity. Tami requests the returns for each investment fund as of December 31, 2019, for an upcoming request for proposals from a large public pension plan. Ariusu calculates the investment performance of the real estate group and determines that the performance results are better when calculated over the lifetime of the fund (since 2010) than when calculated since his arrival to the group in 2013. Ariusu is concerned that the performance of the real estate investment group has declined since he joined the firm, and due to this, elects to report the performance of the real estate investment group since the fund’s inception. At a professional networking event, Ariusu discusses the investment environment with Vert Wheeler of Pam Capital, an asset management firm in the same city as Scrimm. Ariusu describes to Wheeler the performance of the Scrimm real estate fund using investments he recommended, but not approved by the real estate investment committee. Wheeler does not know that the investment performance described by Ariusu is simulated. Wheeler is interested in Ariusu’s investment ideas and invites him to share his work over dinner, where Ariusu shares the simulated investment returns for the Scrimm Capital real estate fund.

6

Ariusu states that the real estate portfolio can be easily replicated by Pam Capital, showing Wheeler all of the investment positions held by the real estate fund, including those Ariusu recommended, but were not approved. Wheeler calls Tami the following day to propose a potential joint marketing opportunity, and to discuss his previous night’s dinner conversation with Ariusu. Wheeler does not want to interfere with Pam Capital and asks for Tami’s permission to use the investment information provided by Ariusu as a way to market the real estate investment vehicle to existing investors of Pam Capital with the potential for them to invest with Scrimm Capital. Tami tells Wheeler that Scrimm will pay a solicitation fee for each new investor Wheeler brings. Since Tami is eager to attract new investors, she agrees to share the investment performance information with Wheeler. 7.

Do the statements by Ariusu and Tami most likely comply with CFA Institute Standards? A. B. C.

8.

Statement 2 Does not comply Complies Complies

Does Ariusu’s calculation of the real estate investment group’s performance since the inception of the fund comply with CFA Institute Standards? A. B. C.

9.

Statement 1 Complies Does not comply Complies

Yes. No; ignoring the lower performance since Ariusu’s arrival does not provide a fair and complete presentation of investment performance. No; it would be considered false and misleading not to provide the riskadjusted performance results since Ariusu’s arrival.

Was Ariusu’s presentation to Wheeler of the real estate fund’s simulated investment returns in compliance with CFA Institute Standards? A. B. C.

Yes. No, because reporting simulated returns does not provide a fair and complete presentation of performance information. No; CFA Institute Standards allow for simulated investment results only if the simulation is applied retroactively to investment performance.

7

10.

Is Ariusu’s use of real estate performance data in his discussion with Wheeler in compliance with CFA Institute Standards? A. B. C.

11.

Would Wheeler’s use of performance information to market Scrimm Capital’s real estate fund to potential investors be in compliance with CFA Institute Standards? A. B. C.

12.

Yes, because Wheeler received permission from Tami to use the information. Yes, because CFA Institute Standards allow for knowledge gained at one employer to be used in discussions with other firms. No.

Yes, because Wheeler received permission from Tami to use the information. Yes, because Ariusu recommended the investments included in the performance data. No.

Regarding Tami’s offer to Wheeler of additional compensation for soliciting investors for Scrimm Capital’s real estate fund: To be in compliance with CFA Institute Standards, Wheeler most likely would need to: A. B. C.

decline any additional compensation arrangements. decline any additional compensation arrangements and inform potential Pam Capital investors of the fee arrangement. inform potential Pam Capital investors of the fee arrangement and obtain permission from Pam Capital prior to accepting additional compensation from Tami.

8

ITEM SET 3: CAPITAL MARKET EXPECTATIONS Questions 13 through 18 are allocated 18 minutes. Oxford Investments is a multinational investment management company that specializes in fixed income and real estate investments. Ron Perumal, a capital market analyst at Oxford, is helping to prepare the annual capital market outlook for clients. Perumal’s task is to provide investment outlook on five asset classes: 1) Danish bonds, 2) Swedish bonds, 3) US bonds, 4) emerging market bonds, and 5) direct real estate. Danish Bonds In forecasting the Danish bonds’ expected rate of return, Perumal notices that Denmark is facing negative short-term rates. He wonders if negative short-term rates will impact market relationships and complicate traditional ways of forecasting rates. Perumal consults Josh Knight, a senior rate strategist at the firm. Knight makes the following general statements about negative interest rates and their implications. Statement 1: To calculate the expected rate of return of Danish bonds, the observed negative short-term rates shouldn’t be used as the risk-free rate. Statement 2: For countries facing negative short-term rates, market relationships (e.g., the yield curve) are unlikely to be distorted by other concurrent monetary policy measures. Swedish Bonds To forecast Swedish bond return expectations, Perumal decides to calculate the target nominal policy rate of Sweden, applying the Taylor rule using the data in Exhibit 1. Exhibit 1 Neutral real policy rate at trend growth and target inflation Target inflation rate Expected inflation rate Trend real GDP growth rate Expected real GDP growth rate

1.2% 0.5% 1.0% 1.0% 2.0%

US Bonds Perumal then shifts his attention to forecasting US bond return expectations and begins estimating the risk premia for five-year US intermediate-term bonds using the data in Exhibit 2. Exhibit 2 One-year nominal risk-free interest rate Term premium (five-year vs. one-year US government bond) Five-year BB credit premium (over five-year US government bond) Estimated liquidity premium on five-year corporate bonds

2.2% 75 bps 50 bps 30 bps

Emerging Market Bonds Perumal forecasts the expected return of emerging market bonds and proceeds to disclose the unique risks of investing in these instruments. 9

Direct Real Estate Lastly, Perumal focuses on forecasting the expected returns of investing in direct real estate. He analyzes the previous ten years of multifamily residential real estate returns data. He is skeptical that the volatility of the observed returns reflects smoothing. Perumal uses a publicly traded REIT index to unsmooth the return stream and appropriately reflect the risk (as measured by standard deviation) of investing in multifamily residential real estate (the variance of the REIT index for the measurement period is 16; λ equals 0.8). The data now unsmoothed, Perumal forecasts the expected rate of return over the next year for investing in multifamily residential real estate. He uses the information shown in Exhibit 3. Exhibit 3 Current cap rate for multifamily properties 5.5% NOI growth rate (real) 1% Inflation expectation 2% Expected cap rate for multifamily properties at end of period 5.3% 13.

Which of Josh Knight’s statements regarding negative short-term rates is most likely correct? A. B. C.

14.

The target nominal policy rate for Sweden, as calculated using the Taylor rule, is closest to: A. B. C.

15.

Only Statement 1 is correct. Only Statement 2 is correct. Both statements are correct.

1.95% 2.95% 2.45%

Perumal’s estimation of the total risk premium for the five-year US government bonds is closest to: A. B. C.

75 bps. 295 bps. 375 bps.

10

16.

Perumal’s disclosure concerning unique investment risks in emerging market bonds is most likely to include: A. B. C.

17.

Perumal’s unsmoothed standard deviation for multifamily properties for the investment period is closest to: A. B. C.

18.

Price fluctuations, based on changes in interest rates. That they are potentially more vulnerable to distress, due to less sophisticated financial markets and institutions, and hence, a higher likelihood of default. Both A and B.

12 18 24

Perumal’s expected return for a Multifamily Suburban Class C property is closest to: A. B. C.

8.7% 9.9% 12.1%

11

ITEM SET 4: ASSET ALLOCATION Questions 19 through 22 are allocated 12 minutes. Angelica Mukasa was recently hired as the CFO of Channel, a leading property and casualty insurer based in a developed European country. Channel is financially strong and the industry outlook is stable. Channel’s profitability is high, primarily driven by robust underwriting results and favorable investment returns on its large reserve of assets. Channel’s investment group is focused on matching premium reserve assets to projected policyholder claims, investing excess assets for growth. The reserve currently has sufficient surplus to support its liabilities. Regulators impose a maximum limit of 10% of total reserve assets (which include matched and excess assets) on non-publicly traded securities. Mukasa’s new assistant, Samiah Pai, presents three possible allocation options for total reserve assets, as shown in Exhibit 1.

Asset Class: Equity Fixed income Real estate Private equity Cash Total

Exhibit 1 Possible Allocations Allocation 1 Allocation 2 Allocation 3 10% 25% 50% 75% 50% 30% 5% 10% 0% 5% 10% 0% 5% 5% 20% 100% 100% 100%

Mukasa also serves as a trustee of Channel’s defined-benefit pension plan. The plan is legally distinct from Channel’s assets. The company has made contributions sufficient to maintain a fully funded status. It is a tax-exempt fund and must hold 20% of its assets in domestic government bonds in order to maintain its tax-exempt status. The plan’s key objective is to meet current and future pension obligations. The plan’s current allocation is 60% global equities, 20% domestic government bonds, 15% domestic corporate bonds, and 5% cash. Mukasa is considering adding a new asset class to Channel’s pension fund to improve expected returns. Pai compiles data for three possible new asset classes (Exhibit 2).

Asset Class Global real estate (REITs) Emerging markets equities Global high-yield corporate bonds

Exhibit 2 Possible Asset Classes Correlation with Sharpe Ratio Current Portfolio 1.40 0.70 1.75 0.70 0.75 0.55

12

Several years later, Channel’s pension plan has grown to over EUR 5 billion in assets. During that time period, the fund’s allocation to illiquid assets (which includes direct real estate, private equity and infrastructure) increased to 30%. Channel maintains its leading position in the insurance industry and its balance sheet remains healthy. However, given heightened competition and increasingly soft pricing conditions, Channel staff members are researching possible cost saving strategies for management consideration. While viewed as an unlikely choice by Mukasa, reducing Channel’s cash contributions to its pension plan is among them. The plan is currently 90% funded. Pai reviews key benefits and constraints of large institutional investors in asset allocation that may be relevant to Channel’s pension plan. He makes the following statements. Statement 1: A substantial allocation to illiquid assets may be inappropriate for Channel’s pension plan if there is a significant probability of Channel lowering its contributions to the plan. Statement 2: Large institutional investors, such as Channel’s pension plan, will likely benefit from deploying active equity strategies, due to manager access, liquidity and trading cost advantages. Statement 3: Channel’s pension fund may rebalance portfolio weights from the strategic allocation in order to exploit perceived opportunities based on its latest five-year capital market expectations. 19.

Which allocation in Exhibit 1 is most appropriate for Channel’s insurance reserve assets? A. B. C.

20.

Which approach is least relevant to a strategic allocation for Channel’s pension plan? A. B. C.

21.

Allocation 1. Allocation 2. Allocation 3.

Shortfall risk. Heuristic approach. Surplus optimization.

Which asset class in Exhibit 2 is most likely to be considered for inclusion by Channel’s pension plan? A. B. C.

Global real estate (REITs). Emerging markets equities. Global high-yield corporate bonds.

13

22.

Which of Pai’s statements is most appropriate for the pension plan, given Channel’s current market circumstances? A. B. C.

Statement 1. Statement 2. Statement 3.

14

ITEM SET 5: ASSET ALLOCATION Questions 23 through 26 are allocated 12 minutes. Greta Carson is a financial consultant for high net worth clients. Carson meets with prospective clients Nick and Hamidah Johnson. They are married, both 50 years old, and working full time as physicians. The couple has two children, both of whom are grown and financially independent. The Johnsons feel that they are on track to accumulate sufficient assets to comfortably retire at age 65. Their investment assets total USD 5 million and are held in a combination of taxable and tax-advantaged accounts. Carson conducted a detailed interview with the Johnsons and developed an assessment of their risk preference and capacity for risk. She noted that between them, their risk attitudes appear to be very different. She estimated the risk aversion coefficients (λ) as: +6 for Nick and –2 for Hamidah. She used the following utility function to determine a preferred asset allocation for each of them. Um = E(Rm) – 0.005λσm2 Carson’s new assistant, Kei Osaka, compiled expected return and risk for three possible portfolios shown in Exhibit 1. In addition, he calculated perceived investor’s utility based on three risk profiles and added the results to Exhibit 1.

