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2019 Level III Mock Exam AM The morning session of the 2019 Level III Chartered Financial Analyst Mock ®

Examination has 60 questions. To best simulate the exam day experience, candidates are advised to allocate an average of 18 minutes per item set (vignette and 6 multiple choice questions) for a total of 180 minutes (3 hours) for this session of the exam. Questions

Topic

Minutes

1–6

Ethical and Professional Standards

18

7–12

Private Wealth

18

13–18

Economics

18

19–24

Asset Allocation

18

25–30

Fixed Income

18

31–36

Fixed Income

18

37–42

Equity

18

43–48

Equity

18

49–54

Derivatives

18

55–60

Performance Evaluation Total:

18 180

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2019 Level III Mock Exam AM

2019 LEVEL III MOCK EXAM AM Foster Asset Management Case Scenario Jerome Foster, CFA, is the CEO of Foster Asset Management and the chair of the firm’s Investment Committee. Twenty years ago, he started the firm with 2 employees, and it has grown to 25 employees, of whom 5 are investment managers. Foster’s clients range from individuals with very conservative risk profiles allowing only money market instruments to large institutional investors with higher risk tolerance profiles. Foster is looking to further expand his business through acquisitions of privately owned asset management companies. He informs Mercy Ogalo, CFA, the head of compliance and risk, of his plans to be out of the office for extended periods of time while conducting initial interviews and due diligence visits. In a surprising turn of events, Constantile Life, a publicly listed insurance firm that wishes to enter the asset management industry, approaches Foster. It is interested in buying Foster Asset Management to complement its product line and to significantly increase its profitability. Constantile presents an extensive list of documents the firm wants to examine as part of its due diligence process. Foster updates Ogalo about the potential buyer and asks her to help gather the due diligence documents, including the contact information of all the current board members and other shareholders, as well as copies of all the firm’s policies and procedures. Ogalo mentions to Foster that she has yet to complete her statutory annual review of the policies and procedures. Ogalo walks into Foster’s office to update him on the gathering of due diligence documents requested by Constantile and finds Foster on the phone. He motions for her to take a seat and hands her a note indicating he is talking with the potential buyer. She overhears Foster tell the buyer, “We haven’t lost a client in over five years. We’ve been able to outperform the market on a consistent basis, so our clients love us!” Ogalo knows the comment about the firm outperforming the market is likely to be true, but the firm lost two clients just in the last month owing to increasing management fees. As a condition of purchasing his firm, Constantile requires Foster to remain the CEO for three years. After the three years, he would be eligible for a significant retirement package if he met certain key performance indicators, including above-­average investment performance. They agreed the performance measurement would be based on the recommended procedures for compliance with Standard III(D): Performance Presentation—specifically, Procedure 1 The firm will create and track weighted composites of similar portfolios based on their risk profiles. Procedure 2 When performance includes simulated results due to the introduction of new products, it will be clearly stated in the performance presentation. Procedure 3 Terminated accounts will be removed from the performance history after 10 years. In the first Foster Asset Management board meeting after the sale, Calvin Lim, CFA, the firm’s chief investment officer (CIO), stated, “My investment team recently added real estate investment trust (REITs) to our model portfolio to see what the impact would be on investment returns for our clients if we added them to their portfolios. But this asset class has a much higher risk profile than our normal allowable assets.” Foster added, “After we analyzed the impact of adding this new asset class to our model portfolio, we made the decision to add the real estate exposure to all of our client accounts. We found it is having a positive impact on portfolio returns and still complies with the firm’s performance measurement policy.”

2019 Level III Mock Exam AM

After her annual review of the firm’s policies and procedures, Ogalo decided to make some changes to strengthen monitoring procedures for the supervisors. Subsequently, Ogalo presented the proposed changes to the board for approval. She mentioned that the suggested changes specifically enhance the requirements for the firm’s supervisors. The c hanges a re a s r ecommended b y t he C FA I nstitute S tandards o f P rofessional Conduct. If approved by the board, supervisors would be required to implement the following policy changes once they detect a violation of the firm’s policies: Policy 1 Give the employee a warning to cease the activity. Policy 2 Place limits on the employee’s activities. Policy 3 Report the misconduct up the chain of command. 1 When learning of Foster’s plans to be out of the office, what CFA Institute Standard of Professional Conduct should Ogalo be least concerned about Foster violating? A Disclosure of Conflicts B Preservation of Confidentiality C Diligence and Reasonable Basis 2 Given Constantile’s due diligence requests, what should Ogalo’s priority be to most likely avoid violating any CFA Institute Standards of Professional Conduct? A Update all of the firm’s policies and procedures. B Get permission from the board and shareholders. C Add the potential buyer to the firm’s restricted list. 3 After overhearing Foster’s phone conversation, what should Ogalo most likely do regarding Foster’s potential violation of any CFA Institute Standards of Professional Conduct? A Find out the context in which Foster responded, “No clients had been lost.” B Anonymously report Foster to the CFA Institute Professional Conduct staff. C Independently confirm that the firm has consistently outperformed the market. 4 Which of the performance reporting procedures agreed upon by Foster and Constantile least likely satisfies the recommended procedures to comply with Standard III(D): Performance Presentation? A Procedure 1 B Procedure 2 C Procedure 3 5 During Lim’s presentation to the board of directors, who mostly likely violated Standard III: Duties to Clients? A Lim B Foster C Lim and Foster 6 Which of Ogalo’s proposed policy changes would most likely prevent supervisors from being in violation of Standard IV(C): Responsibilities of Supervisors? A Policy 1 B Policy 2 C Policy 3

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2019 Level III Mock Exam AM

Edvard Richards Case Scenario Edvard Richards is president and sole owner of More Than Lumber Corporation (MTL), a privately held building materials company. Founded by the Richards family, the company has been run by Edvard Richards for more than 40 years. Richards also owns investment real estate in the form of a warehouse unrelated to MTL, as well as 70,000 common shares of publicly traded Cintas (CTAS) that he inherited. He wants these two items to be considered concentrated positions. Now 68, Richards is seeking advice on how to transition to retirement. He provides information about his holdings, shown in Exhibit 1, to two competing financial advisers, Todd Adams and Linda Boshe. Exhibit 1  Richards’ Values Estimated Value ($ thousands)

