L3 mock sample exam CFA level III guideline answers 2002

LEVEL III, QUESTION 1
Topic:
Minutes:

Portfolio Management
26

Reading References:
1. “Determination of Portfolio Policies: Institutional Investors,” Ch. 4, Keith P. Ambachtsheer,
John L. Maginn, and Jay Vawter, Managing Investment Portfolios: A Dynamic Process, 2nd
edition, John L. Maginn and Donald L. Tuttle, eds. (Warren, Gorham & Lamont, 1990)
2. Cases in Portfolio Management, John W. Peavy III and Katrina F. Sherrerd (AIMR, 1990)
A. “Mid-South Trucking Company”: Case p. 26, Guideline Answers p. 75
B. “Universal Products Inc.”: Case p. 39, Guideline Answers p. 90
C. “Good Samaritan Hospital (A)”: Case p. 45, Guideline Answers p. 101
D. “Good Samaritan Hospital (B)”: Case p. 49, Guideline Answers p. 103
E. “Good Samaritan Hospital (C)”: Case p. 50, Guideline Answers p. 106
3. Question 13, including Guideline Answer, 1996 CFA Level III Examination (AIMR), 2002
CFA Level III Candidate Readings
4. Managing Investment Portfolios: A Dynamic Process, 2nd edition, John L. Maginn and
Donald L. Tuttle, eds. (Warren, Gorham & Lamont, 1990)
A. “Asset Allocation,” Ch. 7, pp. 7-1 through 7-27, William F. Sharpe
Purpose:
To test the candidate’s ability to formulate an investment policy statement and recommend an
asset allocation for an endowment fund.
LOS: The candidate should be able to
“Determination of Portfolio Policies: Institutional Investors” (Study Session 10)
b) appraise and contrast the factors that affect the investment policies of pension funds,
endowment funds, insurance companies, and commercial banks
c) differentiate among the return objectives, risk tolerances, constraints, regulatory
environment, and unique circumstances of endowment funds, pension funds, insurance

companies, and commercial banks
Cases in Portfolio Management (Study Session 10)
a) 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
b) compare and contrast the investment objectives and constraints of institutional investors in
different economic circumstances
c) create a formal investment policy statement for an institutional investor
d) recommend and justify an asset allocation that would be appropriate for an institutional
investor
Question 13, including Guideline Answer, 1996 (Study Session 10)
a) 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
b) critique an existing investment policy statement and its associated asset allocation

2002 Level III Guideline Answers
Morning Session - Page 1


c) create a formal investment policy statement for an institutional investor
d) recommend and justify a general asset allocation that would be appropriate for a particular
institutional investor
“Asset Allocation” (Study Session 11)
b) discuss the major steps in asset allocation
c) formulate the basic elements of the strategic asset allocation process

Guideline Answer:
A.
Prepare the components of an appropriate investment policy statement for the Jarvis

University endowment fund as of June 1, 2002
OBJECTIVES
1. Return.
The required total rate of return for the JU endowment fund is the sum of the spending rate
and the expected long-term increase in educational costs.
• The spending rate = $126 million (current spending need) / ($2,000 million current fund
balance less $200 million library payment) = $126 million / $1,800 million = 7 percent.
The expected educational cost increase is 3 percent. The sum of the two components is
10 percent.
Achieving this relatively high return would ensure that the endowment’s real value is
maintained.
2. Risk.
Evaluation of risk tolerance requires an assessment of both the ability and the willingness of
the endowment to take risk.
Ability: Average Risk
• Endowment funds are long-term in nature, having infinite lives. This long time horizon
by itself would allow for above-average risk.
• However, creative tension exists between the JU endowment’s demand for high current
income to meet immediate spending requirements and the need for long-term growth to
meet future requirements. This need for a spending rate (exceeds 5 percent) and the
university’s heavy dependence on those funds allow for only average risk.
Willingness: Above Average Risk
• University leaders and endowment directors have set a spending rate in excess of 5
percent. To achieve their 7 percent real rate of return, the fund must be invested in
above-average risk securities. Thus the 7 percent spending rate indicates a willingness to
take above-average risk.
• In addition, the current portfolio allocation, with its large allocations to direct real estate
and venture capital, indicates a willingness to take above-average risk.
Taking both ability and willingness into consideration, the endowment’s risk tolerance is
best characterized as “above average”.