Portfolio A B C

Exhibit 1 Three Portfolio Options and Investor’s Utility Standard Expected Deviation Utility 1 Utility 2 Return of Return (λ = –2) (λ =+2) 10.0% 20.0% 14.00% 6.00% 8.0% 12.0% 9.44% 6.56% 5.0% 3.0% 5.09% 4.91%

Utility 3 (λ =+6) –2.00% 3.68% 4.73%

Osaka listens to a podcast series on asset allocation. He writes down a few key criticisms of the traditional mean-variance optimization (MVO) approach in Exhibit 2 and plans to show how they have been addressed in practice. Exhibit 2 Criticisms of Traditional MVO Approach in Asset-Only Asset Allocation • High sensitivity to inputs • Highly concentrated allocations • Non-normal distribution • Single-period framework • Trade/rebalancing costs and taxes

15

Carson carefully reviews the Johnsons’ existing IPS, which was prepared by their previous adviser. She determines that their current asset allocation (Exhibit 3) is appropriate for them. She notes, however, that a rebalancing policy is not clearly documented. Carson discusses portfolio rebalancing with Osaka, and prepares three possible approaches (also shown in Exhibit 3). Exhibit 3 Possible Rebalancing Options

Domestic equity International equity Emerging markets equity Fixed income Total

Strategic Allocation Target 45% 20% 5% 30% 100%

Fixed Width Ranges (+/-5%) 40%–50% 15%–25% 0%–10% 25%–35%

Proportional Ranges (+/- 1,000 bps) 40.5%–49.5% 18%–22% 4.5%–5.5% 27%–33%

Cost-Benefit Analysis 42%–48% 17%–23% 4%–6% 28%–32%

Osaka makes the following statements about portfolio rebalancing: Statement 1: An investor’s beliefs in momentum and mean reversion may favor wider rebalancing ranges. Statement 2: Taxes and transaction costs often lead to wider rebalancing ranges in taxable accounts than in tax-advantaged accounts. Statement 3: Due to the high volatility and low correlation with the rest of the portfolio, and the Johnsons’ moderate to high risk tolerance, the fixed income rebalancing range is narrower than the other asset classes based on the cost-benefit approach shown in Exhibit 3. A few months later, Carson receives a phone call from Hamidah. She’s now on the board of trustees of Artic Foundation for Medical Research (AFMR). AFMR was established to support various medical research initiatives. She is very excited and asks Carson to help identify the return objective of AFMR’s portfolio. Osaka notes the following: • • • • • •

AFMR’s overall investment objective is to maintain its portfolio’s real purchasing power after distributions. The risk-free rate is 4.0%. An expected inflation rate is 3.5%. The portfolio’s standard deviation is 15.0%. The cost of earnings investment returns is 50 bp. AFMR targets a 5.5% annual distribution of assets.

16

23.

Which portfolios would be most appropriate for Nick and Hamidah separately, based solely on the information presented in Exhibit 1? A. B. C.

24.

risk budgeting. surplus optimization. Monte Carlo simulation.

Which of Osaka’s statements about portfolio rebalancing is correct? A. B. C.

26.

Hamidah Johnson Portfolio B Portfolio C Portfolio A

The most appropriate technique for Osaka to consider in addressing the criticisms of MVO stated in Exhibit 2 is: A. B. C.

25.

Nick Johnson Portfolio A Portfolio B Portfolio C

Statement 1. Statement 2. Statement 3.

AFMR’s return objective is closest to: A. B. C.

9.50% 9.74% 10.27%

17

ITEM SET 6: DERIVATIVES AND CURRENCY MANAGEMENT Questions 27 through 30 are allocated 12 minutes. Erica Taylor, CFA, is a derivatives analyst at Alpha Asset Management (Alpha). Taylor is concerned by recent equity market volatility and considers hedging strategies for the client portfolios that she oversees. Justine Fisher, a client of Alpha, holds a significant position in Dropqik Corporation, which currently trades at $30.50 per share. Fisher remains optimistic about the long-term performance of the stock and does not want to sell the shares. She is, however, concerned about potential future volatility and a short-term loss, and wants to protect the position’s value with minimal cost. Exhibit 1 Option Contract Pricing Details for Dropqik Corporation Exercise Price 40 35 30 25 3-month call option price 0.56 1.45 4.05 10.30 3-month put option price 9.56 5.20 2.78 1.56

20 12.42 0.72

Another client, Nithin Rao, does not own any shares of Dropqik Corporation. Rao wants to speculate on the price volatility of Dropqik and expects large deviations in the share price following the new product release in the next month. Rao requests that Taylor recommend suitable strategies to profit from the directional moves in the share price. Taylor prepares the following three strategies to present to Rao. Strategy 1:

A bull call spread combined with a bear put spread using $35 and $25 strike options.

Strategy 2:

A long straddle position at the $30 strike price.

Strategy 3:

A long strangle position using $40 and $20 strike options.

27.

The option strategy Taylor is most likely to recommend to Fisher is a: A. B. C.

28.

covered call. long collar. short straddle.

The breakeven price for an at-the-money (ATM) protective put strategy is closest to: A. B. C.

$25.95 $27.22 $33.28

18

29.

Given the information in Exhibit 1, the minimum cost of implementing Strategy 1 is closest to: A. B. C.

30.

$12.49 $12.75 $12.86

At expiration, the breakeven points for Strategy 2 are closest to: A. B. C.

$23.17 and $36.83. $23.67 and $37.33. $26.45 and $34.55.

19

ITEM SET 7: DERIVATIVES AND CURRENCY MANAGEMENT Questions 31 through 34 are allocated 12 minutes. Alex Duhamel, a CFA Level III candidate, is an investment manager at Nashua Investment Associates Ltd. (Nashua). Duhamel specializes in portfolio management and is responsible for conducting annual reviews with clients. Duhamel begins to review the portfolio of Hannah Duffi, a US resident. Duffi’s portfolio is invested in American and European securities. On January 1, 2019, Duffi had a portfolio of USD 50 million and EUR 50 million allocated between stocks and bonds as shown in Exhibit 1. The exchange rate on January 1, 2019, was 1.1 USD/EUR.

Total Portfolio United States Europe

Exhibit 1 Hannah Duffi’s Portfolio on January 1, 2019 Stocks Beta Bonds 35% 1.2 65% 40% 1.15 60%

Modified Duration 5.8 6.5

On January 1, 2020, the value of Duffi’s European portfolio increased from EUR 50 million to EUR 54 million, with EUR 20 million in stocks and EUR 34 million in bonds. The current USD/EUR exchange rate as of January 1, 2020, is 1.16. The Euro index futures contract is priced at EUR 700, has a multiplier of 10 and a beta is 1.0. Duffi decides to use futures contracts to rebalance the European portfolio to the allocation that existed on January 1, 2019. Duhamel is also meeting with Alyssa Pike, a 65-year-old client considering retirement. Pike’s equity portfolio is presently valued at $3.6 million. Pike has an overall debt of $1 million with an average fixed interest rate of 4.5%. Pike expresses her concern regarding the uncertainty of equity markets and her worry that her portfolio will not generate an adequate return to cover her debt payments during retirement. Pike and Duhamel discuss the performance of the portfolio and use of derivatives to manage risk. They are joined by Marie Kreutz, another CFA Level III candidate, who works at Nashua with Duhamel. Kreutz makes the following statements: Statement 1: A total return swap will reduce the risk of the portfolio and convert the portfolio assets from receiving floating to receiving fixed. Statement 2: Buying a protective put on the portfolio would eliminate the downside risk of the portfolio and generate a fixed return. Statement 3: An interest rate swap can be used to modify fixed-rate liabilities into floating-rate liabilities. Evaluating Kreutz’s statements, Duhamel suggests the use of an equity swap to pay the return on 50% of the equity portfolio’s notional amount and receive a fixed interest rate of 3.75% for the same notional amount. Settlement dates will be annual.

20

After entering the equity swap, the value of Pike’s portfolio declines by 2% just before the first settlement date. 31.

The number of stock index futures contracts Duffi should use to rebalance Duffi’s portfolio is closest to: A. B. C.

32.

For Duffi’s portfolio, the domestic currency return on the European portfolio over the previous year is closest to: A. B. C.

33.

5.45% 8.00% 13.89%

Which of Kreutz’s statements is least likely correct? A. B. C.

34.

Buy 199 Euro index futures. Sell 262 Euro index futures. Buy 263 Euro index futures.

Statement 1. Statement 2. Statement 3.

At the first swap settlement date, Pike would most likely: A. B. C.

pay $36,000. receive $67,500. receive $103,500.

21

ITEM SET 8: FIXED-INCOME PORTFOLIO MANAGEMENT Questions 35 through 38 are allocated 12 minutes. Richard Elliott, CFA, is the head of the fixed income department of Lowell Wealth Management (LWM), a leading investment advisory firm. Elliott works closely with his director of research, Stephen Lee, CFA. LWM recently changed their focus from working only with pensions and endowments to working only with high net worth individuals. As a result, the team is revamping the layout of its presentations and reports. In addition to a core allocation to bullet government bonds, LWM expects to invest in securities that have embedded optionality, such as callable bonds and mortgage-backed securities. Historically, the firm has relied on identifying value from the shape of the yield curve. Current yield curve conditions for on-the-run US Treasuries are shown in Exhibit 1. Exhibit 1 Term Yield to Maturity (years) (%) 2 5.50 10 5.75 30 7.00 Elliott has asked Lee to construct sample portfolio structures by shifting the allocations between three tenors of bullet government bonds: 2-year, 10-year and 30-year US Treasury securities. The allocations in the sample portfolios are shown in Exhibit 2. Additionally, Elliott has asked Lee to prepare expected return estimates for the 2- and 30-year bonds, which are shown in Exhibit 3. Exhibit 2 Sample Portfolio Allocation Sample Portfolio 2-year 10-year 30-year 1 50% 0% 50% 2 20% 70% 10% 3 40% 30% 30%

Coupon yield Current price Expected price in one year 35.

2-Year 4.75 105.00 106.05

Exhibit 3

30-Year 6.00 100.00 101.00

The butterfly spread is closest to: A. B. C.

–1.00% 1.00% 1.50% 22

36.

Which measure of duration is most likely to be included in the revamped presentations and reports? A. B. C.

37.

Given the expected prices over the next year, which bond has the higher expected total return? A. B. C.

38.

Macaulay duration. Modified duration. Effective duration.

The 2-year. The 30-year. Both bonds have the same expected total return.

Which portfolio is most likely to benefit from a flattening yield curve environment? A. B. C.

Portfolio 1. Portfolio 2. Portfolio 3.

23

ITEM SET 9: FIXED-INCOME PORTFOLIO MANAGEMENT Questions 39 through 42 are allocated 12 minutes. Maria Robinson, CFA, is a senior analyst in the Balance Sheet Strategy Division of Bayside Insurance (Bayside), a regional insurance company. Robinson is preparing the material for the monthly meeting of Bayside’s Asset/Liability and Investment committees. Robinson has been asked to contrast the merits of cash flow matching and duration matching. Bayside presently uses both strategies, but given the recent increase in volatility in US interest rates over the last month, Bayside’s management wants to better prepare for future opportunities. Robinson also considers the use of derivatives to manage interest rate risk. This would be a new strategy for Bayside. Robinson determines the number of bond futures needed to immunize the overall interest rate risk exposure of the company. The basis point value (BPV) for the asset portfolio is 96,000, while the liability portfolio has a BPV of 44,000. To facilitate her analysis, Robinson compiles the additional information related to bond futures shown in Exhibit 1. Exhibit 1 5-Year T-Note Yield to maturity 6.02% Modified duration 4.8 BPV per 100,000 in par value 47.22 Conversion factor for cheapest-to-deliver 0.88

10-Year T-Note 6.41% 9.1 88.41 0.90

There has also been much debate at Bayside over passive bond market exposure. The discussion has focused primarily on two key related points: 1) 2)

Should Bayside seek passive bond market exposure? If so, what vehicle would be the most appropriate and effective way to achieve it?

