CFA Level 3 - Portfolio Management and Wealth Planning Session 4 - Reading 10

CFA Level 3 – Portfolio Management and Wealth Planning, Session 4 – Reading 10

(Notes, Practice Questions, Sample Questions)

1.1 Jennifer Moore has worked in a governmental position (administrative assistant) since graduating from high school. She loves her job because she is very good at following her bosses’ orders. At office functions, many of her colleagues ranted and raved about the quality of her baked goods. Some even suggested that they tasted so good that she should quit her job and sell baked goods. Moore is 50 years old and never paid attention to the suggestions of her colleagues.

She plans on retiring from the government in three years.Based on her personality type, what type of investor is Moore?

A)Methodical.
B)Cautious.
C)Individualist

[Explanation: B) Moore appears to be a cautious investor. She appears unwilling/unsure about making decisions on her own (following bosses’ orders), which goes against the individualist and methodical investor.]
1.2 Jennifer Moore recently came into a seven-figure inheritance from a long-lost uncle.

Which of the following statements about Moore is most accurate?

A)Since she didn’t count on the inheritance, she will be willing to take on substantial investment risks.
B)She will be willing to take an active role in the investment process.
C)Moore has little to no familiarity with risk taking and will tend to be more cautious in her investment approach

[Explanation: C) Wealth acquired through inheritance could indicate an individual who has less familiarity with risk taking activity. Given her other personality traits, it appears unlikely that Moore will want to take an active role in the investment process and/or knowledge.

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2.1 Jim Thamen, CFA, recently received an assignment from his supervisor Andy Stone, CFA, to prepare a proposal for managing Ellen and Joe Swathman’s investment portfolio. Ellen, 62, and Joe, 65, recently inherited $2,500,000 from Ellen’s eccentric uncle, Daniel, and wish to invest their money wisely. The Swathmans have two grown children, Marcus, 30, and Sue, 27, who are financially independent from their parents. Although both Marcus and Sue are married, the Swathmans do not have any grandchildren.
For the past 20 years, Ellen has worked as a legal secretary for a regional law practice that specializes in professional malpractice, product liability, and worker’s compensation litigation. Joe is nearing retirement age at the local rock quarry he co-founded with a high school classmate almost 40 years ago. Although the rock quarry has not provided the Swathmans with a large amount of excess discretionary income, they have been able to provide themselves and their children a comfortable living. Joe and his partner Ed Small have executed a buy-sell agreement and maintain life insurance to fund a buy-out in the event of the untimely death of either. Although Ellen is planning to retire within 9 to 12 months, Ed wants to continue working at the quarry for a few more years.
The Swathmans are in relatively good health, have adequate health insurance, property and casualty, disability, liability, and life insurance. All consumer debts have been paid. They plan to spend approximately $200,000 over the next year renovating their home in preparation for retirement.
Thamen recorded the following statements made by Joe Swathman in a recent meeting:

1. “Ellen and I do not consider ourselves wealthy by any measure. Although the inheritance doubles our net worth, I know plenty of others with substantially greater retirement accounts. Besides, we have a quite a bit tied up in the business. On top of that, we will probably live another 25 years. So I think we are average risk-takers.”
2. “Ellen’s work has made her sensitive to potential property and casualty or liability losses. She leaves the investment decisions up to me, but says that we should be careful.”
3. “I had a great return with Netshopper stock and sold it too early. I bought it at $1.25. Last year when they announced a distribution deal with Nike the stock jumped to $8.75 so I sold. It’s still going strong, as both their sales model and management team are winners. Yesterday, I checked and it closed at $26.00.”
4. “I’ve been following a stock called Computrol which was projected to hit $42.50. New information came out from the company with predictions it should hit $85.00 but analysts predicted it will only hit $65.”

