LEVEL III, QUESTION 1

Topic: Portfolio Management - Institutional

Minutes: 20

Reading References:
1. “Managing Institutional Investor Portfolios,” Charles R. Tschampion, Laurence B. Siegel,
Dean J. Takahashi, and John L. Maginn, Managing Investment Portfolios: A Dynamic
Process, 3rd edition (AIMR, forthcoming)

Purpose:
To test the candidate’s ability to create an appropriate investment policy statement for a life
insurance company.

LOS: The candidate should be able to

“Managing Institutional Investor Portfolios” (Study Session 10)
h) create a formal investment policy statement for a foundation, an endowment, and an
insurance company;
j) differentiate among the return objectives, risk tolerances, liquidity requirements, time
horizon, tax considerations, regulatory environment, and unique circumstances of defined
benefit plans, foundations, endowments, and life and nonlife insurance companies.

Guideline Answer:
A. i. The return requirement for the bond portfolio is at least 7.5 percent (6 percent crediting
rate plus 1.5 percent marketing and administrative expenses). This level of return is
needed to cover both the cost of interest-sensitive products and associated marketing and
administrative expenses.

ii. The return requirement for the common stock portfolio is a total return equal to or greater
than the total return of the designated benchmark, the Wilshire 5000 Total Market Index.

2003 Level III Guideline Answers

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B.

Factors specific to
determining the risk Specific evidence for each factor that should be reflected in
objectives of a life Rightland Life’s risk objectives:
insurance company are:
1. Valuation concerns For the surplus, there are risks associated with the decline in the
stock market. Surplus as a percentage of assets has declined from
25 percent in 2000 to 17 percent in 2002. This could potentially
lead to a capital adequacy problem if asset prices erode further.
For the bond portfolio, there are similar risks associated with the
substantial widening of corporate bond spreads that has occurred
even though interest rates in general have declined during the
past two years.

2. Reinvestment risk Returns will suffer if interest rates continue to trend downward
and coupon and principal payments are reinvested at lower rates.

3. Credit risk The bond portfolio is too heavily invested (31 percent vs. an
industry average weighting of 17 percent) in lower-rated (BBB)
securities, resulting in excess credit risk.

4. Cash Flow Volatility Although cash flow volatility is a relevant factor in general, there
is no specific evidence that it should be reflected in Rightland’s
risk objectives.

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C.

Prepare the constraints section of an appropriate investment policy statement for

Rightland Life
1. Liquidity Requirements In the absence of evidence suggesting adverse cash flow volatility,
Rightland needs minimal liquidity.

2. Time Horizon Although life insurance companies generally have long time
horizons, Rightland has a somewhat shorter time horizon, evidenced
by the portfolio’s liability duration of five shown in Exhibit 1-1. The
average maturity of the bond portfolio of ten years may (or may not)
produce a portfolio duration that roughly matches the portfolio
duration of five. The time horizon of the company would be
somewhat longer when the investment of the surplus is considered.

3. Tax Considerations Although Rightland is subject to income, capital gains, and other
taxes, investment income on surplus is taxed whereas investment
income on the policyholders’ share of investment income is not
taxed. Tax considerations are a factor in determining the investment
mix that provides the most favorable after-tax returns.

4. Regulatory/Legal Rightland’s operations must conform to the insurance code of the

Considerations state where Rightland is domiciled. That state limits common stock
holdings of life insurance companies to 20 percent of total assets and
limits non-domestic investments to five percent of total assets.
Rightland needs to set aside an asset valuation reserve to limit the
impact of valuation and credit-related losses on the surplus.
Rightland must also adhere to the prudent person rule.

5. Unique Circumstances Rightland may not hold tobacco or alcohol stocks in its common
stock portfolio.

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Morning Session - Page 3
LEVEL III, QUESTION 2
Topic: Portfolio Management - Institutional
Minutes: 9

Reading References:
1. “Managing Institutional Investor Portfolios,” Charles R. Tschampion, Laurence B. Siegel,
Dean J. Takahashi, and John L. Maginn, Managing Investment Portfolios: A Dynamic
Process, 3rd edition (AIMR, forthcoming)

Purpose:
To test the candidate’s understanding of differences in the investment policy statements of life
and non-life insurance companies.

LOS: The candidate should be able to

“Managing Institutional Investor Portfolios” (Study Session 10)
i) appraise and contrast the factors that affect the investment policies of defined benefit plans,
foundations, endowments, and life and non-life insurance companies.

2003 Level III Guideline Answers

Morning Session - Page 4
Guideline Answer:

Determine whether Rightland

Justify each of your responses
Life or Southaw P&C is the
by providing one
Anget’s three questions more appropriate response to
characteristic of the
each of Anget’s three questions
appropriate company
(circle one for each question)
Rightland has more predictable
cash flows than Southaw.
Rightland Life Rightland has a proportionately
larger surplus compared to the
Southaw P&C industry average than Southaw
Which subsidiary has
(17 percent of assets for
greater ability to take risk?
Rightland vs. five percent for the
industry compared to ten percent
for Southaw vs. eight percent for
the industry).

Rightland’s time horizon is

Rightland Life longer because it has longer-
term (duration) liabilities than
Which subsidiary has a Southaw (Southaw’s estimated
longer time horizon? Southaw P&C duration of liabilities is three
compared to Rightland’s
duration of five).

Southaw has relatively

unpredictable cash flows
Rightland Life compared to the relative cash
flow certainty of Rightland.
Which subsidiary has Southaw’s underwriting cycle
greater liquidity needs? Southaw P&C would typically require the
company to liquidate
investments to fund periodic
cash flow shortfalls.