Historically, Bayside has been a direct investor in fixed income instruments, but it has recently been looking into the possible use of both mutual funds and total return swaps. Robinson has lobbied for the use of total return swaps, because she believes the use of the swaps will increase the correlation between Bayside’s asset portfolio and its benchmark. 39.

Which immunization strategy is most likely to be more negatively impacted by nonparallel shifts in the yield curve? A. B. C.

Cash flow matching. Duration matching. The strategies will perform the same.

24

40.

The number of five-year note futures contracts required to be sold in order to rebalance the immunizing portfolio is closest to: A. B. C.

41.

If Bayside were to use mutual funds to obtain passive bond market exposure instead of direct investment in fixed income instruments, what advantages would it most likely realize? A. B. C.

42.

529 contracts. 969 contracts. 1101 contracts.

Increased diversification and stable income streams. Economies of scale and daily liquidity. Ability to redeem at NAV and intraday liquidity.

Which type of total return swap would Bayside most likely use to decrease tracking risk? A. B. C.

Total return receiver—to capture appreciation in the index. Total return payer—to capture the cash flows of the index. Total return receiver—to avoid counterparty credit risk.

25

ITEM SET 10: EQUITY PORTFOLIO MANAGEMENT Questions 43 through 48 are allocated 18 minutes. The Cherry Street Foundation is a nonprofit institution that provides resources for refugee children around the world. Over the last several years, Cherry Street has experienced a significant increase in donations, resulting in an increase to the foundation’s investment portfolio of more than $100 million. Consequently, Ellie Blumenstock, CFA, Cherry Street’s founder, recently concluded that the time had come to hire a professional chief investment officer (CIO) to manage this large pool of assets. Today, Blumenstock is interviewing A. J. Gelormini, a portfolio manager with over two decades of experience, for the CIO role. At the start of the interview, Blumenstock asks Gelormini to explain his approach to investing in global equities. Gelormini’s response includes the following statements: Statement 1: I would utilize actively managed funds in equity market segments where the manager has confidence that the benchmark can be beaten, the liquidity of the underlying securities in the benchmark is thin, and the number of securities in the benchmark is broad. Cherry Street’s tax-exempt status makes any tax burden associated with an actively managed strategy irrelevant. Statement 2: I would build passively managed funds internally through direct investment in individual securities. My focus would be on constructing funds that minimize tracking error versus the benchmark, subject to a constraint that each fund’s volatility equals that of its relevant benchmark. Cherry Street would have several such funds, all under $5 million in assets, with benchmarks containing over 2,000 constituents. Blumenstock replies that Cherry Street has always used the S&P 500 as the benchmark for its entire investment portfolio and has tried to replicate its returns through direct investment in the underlying constituents. Blumenstock manages this process herself by obtaining a list of S&P 500 constituent weightings and submitting purchase and sell orders to Cherry Street’s broker as necessary to appropriately reflect the weightings. Orders are typically filled immediately after the market’s open. Little cash is kept on hand and trades are commission-free. Blumenstock expresses her frustration that the investment portfolio has nevertheless lagged the S&P 500 and has experienced significant tracking error. Gelormini responds by suggesting that Cherry Street invest in a handful of factor-based strategies that track the S&P 500. He states that these strategies have the potential to improve returns while limiting tracking error versus the benchmark. He then presents Blumenstock with a one-page comparison of several such funds, a summary of which is provided in Exhibit 1. Note that the values provided in Exhibit 1 represent the average quarterly values for each of the underlying holdings in Fund A, Fund B, Fund C and each of the constituents in the S&P 500, calculated on a trailing five-year basis. All data on the underlying holdings and index constituents is sourced from their SEC filings and publicly available market data.

26

Exhibit 1 Factor-Based Funds Summary Data (Trailing Five-Year Weighted Averages) Fund A Fund B Fund C Market cap ($ billions) $72 $18 $13 P/E 24.5x 27.2x 13.8x Dividend yield 1.6% 1.9% 2.8% Trailing 12-month EPS growth 14% 18% 3% Trailing 12-month price return 6% 25% 12% Debt-to-equity ratio 40% 50% 10%

S&P 500 $48 17.2x 2.1% 7% 9% 35%

Before concluding the interview, Blumenstock mentions that she recently read several articles regarding shareholder engagement and activist investing strategies. She was particularly intrigued by the role of activists in advocating for the implementation of ESG standards at large companies. Blumenstock asks Gelormini if it would make sense for Cherry Street to participate in shareholder engagement activities or to commit to a firm that engages in activist investing, and, if so, what approach would make the most sense. Gelormini’s response included the following statements. Statement 3: If Cherry Street were to develop its own internally managed passive funds investing directly in individual securities, it would be difficult to participate in shareholder engagement activities without driving up costs. However, Cherry Street could, at a very low cost, engage in proxy voting for each of the individual securities it held. Statement 4: Plenty of activist managers focusing on ESG issues exist, and investing with one could make sense for Cherry Street. Managers of these strategies utilize the same tactics as more traditional activist investors because they both typically have shorter time horizons and take stakes in target companies greater than 10% of the target’s outstanding equity. Some of these tactics include proposing significant changes in corporate governance, seeking board representation and engaging in proxy contests. 43.

The rationale provided by Gelormini in Statement 1 is most likely incorrect because: A. B. C.

44.

the benchmark should have a limited number of underlying securities. the benchmark’s underlying securities should have significant depth of liquidity. the tax burden is not a factor in considering actively managed strategies.

Given Gelormini’s comments in Statement 2, the best approach he could take to construct passive portfolios for Cherry Street is: A. B. C.

full replication. stratified sampling. optimization. 27

45.

The best change that Blumenstock could make to Cherry Street’s process to reduce the investment portfolio’s tracking error is to: A. B. C.

46.

Which of the factor-based funds in Exhibit 1 best provides exposure to the factors of size, value and quality? A. B. C.

47.

Fund A. Fund B. Fund C.

Which of the following activities, if engaged in by Cherry Street, would prevent the foundation from participating in proxy voting as described in Statement 3? A. B. C.

48.

equitize the portfolio using futures. transact at the market-on-close price. use stratified sampling to mimic the benchmark.

Hiring an external proxy advisory firm. Purchasing the security on margin. Loaning the security to a short seller.

Gelormini’s comments about activists in Statement 4 are most likely incorrect because: A. B. C.

activist investors typically have a longer time horizon. ESG-focused activists use different processes and tactics than traditional activists. activist investors typically take a stake of less than 10%.

28

ITEM SET 11: ALTERNATIVE INVESTMENTS FOR PORTFOLIO MANAGEMENT Questions 49 through 52 are allocated 12 minutes. James Holden, CFA, is creating the asset allocation for the Lehigh Foundation (Lehigh), a nonprofit organization that provides grants and scholarships on an annual basis to researchers and students in environmental protection. Holden would like to add alternative investments to Lehigh’s portfolio, which presently includes only US common equity and debt securities. The dollar amount of the grants provided each year by Lehigh is not fixed, so the organization would like Holden to consider liquidity a priority. Additionally, Lehigh’s investment committee wants to be more mindful about ensuring that the foundation’s investments are in line with the organization’s overall mission of environmental protection. The committee would like Holden to consider a shift to an ESG-focused portfolio. Holden first contemplates the asset allocation approach. He is aware of both the traditional and risk-based approaches, and ultimately decides to use a risk-based approach to asset allocation despite its known limitations. Holden is looking at three potential hedge funds to add to the portfolio: • • •

Fund 1 has a history of consistently high returns buying distressed companies. Fund 2 specializes in quantitative long-short equity strategies. Fund 3 is a long-only equity fund that focuses on high-growth companies.

Holden decides to consult his firm’s annual economic briefing which has a section describing the expectations for the upcoming year. The report highlights many macroeconomic factors, including GDP growth, unemployment rates and consumer spending. The report outlines the following expectations: • • •

GDP growth will remain at 4.5% into the following year. The unemployment rate is expected to drop to 3%. Consumer spending is on track to reach its highest level in three years.

The report also indicates that the US will likely experience high inflation due to recent monetary policy. Finally, Holden looks into the possibility of an ESG-focused portfolio for Lehigh. Holden determines that this objective could be achieved with the current asset classes. However, he is concerned by the lack of transparency of holdings typically associated with ESG funds. Holden sets the asset allocation and plans to meet with the investment committee later to discuss the ESG direction of the portfolio.

29

49.

Which of the following is least likely to be a limitation of Holden’s approach to setting Lehigh’s asset allocation? A. B. C.

50.

Based on the use of the organization’s portfolio, the least suitable hedge fund is: A. B. C.

51.

Fund 1. Fund 2. Fund 3.

Based on the macroeconomic expectations, the alternative asset class that should perform the best over the next year is most likely: A. B. C.

52.

Combining investments with varying risk characteristics into a single portfolio. The impact of the historical sample on risk factor exposure. The need for additional considerations for liquidity and rebalancing.

private equity. gold. real estate.

An alternative investment that would most likely address Holden’s ESG concern is a: A. B. C.

hedge fund specializing in trading commodity derivatives. private real estate fund with holdings in both the US and Canada. hedge fund with a long-short strategy invested only in publicly traded equities.

30

ITEM SET 12: TRADING, PERFORMANCE EVALUATION, AND MANAGER SELECTION Questions 53 through 56 are allocated 12 minutes. Ivy Chatterjee is a senior portfolio manager at Lingonberry Securities, a global investment management firm. Chatterjee manages a US large-cap equity fund that invests in liquid securities, utilizing an active, fundamental investment process. Chatterjee has been researching MPU, a bank stock, and increasing its allocation in the fund she manages. MPU released its quarterly earnings report yesterday and provided a weaker earnings forecast than expected. As a result, MPU closed at $40.00 per share yesterday, a meaningful decline from its previous price. Chatterjee felt that the market overreacted to the bad news, and as a result was provided with an opportunity to buy MPU at a more favorable price. She was concerned that the market overreaction would be short-lived. Chatterjee met with Lenny Angels, the head of trading at Lingonberry Securities, to finalize the trading strategy before the opening of the equity market. Angels made the following general statements about trading strategies. Statement 1: Trading in securities with a higher rate of alpha decay, like MPU, will have better execution if we adopt a longer trade time horizon. Statement 2: The more liquid the security, such as MPU, the higher the market impact of trading will be. Chatterjee decides to buy 10,000 shares of MPU with a decision price of yesterday’s close at $40.00 per share and sets a limit price of $40.50 for the order. The trading venue charges $0.03 per share as a commission. MPU faces strong demand and prices continue rising throughout the trading day. Angels is able to get three trades executed within the limit order set by Chatterjee. After the third trade, MPU shares trade at prices over the limit order and close at $40.90. Chatterjee determines that MPU is now fairly valued and does not want to buy any more MPU shares at the current price. The trade execution details are shown in Exhibit 1. Trades Trade 1 Trade 2 Trade 3

Exhibit 1 Execution Price 40.20 40.35 40.45

Shares Executed 2,000 5,000 1,000

Displeased with the opportunity cost of the trade execution, Chatterjee and Angels discuss ways to reduce it.

31

53.

Which of Lenny Angels’s statements regarding trading strategies is most likely to be correct? A. B. C.

54.

The opportunity cost of the MPU trade is closest to: A. B. C.

55.

20 bps. 45 bps. 57 bps.

The implementation shortfall of the MPU trade is closest to: A. B. C.

56.

Statement 1. Statement 2. Neither Statement 1 nor Statement 2 is correct.

$4,640 $4,400 $4,500

Which of the following improvements is most likely to reduce the opportunity cost of the trade execution? A. B. C.

Knowing beforehand which broker and/or algorithm is best suited to reduce the time between receipt of the order and market execution. Knowing the share quantity that is most likely to be executed within a specified price range. Selecting the proper trading urgency.