Cost Basis ($ thousands)

2,000

2,000

11,000

2,000

Common stock (70,000 shares CTAS)

4,000

1,000

Warehouse

3,000

4,300

Municipal bond portfolio

3,000

3,150

Global all-­cap equity fund

3,400

1,650

300

300

Asset Primary residence (no mortgage) MTL Corp

Cash equivalents Tax Rates Capital gains tax rate = 20% Income tax rate = 40%

Richards asks each adviser to apply a goal-­based planning framework he has read about that uses three risk buckets: personal, market, and aspirational. As a first step, he estimates his own after-­tax primary capital assuming that all assets are sold today and converted into cash. He asks the two advisers to assess his after-­tax primary capital under the same assumptions (all three estimates are provided in Exhibit 2). Exhibit 2  Estimates of After-­Tax Primary Capital ($ thousands) Richards

11,780

Adams

8,380

Boshe

11,640

Richards wants to monetize and eliminate the concentration risk of his CTAS holding without paying taxes on capital gains and then invest the proceeds in a balanced portfolio. He notes the following comments in his discussions with the two advisers:

2019 Level III Mock Exam AM

Richards:

“My broker says he can arrange a cashless collar against CTAS or a short sale against the box. I understand that both methods will avoid incurring an immediate capital gain and both will expose me to the same level of market risk. I can borrow against the position in both cases and offset the cost of borrowing with the CTAS dividends.”

Adams:

“We could help you complete a short against the box transaction. This strategy will provide a high loan-­to-­value (LTV) ratio and avoid counterparty risk. A total return equity swap has these same advantages. You can thus realize the economic gain on CTAS while deferring capital gains taxes.”

Boshe:

“We suggest either a forward conversion with options or an equity forward sale. Either will achieve high LTV ratio monetization without incurring immediate capital gains taxes, and both methods avoid counterparty risk.”

Adams has strong connections to the real estate market and informs Richards that the market value estimate of $3 million for the warehouse is much too low. He advises Richards to consider reducing his real estate risk directly by using the immediate cash inflows net of tax liabilities and costs to increase his stock and bond portfolios. Adams is confident he can arrange any of the following real estate offers: 1 Sell the warehouse for $4.8 million to an outside investor. 2 Enter into a recourse mortgage loan, with the warehouse valued at $5.8 million by the lender and an LTV ratio of 80%. 3 Enter into a sale-­and-­leaseback, with the warehouse valued at $4.9 million and the first year’s rental payment of $150,000 payable at the start of the lease. Boshe has strong connections to the investment banking community. Richards has authorized her to ascertain the level of interest for the sale of MTL. Boshe is confident she can arrange any of the following strategies: MTL Strategy 1:

A private equity firm can arrange to leverage MTL, paying Richards 40% of his estimated value of MTL (as shown in Exhibit 1) in cash up front and rolling the remaining 60% of the value into new shares that pay no dividends. Richards will stay on as president for five years, during which time he will help transition leadership to a new team. After five years, he will sell or monetize the remaining ownership.

MTL Strategy 2:

A small but rapidly growing publicly traded building materials company is willing to acquire 100% ownership and pay Richards $7 million in cash up front and employee stock options that he can exercise after two years and that expire in five years. The public company is too small to support publicly traded stock options. Should the public company’s stock rise, Richards can exercise his employee stock options, which will be taxed as ordinary income. To protect the value of his appreciated stock while participating in further upside potential, he can purchase long-­term protective put options on an industry exchange-­traded fund (ETF) that closely tracks the building materials industry. If the public company’s stock subsequently drops along with the industry, he can sell the puts.

MTL Strategy 3:

Create an employee stock ownership plan (ESOP) that would borrow sufficient funds to purchase 40% of Richards’s ownership. Richards would maintain upside potential in his retained shares, which could be sold at some point in the future.

7 Using the planning framework that Richards suggests, which person’s estimate of the after-­tax primary capital is most accurate?

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2019 Level III Mock Exam AM

A Boshe B Richards C Adams 8 Richards’ understanding about monetizing CTAS is most accurate with respect to: A using the CTAS dividends to offset borrowing costs. B avoiding immediate capital gains under both strategies. C the risk exposure of both strategies. 9 Which of Adams’ and Boshe’s comments about counterparty risk is most accurate? The comment made by: A Boshe about her proposed strategies. B Adams about the total return equity swap. C Adams about the short sale against the box. 10 Using the information in Exhibit 1 and Adams’ real estate proposals, which offer will provide the largest immediate addition of funds to Richards’ stock and bond portfolios? A Offer 3 B Offer 1 C Offer 2 11 Which of Boshe’s MTL strategies least likely describes a staged exit strategy? A MTL Strategy 3 B MTL Strategy 1 C MTL Strategy 2 12 Which of the following statements about Boshe’s proposed exit strategies from MTL is most accurate? A MTL Strategy 2 exhibits cross hedging. B MTL Strategy 2 provides for the possibility of yield enhancement. C MTL Strategy 3 exhibits a mismatch in character.

Ptolemy Foundation Case Scenario The Ptolemy Foundation was established to provide financial assistance for education in the field of astronomy. Tom Fiske, the foundation’s chief investment officer, and his staff of three analysts use a top-­down process that begins with an economic forecast, assignment of asset class weights, and selection of appropriate index funds. The team meets once a week to discuss a variety of topics ranging from economic modeling, economic outlook, portfolio performance, and investment opportunities, including those in emerging markets. At the start of the meeting, Fiske asks the analysts, Len Tuoc, Kim Spenser, and Pier Poulsen, to describe and justify their different approaches to economic forecasting. They reply as follows.

2019 Level III Mock Exam AM

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Tuoc:

I prefer econometric modeling. Robust models built with detailed regression analysis can help predict recessions well because the established relationships among the variables seldom change.

Spenser:

I like the economic indicators approach. For example, the composite of leading economic indicators is based on an analysis of its forecasting usefulness in past cycles. They are intuitive, simple to construct, require only a limited number of variables, and third-­party versions are also available.

Poulsen:

The checklist approach is my choice. This straightforward approach considers the widest range of data. Using a simple statistical method, such as time-­series analysis, an analyst can quickly assess which measures are extreme. This approach relies less on subjectivity and is less time-­consuming.