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LEVEL III, QUESTION 3
Topic: Portfolio Management - Institutional
Minutes: 6

Reading References:
1. “Managing Institutional Investor Portfolios,” Charles R. Tschampion, Laurence B. Siegel,
Dean J. Takahashi, and John L. Maginn, Managing Investment Portfolios: A Dynamic
Process, 3rd edition (AIMR, forthcoming)

Purpose:
To test the candidate’s ability to critique an asset allocation for a nonlife insurance company.

LOS: The candidate should be able to

“Managing Institutional Investor Portfolios” (Study Session 10)
k) compare and contrast the asset/liability management needs of life and nonlife insurance
companies;
l) formulate the overall portfolio management process leading to an investment policy
statement and an asset allocation decision for an institutional investor, including developing
objectives and constraints and analyzing capital market expectations.

Guideline Answer:
A. The shortcoming with respect to the critical goal of asset/liability management is that the
bond portfolio duration (5.2) is mismatched in relation to the estimated duration of liabilities
(1.8).

The recommended changes in the asset allocation are to:

• decrease the allocations to longer duration assets such as U.S. long-term government
bonds, U.S. investment grade corporate bonds, and U.S. intermediate-term government
bonds
• increase the allocation to shorter duration assets such as cash equivalents.

B. The asset allocation is not appropriate with respect to the liquidity needs of the automobile
insurance division.

The current allocation to cash equivalents of two percent is insufficient to meet the liquidity
demands of a casualty business with low liability duration (1.8) and potentially erratic cash
flows.

2003 Level III Guideline Answers

Morning Session - Page 6
LEVEL III, QUESTION 4
Topic: Equity Valuation
Minutes: 8

Reading References:
3. Emerging Stock Markets: Risk, Return, and Performance, Christopher B. Barry, John W.
Peavy III, and Mauricio Rodriguez (Research Foundation of the ICFA, 1997)
A. “Introduction”
B. “Historical Performance of Emerging Equity Markets,” Ch. 1
C. “Portfolio Construction Using Emerging Markets,” Ch. 2

Purpose:
To test the candidate’s ability to interpret the effects of adding an asset class (e.g., emerging
markets) to an existing asset allocation.

LOS: The candidate should be able to

“Introduction” (Study Session 5)
c) discuss the potential benefits of investing in emerging markets.
“Historical Performance of Emerging Equity Markets” (Study Session 5)
a) evaluate the historical performance of emerging equity markets;
b) discuss the importance of currency issues in emerging market investing;
c) discuss the risks involved in investing in emerging markets.
“Portfolio Construction Using Emerging Markets” (Study Session 5)
a) appraise the impact on portfolio risk of adding emerging market stocks to a portfolio
containing securities from developed markets;
b) discuss the variations of various correlations over time among different emerging markets
and between emerging and developed markets, and the implications for portfolio
construction.

Guideline Answer:
Determine whether
each of Houston’s
four comments is If incorrect, give one reason why
Houston’s four comments
correct or incorrect the comment is incorrect
(circle one for each
comment)
1. “For an investor holding There have been periods of strong
only developed market performance despite weak currencies.
equities, the existence of Correct It is also possible that an appreciating
stable emerging market currency could enhance performance.
currencies is one of several
pre-conditions necessary for Incorrect
that investor to realize strong
emerging market
performance.”
2003 Level III Guideline Answers
Morning Session - Page 7
2. “Local currency
depreciation against the dollar
has been a frequent
Correct
occurrence for U.S. investors
in emerging markets. U.S.
investors have consistently
seen large percentages of their Incorrect
returns erased by currency
depreciation. This is true even
for long-term investors.”

3. “Historically, the addition

of emerging market stocks to
a U.S. equity portfolio such as
the S&P 500 has reduced Correct
volatility, volatility has also
been reduced when emerging
market stocks are combined Incorrect
with an international portfolio
such as the MSCI EAFE
Index.”

4. “Although correlations Correlations are not stable over time.

among emerging markets can Also, the portfolio can move
change over the short term, dramatically away from the efficient
such correlations show Correct frontier from one period to the next.
evidence of stability over the
long term. Thus an emerging
markets portfolio that lies on Incorrect
the efficient frontier in one
period tends to remain close
to the frontier in subsequent
periods.”

2003 Level III Guideline Answers

Morning Session - Page 8
LEVEL III, QUESTION 5
Topic: Quantitative Analysis
Minutes: 16

Reading References:
1. Quantitative Methods for Investment Analysis, Richard A. DeFusco, Dennis W. McLeavey,
Jerald E. Pinto, and David E. Runkle (AIMR, 2001)
A. “Multiple Regression and Issues in Regression Analysis,” Ch. 9

Purpose:
To test the candidate’s ability to interpret and analyze the results of a multiple regression model.

LOS: The candidate should be able to

“Multiple Regression and Issues in Regression Analysis” (Study Session 3)
b) determine whether each independent variable in a multiple regression is statistically
significant in explaining the dependent variable and interpret the coefficients;
c) formulate a null and an alternative hypothesis about the population value of a regression
coefficient, calculate the value of the test statistic, determine whether the null hypothesis is
rejected at a given level of significance, and interpret the result of the test;
h) define, calculate, and interpret the F-statistic and discuss how it is used in regression
analysis;
i) distinguish between and interpret the R2 and adjusted R2 in multiple regression;
k) formulate a multiple regression equation, using dummy variables to represent qualitative
factors, and interpret the results;
l) discuss the types of heteroskedasticity and the effects of conditional heteroskedasticity on
statistical inference;
m) discuss the effects of serial correlation on statistical inference;
n) explain how to test and correct for heteroskedasticity and serial correlation;
p) discuss the causes and effects of multicollinearity in regression analysis.

Guideline Answer:
A. Houston’s conclusion is incorrect.

The F-statistic is not the appropriate statistic to judge the significance of individual
independent variables in a multiple regression. The F-statistic measures the joint significance
of all independent variables in a multiple regression; a significant F-statistic indicates that at
least one of the independent variables is significant, but the F-statistic cannot be used to
judge the significance of individual independent variables. The t-statistic should be used to
determine the significance of the individual independent variables in a multiple regression
model.