32

ITEM SET 13: TRADING, PERFORMANCE EVALUATION, AND MANAGER SELECTION Questions 57 through 60 are allocated 12 minutes. Riverdale University Endowment is interested in hiring equity managers who have a demonstrated track record of outperforming the market through a full business cycle. Crestwood Capital Partners, a manager research specialist firm, has been retained by Riverdale to help with the selection of investment managers. Scott Bloomstone, Managing Director at Crestwood, has performed the investment manager due diligence and is presenting his findings to the Riverdale Investment Committee. Bloomstone presents the upside and downside capture ratios of the top three investment manager candidates as shown in Exhibit 1. Exhibit 1 Investment Manager Upside Capture Oakfarm Investments 75% Sailboat Asset Management 90% TripleCircle Investors 90%

Downside Capture 75% 125% 75%

Riverdale does not want to invest in a company that derives any direct or indirect revenue from the sale of guns or ammunitions. Bloomstone makes the following statements regarding customization and choice of investment vehicles: Statement 1: A pooled vehicle offers investors the option to express individual constraints. Statement 2: Investor-specific customization requirements can create tracking risk relative to a benchmark, which can confuse performance attribution. Riverdale has decided to benchmark the portfolio against the S&P 500 Index and is mindful of investment management fees. Bloomstone prepares the following schedules, which outline the fee structure of the top three manager candidates. The investment management fee of each manager consists of two components, a base fee and a performance-based fee, as shown in Exhibit 2. Exhibit 2 Investment Manager Oakfarm Investments

Base Fee 65 bps

Sailboat Asset Management

55 bps

TripleCircle Investors

70 bps

Performance Fee Structure Amount Applied to Applied on 10% Positive returns Return net of base fee only 10% Positive returns Excess return gross of only base fee 1% Both positive and Return net of base fee negative returns

33

To contrast investment management fees charged by the three investment managers, Bloomstone has drawn up a hypothetical performance table for two years, and summarizes the results in Exhibit 3. Exhibit 3 Scenario Portfolio Gross Return S&P 500 Index Return Year 1 8% 6% Year 2 –7% –10% 57.

The investment manager that exhibits a positive asymmetry in its historical returns is most likely represented by: A. B. C.

58.

Which of Scott Bloomstone’s statements regarding vehicle recommendations is most likely correct? A. B. C.

59.

Statement 1. Statement 2. Both Statement 1 and Statement 2.

If Sailboat Asset Management generates the exact return shown in Exhibit 3, Year 1, its total investment management fee for Year 1 is closest to: A. B. C.

60.

Oakfarm Investments. Sailboat Asset Management. TripleCircle Investors.

75 bps. 55 bps. 60 bps.

Given the portfolio returns shown in Exhibit 3, Year 2, the investment manager with the lowest total investment management fee is most likely: A. B. C.

Oakfarm Investments. Sailboat Asset Management. TripleCircle Investors.

END OF AFTERNOON SESSION.

34

CFA® Society Boston Level III 2020 Practice Exam Answer Key

CFA® is a licensed service mark owned by CFA Institute.

LEVEL III MORNING SESSION—GUIDELINE ANSWERS QUESTION 1 Topic: Minutes:

Behavioral Finance 16

LOS: 3-8-b, c; 3-9-a Reference:

Reading 8, The Behavioral Biases of Individuals, Sections 2, 3 & 4; Reading 9, Behavioral Finance and Investment Processes, Sections 2.1 & 2.2.

Guideline Answer: Part A Erving exhibits the characteristics of a Friendly Follower. Justification: • Samuel exhibits medium risk tolerance by holding a concentrated portfolio. • Samuel follows leads from research reports and friends. • Samuel is proactive in following professional investment advice. Part B Any of the two of the following would receive credit. Anchoring Bias:

Anchoring Bias is an information processing bias in which people estimate probabilities based on some initial default number, an “anchor,” which they adjust up or down to reflect subsequent information and analysis. To overcome: • Do not rely on past prices or market levels to influence decisions. • Observe changes in company fundamentals. • Concentrate only on the future potential of the company to influence buy/sell decisions.

Confirmation Bias:

Confirmation bias is a belief perseverance bias in which people tend to look for and notice what confirms their beliefs, and to ignore or undervalue what contradicts their beliefs. To overcome: • Seek contrary viewpoints. • Reevaluate after every change in the company fundamentals.

Conservatism Bias:

Conservatism is a belief perseverance bias in which people maintain their prior views or forecasts by inadequately incorporating new information. To overcome: • Look for new information. 2

•

Use Bayes’s theorem for incorporating new information into an analysis.

Illusion of Control: Illusion of control is a bias in which people believe that they can control or influence outcomes. Samuel seems to believe he has some control over the stock price of the company he is working for. To overcome: • Seek contrary viewpoints. • Maintain records of transactions, rationale behind each trade and reevaluate when new information is available. • Focus on long-term investments that are not impacted by short-term emotions and beliefs. Overconfidence Bias: Overconfidence bias is one in which people demonstrate unwarranted faith in their own intuitive reasoning, judgement and cognitive abilities. To overcome: • Conduct post-investment analysis of successful and unsuccessful investments • Seek contrary viewpoints. • Use Bayes’s theorem for adopting new information into analysis. Part C Mental Accounting: Mental accounting bias is an information processing bias in which people treat one sum of money differently from another sum of equal size based on which mental account the money is assigned to. Consequences: • Neglecting opportunities to reduce risk and increase return. • Holding an under-diversified portfolio. • Suboptimal portfolio performance is likely. Part D Passive Preserver: Joseph exhibits the characteristics of a Passive Preserver by being a passive investor with low risk tolerance and having gained most of his wealth from inheritance. Any three of the following emotional biases or cognitive errors exhibited by a Passive Preserver would be acceptable. • Endowment • Loss aversion • Status quo • Regret aversion • Anchoring and adjustment • Mental accounting

3

QUESTION 2 Topic: Minutes:

Derivatives and Currency Management 12

LOS:

Study Sessions 6-17-a, b, c, d, e, f, g

Reference:

Reading 17, Currency Management: An Introduction, Sections 2.1, 6.1 & 6.3.

Guideline Answer: Part A Domestic currency return = (1+ RFC) (1+ RFX) – 1 USD return for German assets: (1.036) (1.14/1.1) – 1 = 7.37% USD return for UK assets: (1.041) (1.27/1.3) – 1 = 1.70% USD return for Swiss assets: (0.973) {(1/1.01)/(1/0.96)} – 1 = –7.52% Note: For Switzerland, change the exchange rate into a direct quote before calculating the domestic return. Net USD on the overall portfolio is the weighted average return: (0.45 * 7.37%) + (0.25 * 1.70%) + (0.30 * –7.52%) = 1.485% Part B A put spread is buying an OTM put and writing a deeper OTM put to reduce the cost of the long put. Both options will have the same expiration date. USD/CHF on February 1, 2020 is (1/1.01) = 0.99. To implement a put spread, buy an OTM put at the 0.98 strike by paying $0.15 and write the deeper OTM put at strike 0.95, receiving $0.07. Net cost is $0.15 – $0.07 = $0.08. Part C Statement 1 is correct. Dong’s portfolio is 45% invested in German assets. USD/EUR is selling at a forward premium of 5.3% compared to the current spot rate. Dong can sell the base currency at a higher price than the current spot rate, creating a positive roll yield. Forward premium = (1.2/1.14) – 1 = 5.3%

4

Statement 2 is incorrect. CHF/USD is not in direct quote format, so the quote must be converted into a direct quote to calculate forward premium or discount. USD/CHF spot rate = 0.99 USD/CHF six-month forward rate = 0.952 USD/CHF is trading at a discount of 3.83% and selling CHF would create a negative roll yield for Dong’s portfolio. Forward discount = (0.952/0.99) – 1 = 3.83%

5

QUESTION 3 Topic: Minutes:

Portfolio Performance Evaluation 12

LOS:

Study Session 15-35-d, e, g, n

Reference:

Reading 35, Portfolio Performance Evaluation, Sections 3, 3.2, 3.3 & 5.2.

Guideline Answer: Part A Steve Beckman manages the Global Equity Fund as a top-down manager with an absolute return target. Using a factor’s marginal contribution to total risk and specific risk is the best approach to evaluate the Fund. Part B Attribution Approach Returns-based Holdings-based

Attribution Method Returns-based Holdings-based

Description • Uses only total portfolio returns to identify components that have generated the returns • References the beginning-ofperiod holdings of the portfolio. Calculated with daily, weekly or monthly data

Most Appropriate • When underlying portfolio holding information isn’t available with sufficient frequency • For investment strategies with low turnover (e.g., passive strategies) • Extensive data with shorter time intervals

Drawbacks • Low accuracy • Vulnerable to data manipulation • Fails to capture the impact of transactions made during the measurement period • May not reconcile to actual portfolio return

Part C Parameter calculations Allocation = (wi–Wi)*(Bi–B) Selection = Wi *(Ri–Bi) Interaction = (wi–Wi)* (Ri–Bi) For Japan Allocation = (7% – 5%) * (3.2% – 12%) = –0.18% Selection = 5% * (1.3% – 3.2%) = –0.10% Interaction = (7% – 5%) * (1.3% – 3.2%) = –0.04% 6

For the Fund: Incorporating the allocation, selection and interaction effects of Japan (calculated above) with the other countries’ data given in Exhibit 1, we obtain: Allocation = –2.02% Selection = 1.96% Interaction = 0.07%

France Germany China U.S. Japan Total

Portfolio Benchmark Portfolio Benchmark Weight Weight Return Return Allocation Selection Interaction 25.00% 20.00% 10.80% 8.00% –0.20% 0.56% 0.14% 15.00% 20.00% 16.50% 13.70% –0.09% 0.56% –0.14% 35.00% 25.00% 8.40% 6.00% –0.60% 0.60% 0.24% 18.00% 30.00% 21.10% 20.00% –0.96% 0.33% –0.13% 7.00% 5.00% 1.30% 3.20% –0.18% –0.10% –0.04% 100.00% 100.00% 12.00% 12.00% –2.02% 1.96% 0.07%

Country France Germany China United States Japan

Allocation Effect Overweight underperforming country. Detracted from performance. Underweight overperforming country. Detracted from performance. Overweight underperforming country. Detracted from performance. Underweight overperforming country. Detracted from performance. Overweight underperforming country. Detracted from performance.

Selection Effect Performance superior to benchmark Performance superior to benchmark Performance superior to benchmark Performance superior to benchmark Performance inferior to benchmark

At the overall Fund level, selection and interaction outperformance was nullified by allocation underperformance. The Fund did not experience excess return compared to the benchmark. Part D Sortino ratio = (Average fund return – Minimum acceptable return) / Target semi-standard deviation Average fund return for measurement period = 12% MAR = T-bill + 4% = 4% + 4% = 8% 7

Target semi-standard deviation for measurement period = 8% Sortino ratio = (12% – 8%)/ 8% = 0.5

8

QUESTION 4 Topic: Minutes:

Equity Portfolio Management 28

LOS:

10-25-b, c, g, h

Reference:

Reading 25, Active Equity Investing: Portfolio Construction, Sections 3, 4, 7 & 8.

Guideline Answer: Part A Swanson’s approach should be classified as discretionary and bottom-up. On the systematic vs. discretionary spectrum, his approach is best described as discretionary, given the concentrated nature of the portfolio, the relatively small subset of securities examined and the focus on developing a greater depth of understanding of company fundamentals. On the top-down vs. bottom-up spectrum, his approach is best described as bottom-up, given its emphasis on company-specific factors and investment style (quality). Part B Two changes Swanson could make to lower active risk are: 1) reduce the level of security concentration in the portfolio, and 2) increase the sector diversification of the portfolio. This could be achieved for the Legends Fund by adding more stocks to the portfolio and adding exposure to relatively underweighted sectors (such as financials). Reducing the level of security concentration would decrease the active share of the portfolio and lower the level of active risk. Increasing the sector diversification of the portfolio would increase the degree of crosscorrelation of the portfolio and lower the level of active risk. Part C An efficient, well-constructed portfolio should have 1) risk exposures that align with investor expectations, and 2) low idiosyncratic (unexplained) risk relative to total risk. The investment philosophies of both the Legends Fund and the Kingston Fund focus on the quality risk factor. However, the factor risk contributions provided in Exhibit 1 suggest that quality is a significant factor exposure for the Legends Fund at –12.2% but is insignificant for the Kingston Fund at –0.2%. This supports Swanson’s statement. In addition, the amount of idiosyncratic risk is much higher as a percentage of total risk for the Kingston Fund, at 12.2%, versus just 4.2% for the Legends Fund. This also supports Swanson’s statement.