A week later, Thamen is trying to determine the appropriate dynamic asset allocation strategy for the Swathman portfolio given the economic outlook, capital market conditions, and the Swathman’s risk and return objectives. He consults his supervisor, Andy Stone, to discuss it.
Thamen begins by stating that “a buy and hold strategy outperforms a constant mix strategy in a trending market and underperforms the constant proportion portfolio insurance strategy (CPPI) in a flat, but oscillating market.”
Stone replies: “I agree that a buy and hold strategy outperforms a constant mix strategy in a trending market but it also outperforms the CPPI strategy in a flat, but oscillating market.”
In formulating an investment policy statement for the Swathmans, Thamen decides to develop a brief situational profile for his clients. Which of the following best represents the situational risk profile for the Swathmans?

A) With respect to source of wealth, measure of wealth, and age, Joe Swathman’s statements and the additional supporting information indicate below-average to average risk tolerance.
B) With respect to source of wealth, measure of wealth, and age, Joe Swathman’s statements and the additional supporting information indicate an overall average risk tolerance.
C) The Swathman’s substantial net worth, the financial independence of their children, and the fact that the Swathman’s have no grandchildren to provide for in the future indicate an above-average to aggressive risk tolerance

[Explanation: B) The size of their assets in the context of their age (time horizon), suggests the Swathman’s are unlikely to exhaust their savings during retirement. Thus, their financial situation indicates an above-average ability to incur risk. In contrast, Joe’s entrepreneurial background (increased risk tolerance), statement about them being of average risk tolerance, his statement about Ellen saying they should be careful (below average risk tolerance), adequate insurance, and no debt indicates they manage their finances in a responsible manner. Hence their statements and background reflect an average to some what below-average willingness to take risk leaning more towards average. Overall their risk tolerance would be average based on their average willingness to take risk. On the exam you would not want to give a range of risk tolerances but instead state a single level of risk tolerance. For example state something like:
Ability to tolerate risk is above average
Willingness is average
Overall risk tolerance is average

In this particular case of the Swathman’s their asset base is not large enough to average the two risk tolerances of ability and willingness together and recommend counseling to reconcile the two. You would instead defer to the lower level of risk tolerance which is their willingness.]
2.2 Thamen understands that behavioral finance topics are becoming more important when attempting to better understand the relationship between portfolio manager and client. Which of the following behavioral investor traits were exhibited in Swathman’s statements 1-4?

A)Frame dependence and familiarity.
B)Representativeness and loss aversion.
C)Regret and anchoring.

[Explanation: C) Only statements 3 and 4 describe behavior investor traits. Statement 3 is describing regret where the feeling in hindsight is associated with making a bad decision. Statement 4 is describing anchoring which is the inability to fully incorporate the impact of new information on projections.]
2.3 Thamen starts formulating the risk tolerance portion of the investment policy statement. He knows it is important to consider both the willingness and ability to take risk. Which of the following generally has the most impact on an individual’s ability to take risk?

A)Portfolio size and time horizon.
B)Liquidity requirements and tax considerations.
C)Liquidity requirements and portfolio size.

[Explanation: A) The ability to incur risk is determined by the size of an investor’s portfolio relative to his goals, the time horizon, the importance of the investment goals and the amount of volatility the portfolio can sustain without jeopardizing the goals. Other constraints (taxes, liquidity needs, etc.) may impact both the ability and willingness of and individual to take risk but are not generally considered to be as important as time horizon and portfolio size.]
2.4 Regarding the comments by Thamen and Stone about the different dynamic asset allocation strategies:

A)Stone is correct on Buy and Hold, but incorrect on CPPI; Thamen is correct on both Buy and Hold and CPPI.
B)Stone is incorrect on both Buy and Hold and CPPI; Thamen is incorrect on Buy and Hold and correct on CPPI.
C)Stone is correct on both Buy and Hold and CPPI; Thamen is correct on Buy and Hold and incorrect on CPPI.