2003 Level III Guideline Answers

Morning Session - Page 9
B. The R-Squared will generally increase when independent variables are added to the
regression model, whether or not the additional variables materially increase the model’s
explanatory power (i.e., are significant).

The adjusted R-Squared corrects for the loss of degrees of freedom resulting from the
addition of independent variables, and does not automatically increase when insignificant
independent variables are added to a regression model.

Based on the adjusted R-Squared (the preferred measure), the explanatory power of
Houston’s regression has not increased.

C. Multicollinearity is the most likely cause of the result observed by Houston.

The action that Houston should take is to experiment with excluding different independent
variables to determine the source of the multicollinearity and then remove the variable(s)
causing the multicollinearity from the model.

D. The new variables that should be added to Houston’s regression model to test for a month-of-
year effect are dummy variables.

There would be 11 dummy variables, one for each month of the year with one arbitrary
month omitted. Each monthly dummy variable will take a value of one in the specified
month, and zero in all other months.

E.

Identify the evidence that would

Recommend one method
most directly suggest the
Two problems for correcting each
presence of each of the two
problem
problems in a regression model
i. Heteroskedasticity A significant Breusch-Pagan test 1. Compute robust standard
statistic errors using White’s (1980)
or Hansen’s (1982) method.
2. Apply generalized least
squares.
ii. Positive serial A significant Durbin-Watson test Compute robust standard
correlation statistic errors using Hansen’s (1982)
method (also referred to as
the Hansen-White or
Newey-West methods).

2003 Level III Guideline Answers

Morning Session - Page 10
LEVEL III, QUESTION 6
Topic: Risk Management
Minutes: 18

Reading References:
1. “Alternative Measures of Risk,” Roger G. Clarke, Investment Management, Peter L.
Bernstein and Aswath Damodaran, eds. (Wiley, 1998)

Purpose:
To test the candidate’s understanding of, and ability to calculate and interpret, various measures
of risk.

LOS: The candidate should be able to

“Alternative Measures of Risk” (Study Session 15)
d) describe the circumstances in which variance or standard deviation may fail to capture
selected dimensions of risk;
e) calculate and interpret the beta for a stock or a portfolio;
h) calculate the tracking error of a stock and a stock portfolio relative to a market index;
j) describe how changes in security characteristics and market parameters affect the tracking
error of a stock or bond portfolio;
k) contrast tracking error, beta, and standard deviation as measures of risk;
l) appraise and evaluate the probability of shortfall, expected shortfall, and relative
semivariance as risk measures.

2003 Level III Guideline Answers

Morning Session - Page 11
Guideline Answer:
A.

Indicate whether
each of Houston’s
Houston’s three three statements is If incorrect, give one reason why the
statements correct or incorrect statement is incorrect
(circle one for each
statement)
1. “Probability of shortfall Houston’s statement is incorrect
is a useful risk measure because the probability of shortfall
because it shows the Correct does not indicate the potential
manager’s potential for magnitude for losses. The probability
large losses.” of shortfall gives the probability that
Incorrect the undesirable event or return will
occur (the chance that returns from the
portfolio may fall below a chosen
reference point), but does not give any
information about how severe the
undesirable event will be.
2. “If financial market
returns are normally
distributed, standard Correct
deviation is the most
appropriate measure of total
risk.” Incorrect

3. “Expected shortfall is not Houston’s statement is incorrect

a desirable risk measure because expected shortfall does not
because it penalizes Correct address returns over the benchmark
performance above the return and so does not penalize
benchmark index’s return.” Incorrect performance above the benchmark
return. Expected shortfall incorporates
the probability of shortfall and the
magnitude of the potential shortfall if
it does occur. In so doing, expected
shortfall only measures the difference
between the actual return and the
benchmark over the range of returns
when there is a shortfall.

2003 Level III Guideline Answers

Morning Session - Page 12
B. The tracking error (TE) for Mendon Advisors is 11.9%.

The TE is calculated using the following formula:

____________________
TE = √ [(βp – βm)2 × σm2] + σrp2

where

βp = portfolio beta
βm = market beta
σm = market standard deviation
σrp = portfolio residual standard deviation

__________________________
TE = √ [(0.80 – 1.00)2 × 15.02] + 11.52

TE = 11.9%

C.

Indicate whether
each of Houston’s
two conclusions is If incorrect, give one reason why the
Houston’s two conclusions correct or incorrect conclusion is incorrect
(circle one for each
conclusion)
1. If Chariton Partners has a Portfolio beta in absolute terms does not
larger tracking error than determine tracking error, and a higher
Mendon Advisors, that is Correct portfolio beta does not, in and of itself,
because Chariton’s portfolio signify higher tracking error. What
has a higher beta. matters in the calculation of tracking
Incorrect error is the difference between the
portfolio beta and the beta of the market
portfolio. In that regard, Chariton’s beta
of 1.1 is actually closer to the market
beta of 1.0 than is Mendon’s beta of 0.8.

2. If Chariton Partners has a The portfolio Sharpe ratio is not an input

larger tracking error than Correct in calculating or determining tracking
Mendon Advisors, that is error. Instead, the tracking error
because Chariton’s portfolio calculation uses portfolio residual
has a lower Sharpe ratio. Incorrect standard deviation.