9

Part D Adding shorts to a portfolio may amplify, rather than reduce, the portfolio’s tracking error (i.e., active risk) by increasing the portfolio’s active share. Therefore, Swanson’s justification for adding the market-neutral fund to the BTU endowment is incorrect.

10

QUESTION 5 Topic: Minutes:

Private Wealth Management 30

LOS:

12-28-a; 12-29-d, e; 12-30-d, e; 13-31-h, i; 13-32-i; 16-38-g

Reference:

Reading 28, Overview of Private Wealth Management, Section 2; Reading 29, Taxes and Private Wealth Management in a Global Context, Sections 3, 4 & 5; Reading 30, Estate Planning in a Global Context, Sections 2.3 & 4.1; Reading 31, Concentrated Single-Asset Positions, Sections 3.2 & 4.3; Reading 32, Risk Management for Individuals, Section 4.7; Reading 38, Case Study in Risk Management: Private Wealth, Section 6.2.

Guideline Answer: Part A Now that Louis is about to retire, he does not need (nor could he retain) disability insurance. Additionally, with ample assets, no debts, no dependents and no testamentary intentions, he does not need life insurance. Eliminating these two expenses would save Louis at least $32,000 annually (excluding any premium cost increases). All other insurance coverage should remain intact, unless an underlying asset is sold. Part B Louis should either sell the stock forward or establish a zero-cost collar. The expiration of these two strategies should be the later of the next shareholders meeting or the next tax year. The benefits are: • Neither strategy involves borrowing. • Both can be implemented at zero or near-zero cost. • The sale can be pushed into the next tax year. • The sale can be deferred until after the shareholder meeting. Regarding the other strategies: • An outright sale and shorting against the box would trigger an immediate tax liability. • A total return equity swap and a forward conversion with options would also likely be deemed a constructive sale by the IRS, subjecting Louis to immediate taxation. At the very least, the strategy would subject Louis to tax scrutiny and uncertainty. • A prepaid variable forward is a hedge combined with a margin loan and would violate Louis’s aversion to debt of any kind. • Buying a put would be a possible solution for delaying or avoiding adverse tax treatment, but would likely be a more expensive strategy than the forward or the collar. Part C The after-tax return on each of the accounts over the next five years, considering the effect of the government’s share of return, is: 11

After-tax Return Tax-exempt: $1 million x (1.06)5 = $1,338,226 Taxable: $1 million x [1 + (0.10) x (1 – 0.30)]5 = $1,402,552 Tax-deferred: $1 million x (1.09)5 = $1,538,624 – $1 million basis = $538,624 gain x (1 – 0.30) = $377,037 + $1 million basis = $1,377,037

Effective Annual 6.0% 7.0% 6.6%

The highest return would be in the taxable account from both a terminal value and an effective annual after-tax rate of return basis. The lowest return would be in the tax-exempt account. The after-tax standard deviation of each of the accounts is σ (1 – TR). Tax-exempt = 0.10 x (1 – 0) = 0.10 or 10% Taxable = 0.13 x (1 – 0.30) = 0.091 or 9.1% Tax-deferred = 0.12 x (6.6%/9.0%) = 0.088 or 8.8% Note: 9% x (1 – TR) = 6.6%; implies (1 – TR) = 6.6%/9.0% The tax-exempt account has the greatest risk as measured by standard deviation, because no portion of the risk is shared by the government through the tax code. The tax-deferred account has the lowest risk as measured by standard deviation. Part D Fixed Annuity Advantages • Known and constant income stream • Annuitant sheltered from market risk • Investment performance risk borne by annuity provider • Lower fee cost • Transparent pricing allows comparative shopping among providers Disadvantages • Rate of return fixed at onset • Inflation erodes purchasing power of cash flow • No early access to funds once established Variable Annuity Advantages • May better adjust payout for inflation over time • Performance adjusts to current market environment • Growth within annuity product tax-deferred • Possible to reclaim some assets early Disadvantages • Payout uncertain • Performance risk borne by annuitant 12

• • • •

Eventual success depends on asset allocation to subaccounts Spending may need to be reduced during periods of investment stress Higher fee cost Opaque pricing makes comparative shopping difficult

Part E Because Charles and the niece are in the same tax bracket and the assets will earn the same rate of return in either one’s possession, these issues become moot and do not factor into the decision to gift or to bequeath. The crucial factor then becomes the gift and estate tax treatment upon transfer. No generation-skipping transfer tax would apply in this case. An immediate gift to the niece of $2 million would trigger a gift tax of $1 million due immediately from the donor. Charles would pay this tax in full using the remaining funds in the account. If the fund was left to the niece at death and Charles died today, the 50% rate would apply to the entire bequest of $3 million (ignoring subsequent reinvested income and capital gains), triggering an immediate estate tax due of $1.5 million. After paying the estate tax, the remaining funds of $1.5 million would be inherited by the niece. The better approach would be to gift the $3 million fund immediately to the niece, benefitting her with an incremental $0.5 million. All post-gifting income and capital gains would accrue to the niece and not become part of Charles’s subsequent estate and subject to the 50% estate tax rate. Part F IPS Parameters Objectives Return

Risk

Constraints Liquidity

Edmund’s IPS

Pension Plan’s IPS

Broadly defined, variable, and may have multiple return objectives; may conflict internally and change over time; return may be tilted towards income, if current income is needed, or growth, if tax rates are high and current income unnecessary Difficult to determine; subject to behavioral influences; smaller asset base increases sensitivity to risk

Specific, clearly defined, actuarially based; total return focus

May be variable and subject to periodic shortfall; may

Specific liability stream that is formally managed; plan

More objective using established risk measures and formal governance structures to control risk; greater asset base may allow greater risk to be undertaken

13

Time Horizon

Tax Legal/Regulatory

borrow or sell assets to bridge liquidity gap Long (>10 years), but shorter than the pension plan; extends over Edmund’s life and those of his dependents Fully taxable, with some taxadvantaged and tax-exempt accounts Ordinarily very few, but Edmund is a company officer and fiduciary of the pension plan subject to SEC, ERISA and state oversight

sponsor is source of regular and extraordinary funding Very long, assuming enrollment to new participants remains open; potentially infinite Tax-exempt Highly regulated by ERISA at the federal level

14

QUESTION 6 Topic: Minutes:

Alternative Investments 18

LOS:

11-26-b, i

Reference:

Reading 26, Hedge Fund Strategies, Sections 3 & 10.

Guideline Answer: Part A Benefits of an equity market neutral strategy over a long-short strategy include: • More diversification from a more quantitative methodology. • No constraints stemming from the need for an event or expertise in a specific sector. • Lower standard deviation due to the removal of general market movement (no beta risk). • More liquidity since positions are adjusted over shorter time horizons. Part B Risks of an equity market neutral strategy include: • The general market could trend upward with no benefit to the portfolio. • The success of the strategy is sensitive to historical data. • The long position could decrease and the short position could increase in value. Part C The pairs trade would include shorting the overvalued company, DTY, and purchasing an equal amount of the fairly valued company, GHT. Based on historical trends, these two stocks should converge in the future, at which time the profit of the strategy would be based on the amount of convergence. Part D Fund 3 is most suitable. The addition of Fund 3 to the current portfolio would increase both the Sharpe and Sortino ratios as well as lower the max drawdown.

15

QUESTION 7 Topic: Minutes:

Fixed Income Portfolio Management 34 minutes

LOS:

7-18-b; 8-20-d, e, f, i; 8-21-b, c, e

Reference:

Reading 18, Overview of Fixed-Income Portfolio Management, Section 3.1; Reading 20, Yield Curve Strategies, Sections 3.1, 3.2 & 7; Reading 21, FixedIncome Active Management: Credit Strategies, Sections 3.1, 3.2, 4.3 & 5.1.

Guideline Answer: Part A Cash flow matching strategies would have the following key features relating to simplicity. • No yield curve assumptions required. • Rebalancing not required. • Complexity of the strategy is low. • Cash flows of the asset portfolio align with the cash flows of the liability portfolio. Part B i. The existing portfolio has a PVBP (price value of a basis point) of ($100 million x 7)/10,000 = $70,000 To get to a new duration of 9, the PVBP must go to $90,000, meaning an additional $20,000 of PVBP must be purchased. The 7-year bond has a duration of 6.9, so the calculation for the amount of bonds to be purchased is: ($20,000/6.9) x 10,000 = $28,985,507 ii.

The rebate rate is equal to the collateral earnings rate less the security lending rate. 4.00% – 2.00% = 2.00%

Part C i. A strategy to sell convexity would be consistent with NorthWake’s requirements. Purchasing bonds with embedded options (that have negative convexity), such as mortgage-backed securities or callable bonds, benefit in stable yield curve environments, due to the additional premiums earned through the sold options. ii.

Robbins’s recommendation is inappropriate. Barbell structures typically outperform bullet portfolios when the yield curve is flattening. Moving to a bullet structure would not take advantage of the expected change in the yield curve.

Part D i. Yield income = Annual coupon payment/Current bond price 2.25%/98.76 = 2.278%. 16

ii.

Roll down return equals (End of period bond price – Current period bond price)/Current bond price (103.39 – 102.22)/102.22 = 1.145%

Part E i. When the market perceives a particular country’s government bonds to have credit risk, the I-spread or G-spread does not provide a good proxy for the risk-free rate. Accordingly, based solely on the I- or G-spread, the credit risk in the purchased bond will be understated because it is being benchmarked against an instrument that itself carries additional credit risk. ii.

When a bond contains optionality, the timing of future cash flows is uncertain. In this case, the use of OAS is more appropriate than the Z-spread.

Part F i. The CEO’s statement is not accurate. The equity research group uses a bottom-up approach in researching the value of individual companies. A top-down approach considers macro factors and value between sectors before conducting individual company analysis. ii.

Average daily trading volume is likely to be the most effective metric in managing liquidity risk. Analyzing trade volume allows investors to assess activity and interest in a particular bond, which could impact their ability to sell the position in the future. Effective duration and OAS relate to the management of interest rate and credit risk, respectively.

iii.

(Credit spread x Target horizon) – [(Expected spread – Current spread) x Spread duration] (2.00% x 0.75) – [(1.50% – 2.00%) x 6.25) = 1.50% – (-3.125%) = 4.625%

iv.

Expected annual credit loss = Expected probability of default x Expected loss severity 0.50% x 70% = 35%

17

QUESTION 8 Topic: Minutes:

Institutional Investors 30

LOS:

14-33-b, c, e, f, h; 16-37-a, b, c

Reference:

Reading 33, Portfolio Management for Institutional Investors, Sections 4 & 6; Reading 37, Case Study in Portfolio Management: Institutional, Sections 2, 2.5, 3.3 & 3.6.