[Explanation: C) Stone’s statement is correct. The Buy and Hold strategy outperforms a Constant Mix strategy in a trending market and outperforms the CPPI strategy in a flat but oscillating market. Thamen was right about Buy and Hold but wrong on CPPI.
The Constant Mix strategy outperforms a comparable Buy and Hold strategy, which, in turn, outperforms a CPPI strategy in a flat but oscillating market.
The CPPI strategy outperforms a comparable Buy and Hold strategy, which, in turn, outperforms a Constant Mix strategy in trending markets.]
2.5 Thamen wants to incorporate the information ratio in the portfolio management process. Which of the following statements best describes the information ratio?

A)The information ratio uses tracking error in the numerator of the equation which represents the standard deviation of monthly alphas.
B)The information ratio shows the relationship between the manager’s alpha and the standard deviation of alpha.
C)The lower the information ratio, the more likely it is that a manager’s performance is the result of skill rather than luck.

[Explanation: B) The information ratio is used to determine if a manager’s alpha is a result of mere chance, or the manager’s skill. It shows the relationship between the manager’s alpha and the standard deviation of alpha (tracking error): information ratio = alpha / tracking error. ]
2.6 Thamen has been reading about the benefits of using Monte Carlo approaches in retirement planning. Which of the following is NOT a correct statement with regard to the benefits of using a Monte Carlo approach?

A)Monte Carlo forecasting techniques result in greater reliability than deterministic techniques.
B)Monte Carlo techniques often better represent trade-offs between short term risks and long-term goals.
C)Probabilistic forecasts are often better than point estimates in financial markets.

[Explanation: A) The results of Monte Carlo techniques are only as good as the inputs used. A weakness of Monte Carlo simulations is the need to pre-specify the distribution of the variables used or rely on historical distributions.]
3. Which of the following is NOT determined using situational profiling? Investor:

A)behavior.
B)biases.
C)philosophy.

[Explanation: A) Situational profiling does not determine investor behavior, but represents an analysis of behavior in determining preferences and biases, as well as philosophy]
4. Sheryl Rubenstein is a stunt double in Hollywood. Her studio took out a life insurance policy on her. What method of handling risk is her studio using? Risk:

A)transference.
B)reduction.
C)avoidance.

[Explanation: A) The studio is using a risk transference method by purchasing life insurance. That way, they will not bear the risk of lost income if she dies while performing a stunt. Instead, they will receive the insurance proceeds]
5. Which of the following statements regarding situational profiling is least accurate?

A)Situational profiling considers an individual’s preferences, economic resources, goals, and desires.
B)With situational profiling, the source of an investor’s wealth is considered an indicator of the investor’s risk tolerance.
C)When properly used, situational profiling will provide a great degree of insight into an investor’s preferences, economic situation, goals, and desires

[Explanation: C) Due to the extensive number of possible individual situations, situational profiling must be applied cautiously. It should be applied as only an initial step in developing an understanding of an individual’s preferences, economic situation, goals, and desires]
6. An investor’s source of wealth is often considered important in determining attitudes towards risk taking. Which source of wealth is considered commensurate with greater risk tolerant profiles?

A)Passively acquired sources of wealth.
B)Actively acquired sources of wealth.
C)Inherited sources of wealth

[Explanation: B) Actively acquired sources of wealth are often associated with entrepreneurial or other risk taking activities. Individuals with actively acquired sources of wealth are often considered to have taken risk and know and understand what it means to take risks in order to create wealth]
7. Risk objectives should be evaluated during which stage of the investment policy statement process? Concurrently with the:

A)capital market expectations formations.
B)investment strategy decision.
C)return objectives

[Explanation: C) Discussions of risk objectives should occur simultaneously with those of return objectives]
8. Return requirements are those return levels associated with returns needed to meet:

A)secondary goals.
B)educational goals.
C)major goals

[Explanation: C) Return requirements are returns needed to attain major goals]
9. Which of the following statements distinguishes the ability to take risk from the willingness to take risk? The:

A)ability to take risk is more qualitative in nature whereas the willingness to take risk can be measured in a quantitative nature.
B)ability to take risk is more amenable to quantitative measures whereas the willingness to take risk is more qualitative in nature.
C)willingness to take risk is connected with primary goals and objectives

[Explanation: B) The ability to take risk is usually associated with specific goals and time horizons and is more quantitative than willingness to take risk. Willingness to take risk is more subjective from the investor’s perspective and is therefore more qualitative in nature]
10. Dan Kreuz, age 35, is a supervisor with BHS Consumer Finance and earns an annual salary of $95,000 per year before taxes. His spouse, Szeren Kreuz, age 36, is a marketing manager for a firm specializing in rental property, and earns $55,000 per year. Dan and Szeren recently inherited $800,000 from Szaren’s father’s estate. In addition to their income and their inheritance, the Kreuz’s have accumulated the following assets:
$10,000 in cash
$150,000 in stock and bond mutual funds
$240,000 in BHS common stock.

The Kreuz’s annual living expenses are $90,000 per year and their tax rate is 40 percent. After-tax salary increases will offset any future increases in living expenses.

In a discussion with their financial advisor, Joel Douglas, the Kreuz’s express concern about having enough assets for a comfortable retirement. The Kreuz’s make the following comments to Douglas:
We want to retire in 20 years.
We were very uncomfortable with the decline in the stock market from 2000-2002, and cannot tolerate a drop in our investments of more than 10% in any given year.
We do not plan to have children.

After the discussion with Douglas, he goes back to his office to prepare an investment policy statement for the Kreuz’s. He determines that to meet their goals, they will need $2,500,000 in 20 years. Which of the following is the most appropriate description of the risk objective for the Kreuz’s?

Willingness to Take Risk Ability to Take Risk Overall Conclusion

A)Below Average Below Average Below Average
B)Below Average Above Average Below Average
C)Below Average Above Average Above Average

[Explanation: B) The Kreuz’s indicate a below average willingness to take risk based on their unhappiness with the 2000-2002 bear market in stocks and an unwillingness to accept a decline in the value of their portfolio of more than 10%.
The ability to take risk is best classified as above average. They have a substantial asset base, a long time horizon, and do not depend on their portfolio to meet their living expenses. Their after-tax income is $150,000(1 – 0.4) = $90,000, which exactly covers their living expenses. Also, their required return is equal to N = 20; PV = $1,200,000; FV = $2,500,000; PMT = 0; CPT I/Y → 3.74% on an after-tax basis, which is equal to 3.74 / (1 – 0.4) = 6.23% on a pretax basis, which is a reasonable return for a balanced portfolio.
Overall, with an above average ability and below average willingness, their risk objective is below average as their willingness to take risk dominates their ability to take risk in determining overall risk tolerance. On the exam, if a conflict arises between willingness and ability to take risk, honor willingness to take risk unless doing so would jeopardize the portfolio’s ability to meet investor goals]
11. Brad Piasecki is a successful 35 year old executive in the technology industry with a company that is growing rapidly. Piasecki has a pre-tax income of $150,000 per year, and manages to live well below his means. Piasecki is currently saving for both his retirement, which will take place in 30 years, as well as funding his daughter’s college education, which will begin in 15 years. Piasecki’s investment manager has determined that based on contributions to his portfolio, Piasecki requires at a minimum, an 8 percent annualized return on his investments in order to meet his goals. He also states that Piasecki should invest in a diversified stock and corporate bond portfolio that provides total return with an emphasis on capital gains. When his investment manager gives Piasecki his recommendations, Piasecki replies “I have seen too many of my colleagues buy risky stocks and have their portfolios wiped out. I only want to buy Treasury bonds for my portfolio.” Piasecki checks the yields on Treasury bonds, and sees that best yield he can obtain is 4.5 percent. Which of the following would be the best course of action for Piasecki’s investment manager?