2003 Level III Guideline Answers

Morning Session - Page 13
LEVEL III, QUESTION 7
Topic: Portfolio Performance Measurement
Minutes: 9

Reading References:
2. “Evaluating Portfolio Performance,” Ch. 14, pp. 14-23 through 14-47, Peter Dietz and
Jeannette Kirschman, Managing Investment Portfolios: A Dynamic Process, 2nd edition, John
L. Maginn and Donald L. Tuttle, eds. (Warren, Gorham & Lamont, 1990)
3. “Measuring and Evaluating Performance,” Frank J. Fabozzi, Ch. 9, pp. 271−278 and
281−299, Fixed Income Readings for the Chartered Financial Analyst Program, Frank J.
Fabozzi, ed. (Frank J. Fabozzi Associates, 2000)

Purpose:
To test the candidate’s ability to measure and evaluate portfolio performance.
LOS: The candidate should be able to
“Evaluating Portfolio Performance” (Study Session 16)
b) appraise the advantages and limitations of using manager universes, benchmark indexes,
normal portfolios, and attribution analysis to evaluate investment manager performance;
d) critique the use of publicly available indexes (e.g., S&P 500) as benchmarks;
f) judge a portfolio manager’s performance relative to a market index or benchmark, especially
considering the effect of returns resulting from exposure to various industry sectors and the
specific investment objectives of the portfolio.
“Measuring and Evaluating Performance” (Study Session 16)
e) explain the decomposition of both a domestic and a global fixed-income portfolio’s return
into factors;
f) interpret a return attribution for both a domestic and a global fixed-income portfolio and for
the relevant benchmark;
g) evaluate, based on a return attribution, the consistency of an investment manager’s
performance versus the manager’s stated investment style.

2003 Level III Guideline Answers

Morning Session - Page 14
Guideline Answer:
A. i. Very little of Broughton’s performance results can be attributed to relying on active
interest rate management decisions.

The performance contribution for Interest Rate Management Effect—the primary

indicator of effective active interest rate management decisions—was only 0.16,
indicating Broughton’s lack of success at anticipating interest rate changes and
incorporating those changes in the portfolio allocation. Nearly all of Broughton’s positive
performance—1.37 percent of the total 1.66 percent—was a result of the Interest Rate
Effect, a totally passive effect that is not related to active manager decisions.

ii. Very little of Broughton’s performance results can be attributed to identifying individual
issues that are mispriced.

The performance contribution for Bond Selectivity—the most direct measure of success
in security selection—was only 0.12. Nearly all of Broughton’s positive performance—
1.37 percent of the total 1.66 percent—was a result of the Interest Rate Effect, an effect
that is not related to successfully identifying mispriced securities.

B. A substantial portion of Matthews’ performance results can be attributed to identifying

undervalued sectors. The performance contribution for Sector/Quality was 1.15 percent,
which represented a large proportion of Matthews’ overall return of 1.61 percent.

2003 Level III Guideline Answers

Morning Session - Page 15
LEVEL III, QUESTION 8
Topic: Portfolio Performance Standards
Minutes: 12

Reading References:
1. GIPS Handbook, Edition 1, CFA Candidate Version, pp. 1−116 and 146−148 (AIMR, 2002)
2. “Global Investment Performance Standards – Level III Workbook” (AIMR, 2002)

Purpose:
To test the candidate’s understanding of GIPS and ability to modify a performance report to
make the report GIPS-compliant.

LOS: The candidate should be able to

“GIPS Handbook” and “Global Investment Performance Standards − Level III Workbook”
(Study Session 17)
e) describe the minimum historic performance record requirement and the proper treatment of
non-complaint performance record;
g) discuss the requirements and recommendations of the GIPS standards with respect to input
data, including supporting information, portfolio valuation, and accounting methods;
h) discuss the requirements and recommendations of the GIPS standards with respect to
calculation methodology, including return calculations, composite weightings, cash returns,
expenses, and minimum asset levels;
i) discuss the requirements and recommendations of the GIPS standards with respect to
composite construction, including inclusion of all portfolios, composite definitions,
terminated portfolios, switching portfolios, carve-out single asset classes, and simulated or
model portfolios;
j) discuss the requirements and recommendations of the GIPS standards with respect to
disclosures, including the definition of firm, firm assets, list of composites, valuation
methodology, asset level requirements, currency used, the use of leverage or derivatives,
management fees, accounting methods, benchmark discussions, fees, conformation to local
laws or regulations, compliance periods, and cash allocation methods;
k) discuss the requirements and recommendations of the GIPS standards with respect to
presentation and reporting, including time frame of performance records, annual returns,
composite and firm assets, dispersion measures, compliance statement, creation dates, non-
compliant performance linking, annualization, portability of records, carve-out asset classes,
and benchmarks.

2003 Level III Guideline Answers

Morning Session - Page 16
Guideline Answer:
Note: Statement 1 is completed in the Template as an example.
Five statements in Explain one additional requirement that Matthews Advisors
Matthews Advisors’ must satisfy for each of Matthews’ statements 2 through 5 to
annual performance be in compliance with the Global Investment Performance
report Standards (GIPS)
Example: Example:

1. “Matthews Advisors According to GIPS, Matthews has discretion in the selection of an

does not include appropriate benchmark, but if Matthews has determined that no
benchmark returns in its benchmark is appropriate, the firm must explain why benchmark
performance report.” returns are not disclosed.

2. “To show performance The GIPS Standards allow firms to link non-GIPS compliant
returns since our inception, performance to their five-year compliant history, but firms must
Matthews Advisors has disclose which periods are not in compliance and the reasons the
linked non-GIPS compliant performance does not comply with GIPS Standards. To be in
performance to our five compliance, Matthews must disclose which periods are
years of GIPS compliant noncompliant and the reasons why the noncompliant periods were
returns.” not in compliance.

3. “Matthews Advisors If Matthews includes non-fee paying portfolios in the composite,

manages the fixed income the firm must disclose the percentage of composite assets
portion of its employee represented by non-fee paying portfolios for each year the firm
pension plan using an claims compliance with GIPS Standards. To be in compliance,
active sector rotation Matthews must include the percentage of composite assets
strategy and includes the represented by the employee pension plan account.
account in the composite
shown. This account does
not pay a management
fee.”