The team then discusses what the long-­term growth path for US GDP should be in the aftermath of exogenous shocks because of the financial crisis that began in 2008. They examine several reports from outside sources and develop a forecast for aggregate trend growth using the simple labor-­based approach and appropriate data chosen from the items in Exhibit 1. Exhibit 1  10-­Year Forecast of US Macroeconomic Data Growth in real consumer spending

3.1%

Growth in potential labor force

1.9%

Growth in labor force participation

–0.3%

Growth in labor productivity

1.4%

Yield on 10-­year Treasury bonds

2.7%

Growth in total factor productivity Change in trade deficit

0.5% –0.5%

Upon a review of the portfolio and his discussion with the investment team, Fiske determines a need to increase US large-­cap equities. He prefers to forecast the average annual return for US large-­cap equities over the next 10 years using the Grinold–Kroner model and the data in Exhibit 2. Exhibit 2  Current and Expected Market Statistics, US Large-­Cap Equities Expected dividend yield

2.1%

Expected repurchase yield

1.0%

Expected real earnings growth

2.6%

Expected inflation rate

2.3%

Current P/E

15.6

Expected P/E 10 years hence

15.0

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2019 Level III Mock Exam AM

The analysts think that adding to US Treasuries would fit portfolio objectives, but they are concerned that the US Federal Reserve Board is likely to raise the fed funds rate soon. They assemble the data in Exhibit 3 in order to use the Taylor rule (giving equal weights to inflation and output gaps) to help predict the Fed’s next move with respect to interest rates. Exhibit 3  Current Data and Forecasts from the Fed Statistic

Status

Fed funds rate

Current

GDP growth rate

Value (%) 3

Neutral

2.5

Trend

4.5

Forecast Inflation

3

Target

2.5

Forecast

3.2

To assess the attractiveness of emerging market equities, Fiske suggests that they use the data in Exhibit 4 and determine the expected return of small-­cap emerging market equities using the Singer–Terhaar approach. Exhibit 4  Data for Analyzing Emerging Markets

Asset Class Emerging small-­cap equity Global investable market (GIM)

Standard Deviation

Correlation with GIM

Degree of Integration with GIM

23%

0.85

65%

7.00%

Additional information Risk-­free rate: 2.5% Illiquidity premium: 60 bps Sharpe ratio for GIM and emerging small-­cap equity: 0.31

Finally, after examining data pertaining to the European equity markets, the investment team believes that there are attractive investment opportunities in selected countries. Specifically, they compare the recent economic data with long-­term average trends in three different countries, shown in Exhibit 5. Exhibit 5  Relationship of Current Economic Data to Historical Trends: Selected European Countries Ireland

Spain

Production

Above trend, declining

Well above trend

Below trend, rising

Inflation

Above trend, declining

Average, rising

Below trend, stable

Above trend

Average, rising

Below trend

Capacity utilization

Hungary

2019 Level III Mock Exam AM

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Exhibit 5  (Continued)

Confidence Fiscal/monetary policies

Ireland

Spain

Hungary

Average, declining

Well above trend

Below trend, rising

Cautionary

Restrictive

Stimulatory

13 Regarding the approaches to economic forecasting, the statement by which analyst is most accurate? A Poulsen B Tuoc C Spenser 14 Using the data in Exhibit 1 and the labor-­based method chosen by the team, the most likely estimate for the 10-­year annual GDP growth is: A 3.0%. B 3.5%. C 3.6%. 15 Using the data in Exhibit 2 and Fiske’s preferred approach, the estimated expected annual return for US large-­cap equities over the next 10 years is closest to: A 7.9%. B 7.6%. C 7.4%. 16 Using the data in Exhibit 3 and the investment team’s approach to predict the Fed’s next move, the new fed funds rate will most likely be: A 2.9%. B 2.6%. C 2.1%. 17 Using the data in Exhibit 4 and Fiske’s suggested approach, the forecast of the expected return for small-­cap emerging market equities is closest to: A 8.9%. B 9.9%. C 9.5%. 18 Among the three countries examined by the investment team, which is in the most attractive phase of the business cycle for equity returns? A Hungary B Ireland C Spain

Remington Wealth Partners Case Scenario Preston Remington is the managing partner of Remington Wealth Partners. The firm manages high-­net-­worth private client investment portfolios using various asset allocation strategies. Analyst Hannah Montgomery assists Remington. Remington and Montgomery’s first meeting of the day is with a new client, Spencer Shipman, who recently won $900,000 in the lottery. Shipman wants to fund a comfortable retirement. Earning a return on his investment portfolio that outpaces inflation

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2019 Level III Mock Exam AM

over the long term is critical to him. He plans to withdraw $54,000 from the lottery winnings investment portfolio in one year to help fund the purchase of a vacation home and states that it is important that he be able to withdraw the $54,000 without reducing the initial $900,000 principal. Montgomery suggests they use a risk-­adjusted expected return approach in selecting one of the portfolios provided in Exhibit 1. Exhibit 1  Investment Portfolio One-­Year Projections Return

Standard Deviation

Portfolio 1

10.50%

20.0%

Portfolio 2

9.00

13.0

Portfolio 3

7.75

10.0

All data are tax adjusted.

Remington and Montgomery discuss the importance of strategic asset allocation with Shipman. Remington states that the firm’s practice is to establish targeted asset allocations and a corridor around the target. Movements of the asset allocations outside the corridor trigger a rebalancing of the portfolio. Remington explains that for a given asset class, the higher the transaction costs and the higher the correlation with the rest of the portfolio, the wider the rebalancing corridor. Montgomery adds that the higher the volatility of the rest of the portfolio, excluding the asset class being considered, the wider the corridor. Remington and Montgomery next meet with client Katherine Winfield. The firm had established Winfield’s current asset allocation on the basis of reverse optimization using the investable global market portfolio weights with further adjustments to reflect Winfield’s views on expected returns. Remington and Montgomery discuss with Winfield some alternative asset allocation models that she may wish to consider, including resampled mean–variance optimization (resampling). Remington explains that resampling combines mean–variance optimization (MVO) with Monte Carlo simulation, leading to more diversified asset allocations. Montgomery comments that resampling, like other asset allocation models, is subject to criticisms, including that risker asset allocations tend to be under-­diversified and the asset allocations inherit the estimation errors in the original inputs. Montgomery inquires whether asset allocation models based on heuristics or other techniques might be of interest to Winfield and makes the following comments: 1 The 60/40 stock/bond heuristic optimizes the growth benefits of equity and the risk reduction benefits of bonds. 2 The Norway model is a variation of the endowment model that actively invests in publicly traded securities while giving consideration to environmental, social, and governance issues. 3 The 1/N heuristic allocates assets equally across asset classes with regular rebalancing without regard to return, volatility, or correlation. Finally, Remington and Montgomery discuss Isabelle Sebastian. During a recent conversation, Sebastian, a long-­term client with a $2,900,000 investment portfolio, reminded Remington that she will soon turn age 65 and wants to update her investment goals as follows:

2019 Level III Mock Exam AM

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Goal 1:

Over the next 20 years, she needs to maintain her living expenditures, which are currently $120,000 per year (90% probability of success). Inflation is expected to average 2.5% annually over the time horizon, and withdrawals take place at the beginning of the year, starting immediately.

Goal 2:

In 10 years, she wants to donate $1,500,000 in nominal terms to a charitable foundation (85% probability of success).

Exhibit 2 provides the details of the two sub-­portfolios, including Sebastian’s allocation to the sub-­portfolios and the probabilities that they will exceed the expected minimum return. Exhibit 2  Investment Sub-­Portfolios & Minimum Expected Return for Success Rate Sub-­Portfolio

BY

CZ

Expected return (%)

5.70

7.10

Expected volatility (%)

5.10

7.40

Current portfolio allocations (%) Probability (%)

40

60

Minimum Expected Return (%)

Time horizon: 10 years  99

2.90

2.50

 90

3.40

2.80

 85

3.60

3.00

 95

5.10

5.40

 90

5.20

5.70

 85

5.60

5.90

Time horizon: 20 years

Assume 0% correlation between the time horizon portfolios.

19 Which of the portfolios provided in Exhibit 1 has the highest probability of enabling Shipman to meet his goal for the vacation home? A Portfolio 1 B Portfolio 2 C Portfolio 3 20 When discussing asset allocation corridors with Shipman, which of Remington’s and Montgomery’s statements is the least accurate? The one regarding: A volatility. B correlation. C transaction costs. 21 The model on which Winfield’s current asset allocation is based is best characterized as: A mean–variance optimization. B Black–Litterman. C reverse optimization.

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2019 Level III Mock Exam AM

22 In Remington and Montgomery’s discussion with Winfield on resampling, Montgomery’s comment is most likely: A correct. B incorrect regarding estimation errors. C incorrect regarding diversification of asset allocations. 23 In describing heuristics and other modeling techniques, Montgomery is most accurate with respect to: A Comment 1. B Comment 2. C Comment 3. 24 Using Exhibit 2, which of the sub-­portfolio allocations is most likely to meet both of Sebastian’s goals? A The current sub-­portfolio allocation B A 43% allocation to sub-­portfolio BY and a 57% allocation to sub-­portfolio CZ C A 37% allocation to sub-­portfolio BY and a 63% allocation to sub-­portfolio CZ

Betty Derran Case Scenario Betty Derran has a $30.0  million investment portfolio that is invested entirely in growth-­oriented equity securities. Prior to the recent and unexpected death of Derran’s husband, the portfolio’s investment policy prioritized long-­term wealth generation. Derran’s financial adviser is Tim Edge, of HSCC Advisers, a fee-­only financial advisory firm. Because of the death of her husband, Derran has asked Edge to contemplate a revision to the investment policy. Going forward, Derran would like for the investment portfolio returns to fund her modest living expenses and her donations to the endowment of Placid Lake University (PLU), her alma mater. Bryan Shield, CFA, of BND Asset Management, manages Derran’s investment portfolio. Derran and Edge are meeting with Shield to discuss the contemplated revisions to the investment policy. Derran informs Edge and Shield of her intention to donate $1.5 million in each of the next 10 years to the PLU endowment. Further, she states that upon her death, the remaining balance of her estate is to be donated to the PLU endowment. Shield considers Derran’s financial situation and her stated objectives. He suggests repositioning the portfolio by selling equities and purchasing bonds such that the aggregate effect on the portfolio will be to produce regular cash flows, reduce volatility, and create a direct link between the amount of the reallocated principal and an index of consumer prices. To accommodate the addition of bonds, Shield recommends an investment approach that combines immunization with duration matching in order to reduce the risk associated with changes in market interest rates. Edge acknowledges the benefits of adding bonds to the portfolio but expresses concern about the liquidity of bonds relative to publicly traded stocks. Shield responds by advising that liquidity varies across various subsectors of the bond market and that the portfolio be structured such that it benefits from illiquid sectors. Edge is mindful that the aggregate nominal amount of the $1.5 annual giving program equals one half of the current $30.0 million portfolio value. Given a life expectancy of an additional 20 years for Derran, Edge asks Shield about the yield income of the fixed income portfolio. Shield replies by stating that fixed income investment

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2019 Level III Mock Exam AM

strategies should be evaluated in terms of expected return, of which yield income is one component. Shield illustrates by providing the characteristics of a corporate bond, shown in Exhibit 1. Exhibit 1  Corporate Bond Characteristics Par amount

$100

Coupon amount (annual frequency)

$4.25

Current bond price

$97.0000

Expected bond price at investment horizon (assuming an unchanged yield curve)

$97.2425

Convexity

0.25

Duration

4.00

Expected yield and yield spread change

0.15%

Shield states that his return expectation for a portfolio of corporate bonds is 3%–6% per annum over a 10-­year period. Edge questions whether that level of return is sufficient for Derran and offers the following suggestions with respect to increasing portfolio returns. Suggestion 1 Overweight the portfolio with bonds of highly leveraged companies because their yields generally exceed those of companies that have lower debt levels. Suggestion 2 Consider using inverse floaters and fixed-­rate receiver swaps in order to position the portfolio to benefit from any decline in interest rates over the 10-­year market cycle. Suggestion 3 Enter into repurchase agreements and securities lending transactions with counterparties that are conservatively leveraged. Derran thanks Shield and Edge for their counsel. She decides that she would like to alter the portfolio by reducing the allocation to equity securities and adding exposure to both inflation-­protected notes and corporate bonds. Because she will be paying capital gains taxes on the sale of the equity securities, she wishes to minimize future investment-­related taxes. Derran makes the following comment: “My priority is for the annual donation to the PLU endowment to be funded from interest income and maturing bonds. At times, we may need to swap similar bonds for tax management purposes. Unless you are offsetting gains with losses, you should realize short-­term gains while deferring short-­term losses because I consider myself to be a patient investor.” 25 In repositioning the portfolio, Shield should most likely add: A

inflation-­linked bonds.