2002 Level III Guideline Answers
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CONSTRAINTS
1. Time Horizon.
A two-stage time horizon is needed. The first stage recognizes short-term liquidity
constraints ($200 million library payment in eight months). The second stage is an infinite
time horizon (endowment funds are established to provide permanent support).
2. Liquidity.
Generally, endowment funds have long time horizons and little liquidity is needed in excess
of annual distribution requirements. However, the JU endowment requires liquidity for the
upcoming library payment in addition to the current year’s contribution to the operating
budget. Liquidity needs for the next year are:
Library Payment
+$200 million
Operating Budget Contribution +$126 million
Annual Portfolio Income
–$ 29 million*
Total
+$297 million
*Annual portfolio income = (.04 × $40 million) + (.05 × $60 million) + (.01 × $300 million)
+ (.001 × $400 million) + (.03 × $700 million) = $29 million
3. Taxes.
U.S. endowment funds are tax-exempt.
4. Legal/Regulatory.
U.S. endowment funds are subject to predominantly state (but some federal) regulatory and
legal constraints, and standards of prudence generally apply. Restrictions imposed by
Bremner may pose a legal constraint on the fund (no more than 25 percent of the initial

share of Bertocchi Oil and Gas shares may be sold in any one-year period).
5. Unique Circumstances.
Only 25 percent of donated Bertocchi Oil and Gas shares may be sold in any one-year
period (constraint imposed by donor). A secondary consideration is the need to budget the
one-time $200 million library payment in eight months.

2002 Level III Guideline Answers
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B.

Asset
U.S. Money Market
Fund

Determine the most
appropriate revised
allocation percentage
for each asset as of
June 1, 2002
15 (14-17) %

Justify each revised allocation
percentage
with one reason
Liquidity needs for the next year are:
--Library payment
+$200 million
-- Operating budget

contribution
+$126 million
--Annual portfolio
income
–$ 29 million*
Total
+$297 million
Total liquidity of at least $297 million is
required (14.85 percent of current
endowment assets). Additional allocations
(more than 2 percent above the suggested
15 percent) would be overly conservative.
This cushion should be sufficient for any
transaction needs (i.e., mismatch of cash
inflows/outflows).

Intermediate Global
Bond Fund

20 (15-25) %

*Annual portfolio income = (.04 × $40
million) + (.05 × $60 million) + (.01 ×
$300 million) + (.001 × $400 million) +
(.03 × $700 million) = $29 million
To achieve a 10 percent portfolio return,
the fund needs to take above average risk
(e.g., 20 percent in Global Bond Fund and
30 percent in Global Equity Fund). An
allocation below 15 percent would

involve taking unnecessary risk that
would put the safety and preservation of
the endowment fund in jeopardy. An
allocation in the 21-25 percent range
could still be tolerated because the slight
reduction in portfolio expected return
would be partially compensated by the
reduction in portfolio risk. An allocation
above 25 percent would not satisfy the
endowment fund return requirements.

2002 Level III Guideline Answers
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Global Equity Fund

30 (25-35) %

Bertocchi Oil and Gas
Common Stock

15%

Direct Real Estate
Venture Capital
Total

10%
10%

100%

To achieve a 10 percent portfolio return,
the fund needs to take above average risk
(e.g., 30 percent in Global Equity Fund
and 20 percent in Global Bond Fund). An
allocation above 35 percent would
involve taking unnecessary risk that
would put the safety and preservation of
the endowment fund in jeopardy. An
allocation in the 25-29 percent range
could still be tolerated, as the slight
reduction in portfolio expected return
would be partially compensated by the
reduction in portfolio risk. An allocation
below 25 percent would not satisfy the
endowment fund return requirements.
There is a single issuer concentration risk
associated with the current allocation, and
a 25 percent reduction ($100 million),
which is the maximum reduction allowed
by the donor, is required ($400 million –
$100 million = $300 million remaining).
Not required
Not required

2002 Level III Guideline Answers
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The suggested allocations (point estimates) would allow the JU endowment fund to meet the 10
percent return requirement, calculated as follows:
Asset
U.S. Money Market Fund
Intermediate Global Bond Fund
Global Equity Fund
Bertocchi Oil and Gas Common Stock
Direct Real Estate
Venture Capital
TOTAL

Suggested
Allocation
0.15
0.20
0.30
0.15
0.10
0.10
1.00

Expected Return

Weighted Return

4.0%
5.0%
10.0%
15.0%
11.5%

20.0%

0.60%
1.00%
3.00%
2.25%
1.15%
2.00%
10.00%

The allowable allocation ranges, taken in proper combination, would also be consistent with the
10 percent return requirement.