A)Recommend investor education and a reassessment of portfolio objectives since the investor’s view is inconsistent with his goals and ability to take risk.
B)Invest 50 percent in Treasury bonds and 50 percent in the diversified stock/corporate bond portfolio to provide a balance between Piasecki’s risk tolerances and required return.
C)Invest in the Treasury bonds since willingness to take risk always supersedes ability to take risk

[Explanation: A) Given his age, income, and lifestyle, Piasecki would seem to have a high ability to take risk, which conflicts with his willingness to take risk. Also, his required return cannot be achieved given his willingness to take risk. On the exam, a general rule is to go with client’s willingness to take risk unless doing so would jeopardize the portfolio’s ability to meet the investor’s goals (going ahead and investing in the Treasury bonds would not be an option). In this case, investor education and a reassessment of portfolio objectives is the best option. The client obviously cannot meet both his return requirement and risk tolerance goals at the same time, so something has to change – either the client changes his views on risk through education, or he changes the goals of his portfolio. Taking any of the other two actions would either not meet the required return, or would violate the risk tolerance, so investor education is the key. If you see a conflict like this on the exam, make sure the inconsistency is noted and that you recommend investor education]
12. The willingness to take risk is best judged by the:

A)subjective nature of the perspective investments.
B)psychological profile of the investor.
C)financial profile of the investor

[Explanation: B) The willingness to take risk is related to the psychological characteristics of investors and is best measured in subjective terms]
13. Which of the following statements regarding institutional and individual investors is CORRECT?

A)Institutions and not individual investors should focus on total return.
B)Time horizon factors are typically more crucial to individuals than institutions.
C)Portfolio growth is not important when an individual client is faced with substantial income requirements

[Explanation: B) Institutions as well as individuals should consider a total return perspective. Spending objectives usually represent an income component while growth objectives represent a capital gains component. Even though a client may have a significant current income requirement, attention to portfolio growth is also required. The same is true with respect to inflation. One of the distinguishing factors between individual and institutional investors is time horizon. Institutional investors may have infinite lives, but individuals do not]
14. The ability to take risk is best judged by:

A)the time horizon of only short term objectives.
B)the time horizon of both short- and long-term objectives.
C)the time horizon of long term objectives

[Explanation: B) The time horizon of both short- and long-term objectives will have direct consequences on an investor’s ability to take risk]
15. Although legal and regulatory constraints do not usually impact an individual investor’s policy statement, attention must often be paid between two parties of personal trusts. Which parties exhibit the greatest tension in setting investment policy for a personal trust?

A)Grantor and remaindermen.
B)Income beneficiary and remaindermen.
C)Income beneficiary and the trust officer

[Explanation: B) A creative tension exists between the income beneficiary and remaindermen listed in a personal trust. Income beneficiaries would like to have as much current income from the trust as possible. Remaindermen wish to have as large of a portfolio passed to them after the income beneficiary dies. The conflict between current income and longer-term portfolio growth is a situation that must be addressed in formulating investment policy for a personal trust]
16. Which class of liquidity constraints is usually NOT considered a factor when formulating an individual’s investment policy statement?

A)Negative liquidity events.
B)Cash carried on the person.
C)Ongoing expenses

[Explanation: B) The amount of cash an investor carries with them should not impact the investment policy statement. The primary liquidity constraints impacting the long-term policy statement are those cash outflows required in meeting ongoing expenses and negative liquidity events]
17. Vivian Collins is a client of ESP Financial Advisors. She presents her situation as follows: Collins is currently a divorced mother to a 5-year-old daughter, Daija. She is 35 years old. She has worked at her current job with the government for the last 13 years, and assumes that she will remain there until retirement and collect her pension. Collins wants to be able to send Daija to the college of her choice. Collins expects her daughter to eventually marry and have children. She would love to be able to leave something to these future grandchildren. How many time horizons does Collins have?

A)3.
B)4.
C)5.