4. “Matthews Advisors If Matthews uses swaps, which are derivative instruments, the
uses swap instruments to firm must also disclose information sufficient to identify the risks
enhance returns in fixed of the derivative instruments. To be in compliance, Matthews
income portfolios under must specifically include a description of the: 1) use, 2) frequency,
management.” and 3) characteristics of the instruments.

2003 Level III Guideline Answers

Morning Session - Page 17
5. “All the portfolio The GIPS Standards are based on the concept that performance
managers from the fixed belongs to the firm and not to the individuals who manage the
income investment advisor portfolio(s). When a group of managers joins a new firm, a
Mayer, Garcia and Nicks composite’s past performance can be linked with the results of a new
(MGN) joined Matthews firm only if: 1) the investment decision-making process remains
Advisors in May 2001. substantially unchanged, 2) the staff and decision-makers remain
The MGN performance independent within the new firm, 3) the new firm discloses the
record has been linked to linking of performance results from the old firm to the new one
the performance record of (which Matthews does), and 4) the new firm has records and
Matthews Advisors.” documents that support the performance record. To be in compliance,
Matthews must meet all the above tests of portability.

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Morning Session - Page 18
LEVEL III, QUESTION 9
Topic: Portfolio Management- Individual
Minutes: 22

Reading References:
1. Managing Investment Portfolios: A Dynamic Process, 3rd edition (AIMR, forthcoming)
A. “The Portfolio Management Process and the Investment Policy Statement,” John L.
Maginn, Donald L. Tuttle, Dennis W. McLeavey, and Jerald E. Pinto
B. “Managing Individual Investor Portfolios,” James W. Bronson, Matthew H. Scanlan, and
Jan R. Squires

Purpose:
To test the candidate’s ability to prepare an investment policy statement for an individual
investor.

LOS: The candidate should be able to

“The Portfolio Management Process and the Investment Policy Statement” (Study Session 9)
m) discuss the determination of the risk objective;
n) discuss the determination of the return objective;
o) discuss the liquidity requirement and explain how a liquidity requirement can be considered a
constraint;
p) discuss the types of time horizons and explain how time horizon can be considered a
constraint;
q) explain how tax concerns can be considered a constraint;
r) explain how legal and regulatory factors can be considered a constraint;
s) explain how unique circumstances can be considered a constraint.
“Managing Individual Investor Portfolios” (Study Session 9)
i) discuss each of the major objectives that are part of an individual investor’s investment
policy statement;
j) distinguish between an individual investor’s ability to take risk and willingness to take risk;
k) discuss each of the major constraints that are part of an individual investor’s investment
policy statement;
l) prepare an investment policy statement for an individual investor.

2003 Level III Guideline Answers

Morning Session - Page 19
Guideline Answer:
A. Objectives

1. Risk Tolerance

Ability. The Trust has average ability to assume risk, largely because the total return
requirement is a relatively modest 6.71 percent (see calculation below). Compared to
portfolio assets, before-tax expenses plus inflation equals 3.71 percent + 2 percent = 5.71
percent, which is an achievable level given the size of the portfolio. The Petrie
Enterprises stock, however, represents 12 percent of the portfolio. If the value of the
portfolio were to drop significantly, it would be more difficult for the portfolio to meet its
return requirements. Because the portfolio is the only source of support for Bavier, the
Trust’s ability to assume risk is lower than it might otherwise be.

Willingness. The Trust has below average willingness to assume risk. The Trust
document requires that the account be invested so that shortfall risk (defined as expected
total return minus two standard deviations) is limited to a –10 percent return in any one
year. This limitation implies that the Trust will be unwilling to tolerate any substantial
volatility in portfolio returns. Bavier has a below average willingness to assume risk,
given her unfortunate prior experience of receiving poor financial advice and seeing her
inherited assets shrink. In addition, Bavier is relying on steady returns to meet her current
and future living expenses.

Overall risk tolerance. The Trust has below average risk tolerance and will continue to
have it for many years, especially while Bavier is alive.

2. Return Requirement

The return requirement reflects two major factors: the need to cover living expenses and
the need to protect the portfolio from the adverse effects of inflation. Specifically, the
Trust must generate a total before-tax return of at least 6.71 percent on an annual basis to
meet the return requirements.

The living expenses are estimated at $78,000 per year. However, because income and
capital gains are taxed at 30 percent, the Trust will need to generate $111,429 before tax
to meet the living expenses of Bavier and Campbell, which equals a 3.71 percent return
on the $3,000,000 portfolio. Adding inflation and growth results in the total return of
6.71%, as follows:
(($78,000 / (1 – 0.30)) / $3,000,000) + 2% inflation + 1% (minimum) for growth =
($111,429 / $3,000,000) + 2% inflation +1% (minimum) for growth =
3.71% + 2% + 1% = 6.71%

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Morning Session - Page 20
B. Constraints

1. Liquidity Requirements

The Trust has minimal liquidity needs, at least until Campbell begins his university
education, but should maintain liquidity, in case of emergencies, of $83,571, which is
equal to nine months of the first year's estimated living expenses on a pre-tax basis (as
mandated by the Trust), or [($78,000 / 0.70) × (9 / 12)].

2. Time Horizon

Based on the assumption that Campbell lives longer than Bavier, the Trust faces a time
horizon comprising three stages:

• The first stage is years 1 through 6, when the living expenses of Bavier and Campbell
are expected to increase consistent with inflation.
• The second stage would be years 7 through 10, when Bavier’s expenses continue and
Campbell’s expenses increase with the cost of his university education.
• The third and probably final stage would extend from year 11 onward to Bavier’s
death or year 20, whichever is later. As long as Bavier is alive, her expenses will
continue. If Bavier dies, this third stage would last until year 20, when Campbell
turns 32. During this period between Bavier’s death and year 20, if it occurs,
Campbell would receive distributions from the Trust sufficient to cover essential
expenses in excess of his after-tax income.