B

fixed-­coupon bonds.

C

floating-­coupon bonds.

26 The investment approach Shield recommends is best described as: A absolute return. B horizon matching. C enhanced indexing. 27 In comparing bonds with publicly traded stocks, Shield should most likely suggest buying and holding: A longer-­maturity, smaller-­issue, BBB rated corporate bonds.

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2019 Level III Mock Exam AM

B recently issued sovereign government bonds. C shorter-­maturity, larger-­issue, AA rated corporate bonds. 28 Based on Exhibit 1, the expected return over a one-­year horizon for the corporate bond is closest to: A 3.90%. B 4.63%. C 4.03%. 29 Which one of Edge’s suggestions least likely uses portfolio leverage to increase returns? A Suggestion 3 B Suggestion 2 C Suggestion 1 30 Is Derran’s comment most likely correct as it relates to tax loss harvesting? A No. She is incorrect about short-­term gains and short-­term losses. B Yes C No. She is incorrect about offsetting gains with losses.

Pavonia Case Scenario Pavonia LDI Consultants offers asset management and advisory services to small firms with defined benefit plans and to individuals planning for retirement. At the beginning of 2019, Whitney Adams, senior adviser, meets with her new client, Donald Berendsen, in order to review the fixed-­income portion of his retirement portfolio. Berendsen, who plans to retire in four years, intends to use this part of the portfolio to supplement income he will be receiving from Social Security, a US government retirement income program. Berendsen explains to Adams, “I plan to continue saving for retirement, regularly adding funds to the portfolio until I retire, and I would like a low-­risk solution to provide additional retirement income.” Adams replies to Berendsen, “We focus on the ability of the portfolio to meet future cash flow needs and seek to immunize the liabilities as an objective in the management of the portfolio. If the fixed-­income portfolio achieves an average annual investment return of at least 4% for the next four years, the proceeds of its liquidation will be enough to purchase an annuity sufficient to provide the funds needed to supplement your Social Security benefits. Until then, we will observe the following principles for managing the portfolio: Principle I.

Our investment strategy is structured to address a Type I liability.

Principle II.

The strategy should begin by analyzing the size and timing of liabilities.

Principle III.

The solution will require an asset-­driven liability framework as opposed to a liability-­driven investing one.

I have summarized your fixed-­income portfolio consisting of three government bonds in Exhibit 1. The yield curve has steepened since the bonds were purchased, which can be seen by comparing their respective yield to maturities (YTMs) of the purchase price yield to today’s yield.”

2019 Level III Mock Exam AM

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Exhibit 1  Berendsen Fixed-­Income Portfolio Characteristics Bond A

Bond B

Bond C

Coupon rate

0.50%

9.00%

4.45%

Maturity date

15-­Feb-­2021

15-­Aug-­2023

15-­Feb-­2027

2.95%

4.72%

4.97%

YTM at time of purchase YTM at current price

1.85%

4.70%

5.07%

USD732,412

USD930,720

USD986,100

Allocation

28%

35%

37%

Macaulay duration

1.49

3.48

6.43

Market value

Note 1: Interest earned on cash: 1.00% Note 2: Portfolio cash flow yield: 4.15%

Adams states, “Generally when we evaluate similar situations, we will use a passive, as opposed to an active, management strategy for the fixed-­income portfolio, which means the risk of measurement error will be greater than asset liquidity risk.” Later, Adams and junior portfolio manager Frank Neeson review the fixed-­income portfolios of two new defined benefit plan clients, Lawson Doors & Cabinets, Inc., and Wharton Farms. Lawson’s plan has 30 participants, who are mostly experienced craftsmen and machinists, whereas Wharton has over 100 participants in its plan. The average participant age is 15 years younger for the Wharton plan compared with the Lawson plan. In both plans, participants receive a monthly benefit upon retirement based on average final pay and have no option for a lump sum distribution. The two plans’ portfolio characteristics are shown in Exhibit 2. Exhibit 2  Selected Plan Portfolio Statistics

Market value of assets Duration of assets

Lawson

Wharton

USD15,498,000

USD8,351,000

7.79

7.82

Duration of liabilities

7.78

10.01

Semiannual portfolio dispersion

46.07

147.22

Accumulated benefit obligation

USD14,389,000

USD7,470,000

4.47%

4.51%

Portfolio cash flow yield

Adams states to Neeson, “For the Lawson and Wharton plans, we can consider one of three alternative strategies to manage the multiple liabilities associated with these plans. Whenever a plan’s surplus is less than 5%, we favor passive management strategies. We could also use a derivatives strategy, and I prefer derivatives strategies that protect the portfolio against an increase in interest rates but will not produce large losses if rates decrease.” Neeson comments, “The durations for almost half of the bonds in the Wharton portfolio are clustered around 4 years, and the durations of the remainder around 12 years, while the durations of the Lawson portfolio bonds are clustered between 6 years and 8 years. In general, a laddered bond portfolio approach would improve