Guideline Answer: Part A Time Horizon While both retirement plans can be considered long-term, the time horizon of the defined benefit pension plan is shorter than that of the defined contribution plan because of its frozen status. No new participants will be joining the pension plan and it will be wound down over time as existing participants and their beneficiaries die. Liquidity Constraints The defined benefit pension plan has a greater liquidity constraint due to its older workforce and the fact that the benefit will be paid out over the indeterminate lives of the participants and their beneficiaries. The possibility of early retirement and lump-sum payouts amplifies this situation. Further, the pension plan’s benefits are indexed to inflation, increasing the magnitude of benefit payouts going forward. Part B Return Objective The return objective of the pension plan is lower than that of the defined contribution plan, which has no well-defined benefit target. While the return of the defined contribution plan may be oriented more towards growth media in pursuit of higher alpha strategies, the pension plan has ongoing and increasing payout targets to meet. The pension plan cannot focus exclusively on the production of income. It will need to invest in growth-oriented media to preserve the purchasing power of its contractual benefits as well as to amortize its underfunded status over time. Risk Objective The defined contribution plan can undertake greater risk than the pension plan because its workforce is younger, benefits commence at a later age, there is no predetermined benefit target to meet, and the benefits are not indexed to inflation. The asset base of the defined contribution plan, unlike that of the pension, is expected to increase, allowing the plan to invest in riskier investments. Part C Allocation B is the most appropriate asset allocation. It has the largest allocation to JPY assets (currency hedging is not permitted). It has the largest allocation to developed country equity with 18

no allocation to volatile emerging markets. While gold can be considered an inflation hedge, bullion produces no current income. The global real estate position of Allocation B better addresses both inflation and current income concerns. Allocation A has: • Too much non-JPY cash (no currency hedging) • Too little in JPY bonds (no currency hedging) • Too little in JPY equities (no currency hedging) • Too much gold • Too much real estate Allocation C has: • No JPY cash • Too much non-JPY cash (no currency hedging) • Too little in JPY bonds • Too much non-JPY bonds (no currency hedging) • Too much in emerging markets • Too much gold Allocation D has: • Too much JPY cash • Too little in JPY bonds • Too much in non-JPY bonds (no currency hedging) • Too little in JPY equities (no currency hedging) • Too much in emerging markets • Too much gold Part D Any two of the following would receive credit. Descriptions may be obtained from the reading. • Liquidity profiling and time-to-cash tables • Rebalancing and commitment strategies • Stress testing analyses • Derivatives Part E Any two of the following would receive credit. • Private real estate • Private equity • Infrastructure • Hedge funds • Venture capital • Natural resources • Distressed debt

19

Part F Fewer data points would lower the observed return volatility of illiquid asset classes, making these investments appear more attractive. If Donovan applied unsmoothing techniques, the resulting volatility would be increased and thereby provide a more realistic picture of the asset class’s risk-return profile. Part G Asset Class X is the preferred addition to the existing portfolio. Return All three asset classes have expected nominal returns greater than the current portfolio and would therefore increase the overall nominal return of the combined portfolio. Standard Deviation Asset Class X has the smallest standard deviation of the three choices. Sharpe Ratio While the three choices have raw Sharpe measures that are less than that of the existing portfolio, Asset Class X’s Sharpe exceeds that of the existing portfolio when the existing portfolio’s Sharpe is adjusted for correlation with the proposed asset classes. SX > SP x ρX,P = 0.32 > 0.35 x 0.88 = 0.31 SY < SP x ρY,P = 0.31 < 0.35 x 0.90 = 0.32 SZ < SP x ρZ,P = 0.32 < 0.35 x 0.95 = 0.33 Risk Threshold Asset Class X does not violate the nominal loss parameter for any year. The other asset classes do. Nominal lossX = 7.4% – 2 x 15.3% = –23.2% Nominal lossY = 7.8% – 2 x 17.2% = –26.6% Nominal lossZ = 7.9% – 2 x 16.8% = –25.7% Capital Commitment/Implementation Flexibility Both asset classes X and Z require a smaller commitment of capital to an unfamiliar asset class and untested premium capture strategy, but Asset Class X phases in its commitment over three years, whereas Asset Class Z requires the full commitment of capital in a single year.

20

LEVEL III AFTERNOON SESSION—GUIDELINE ANSWERS ITEM SET 1: Ethics—Questions 1 through 6 1.

A LOS: Study Session 1-2-a McDougal’s decision to change the recommendation on a stock based on overhead conversations is not a reasonable course of action for a professional analyst, even though the content of the conversations turned out to be true. The standard violated is Standard V(A) Diligence and Reasonable Basis. Reference:

2.

Reading 2, Standard V(A) Diligence and Reasonable Basis.

A LOS: Study Session 1-2-a Under Standard I(B) Independence and Objectivity, the best course of action for McDougal to avoid any conflict is to decline the offer and to proceed on her own budget as planned to attend the seminar and write objective research. Reference:

3.

Reading 2, Standard I(B) Independence and Objectivity.

C LOS: Study Session 1-2-a This involves Standard IV(B) Additional Compensation Arrangements. McDougal is required to disclose any fee arrangements to her employer. This allows Cratter Finance to consider the outside arrangement when considering the actions and motivations of McDougal. Reference:

4.

Reading 2, Standard IV(B) Additional Compensation Arrangements.

A LOS: Study Session 1-2-a Standard III(B) Fair Dealing requires that the portfolio managers treat all accounts fairly when taking investment action. In this case they are giving trading priority to specific accounts, knowing that the report has been circulated for review and is not yet available to all clients. They are not in violation of Priority of Transactions as they are not trading their own account in conflict with any of Cratter Finance’s client accounts. They are not in violation of Diligence and Reasonable Basis since they are basing their actions on research recommendations by their firm.

21

Reference: 5.

Reading 2, Standard III(B) Fair Dealing.

C LOS: Study Session 1-2-a Standard VI(C) Referral Fees deals with the disclosure of referral fees. It explicitly states that the purpose of disclosure is (1) to evaluate any partiality shown in any recommendations of services and (2) to evaluate the full cost of services. Reference:

6.

Reading 2, Standard VI(C) Referral Fees.

C LOS: Study Session 1-1-a This question deals with the CFA Institute’s professional conduct program (PCP) as stated in the CFA Institute bylaws and rules of proceedings related to professional conduct. The CFA Institute cannot impose a monetary fine. Reference:

Reading 1, Code of Ethics and Standards of Professional Conduct.

22

ITEM SET 2: Ethics—Questions 7 through 12 7.

C LOS: Study Session 2-6-b Both statements comply with CFA Institute Standards. Firms cannot claim to be in compliance with GIPS standards with regard only to certain asset classes, investment strategies, products or composites that fall within the definition of the firm. Scrimm Capital is entitled to define the firm’s real estate business as a distinct business entity. Reference:

8.

Reading 6, Overview of the Global Investment Performance Standards, Section 3.1.

A LOS: Study Session 1-2-a Standard III(D) Performance Presentation requires members and candidates to provide credible performance information to clients and prospective clients and to avoid misstating performance or misleading clients and prospective clients about the investment performance of members or candidates or their firms. This standard encourages full disclosure of investment performance data to clients and prospective clients. Ariusu is in compliance with this standard by providing the real estate fund’s performance since its inception. Reference:

9.

Reading 2, Standard III(D) Performance Presentation.

B LOS: Study Session 1-2-a Ariusu violated Standard III(D) Performance Presentation by failing to clearly identify simulated performance results. Standard III(D) prohibits members and candidates from making any statements that misrepresent the performance achieved by them or their firms and requires members and candidates to make every reasonable effort to ensure that performance information presented to clients is fair, accurate and complete. Use of the simulated results should be accompanied by full disclosure as to the source of the performance data. Ariusu did not disclose to Wheeler that the investment performance he discussed was simulated. Reference:

10.

Reading 2, Standard III(D) Performance Presentation.

C LOS: Study Session 1-2-a Except with the prior consent of their employer, which Ariusu did not obtain, employees may not take employer property, which includes books, records, reports and other 23

confidential information. Taking any employer records, even those the member or candidate prepared, violates Standard IV(A) Loyalty. Reference: 11.

Reading 2, Standard IV(A) Loyalty.

C LOS: Study Session 1-2-a Use of the performance data provided by Ariusu to Wheeler would violate Standard III(D) Performance Presentation by failing to clearly identify simulated performance results. Standard III(D) prohibits members and candidates from making any statements that misrepresent the performance achieved by them or their firms and requires members and candidates to make every reasonable effort to ensure that performance information presented to clients is fair, accurate and complete. Use of the simulated results should be accompanied by full disclosure as to the source of the performance data. Reference:

12.

Reading 2, Standard III(D) Performance Presentation.

C LOS: Study Session 1-2-a Standard IV(B) Additional Compensation Arrangements requires members and candidates to obtain written consent from their employer before accepting compensation or other benefits from third parties for the services rendered to the employer or for any services that might create a conflict of interest with their employer’s interest. Compensation and benefits include direct compensation by the client and any indirect compensation or other benefits received from third parties. Written consent includes any form of communication that can be documented (for example, communication via email). Additionally, potential investors in Scrimm Capital’s real estate fund should be given notice of Wheeler’s fee arrangement with Scrimm Capital for attracting investors to the real estate fund so that the conflict of interest is disclosed prior to potential investors making a commitment to the real estate fund. Reference:

Reading 2, Standard IV(B) Additional Compensation Arrangements; Reading 2, Standard VI(A) Disclosure of Conflict.

24

ITEM SET 3: Capital Market Expectations—Questions 13 through 18 13.

A LOS: Study Session 4-10-i Statement 1 is correct. When short-term rates are negative, the long-run equilibrium short-term rate can be used as the risk-free rate, rather than the observed negative rate. Statement 2 is incorrect. Market relationships (e.g., the yield curve) are likely to be distorted by other concurrent policy measures such as quantitative easing. Reference:

14.

Reading 10, Capital Market Expectations, Part 1: Framework & Macro Considerations, Section 3.5.

B LOS: Study Session 4-10-i i* = rneutral + πe +0.5*(Ye–Ytrend) + 0.5* (πe– πtarget) Target nominal policy rate = 1.2% + 1% + 0.5*(2% – 1%) + 0.5*(1% – 0.5%) = 2.95% Reference:

15.

Reading 10, Capital Market Expectations, Part 1: Framework & Macro Considerations, Section 3.5.

A LOS: Study Session 4-11-a The risk premium for the five-year US government bond is equal to the term premium (five-year vs. one-year US government bond) of 75 bps. Credit premium and liquidity premium are extraneous information and do not apply. Expected return = Risk-free rate + Risk premium = 220 + 75 bps = 295 bps, but the question asks about the risk premium only, not the expected return. Reference:

16.

Reading 11, Capital Market Expectations, Part 2: Forecasting Asset Class Returns, Section 3.2.

B LOS: Study Session 4-11-b Response B is correct and often the case for emerging markets. Interest rate risk is not unique to emerging markets. It is true for investing in fixed income in all markets—developed as well as emerging.

25

Reference: 17.

Reading 11, Capital Market Expectations, Part 2: Forecasting Asset Class Returns, Section 3.

A LOS: Study Session 4-11-g Var(r) = {(1+λ)/(1- λ)}*var(R) Var (r) = {(1+0.80/(1–0.8)}*16 = 144 Standard deviation = 12 Reference:

18.

Reading 11, Capital Market Expectations, Part 2: Forecasting Asset Class Returns, Section 7.4.

C LOS: Study Session 4-11-e Expected return E(Re) = Cap rate + NOI growth rate (nominal) – %ΔCap rate %ΔCap rate = (5.3%–5.5%)/5.5% = 3.64% decrease Expected Return = 5.5% + 1% + 2% – (–3.64%) = 12.14% Reference:

Reading 11, Capital Market Expectations, Part 2: Forecasting Asset Class Returns, Section 5.3.

26

ITEM SET 4: Asset Allocation—Questions 19 through 22 19.

A LOS: Study Sessions 5-12-c, d, g; 5-13-j, k, l; 5-14-a P&C insurers such as Channel are primarily focused on matching assets to the projected, probabilistic cash flows of the risks they are underwriting. Therefore, fixed-income assets are likely the largest component of their asset base. An allocation to higher risk assets, such as equity, is likely much smaller. Thus, Allocation 1 is more appropriate than either Allocation 2 or 3. In addition, the regulation limits non-publicly traded securities such as real estate and private equity, to 10%, which would eliminate Allocation 2 from consideration. Allocation 3 is less appropriate than Allocation 1, given the small allocation to fixed income and relatively large allocations to equity and cash. Reference:

20.

Reading 12, Overview of Asset Allocation, Sections 5.1, 5.2 & 6.2; Reading 13, Principles of Asset Allocation, Section 3; Reading 14, Asset Allocation with Real-World Constraints, Section 2.4.