[Explanation: B) Collins has 4 distinct time horizons. The first is now until the time that Daija enrolls in college. The second is supporting Daija’s college education. The third is her remaining years before retirement and after supporting Daija through college. The fourth is retirement. In retirement if a goal is to leave some assets to her grandchildren then the portfolio would need to be managed with that in mind]
18. With respect to the constraints portion of an investor’s investment policy statement, issues relating to on-going expenses, emergency reserves, alterations in on-going expenses, and transactions costs are all examples of:

A)time horizon issues.
B)unique circumstances.
C)liquidity issues

[Explanation: C) The issues listed in the stem of the question are concerned with the investor’s liquidity requirement]

19. Which two constraints greatly impact an individual’s investment policy statement?

A)Legal/regulatory and unique circumstances.
B)Time horizon and tax considerations.
C)Legal/regulatory and liquidity concerns

[Explanation: B) Individual investors have finite lives and are taxable entities. Legal/regulatory factors may have an impact, but for the most part, individual investors can invest in almost any manner they please]
20.1 An analyst is developing an investment policy statement for Sally Edgewood, a 48-year old orthodontist with an annual income in excess of $400,000. Edgewood has accumulated an investment portfolio with a current value of $4 million. Her portfolio is concentrated in small capitalization stocks with a bias toward high-tech companies. She has expressed a desire to earn a return equal to the return of 12 percent above the return of the Russell 2000 small capitalization stock index. Edgewood lives well on 50 percent of her annual income. She has always been a ski enthusiast and this year she plans to purchase a second home in the mountains in western Wyoming. This purchase will be mortgaged and require her to make an $80,000 down payment. Edgewood plans to retire at the age of 63 and is currently paying taxes at a rate of 30 percent on both income and capital gains.Which of the following most accurately portrays Edgewood’s overall risk tolerance? Edgewood’s willingness:

A)to accept risk is average and her ability to accept risk is above average. Thus, her overall risk tolerance is average.
B)and ability to accept risk is above average. Thus, her overall risk tolerance is above average.
C)to accept risk is above average and her ability to accept risk is average. Thus, her overall risk tolerance is average

[Explanation: B) Edgewood’s ability to assume risk is above average as indicated by the fact that her income is relatively large and exceeds her annual living expenses by a substantial amount. Also, being invested in small, high tech firms is an indication of Edgewood’s above average willingness to accept risk.]
20.2 Which of the following most accurately describes Edgewood’s tax, liquidity, and time horizon constraints? Edgewood’s overall time horizon is:

A)long, her tax constraints are significant, and her liquidity needs are high.
B)long, her tax constraints are significant, and her liquidity needs are low.
C)short, her tax constraints are significant, and her liquidity needs are low.

[Explanation: B) Edgewood’s overall time horizon is long—25 years or more—and it consists of two states: pre-retirement and post-retirement. A 30 percent income and capital gains tax is significant. Her liquidity needs are low and can easily be paid out of income]
21. When developing an investment policy statement (IPS), which of the following items should be one of the first considerations?

A)Unique circumstances.
B)Liquidity.
C)Return objectives.

[Explanation: C) When constructing an IPS, the first two considerations deal with objectives: return objectives and risk tolerance. The constraints are dealt with after the objectives have been stated]
22. Which of the following parts of an investment policy statement (IPS) is NOT considered a constraint?

A)Taxes.
B)Time horizon.
C)Risk tolerance

[Explanation: C) Risk tolerance levels are part of the objectives part of the IPS, not a constraint]
23. When constructing an investment policy statement (IPS), which of the following statements would be considered least accurate?

A)If there are liquidity requirements, the applicable after-tax return will need to be calculated.
B)One of the distinguishing factors between individual and institutional investors is time horizon.
C)The use of total return analysis is almost always the wrong way to approach an IPS

[Explanation: C) Use of a total return statement is almost never incorrect. Institutional investors may have infinite life but individuals do not. The other statements are true statements with respect to liquidity and time horizon]