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2019 Level III Mock Exam AM

liquidity management for both, although the Lawson portfolio would experience an increase in cash flow reinvestment risk and the Wharton portfolio would experience a decrease in convexity.” 31 Which of Adams’s three principles is least likely relevant for managing Berendsen’s fixed-­income portfolio? A Principle I B Principle II C Principle III 32 According to the information in Exhibit 1 and assuming Berendsen retires in four years, the fixed-­income portfolio most likely: A should have a shorter duration. B needs a higher cash flow yield. C has currently achieved zero replication. 33 Is Adams most likely correct in her assessment of measurement error? A Yes B No, because passive management would preclude measurement error C No, because asset liquidity risk is greater than the risk of measurement error 34 Which of the following three strategies is least likely appropriate for the plans in Exhibit 2? A Duration matching B Cash flow matching C Contingent immunization 35 Which of the following strategies most likely meets Adams’ preferences? A Buy a payer swaption. B Write a receiver swaption. C Enter into a pay fixed swap. 36 Is Neeson most likely correct in his assessment of the effects of a laddered bond portfolio approach on the Wharton and Lawson portfolios? A Yes B No, because the Lawson portfolio is a bullet portfolio where the duration of its assets are matched to the duration of its liabilities C No, because the duration of the Wharton liabilities is greater than that of the Lawson liabilities owing to the younger age of its participants

Lisette Langham Case Scenario Lisette Langham is an independent consultant specializing in analysis of active equity portfolio management, and in her work she often uses such accepted concepts as alternative beta, Active Share, and active risk. A client, Bob Shaw, asks her to help evaluate various funds he owns that are managed by the Master Fund Company (MFC). Langham describes how she uses rewarded factor analysis, regardless of whether a manager uses factor exposure explicitly. She shows Shaw her analysis of the MFC Value Fund compared with its benchmark (Exhibit 1).

2019 Level III Mock Exam AM

17

Exhibit 1  Rewarded Factor Results Factor Sources of Performance over 15 years

Market

Market

0.71%

Size

0.0%

Russell 1000 Value (Benchmark)

MFC Value Fund

0.59%

0.50%

–0.04%

0.02%

Value

0.0%

0.08%

0.11%

Momentum

0.0%

0.08%

0.05%

Alpha (non-­factor related)

0.0%

–0.05%

–0.05%

Total monthly performance

0.71%

0.66%

0.63%

On viewing Exhibit 1, Shaw makes the following comments about the MFC Value Fund: ■

The small-­cap tilt helped.

■

Value funds were out of favor, as shown by the Value factor results.

■

Of course, the MFC Value Fund must have a lower alpha because its performance was 0.03 percentage point worse than its benchmark.

Shaw has particular interest in MFC’s popular Soar Fund (Soar), which relies on returns from factor exposures. The description of the fund states that it emphasizes security-­specific factors, maintains low security concentration to keep idiosyncratic risk down, and embraces quality and value styles. Soar occasionally considers the economic and geopolitical environment, especially during unusual economic conditions. Langham tells Shaw how she classifies Soar’s portfolio construction approach. Noting that MFC has two managers who use the same index as their benchmark, Shaw observes that Fund A and Fund B have similar Active Share and a similar number of positions, but Fund A’s realized active risk of 7% is almost three times greater than that of Fund B. Shaw makes the following comments: ■

I think Fund B makes a lot of sector bets.

■

Fund A likely has higher fees than Fund B

■

Fund A should have a greater dispersion of returns about the benchmark.

Shaw next asks Langham to show how risk targets and constraints might differ between fund managers depending on their respective skills. Langham has Shaw consider three fund managers, each of whom use the MSCI World Index benchmark. For each fund, risk targets have been assigned that allow the portfolio managers some flexibility to exercise their perceived skillsets. Skills include stock picking, factor exposure, and sector rotation. Based on only the data shown in Exhibit 2, Langham identifies the skill applied by each manager. Exhibit 2  Risk Targets and Constraints Manager constraints Target active risk

Max. sector deviations

Max. risk contribution, single security

Fund X

Fund Y

Fund Z

8%

7%

4%

1%

15%

10%

4%

2%

1%

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2019 Level III Mock Exam AM

Another of Langham’s clients, Marianne Quint, sits on the investment committee of the Amity Island Endowment. The $2 billion equity portion of the Amity fund is invested using a global equity index approach. Quint has been charged with identifying an active equity fund to replace 20% of the indexed portfolio. Three candidate funds with similar performance histories, benchmarks, and fees have been identified. Based on the characteristics shown in Exhibit 3, Quint asks Langham to recommend the fund that has demonstrated the best risk-­efficient delivery of results. Exhibit 3  Characteristics of Candidates for Amity Equity Portfolio Fund Name

Blue

Ash

March

Sharpe ratio

1.11

0.90

0.92

5.5%

6.0%

3.2%

0.41

0.48

0.75

340

290

140

11.5%

14.7%

14.9%

Low

High

Low

Annualized active risk

Active Share

Number of securities

Annualized portfolio volatility Covariance with Amity Fund

Langham also identifies the fund that could minimize the active risk of the total $2 billion Amity equity portfolio after replacement is complete. 37 Which of Shaw’s comments about the MFC Value Fund in Exhibit 1 is most accurate? The comment concerning: A alpha. B

small-­cap tilt.

C value being out of favor. 38 From the description of the Soar Fund, the most appropriate classification of its portfolio construction process is: A

top-­down systematic.

B

bottom-­up systematic.

C

bottom-­up discretionary.

39 In regard to Shaw’s comments about Fund A and Fund B, the one that is most accurate concerns: A Fund A’s fees. B Fund A’s dispersion. C Fund B’s sector bets. 40 Among the funds shown in Exhibit 2, which one is most likely managed using a diversified multi-­factor investor approach? A Fund X B Fund Y C Fund Z 41 The fund in Exhibit 3 that is most consistent with Quint’s requirements is: A Ash. B Blue. C March.

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42 From Exhibit 3, the replacement candidate fund that, if included, will most likely minimize the active risk of the final Amity equity fund is: A Ash. B Blue. C March.