3. Tax Considerations

The Trust will be subject to taxes; therefore after-tax returns of individual securities and
of the portfolio will be critical. Income and capital gains are both taxed at the 30 percent
rate. The Trust should evaluate assets and portfolio returns on an after-tax basis and
consider the possible attractiveness of tax-advantaged securities.

4. Regulatory/Legal Considerations

The Trustee will need to follow the Prudent Investor statutes. The Trust also has the usual
fiduciary responsibilities.

5. Unique Circumstances

The restriction on selling the Petrie Enterprises common stock is a material unique
circumstance.

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Morning Session - Page 21
LEVEL III, QUESTION 10
Topic: Portfolio Management- Individual
Minutes: 22

Reading References:
1. Managing Investment Portfolios: A Dynamic Process, 3rd edition (AIMR, forthcoming)
B. “Managing Individual Investor Portfolios,” James W. Bronson, Matthew H. Scanlan, and
Jan R. Squires

Purpose:
To test the candidate’s: 1) understanding of the factors affecting the asset allocation for an
individual investor, and 2) ability to determine an appropriate asset allocation.

LOS: The candidate should be able to

“Managing Individual Investor Portfolios” (Study Session 9)
o) describe how a process of elimination can be used to arrive at an appropriate strategic asset
allocation for an individual investor.

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Morning Session - Page 22
Guideline Answer:
Portfolio B is the most appropriate asset allocation for the Trust.

The following table summarizes the five alternative portfolios in the context of the Trust’s
objectives and constraints:
Alternative Portfolios
Trust Objectives and Constraints A B C D E
Minimum Return (pre tax) = 6.71% 6.89% 6.74% 6.52% 6.06% 7.23%
Downside risk no worse than –10% –9.71% –8.68% –8.20% –7.00% –10.35%
Minimum Cash Equivalents = 2.79% of assets 2.00% 4.00% 10.00% 2.00% 5.00%

Recommendation of Portfolio B is justified by the following:

• Portfolio B has a before-tax expected return of 6.74%, which meets the Trust's return
requirement of 6.71% (see Question 10A for explanation of the return requirement).
• Portfolio B has an anticipated downside risk of –8.68% [measured by the expected return
minus two standard deviations, (6.74% – (2 × 7.71%) = –8.68%)], which falls within the
downside risk tolerance criterion of no worse than –10%.
• Portfolio B has cash equivalents equal to 4.00% of assets, which meets the Trust’s
liquidity requirement of nine months’ living expenses [($78,000 / 0.7) × (9 / 12) =
$83,571 or 2.79% of the $3,000,000 in assets].

Portfolio A fails to meet the minimum liquidity requirement and barely meets the downside risk
requirement while having greater downside risk exposure than Portfolio B.

Portfolios C and D fail to meet the minimum return requirement and Portfolio D fails to meet the
liquidity requirement.

Portfolio E fails to meet the downside risk requirement.

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Morning Session - Page 23
LEVEL III, QUESTION 11
Topic: Portfolio Management- Individual
Minutes: 18

Reading References:
1. Managing Investment Portfolios: A Dynamic Process, 3rd edition (AIMR, forthcoming)
B. “Managing Individual Investor Portfolios,” James W. Bronson, Matthew H. Scanlan, and
Jan R. Squires
2. “The Psychology of Risk,” Amos Tversky, Quantifying the Market Risk Premium
Phenomenon for Investment Decision Making (AIMR, 1990)
3. “Behavioral Risk: Anecdotes and Disturbing Evidence,” Arnold Wood, Investing Worldwide
VI (AIMR, 1996)
4. “Behavioral Finance: Past Battles and Future Engagements,” Meir Statman, Financial
Analysts Journal (AIMR, November/December 1999)

Purpose:
To test the candidate’s: 1) understanding of behavioral issues that affect an individual investor,
and 2) ability to modify an individual investor’s investment policy statement to reflect changed
circumstances.

LOS: The candidate should be able to

“Managing Individual Investor Portfolios” (Study Session 9)
a) define situational profiling for individual investors and describe source of wealth, measure of
wealth, and stage of life as approaches to situational profiling;
b) prepare an elementary situational profile for an individual investor;
c) discuss the basic principles of the behavioral finance investment framework;
d) describe how investor psychology influences wealth creation and investment choices;
e) describe how risk attitudes and decision-making styles can be related to individual investor
personality types;
j) distinguish between an individual investor’s ability to take risk and willingness to take risk;
k) discuss each of the major constraints that are part of an individual investor’s investment
policy statement;
l) prepare an investment policy statement for an individual investor.
“The Psychology of Risk” (Study Session 9)
a) contrast the assumptions of rational investment decision making to observed investor
behaviors such as loss aversion, reference dependence, asset segregation, mental accounting,
and biased expectations.
“Behavioral Risk: Anecdotes and Disturbing Evidence” (Study Session 9)
b) appraise how prospect theory can be used to explain how investors treat losses differently
than gains.
“Behavioral Finance: Past Battles and Future Engagements” (Study Session 9)
a) contrast the standard finance view of human investor behavior and a behavioral finance
framework.

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Morning Session - Page 24
Guideline Answer:
A.