2002 Level III Guideline Answers
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LEVEL III, QUESTION 2
Topic:
Minutes:

Portfolio Management
11

Reading References:
“Dynamic Strategies for Asset Allocation,” Andre Perold and William Sharpe, Financial
Analysts Journal (AIMR, January/February 1988), 2002 CFA Level III Candidate Readings
Purpose:
To test the candidate’s understanding of the dynamic strategies available to rebalance a portfolio
in the context of changes in general market conditions, investor return objectives and risk

tolerance, and the transaction costs associated with rebalancing.
LOS: The candidate should be able to
“Dynamic Strategies for Asset Allocation” (Study Session 11)
a) contrast the risk-return tradeoffs of the alternative dynamic portfolio rebalancing strategies
b) appraise the appropriateness of the alternative rebalancing strategies under various sets of
investor risk tolerances and asset return expectations
c) appraise the impact of rebalancing strategies on the return and risk of a portfolio

Guideline Answer:
A. i. Buy-and-hold strategy. The buy-and-hold strategy maintains an exposure to equities that
is linearly related to the value of equities in general. The strategy involves buying, then
holding, an initial mix (equities/bills). No matter what happens to relative values, no
rebalancing is required; hence this is sometimes termed the “do nothing” strategy. The
investor sets a floor below which s/he does not wish portfolio value to fall. An amount
equal to the value of that floor is invested in some non-fluctuating asset (i.e., Treasury
bills, money market funds). The payoff diagram for a buy-and-hold strategy is a straight
line, so the value of the portfolio rises (falls) as equity values rise (fall), with a slope
equal to the equity proportion in the initial mix. The value of the portfolio will never fall
below the specified floor, and the portfolio has unlimited upside potential. Increasing
equity prices favor a buy and hold strategy; the greater the equity proportion in the initial
mix, the better (worse) the strategy will perform when equities outperform
(underperform) bills.
The strategy is particularly appropriate for an investor whose risk tolerance above the
specified floor varies with wealth, but drops to zero at or below that floor. After the initial
portfolio transaction, transaction costs are not an issue. The strategy is tax efficient for
taxable investors.
ii. Constant-mix strategy. The constant-mix strategy maintains an exposure to equities that
is a constant percentage of total wealth. Periodic rebalancing to return to the desired mix
requires the purchase (sale) of equities as they decline (rise) in value. This strategy,

2002 Level III Guideline Answers
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which generates a concave payoff diagram, offers relatively little downside protection
and performs relatively poorly in up markets. The strategy performs best in a relatively
flat (but oscillating or volatile) market and capitalizes on market reversals. The constantmix strategy performs particularly well in a time period when equity values oscillate
greatly, but end close to their beginning levels; greater volatility around the beginning
values accentuates the positive performance.
The constant-mix strategy is particularly appropriate for an investor whose risk tolerance
varies proportionately with wealth; such an investor will hold equities at all levels of
wealth. This strategy requires some rule to determine when rebalancing takes place;
typical approaches avoid transaction costs until either the value of a portion of the, or of
the entire, portfolio has changed by a given percentage. At this point, transaction costs
are incurred to rebalance. Taxes can be material for taxable investors.
iii. Constant-proportion strategy. The constant-proportion strategy maintains an exposure to
equities that is a constant multiple of a “cushion” specified by the investor. The investor
sets a floor below which s/he does not wish assets to fall, and the value of that floor is
invested in some non-fluctuating asset (i.e., Treasury bills, money market funds). Under
normal market conditions the value of the portfolio will not fall below this specified
floor. The investor then selects a multiplier to be used. The initial commitment to equities
equals the multiplier times the “cushion” (the difference between the value of the total
assets to be invested and the value of the floor) [e.g., $ in equities = multiplier × (assets –
floor)]. As equity values rise (fall), the constant-proportion strategy requires the investor
to purchase (sell) additional equities. Thus following this strategy (via the formula
indicated above) keeps equities at a constant multiple of the cushion (assets – floor) and
generates a convex payoff diagram. The constant-proportion strategy tends to give good
downside protection and performs best in directional, especially up, markets; the strategy
does poorly in flat but oscillating markets and is especially hurt by sharp market
reversals.