Sapphire Bay Foundation Case Scenario Edward Cullen advises the board of directors of the Sapphire Bay Foundation (Sapphire) regarding all aspects of the investment portfolio of Sapphire’s endowment fund. Traditionally, Cullen drove the selection of active investment managers for the various asset classes. Despite historically ranking well among peers, several of the managers have performed below the level of their respective benchmarks in the past few years. Cullen’s colleague Paige Stapleton recommends that some passive management should be introduced into Sapphire’s investment mix using pooled investments. They agree to introduce the idea to Sapphire’s board at its next meeting. At the next board meeting, Cullen begins by introducing passive investing to Sapphire’s board. He states that open-­end mutual funds and exchange-­traded funds (ETFs) are appropriate approaches. Both alternatives are readily available, offer a broad spectrum of investment choices, and are easy to buy and sell. He makes the following comments comparing the two alternatives. 1 Both mutual funds and ETFs can be purchased on margin. 2 Investors can take short positions in ETFs but not in mutual funds. 3 Both mutual funds and ETFs have the same degree of liquidity. Stapleton then begins a description of factor-­based strategies. These include common equity factors, such as value, size, and quality, and they can be used either in place of or to complement market-­cap-­weighted indexing. She points out that relative to market-­cap weighting, factor-­based strategies tend to diversify risk exposures; are transparent in terms of factor selection, weighting, and rebalancing; but can be copied by other investors, which can reduce the advantages of a strategy. Cullen provides Sapphire’s board with an example comparing the performance of the River Valley Fund, a factor-­based fund, with its benchmark portfolio (Exhibit 1). The fund uses benchmark segments of four mutually exclusive sub-­categories. Cullen calculates the percentage of River Valley’s excess return that resulted from active factor-­weighting decisions. Exhibit 1

 Attribution Data for River Valley Fund and Benchmark River Valley Fund

Factor

Weight

% Return

Benchmark Portfolio

# of Stocks

Weight

% Return

# of Stocks

Growth

0.22

7.9

23

0.25

7.9

23

Value

0.19

5.2

27

0.19

5.2

27

Quality

0.29

6.7

20

0.26

6.7

20

Momentum

0.30

3.9

24

0.30

4.5

30

Total

1.00

5.84

94

1.00

6.06

100

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2019 Level III Mock Exam AM

For the large-­cap US equity portion of Sapphire’s investment portfolio, Cullen believes that there are some existing passive indexed-­based funds that track the S&P 500 Index that the foundation should consider. Cullen presents Exhibit 2 to Sapphire’s board. Exhibit 2 S&P  500 Index Funds Manager A

Manager B

Manager C

Benchmark

S&P 500

S&P 500

S&P 500

Number of holdings: fund/ index

498/500

504/500

475/500

Dividends reinvested

Next day

Same day

Next day

12

15

10

Rebalance

Quarterly

Quarterly

Quarterly

Reconstitution

Quarterly

Quarterly

Semi-­Annually

Management fee (in basis points)

For the international portion of the investment portfolio, Stapleton suggests that Sapphire invest in an MSCI EAFE index portfolio specifically tailored for the foundation rather than investing in an existing index fund. Anne Rowland, Sapphire’s board chair, asks her how this could be accomplished, given that the initial allocation is only $15 million. Stapleton suggests that Sapphire hire a manager to purchase a portfolio of securities that are a mutually exclusive yet comprehensive subgroup of the index designed to track the index return and risk characteristics. 43 In comparing mutual funds and ETFs, Cullen is most accurate in: A Comment 1. B Comment 2. C Comment 3. 44 When comparing factor-­based strategies relative to the market-­cap weighting of an index, Stapleton’s comments are most likely: A incorrect regarding transparency. B correct. C incorrect regarding risk exposure. 45 In Exhibit 1, the percentage of the excess return of the River Valley Fund arising from active factor weighting is closest to: A 18.18%. B –0.04%. C –0.22%. 46 Based on Exhibit 2, the portfolio manager most likely to have the largest tracking error is: A Manager A. B Manager C. C Manager B. 47 As an indexing technique, the number of holdings in Manager B’s index most likely illustrates: A reconstituting.

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21

B packeting. C buffering. 48 The portfolio method suggested by Stapleton to replicate the MSCI EAFE Index is best described as: A optimization. B stratified sampling. C a blended approach.

Kamiko Watanabe Case Scenario Kamiko Watanabe, CFA, is a portfolio adviser at Wakasa Bay Securities. She specializes in the use of derivatives to alter and manage the exposures of Japanese equity and fixed-­income portfolios. She has meetings today with two clients, Isao Sato and Reiko Kondo. Sato is the manager of the Tsushima Manufacturing pension fund, which has a target asset allocation of 60% equity and 40% bonds. The fund has separate equity and fixed-­income portfolios, whose characteristics are provided in Exhibits 1 and 2. Sato expects equity values to increase in the coming two years and, in order to avoid substantial transaction costs now and in two years, would like to use derivatives to temporarily rebalance the portfolio. He wants to maintain the current beta of the equity portfolio and the current duration of the bond portfolio. Exhibit 1  Tsushima Pension Fund Equity Portfolio Characteristics Current market value

¥27.5 billion

Benchmark

Nikkei 225 Index

Current beta

1.15

Exhibit 2  Tsushima Pension Fund Bond Portfolio Characteristics Current market value Benchmark Current duration

¥27.5 billion Nikko Bond Performance Index composite 4.75

In order to rebalance the pension fund to its target allocations to equity and bonds, Watanabe recommends using Nikkei 225 Index futures contracts, which have a beta of 1.05 and a current contract price of ¥1,525,000, and Nikko Bond Performance Index futures, which have a duration of 6.90 and a current contract price of ¥4,830,000. She assumes the cash position has a duration of 0.25. Sato wants to know if other derivatives could be used to rebalance the portfolio. In response, Watanabe describes the characteristics of a pair of swaps that, together, would accomplish the same rebalancing as the proposed futures contracts strategy. Kondo manages a fixed-­income portfolio for the Akito Trust. The portfolio’s market value is ¥640 million, and its duration is 6.40. Kondo believes interest rates will rise and asks Watanabe to explain how to use a swap to decrease the portfolio’s duration