Determine whether Bavier

and Campbell are
Three
generally alike or different
situational Justify each of your responses with one reason
with respect to each of the
profiles
three situational profiles
(circle one for each profile)
The source of wealth for both Bavier and Campbell
Alike is the Trust. Campbell now has a salary but as yet
Source of has no independent wealth accumulation.
wealth
Different

Bavier measures wealth in terms of the Trust

portfolio’s ability to generate enough distributions
to provide for her lifetime living expenses. She has
expressed concern about the Trust’s ability to meet
Alike these needs even over her relatively short remaining
Measure of lifetime.
wealth
Campbell measures wealth in terms of the Trust
Different portfolio’s ability to generate near-term returns (for
Bavier) and provide long-term growth to meet his
future obligations. He views the growth of the
Trust as vital.
Bavier is elderly and in failing health, and is most
concerned with maintaining sufficient cash flow to
cover spending needs during her remaining lifetime.
Stage of life Her time horizon is at most three years and she is
primarily concerned with maintaining her current
Alike living standard through the returns and asset values
provided by the Trust.
Campbell is young and most concerned with
Different growing the assets to meet his partnership
obligations and taking full advantage of his long-
term time horizon to enhance his living standard.
Although the difference might be less than is
suggested merely by comparing their ages, there is
clearly a difference with respect to perspective
imparted by their respective stages of life.

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Morning Session - Page 25
B. The behavioral finance principle of biased expectations/overconfidence is most consistent
with Bavier’s first statement.

Petrie stock provides a level of confidence and comfort for Bavier, because of the
circumstances in which she acquired the stock and her recent history with the returns and the
income from the stock. However, Bavier exhibits overconfidence in the stock given the needs
of the Trust and the brevity of the recent performance history. Maintaining a 15 percent
position in a single stock is inconsistent with the overall strategy of the Trust, and her level of
confidence should reflect the stock’s overall record, not just the past two years.

The behavioral finance principle of mental accounting is most consistent with Bavier’s
second statement.

Bavier has segregated the monies distributed from the Trust into two “accounts”—the returns
the Trust receives from the Petrie stock, and the remaining funds that the Trust receives for
her benefit. She is maintaining a separate set of mental accounts with regard to the total funds
distributed. Bavier’s “specific uses” should be viewed in the overall context of the spending
needs of the Trust and should consider the risk and return profile of the entire Trust.

C. i. The Bavier-Campbell Trust’s willingness to take risk is below average because of its
need to have a high probability of covering Bavier’s living expenses during the remainder
of her lifetime, which encompasses a short time horizon. The below average willingness
of Bavier (coupled with her short time horizon) dominates the above average willingness
of Campbell (coupled with his long time horizon).

ii. Campbell’s willingness to take risk is above average because of the relatively long time
horizon that results from his desire for the Trust to grow enough to cover his fixed
payments of $600,000 per year in years 11 through 15. His willingness is further
enhanced by the fact that the Trust assets themselves will be distributed to him upon
termination of the Trust. His willingness may be tempered somewhat by his desire to
have the entire amount of his obligation available when the first payment is due.

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Morning Session - Page 26
LEVEL III, QUESTION 12
Topic: Equity Valuation
Minutes: 27

Reading References:
5. “The Reality of Hedge Funds,” pp. 26–35 (up to “Conclusions Drawn from the Data”),
Appendix B, and Appendix C, Dave Purcell and Paul Crowley, Journal of Investing
(Institutional Investor, Fall 1999)
6. Alternative Investing (AIMR, 1998)
A. “Controlled Risk Strategies,” Bruce I. Jacobs
7. “The Search for Alpha Continues−Do Fund of Hedge Funds Managers Add Value?”
Alexander M. Ineichen, pp. 26−61 and 73−80, UBS Warburg Global Alternative Investment
Strategies (September 2001)

Purpose:
To test the candidate’s understanding of hedge fund strategies and controlled risk strategies.

LOS: The candidate should be able to

“The Reality of Hedge Funds” (Study Session 8)
b) identify the general approaches to investment that are common to hedge funds;
c) contrast the different segments of the hedge fund universe in terms of investment strategy,
use of leverage, and risk control;
d) analyze the risks inherent in hedge funds.
“Controlled Risk Strategies” (Study Session 8)
d) discuss how to equitize a long-short strategy;
e) explain why the alpha generated from a long-short strategy is transportable to other asset
classes.
“The Search for Alpha Continues−Do Fund of Hedge Funds Managers Add Value?” (Study
Session 8)
c) discuss the advantages and disadvantages of investing in funds of hedge funds;
d) discuss the investment process of the funds of hedge funds manager (i.e., manager selection
and review; portfolio construction and risk management);
e) differentiate between the dispersion of returns of directional and non-directional hedge fund
strategies;
f) discuss risk and performance monitoring related to funds of hedge funds (i.e., transparency,
market risk exposure, leverage, style drift, and legal and compliance).

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Morning Session - Page 27
Guideline Answer:
A. 1. The alpha from the long-short strategy can be transported to other asset classes by
combining a long-short portfolio with other derivatives such as swaps and futures. The
appropriate derivatives to overlay on the long-short position would be determined by the
type of return that the investor seeks to replicate.

2. The three major quantifiable sources of risk are:

i) Market risk
ii) Credit risk
iii) Liquidity risk

Supplemental information (not required):

i) Market risk refers to losses that could arise as a result of changes in market factors.
ii) Credit risk refers to losses that could arise as a result of declines in the creditworthiness
of the fund’s investments or counterparties.
iii) Liquidity risk refers to losses that could arise as a result of changes in a fund’s investment
strategies, the liquidity of assets, and the rights of investors to redeem their investments.

3. Risk-based leverage uses a measure of market risk (such as VAR) relative to a measure
of the resources available to absorb risk (such as cash or equity). Accounting-based
leverage is based on the traditional concept of measuring asset values relative to equity
capital.

B. The hedge fund investment strategies best characterized by each of the three strategy
components reviewed by Marco are:

1. Quantitative strategy
2. Arbitrage/relative value strategy
3. Quantitative strategy

Supplemental information (not required):

1. The first component—describing a quantitative strategy—involves purchasing stocks
after positive earnings surprise announcements, anticipating that stock prices will rise in
the short term. This strategy employs a tested, historically profitable trading pattern.
2. The second component—describing an arbitrage/relative value strategy—involves buying
and selling stocks of companies that have announced or are rumored to be considering a
merger or acquisition transaction. In this strategy, investors predict the likelihood that the
announced or rumored transactions actually will be closed.
3. The third component—describing a quantitative strategy—involves using neural
networks to detect patterns in historical data; computer-generated analyses of past trading
patterns are used to determine future trading strategies.