The strategy is particularly appropriate for an investor who has zero tolerance for risk
below the stated floor but whose risk tolerance increases quickly as equity values move
above the stated floor. This strategy requires some rule to determine when rebalancing
takes place; typical approaches avoid transaction costs until either the value of a portion
of the, or of the entire, portfolio has changed by a given percentage. At this point
transaction costs are incurred to rebalance. Taxes can be material for taxable investors.

2002 Level III Guideline Answers
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B. The constant-proportion strategy is the most appropriate rebalancing strategy for the JU
endowment fund, taking into account the major circumstances described: the endowment’s
increased risk tolerance, the outlook for a bull market in growth assets over the next five
years, the expectation of lower than normal volatility, and the endowment’s desire to limit
downside risk.
•

The constant-proportion strategy is consistent with higher risk tolerance, because the
strategy calls for purchasing more equities as equities increase in value; higher risk
tolerance is reflected in the resulting increased allocation to equities over time.

•

The constant-proportion strategy will do well in an advancing equities market; by buying
equities as their values rise, each marginal purchase has a high payoff.

•

The constant-proportion strategy would do poorly in a higher volatility environment for

equities, because the strategy would sell on weakness but buy on strength, only to
experience reversals; conversely, the strategy does much better in the face of lower
volatility.

•

The constant-proportion strategy provides good downside protection, because the strategy
sells on weakness and reduces exposure to equities as a given floor is approached.

In summary, given that JU receives little other funding support, the endowment fund must
produce the maximum return for a specified level of risk. Given that the level of acceptable
risk is generally higher, although with a very specific downside floor, the market outlook
suggests that the constant-proportion strategy is the endowment fund’s best rebalancing
strategy.

2002 Level III Guideline Answers
Morning Session - Page 9


LEVEL III, QUESTION 3
Topic:
Minutes:

Portfolio Management
22

Reading Reference:
1. “Evaluation of Portfolio Performance,” Ch. 24 (omit pp. 658-664), Modern Portfolio Theory
and Investment Analysis, 5th edition, Edwin Elton and Martin Gruber (John Wiley & Sons,
1995), 2002 CFA Level III Candidate Readings

2. “Evaluation of Portfolio Performance,” Ch. 27, Investment Analysis and Portfolio
Performance, 5th Edition, Frank K. Reilly and Keith C. Brown (Dryden, 1997), 2002 CFA
Level III Candidate Readings
Purpose:
To test the candidate’s understanding of: 1) the different approaches to performance
measurement and attribution, and 2) the Sharpe, Treynor, and Jensen measures of performance.
LOS: The candidate should be able to
“Evaluation of Portfolio Performance” (Study Session 16)
b) compare and contrast the Sharpe ratio, the Treynor measure, and Jensen’s alpha
c) calculate the Sharpe ratio and the Treynor measure
d) appraise investment manager performance using the Sharpe ratio, the Treynor measure, and
Jensen’s alpha
e) evaluate a manager’s performance after that performance has been attributed to
diversification effect, market timing effect, and other sources of return
“Evaluation of Portfolio Performance” (Study Session 16)
a) prepare a performance attribution analysis for a portfolio and determine whether value was
added through allocation effects (market timing or sector rotation) and /or selection effects

Guideline Answer:
A. i. Sharpe ratio = (portfolio return – risk-free rate) / standard deviation
Sharpe ratio: Williamson Capital = (22.1% – 5.0%) / 16.8% = 1.02
Sharpe ratio: Joyner Asset Management = (24.2% – 5.0%) / 20.2% = 0.95
ii. Treynor measure =(portfolio return – risk-free rate) / portfolio beta
Treynor measure: Williamson Capital = (22.1% – 5.0%) / 1.2 = 14.25
Treynor measure: Joyner Asset Management = (24.2% – 5.0%) / 0.8 = 24.00