B LOS: Study Sessions 5-12-c, d; 5-13-k, n; 5-14-a A heuristic approach is least relevant. Heuristics refers to rules that provide a reasonable but not necessarily optimal solution. Some investors may skip the various optimization techniques and simply adopt an asset allocation mix (such as the “120 minus your age” rule or a 60/40 stock/bond mix). Shortfall risk is a liability-relative approach focused on the risk of having insufficient assets to pay obligations when due. Surplus optimization is a liability-relative allocation approach that involves applying mean-variance optimization (MVO) to an efficient frontier based on the volatility of the surplus (known as surplus volatility or surplus risk) as the measure of risk. Reference:

21.

Reading 12, Overview of Asset Allocation, Sections 5.1, 5.2 & 6.2; Reading 13, Principles of Asset Allocation, Section 5; Reading 14, Asset Allocation with Real-World Constraints, Section 2.4.

A LOS: Study Sessions 5-12-e; 5-13-b Global real estate is most likely to be considered for inclusion by Channel’s pension plan for any of the following reasons:

27

•

Asset classes should be mutually exclusive for the purpose of asset allocation. Overlapping asset classes will reduce the effectiveness of asset allocation in controlling risk. Thus, given the plan’s current investment in global equities, emerging markets equities should be excluded from consideration. In addition, we assume that the plan’s current allocation to domestic corporate bonds includes both investment grade and high yields. While the high yield allocation is not explicitly defined, global high-yield corporate bonds are likely to overlap somewhat and should be excluded from consideration.

•

Asset classes should be diversifying. A new asset class should not have extremely high expected correlations (over 0.95) with existing asset classes. Otherwise, the new asset class will be effectively redundant in a portfolio because it will duplicate risk exposures already present. None of the possible asset classes presented in the example have high expected correlations with the current portfolio.

•

The asset classes as a group should make up a preponderance of world investable wealth. Selecting an asset allocation from a group of asset classes satisfying this criterion should increase expected return for a given level of risk (Sharpe ratio).

Based on global real estate’s Sharpe ratio (relatively high) and its correlation to the existing portfolio (reasonably low), while the existing portfolio’s Sharpe ratio is not provided, we can make a reasonable assumption that adding this asset class will likely improve the portfolio’s expected return. Note that global real estate is the only asset class left after the two other asset classes were eliminated based on mutual exclusivity. Other remaining criteria to help specify asset classes include: Assets within an asset class should be relatively homogeneous. Asset classes selected for investment should have the capacity to absorb a meaningful proportion of an investor’s portfolio without seriously affecting the portfolio’s liquidity. Reference: 22.

Reading 12, Overview of Asset Allocation, Section 5.3; Reading 13, Principles of Asset Allocation, Section 2.

A LOS: Study Sessions 5-12-c, d, j; 5-13-d, j, k, l, o; 5-14-c, d The change to the expected cash contributions to the pension fund, if adopted, would materially affect the fund’s asset allocation strategy. The odds of that happening, however, appear low at present according to Mukasa. At this point, this indicates a need for the pension plan to increase sensitivity to liquidity concerns, but is not necessarily cause for immediate revisions to the current allocation. Large institutional investors, including Channel’s pension plan, may benefit from operational efficiencies and other competitive advantages (such as scale, expertise and 28

resources). However, scale may also impose obstacles related to the liquidity conditions and trading costs of the underlying assets. A very large size might make it difficult to deploy capital effectively in certain active equity strategies—for example, to benefit from opportunistic investments in niche markets or from skilled investment managers who have a small set of unique ideas or concentrated bets. Therefore, Statement 2 is not necessarily correct. Statement 3 is mixing portfolio rebalancing (to a strategic asset allocation) and tactical asset allocation (relative to strategic asset allocation). Rebalancing is the discipline of adjusting portfolio weights to more closely align with the strategic asset allocation. Changes in asset prices may cause the portfolio asset mix to deviate from strategic target weights even in the absence of changing investor circumstances, a revised economic outlook, or tactical asset allocation views. In contrast, tactical asset allocation (TAA) involves short-term tilts away from the strategic asset allocation (SAA) in order to exploit perceived opportunities in financial market conditions (e.g., temporary asset mispricing). These short-term bets are expected to increase risk-adjusted return. SAA is developed based on long-term economic forecasts and capital market expectations (long-term expected asset class returns). Reference:

Reading 12, Overview of Asset Allocation, Sections 5 & 8; Reading 13, Principles of Asset Allocation, Sections 2.5, 3 & 6; Reading 14, Asset Allocation with Real-World Constraints, Sections 2.1, 2.2, 2.4, 4 & 5.

29

ITEM SET 5: Asset Allocation—Questions 23 through 26 23.

C LOS: Study Session 5-13-b Portfolio C is preferable for Nick, based on his moderate risk aversion (λ = +6). It is likely to provide the highest risk-adjusted expected return (4.73%) among the three options. In contrast, Portfolio A would be the preferred allocation for Hamida, based on her high risk tolerance (λ = –2), because it has the highest expected utility value (14.00%) among the three portfolios. Reference:

24.

Reading 13, Principles of Asset Allocation, Section 2.1.

C LOS: Study Session 5-13-a, g, k Monte Carlo simulation addresses the limitation of a single-period framework. The other two choices are alternative methods of asset allocation and are not designed to address the criticisms stated. Risk budgeting is an allocation of portfolio risk. Surplus optimization involves MVO applied to surplus returns. Reference:

25.

Reading 13, Principles of Asset Allocation, Section 2.

B LOS: Study Sessions 5-12-j; 5-13-o; 5-14-b Higher transaction costs for an asset class imply wider rebalancing ranges. High transaction costs set a high hurdle for rebalancing benefits to overcome. Taxes, as a cost, are much larger than other transaction costs, which leads to wider rebalancing ranges in taxable portfolios than in tax-advantaged portfolios. Statement 1 is incorrect; a belief in mean reversion encourages tighter ranges. Statement 3 is incorrect; moderate to high risk tolerant investors would have a wider range. Reference:

26.

Reading 12, Overview of Asset Allocation, Section 8; Reading 13, Principles of Asset Allocation, Section 6; Reading 14, Asset Allocation with Real-World Constraints, Section 3.

B LOS: Study Sessions 5-12-c; 5-13-a The calculation is (1.055) (1.035) (1.005) – 1 = 9.74%.

30

AFMR’s assets should be invested with the objective of earning a nominal average annual return of 9.74%. This level reflects a spending rate of 5.5%, an expected inflation rate of 3.5% and a 50 bp cost of earning investment returns. Reference:

Reading 12, Overview of Asset Allocation, Section 5.1; Reading 13, Principles of Asset Allocation, Section 2.1.

31

ITEM SET 6: Derivatives and Currency Management—Questions 27 through 30 27.

B LOS: Study Session 6-15-e, f Fisher is already holding the Dropqik shares. Taylor should recommend Fisher establish a collar by buying an OTM or ATM put and writing an OTM call to finance part (or all) of the put cost in order to minimize the cost of the strategy. Both the put and the call would have the same expiration date. Fisher is fully protected below the put’s strike price, less the net cost of the put. A covered call offers only limited downside protection for Fisher and is limited to the call premium received. To reduce the probability that the shares will not be called away, an OTM call is appropriate. However, the higher the strike price selected to increase upside potential, the smaller the premium received. This is not the best strategy. A short straddle is a bet against volatility, which is not consistent with the narrative presented. Like the covered call, it offers only limited downside protection, and in fact additional shares may have to be purchased as a result of the short put. Having the same strike price as the put, upside gain is limited and there is an increased probability that Fisher’s shares will be called because of the short call. This also is not the best strategy. Reference:

28.

Reading 15, Options Strategies, Section 4.3.

C LOS: Study Session 6-15-a, c A protective put strategy is implemented by holding the shares and buying an ATM put to cover any downside risk. The cost of the ATM put option (i.e., $30 strike) is $2.78. Breakeven price = S0 + p0 Breakeven price = $30.50 + $2.78 = $33.28 Reference:

29.

Reading 15, Options Strategies, Section 3.2.

A LOS: Study Session 6-15-a, f A bull call spread is constructed by buying a lower exercise call and writing a higher exercise call. A bull spread becomes more valuable when the price of the underlying asset rises. The minimum cost implementation would typically use options with strike prices close to the current market price.

32

Buy $25 strike call and sell $35 strike call Net premium for a bull call spread Vo = cL – cH = $10.30 – $1.45 = $8.85 A bear put spread is constructed by buying a higher exercise put and writing a lower exercise put. A bear spread becomes more valuable when the price of the underlying asset declines. The minimum cost implementation would typically use options with strike prices close to the current market price. Buy $35 strike put and sell $25 strike put Net premium for a bull call spread Vo = pH – pL = $5.20 – $1.56 = $3.64 Total cost = $8.85 + $3.64 = $12.49 Reference: 30.

Reading 15, Options Strategies, Section 4.1.

A LOS: Study Session 6-15-a, e, f A long straddle is an option combination in which one buys both puts and calls with the same exercise price and same expiration date on the same underlying asset. Buy a $30 call option at $4.05 Buy a $30 put option at $2.78 Total cost of long straddle = $4.05 + $2.78 = $6.83 Lower breakeven point = X – c0 – p0 = $30 – $4.05 – $2.78 = $23.17 Higher breakeven point = X + c0 + p0 = $30 + $4.05 + $2.78 = $36.83 Reference:

Reading 15, Options Strategies, Section 4.2.

33

ITEM SET 7: Derivatives and Currency Management—Questions 31 through 34 31.

C LOS: Study Session 6-16-f Total Portfolio United States USD 50 million Europe EUR 50 million Total Portfolio United States USD 50 million Europe EUR 50 million Europe EUR 54 million

Hannah Duffi’s Portfolio on January 1, 2019 Stocks Stocks Bonds 35% USD 17.5 million 65% 40%

EUR 20 million

60%

Hannah Duffi’s Portfolio on January 1, 2020 Stocks Bonds 35% USD 17.5 million 65% 37%

EUR 20 million

63%

40%

Rebalancing Targets EUR 21.6 million 60%

Bonds USD 32.5 million EUR 30 million

USD 32.5 million EUR 34 million EUR 32.4 million

To synthetically rebalance EUR 1.6 million into the European equity portfolio with a beta of 1.15 using Euro index futures contracts, Duhamel will need to buy: NSf = {(βT – βS)/βf} × {S / (fs × m)} where: NSf = number of Euro index futures contracts βT = target beta (1.15) βS = beta of synthetic cash (0) from the presumed sale of European bonds βf = futures beta (1.0) S = market value of equity position ($1,600,000) fs = Euro index futures contract price (700) m = multiplier (10) Number of futures to buy = {(1.15 – 0) / 1.0} × {$1,600,000 / (700 × 10)} = 262.857 Duhamel should buy 263 Euro index futures contracts. Reference: 32.

Reading 16, Swaps, Forwards and Future Strategies, Section 4.3.

C LOS: Study Session 6-17-a, b, c 34

For a US resident: Foreign currency return = RFC = {(54 – 50)/50} * 100 = 8% Percentage change of foreign currency against domestic currency is RFX = {(1.16 – 1.1)/1.1} * 100 = 5.45% Domestic currency return = (1+ RFC) (1+ RFX) – 1 = (1.08) (1.0545) – 1 = 13.89% Reference: 33.

Reading 17, Currency Management – An Introduction, Section 3.1.

B LOS: Study Sessions 6-15-a, c; 6-16-a; 6-17-a A protective put strategy is implemented by holding the shares and buying an ATM put to cover downside risk. The protective put does not generate any fixed return on the portfolio. Hence, Statement 2 is incorrect. A total return swap is a derivative contract in which one party agrees to pay (receive) all cash flows based on an underlying to receive (pay) fixed/floating interest rate from the other party. Statement 1 is correct. An interest rate swap is an OTC contract between two parties to exchange cash flows on specified payment dates based on floating vs. fixed interest rates. Statement 3 is also correct. Reference:

34.

Reading 15, Options Strategies, Section 3.2; Reading 16, Swaps, Forwards and Future Strategies, Sections 2.1, 2.3 & 4.1.