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2019 Level III Mock Exam AM

to 3.50. Watanabe proposes a strategy that uses a pay-­fixed position in a three-­year interest rate swap with semi-­annual payments. Kondo decides he wants to use a four-­ year swap to manage the portfolio’s duration. After some calculations, Watanabe tells him a pay-­fixed position in a four-­year interest rate swap with a duration of –2.875 would require a notional principal of ¥683 million (rounded to the nearest million yen) to achieve his goals. Kondo asks Watanabe whether it would be possible to cancel the swap prior to its maturity. Watanabe responds with three statements: Statement 1 If you purchase a swaption from the same counterparty as the original swap, it is common to require the payments of the two swaps be netted or cash settled if the swaption is exercised. Statement 2 You could purchase a payer swaption with the same terms as the original swap. This approach would protect you from falling fixed swap rates but at the cost of the premium you would pay to the swaption counterparty. Statement 3 During the life of the swap, you could enter into a new pay-­ floating swap with the same terms as the original swap, except it would have a maturity equal to the remaining maturity of the original swap. However, the fixed rate you receive might be lower than the fixed rate you are paying on the original swap. 49 The number of Nikko Bond Performance Index futures Sato must sell to rebalance the Tsushima pension fund to its target allocation is closest to: A 743. B 149. C 1,594. 50 The number of Nikkei 225 Index futures Sato must buy to rebalance the Tsushima pension fund to its target allocation is closest to: A 3,950. B 3,293. C 4,148. 51 Which of these is most likely to be a characteristic of one of the two swaps Watanabe describes to Sato? A Receive return on Nikko Bond Performance Index B Receive Libor C Pay return on Nikkei 225 Index 52 The duration of the swap in Watanabe’s first proposal to Kondo is closest to: A –2.00. B –1.75. C –2.75. 53 Is the notional principal of the swap Watanabe recommends to Kondo most likely correct? A No, it is too high. B No, it is too low. C Yes. 54 Which of Watanbe’s three statements to Kondo is least likely correct? A Statement 1

2019 Level III Mock Exam AM

23

B Statement 3 C Statement 2

Claire Andrews Case Scenario Downing Funds (DF) provides investment opportunities for clients by creating funds that invest in a mix of other existing funds. Claire Andrews evaluates the managers of funds in which DF currently invests and the managers of funds that may create future investment opportunities for DF. Currently, Andrews is considering the performance of the BITR3 fund with some limited information, shown in Exhibit 1. Exhibit 1  One Month of Fund Performance for BITR3 Fund (in € millions) Day

Fund Value

Contribution/ (Withdrawal)

Fund Value with Contributions

0

9.5

0

9.5

10

9.8

–2.5

7.3

25

8

1.5

9.5

30

9.6

0

9.6

Rates of Return Time-­weighted (TWR): 14.24% Money-­weighted (MWR): 13.57%

Andrews also receives incomplete attribution information for another fund, EATR7, shown in Exhibit 2. Similar to the BITR3 fund, the EATR7 fund may have some future investment potential. She requests that her analyst, Ted Kukar, complete the analysis. Exhibit 2  EATR7 Fund Attribution Information (in $ millions)

Investment Alterative

Fund Value

Beginning value

104.56

Net contributions

105.77

Risk-­free asset

107.72

Incremental Return Contribution

Incremental Value Contribution

0.00%

1.21 1.95

Asset category

115.7

7.98

Benchmarks

116.23

0.53

Investment managers

118.55

2.32

Allocation effects

120.33

1.78

Total fund

120.33

15.77

Kukar tells Andrews that he has heard that the EATR7 fund generates a portion of its return from investing in smaller companies within its sector that are about to be acquired.

24

2019 Level III Mock Exam AM

Kukar states that he cannot confirm whether the fund is following this “small company” strategy based on the existing data. He further states that with aggregate industry sector data supplied by the EATR7 fund, he could determine whether this strategy is being used. After receiving the assignment and discussing it with Andrews, Kukar discusses some benchmarking issues with a fellow analyst, Rob Kinney. Kukar states: “I want to calculate a return based on a given manager’s style of investing. I intend to find an appropriate benchmark portfolio that is not a market index and subtract the benchmark portfolio return from the manager’s portfolio return.” Kinney replies: “I believe your calculation will capture the manager’s active return and not a style return.” Kinney continues: “To capture the style return, you will need to subtract a market index return instead of a benchmark portfolio return from the manager’s portfolio return.” Andrews assigns Kinney to perform a micro attribution analysis for a current fund manager within the DF family of funds. This manager invests in four specific sectors of the US economy and holds some cash, as shown in Exhibit 3. Exhibit 3

 Micro Attribution Data for DF Fund Manager Portfolio Weight (%)

Benchmark Portfolio Weight (%)

Portfolio Return (%)

Benchmark Portfolio Return (%)

1

20

30

–0.4

–0.7

2

40

30

3.8

4.2

3

10

20

2.4

2.6

4

25

20

5.4

2.92

Cash:

5

0

0.09

0

Sector:

Note: DF fund manager has trading costs of 27 basis points.

Before Andrews leaves, Kukar states that he has calculated the Sharpe ratios for a fund and a benchmark that is based on the market portfolio when the risk-­free rate is zero, as indicated in Exhibit 4. Exhibit 4  Sharpe Ratios for a Fund and Its Benchmark

Sharpe Ratio Expected Return

Fund

Benchmark

0.35

0.4

7.20%

6.80%

Risk-­free rate: 0%; Benchmark is based on the market portfolio

Kukar tells Kinney and Andrews that the information ratio should simply be the difference between the two Sharpe ratios. ■■

■■

Kinney disagrees but says that at least M2 for the fund could be calculated by multiplying the Sharpe ratios.

Andrews disagrees with both analysts and states that M2 for the fund can be calculated as the product of the fund’s Sharpe ratio and the expected return of the benchmark, divided by the benchmark’s Sharpe ratio.

2019 Level III Mock Exam AM

55 The primary reason for the TWR differing from the MWR for the BITR3 fund is most likely: A a contribution prior to the fund value rising. B withdrawals being larger in magnitude than contributions. C a withdrawal prior to the fund value rising. 56 The incremental return contribution of the total fund for the EATR7 fund is closest to: A 13.9%. B 14.9%. C 15.1%. 57 When Kukar discusses the data in Exhibit 2 with Andrews, his statement with regard to analyzing the “small company” strategy is most likely: A incorrect in regard to the additional data requirements. B correct in regard to the existing data and the additional data requirements. C incorrect in regard to the existing data. 58 In the conversation between Kukar and Kinney about benchmarking, which statement is most accurate? A Kukar’s statement about the style of investing B Kinney’s statement about active return C Kinney’s statement about the style of investing 59 The total value-­added return by the DF fund manager is closest to: A 0.9%. B 2.8%. C 0.6%. 60 When discussing the Sharpe ratios in Exhibit 4, the person who makes the most accurate assessment regarding the information ratio or the M2 measure is: A Kinney. B Kukar. C Andrews.

25