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Morning Session - Page 28
C.

Judge whether
each of Marco’s
five Conclusions If incorrect,
Marco’s five
is correct or give one Reason why the Conclusion is
Conclusions
incorrect incorrect
(circle one for
each Conclusion)
1. Investing in a fund of
hedge funds is likely to
increase the client’s Correct
portfolio diversification
and allow the client’s
portfolio to have
exposure to a wide Incorrect
variety of hedge funds
that may not otherwise be
available to the client.

2. A lack of transparency Managers of a fund of hedge funds can add

and the fund manager’s value through portfolio construction,
inability to add value including asset allocation, manager
Correct
through portfolio selection analyses, or monitoring
construction are both investments or managers. (A lack of
disadvantages of Incorrect transparency is a disadvantage of a fund of
investing in a fund of hedge funds.)
hedge funds.

3. Because a directional A directional hedge fund is expected to

hedge fund is expected to have a higher dispersion (not lower) of
exhibit a lower returns than a non-directional hedge fund.
Correct
dispersion of returns than A non-directional hedge fund strategy
a non-directional hedge would carry a lower standard deviation of
fund, a directional hedge Incorrect returns and be more consistent with this
fund is a more client’s objective of reduced portfolio risk.
appropriate investment
for this client.

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4. One appropriate A macro strategy involves investing in
hedge fund investment forwards and futures and taking positions
strategy for this client is in the bond, equity, and currency
a macro hedge fund, Correct markets. Thus, a macro strategy is
which is likely to directional and is more volatile than
provide increased Incorrect many other hedge fund strategies. Such a
returns with a relatively strategy is inconsistent with the risk
low standard deviation objectives of this client.
of returns.

5. Another approach that An equitized long-short strategy exposes

is consistent with the the client’s portfolio to market risk. This
client’s objectives is to Correct increase in the risk of the client’s
use an equitized long- portfolio is inconsistent with the client’s
short strategy, which can objectives. The hedge fund approach
Incorrect
be expected to neutralize more likely to neutralize market risk is a
market risk. long-short (market neutral) strategy.

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Morning Session - Page 30
LEVEL III, QUESTION 13
Topic: Portfolio Management- Economic Analysis
Minutes: 8

Reading References:
1. Economic Analysis for Investment Professionals (AIMR, 1997)
B. “Economic Forecasts and the Asset Allocation Decision,” Abby Joseph Cohen
3. Improving the Investment Decision Process—Better Use of Economic Inputs in Securities
Analysis and Portfolio Management (AIMR, 1992)
B. “Developing a Recommendation for a Global Portfolio,” Charles I. Clough, Jr.

Purpose:
To test the candidate’s understanding of economic factors that affect sector and market risks and
returns.

LOS: The candidate should be able to

“Economic Forecasts and the Asset Allocation Decision” (Study Session 4)
b) contrast consumer and business behavior in an environment of high inflation expectations
with behavior in an environment of low inflation expectations;
c) analyze the factors that influence changes in unit labor costs;
d) discuss the relationships between equity price-to-earnings (P/E) multiples and inflation, and
between dividend yields and inflation;
f) relate structural changes in an economy to sector performance;
g) relate fund flows in international securities markets to economic activity and capital
market returns.
“Developing a Recommendation for a Global Portfolio” (Study Session 4)
a) explain the effects of macroeconomic factors—money and credit conditions, demographic
trends, unit labor costs, trade and capital flows, and government policies—on expected
returns and risks of the bond and stock markets in the United States and other countries;
b) recommend and justify changes in the component weights of a global investment portfolio
based on expected changes in macroeconomic factors.

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Morning Session - Page 31
Guideline Answer:
A.

Judge whether each of

Marco’s two statements is If incorrect, give one reason
Marco’s two statements correct or incorrect why the statement is
(circle one for each incorrect
statement)
1. “Forecasts of a near-term
credit contraction with a
decline in the money supply
and a reduction in the Correct
aggregate liabilities of banks
is likely to result in no
expansion of bank loan Incorrect
activity and no increase in
nominal disposable income.”

2. “When economic growth With increasing economic

increases, industrial growth, industrial production
production is likely to expand Correct tends to increase more slowly
at a faster rate than the than the domestic money
domestic money supply.” supply; industrial production
Incorrect growth tends to be driven by
(lag) a faster than normal
growth in the money supply.

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Morning Session - Page 32
B.

Evaluate whether each

of Marco’s two
recommendations is
If inappropriate, justify with one
Marco’s two appropriate or
reason why the recommendation
recommendations inappropriate, if the
is inappropriate
inflation rate increases
(circle one for each
recommendation)
1. “Retail consumption should With rising inflation, retail
decrease because rising consumption tends to increase as
inflation will drive prices Appropriate consumers anticipate higher prices.
higher. I expect equities in the Therefore, equity prices in the
retail sector to under perform retail sector tend to advance with
the market, so we should Inappropriate the onset of rising inflation, and
recommend that our clients exposure to the retail sector should
reduce their exposure to this be increased, not reduced.
sector.”

2. “Because of the changing With increasing domestic inflation

inflationary environment, we relative to increases in non-
should recommend that our Appropriate domestic inflation, real equity
clients reduce their current values in non-domestic markets
exposures to international become higher relative to those in
equities relative to domestic Inappropriate domestic markets, because
equities.” domestic equity values are
weakened by inflation. Thus
international equity exposure
should be increased, not reduced.

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Morning Session - Page 33