C LOS: Study Sessions 6-15-a, c; 6-16-a; 6-17-a Portfolio decline is –2% = $3.6 million * –2% = – $72,000 Swap Settlement Pike would receive the negative returns on the portfolio in addition to the fixed interest rate of 3.75% on a notional principal of $1.8 million. Negative return on 50% of the portfolio = 0.5 * $3.6 million * 2% = $36,000. (Pike will receive the negative performance on the portfolio.) Fixed return of 3.75% on 50% of the portfolio = 0.5 * $3.6 million * 3.75% = $67,500. (Pike will receive the fixed interest payment on the swap.)

35

Net payment on the swap that Pike will receive = $36,000 + $67,500 = $103,500. Reference:

Reading 16, Swaps, Forwards and Future Strategies, Sections 2.1 & 2.3.

36

ITEM SET 8: Fixed-Income Portfolio Management—Questions 35 through 38 35.

A LOS: Study Session 8-20-a The formula of a butterfly spread is: Butterfly spread = – (Short-term yield) + (2 x Medium-term yield) – Long-term yield. Given the provided rates: Butterfly spread = – (5.50%) + (2 x 5.75%) – 7.00% = – 1.00%. Reference:

36.

Reading 20, Yield Curve Strategies, Section 2.1.

C LOS: Study Session 8-20-a The question relates to the different measures of duration. Effective duration is most likely to be included, given that LWM intends to invest in securities with embedded optionality. The calculation of effective duration is flexible, allowing its use in cases where the bond has an embedded option. Reference:

37.

Reading 20, Yield Curve Strategies, Section 2.2.

B LOS: Study Session 8-20-i The total return for fixed income securities includes both yield income and price appreciation. The expected price appreciation for both securities is 1.00%, but as the 30year yield income is 1.50% more than the 2-year, it will have a higher expected total return. Total return = Yield income + Price appreciation Yield income = Coupon yield/ Price Price appreciation= (Future price – Current price)/Current price 2-year: Yield income = 4.75/105 = 4.5% 2-year: Price appreciation = (106.05 – 105)/105 = 1% Total return = 4.5% + 1% = 5.5% 30-year: Yield income = 6.00/100 = 6% 30-year: Price appreciation = (101 – 100)/100 = 1% Total return = 6% + 1% = 7% Reference:

38.

Reading 20, Yield Curve Strategies, Section 7.

A LOS: Study Session 8-20-h 37

Portfolio A is most likely to benefit from a flattening yield curve, as it is constructed using a barbell approach, with higher allocations at the short and long ends of the yield curve. Reference:

Reading 20, Yield Curve Strategies, Section 6.6.

38

ITEM SET 9: Fixed-Income Portfolio Management—Questions 39 through 42 39.

B LOS: Study Session 7-19-c, d A duration matching strategy is more likely than a cash flow matching strategy to be negatively impacted by non-parallel shifts in the yield curve. With cash flow matching, assets are selected to mirror the timing of payments in the liability portfolio. In a duration matching strategy, the potential for greater dispersion of the maturities may lead to unexpected risk exposures as interest rates change over time. Reference:

40.

Reading 19, Liability-Driven and Index-Based Strategies, Sections 4.1 & 4.2.

B LOS: Study Session 7-19-c, d With derivative overlay strategies, in order to calculate the number of contracts needed, the futures BPV must be adjusted to reflect the conversion factor: Futures BPV = Note BPV / Conversion Factor 47.22/0.88 = 53.66 Number of contracts = (Asset BPV – Liability BPV) / Futures BPV (96,000 – 44,000)/53.66 = 969 Reference:

41.

Reading 19, Liability-Driven and Index-Based Strategies, Section 4.3.

B LOS: Study Session 7-19-g Mutual funds offer economies of scale and daily liquidity, but do not have fixed maturity dates (Response A) nor the ability to be redeemed throughout the trading day (Response C). Reference:

42.

Reading 19, Liability-Driven and Index-Based Strategies, Section 8.

A LOS: Study Session 7-19-g There are alternative methods for establishing passive bond market exposure. A total return receiver swap would entitle the investor to receive the cash flows and compensation for the appreciation in the index in exchange for paying a floating rate plus a spread. This would give the investor exposure to the index, which would help to reduce tracking risk. Reference:

Reading 19, Liability-Driven and Index-Based Strategies, Section 8. 39

ITEM SET 10: Equity Portfolio Management—Questions 43 through 48 43.

B LOS: Study Session 9-22-e The rationale provided by Gelormini in Statement 1 is incorrect because active managers normally must have benchmarks with sufficient liquidity of underlying securities. Reference:

44.

Reading 22, Overview of Equity Portfolio Management, Section 6.3.

C LOS: Study Session 9-23-d Optimization typically involves maximizing a desirable element or minimizing an undesirable characteristic, subject to one or more constraints. In this case, Gelormini has stated that he would build portfolios that would minimize tracking error, subject to a constraint on portfolio volatility. Reference:

45.

Reading 23, Passive Equity Investing, Section 4.3.

B LOS: Study Session 9-23-e Intraday trading can create positive or negative excess returns because the price levels used to report index returns are struck at the close of the trading day. Any securities that are bought or sold at a different price than that of the index will contribute to tracking error. Because Blumenstock is purchasing and selling stocks immediately after the market open, the best option for reducing tracking error is to sell at the market-on-close price (or as near to market closing time as possible). Equitizing the portfolio using futures would have little impact because not much cash is held in the portfolio (i.e., cash drag is not a factor). Stratified sampling would not have much impact either, because the portfolio is large (over $100 million) and covers a relatively narrow and very liquid index. Reference:

46.

Reading 23, Passive Equity Investing, Section 5.2.

C LOS: Study Session 9-23-b Given the information provided, the potential factors we can assess are size (market cap), value (P/E), yield (dividend yield), growth (EPS growth), momentum (price return) and quality (debt-to-equity ratio). A small relative market cap, low relative P/E and low relative debt-to-equity ratio suggest that Fund C focuses on the size, value and quality factors. 40

A high relative P/E and EPS growth suggests that Fund A focuses on the growth factor. Fund A does not appear to have exposure to the size, yield, momentum or quality factors. A high relative P/E and EPS growth, small relative market cap and high trailing twelvemonth price return suggest that Fund B focuses on the size, growth and momentum factors. Reference: 47.

Reading 23, Passive Equity Investing, Section 2.4.

C LOS: Study Session 9-22-d When an investor loans shares, the transaction is an assignment of title with a repurchase option. As such, voting rights are transferred to the borrower. Reference:

48.

Reading 22, Overview of Equity Portfolio Management, Section 5.3.

C LOS: Study Session 10-24-e Activists typically aim to achieve their goals with smaller stakes in their target companies, usually with a less than 10% stake in the target’s equity. Reference:

Reading 24, Active Equity Investing: Strategies, Section 3.4.

41

ITEM SET 11: Alternative Investments for Portfolio Management—Questions 49 through 52 49.

A LOS: Study Session 11-27-c The risk-based approach to asset allocation does not have the limitation of combining investments with varying risk characteristics into a single portfolio. This is a limitation of the traditional approach. Reference:

50.

Reading 27, Asset Allocation to Alternative Investments, Section 4.3.

A LOS: Study Session 11-27-e, g Liquidity is a priority for the organization. Funds that purchase distressed companies typically have long timelines and therefore lower liquidity than the other two fund types listed. Reference:

51.

Reading 27, Asset Allocation to Alternative Investments, Section 5.4.

C LOS: Study Session 11-27-b, d The economic factors indicate economic growth (high GDP growth, low unemployment, high consumer spending). Real estate performs best when both growth and inflation are high. Response B is incorrect. Gold performs well in high inflation environments, but historically has not performed as well as real estate or private equity when the economy is growing. Response A is incorrect. Private equity does not perform as well as the other options in a high inflation environment. Reference:

52.

Reading 27, Asset Allocation to Alternative Investments, Section 4.1.

B LOS: Study Session 11-26-d Private real estate funds typically report details on all properties owned, making it more transparent than either of the hedge funds, which do not typically share all holdings or strategies. Reference:

Reading 27, Asset Allocation to Alternative Investments, Section 6.4.

42

ITEM SET 12: Trading, Performance Evaluation, and Manager Selection—Questions 53 through 56 53.

C LOS: Study Session 15-34-b Depending on the expected rate of alpha decay, portfolio managers are better off trading the order faster (by selecting a higher trade urgency). Higher rates of alpha decay, or alpha loss, require faster (or more accelerated) trading, to realize alpha before it is traded on by other market participants. All else being equal, greater liquidity reduces market impact. Reference:

54.

Reading 34, Trading, Performance Evaluation, and Manager Selection, Section 3.1.

B LOS: Study Session 15-34-g Opportunity cost = (S – Σ Sj) * (pn – pd) = {10,000 – (2,000 + 5,000 + 1,000)}*($40.90 – $40) = $1,800 = 1,800*104/ (10,000*40) bps = 45 bps Reference:

55.

Reading 34, Trading, Performance Evaluation, and Manager Selection, Section 5.1.

A LOS: Study Session 15-34-g Implementation shortfall (IS) = Execution cost + Opportunity cost + Fees Execution cost Opportunity cost Fees IS

= (2,000* 40.20 + 5,000*40.35 + 1,000*40.45) – (8,000 * 40) = $2,600 = {10,000 – (2,000 + 5,000 + 1,000)}*($40.90 – $40) = $1,800 = 8,000*0.03 = $240

= $2,600 + $1,800 + $240 = $4,640

Reference:

Reading 34, Trading, Performance Evaluation, and Manager Selection, Section 5.1.

43

56.

B LOS: Study Session 15-34-h Opportunity cost can be reduced by knowing the order size and share quantity that is most likely to be executed in the market within a specified price range. Knowing beforehand which broker and/or algorithm is best suited to reduce the time between receipt of the order and market execution could help reduce the delay cost. Selecting the proper trading urgency can reduce the trading cost. Reference:

Reading 34, Trading, Performance Evaluation, and Manager Selection, Section 5.1.

44

ITEM SET 13: Trading, Performance Evaluation, and Manager Selection —Questions 57 through 60 57.

C LOS: Study Sessions 15-36-d; 15-35-n Capture ratio is the upside capture divided by the downside capture. It measures the asymmetry of return. A capture ratio greater than one indicates positive asymmetry, or a convex return profile, whereas a capture ratio less than one indicates a negative asymmetry, or concave return profile. Capture ratio = Upside capture/ Downside capture Capture ratio calculations for each firm are shown below. Oakfarm Investments = 75/75 = 1 Sailboat Asset Management = 90/125 = 0.72 TripleCircle Investors = 90/75 = 1.2 Reference:

58.

Reading 36, Investment Manager Selection, Section 3.2; Reading 35, Portfolio Performance Evaluation, 5.2.

B LOS: Study Session 15-36-f SMAs allow the investor to express individual constraints or preferences within the portfolio. Pooled vehicles do not offer such customization. Statement 2 is true. Investor-specific customization requirements can create tracking risk relative to the benchmark, which can confuse performance attribution because performance will then reflect investor constraints rather than managerial decisions. Reference:

59.

Reading 36, Investment Manager Selection, Section 4.4.

A LOS: Study Session 15-36-i Investment management fee = Base fee + Performance fee Sailboat Asset Management charges a base fee of 55 bps and a performance fee of 10% on excess return. (Excess returns = Strategy return – Benchmark return) Year 1 gross excess return = 8% – 6%= 2% Sailboat performance fee = 10% of 2% = 0.2% Sailboat base fee = 55 bps = 0.55% Sailboat total investment management fee = 0.55% + 0.2% =0.75% = 75 bps.

45

Reference: 60.

Reading 36, Investment Manager Selection, Section 4.4.

B LOS: Study Session 15-36-i Investment fee = Base fee + Performance fee • • •

Oakmark Investments = 65 bps (Base fee only. Performance fee is not applied because the portfolio return is negative.) Sailboat Asset Management = 55 bps (Base fee only. Performance fee is not applied because the portfolio return is negative.) TripleCircle Investors = 0.7% + 0.01*(–7% – 0.7%) = 0.7% – 0.077% = 0.623 % = 62.3 bps

Reference:

Reading 36, Investment Manager Selection, Section 4.4.

46