2002 Level III Guideline Answers
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B.
Calculate the following five components of investment performance for
Joyner Asset Management
i.
ii.
iii.
iv.
v.
Overall
Risk
Selectivity
Diversification Net selectivity
performance
Williamson
Capital
Joyner Asset
Management

16.68
19.20

11.12

8.08

0.24

0.18

9.23

−1.15

Supporting calculations:
i.
ii.
iii.
iv.
Overall
Risk
Selectivity
Diversification
= (market
= overall
= (risk-free rate + (std dev. of
Performance =
return – risk- performance the portfolio / std. dev. of the
portfolio
free rate) ×
– risk
market) × (market return –
return –
portfolio beta
risk-free rate)) – (risk-free rate
risk-free
+ (portfolio beta × (market
rate
return – risk-free rate)))
W 22.1% –
5.0% =

J

17.10%
24.2% –
5.0% =
19.20%

(18.9% –
5.0%) × 1.2
=
16.68%
(18.9% –
5.0%) × 0.8
=
11.12%

17.10% –
16.68% =
0.42%
19.20% –
11.12% =
8.08%

(5.0% + (16.8% / 13.8%) ×
(18.9% – 5.0%)) – (5.0% +
(1.2 × (18.9% – 5.0%))) =
0.24%
(5.0% + (20.2% / 13.8%) ×
(18.9% – 5.0%)) – (5.0% +
(0.8 × (18.9% – 5.0%))) =

9.23%

v.
Net Selectivity
= selectivity –
diversification

0.42% – 0.24%
=
0.18%
8.08% – 9.23%
=
−1.15%

C. i. The Sharpe ratio versus the Treynor measure. The difference in the ranking of
Williamson and Joyner results directly from the difference in diversification of the
portfolios. Joyner has a higher Treynor measure (24.00) and lower Sharpe ratio (0.95)
than Williamson (14.25 and 1.02), so Joyner must be less diversified than Williamson;
the Treynor measure indicates that Joyner has a higher return per unit of systematic risk
than Williamson, while the Sharpe ratio indicates that Joyner has a lower return per unit
of total risk than Williamson.
ii. Overall performance versus net selectivity. Overall performance is the portfolio’s return
net of the risk-free rate and is therefore a return measure that does not consider risk.
Because Joyner’s average annual rate of return is higher than Williamson’s, its overall
performance is also higher. Net selectivity, however, is a return measure that has been

2002 Level III Guideline Answers
Morning Session - Page 11

adjusted both for systematic risk and for unsystematic risk. To compute net selectivity,
diversification is subtracted from selectivity. Because the diversification term is much
higher for Joyner than for Williamson (the difference is 8.99% = 9.23% – 0.24%), to
achieve the same net selectivity as Williamson, Joyner would need commensurately
higher selectivity, which Joyner did not achieve (the difference is 7.66% = 8.08% –
0.42%). The diversification measure indicates how much return would be required for the
amount of non-systematic risk a manager is taking if non-systematic risk received the
same return as systematic risk.

2002 Level III Guideline Answers
Morning Session - Page 12


LEVEL III, QUESTION 4
Topic:
Minutes:

Portfolio Management
16

Reading References:
1. “How Should Plan Sponsors Approach AIMR Performance Presentation Standards (PPS)? –
Learning from the Kentucky Retirement System Example,” Chris Tobe, The Journal of
Performance Measurement (The Spaulding Group, Winter 1998/1999), 2002 CFA Level III
Candidate Readings
2. Question 5, including Guideline Answer, 1998 CFA Level III Examination (AIMR), 2002
CFA Level III Candidate Readings
3. “Global Investment Performance Standards,” including Appendix A (AIMR, 1999), 2002
CFA Level III Candidate Readings
Purpose:

To test the candidate’s: a) understanding of the Global Investment Performance Standards, and
b) ability to determine whether performance reports are in compliance with these standards.
LOS: The candidate should be able to
“How Should Plan Sponsors Approach AIMR Performance Presentation Standards (PPS)? –
Learning from the Kentucky Retirement System Example” (Study Session 17)
a) identify the violations of the AIMR-PPS standards
b) recommend changes to the performance presentations that would bring the presentations into
compliance with the AIMR-PPS standards
Question 5, including Guideline Answer, 1998 (Study Session 17)
criticize a performance presentation that is not in compliance with the AIMR-PPS standards
“Global Investment Performance Standards” (Study Session 17)
c) explain the requirements and recommendations of GIPS standards with respect to input data,
calculation methodology, composite construction, disclosures, and presentation and reporting
d) explain the minimum procedures that must be followed to verify that an investment entity is
GIPS compliant

Guideline Answer:
A. Items included in the Bristol Capital Management performance presentation report that are
not compliant with GIPSđ:
ã
ã
ã

GIPS states that performance periods of less than one year must not be annualized, as
Bristol does for the first quarter of 2002.
GIPS verification cannot be performed for a single composite as is stated in the notes to
the Bristol report. Third party verification is performed with respect to the entire firm.
For periods beginning January 1, 2001, portfolios must be valued at least monthly.
Bristol is still valuing portfolios quarterly.

2002 Level III Guideline Answers
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•

•
•
•

A firm must use the compliance statement as specified in the GIPS. There are no
provisions for partial compliance. If a firm does not meet all the GIPS requirements, then
the firm is not in compliance with GIPS. Bristol’s use of the “except for” compliance
statement is a violation of GIPS.
The column titled “Composite Dispersion (%)” is incomplete; it should be accompanied
by a footnote describing the measure of dispersion being used.
The column titled “Benchmark Return (%)” is incomplete; it should be accompanied by a
footnote describing the composition of the benchmark.
GIPS states that accrual accounting must be used for fixed-income securities and all other
assets that accrue interest income; Bristol states that it uses cash basis accounting for the
recognition of interest income.

B. Omissions that prevent the Bristol Capital Management performance report from being GIPS
compliant:
•
•
•
•
•
•

•

The availability of a complete list and description of all of Bristol’s composites is not
disclosed as is required.
Although Bristol does disclose the use of derivatives, the firm has omitted the required
description of the extent of use, frequency, and characteristics of the instruments that
must also be disclosed in sufficient detail to identify the risks.
If the firm has included non-fee paying accounts in its composite, the percentage of the
composite represented by these accounts must be disclosed.
The composite creation date must be disclosed.
Because the composite represents a global investment strategy, the presentation should
include information about the treatment of withholding tax on dividends, interest income,
and capital gains.
Because the composite is a global strategy, managed against a specific benchmark, the
presentation should include information about the percentage of the composite invested
in countries/regions not included in the benchmark.
Because the composite is a global strategy, managed against a specific benchmark,
exchange rates presumably are a major performance factor; any known inconsistencies
between the chosen source of exchange rates and the exchange rates of the benchmark
must be described and presented.

2002 Level III Guideline Answers
Morning Session - Page 14


LEVEL III, QUESTION 5
Topic:
Minutes:

Portfolio Management

36

Reading References:
1. “The Importance of the Investment Policy Statement” (AIMR, 1999), 2002 CFA Level III
Candidate Readings
2. “Individual Investors,” Ch. 3, Ronald W. Kaiser, Managing Investment Portfolios: A
Dynamic Process, 2nd edition, John L. Maginn and Donald L. Tuttle, eds. (Warren, Gorham
& Lamont, 1990)
3. “Tax Considerations in Investing,” Ch. 8, Robert H. Jeffrey, The Portable MBA in
Investment, Peter L. Bernstein, ed. (John Wiley & Sons, 1995), 2002 CFA Level III
Candidate Readings
4. Cases in Portfolio Management, John W. Peavy III and Katrina F. Sherrerd (AIMR, 1990)
a. “Introduction”
b. “The Allen Family (A)”: Case p. 15, Guideline Answers p. 58
c. “The Allen Family (B)”: Case p. 18, Guideline Answers p. 62
5. Questions 1 and 2, including Guideline Answers, 1995 CFA Level III Examination (AIMR),
2002 CFA Level III Candidate Readings
6. Question 1, including Guideline Answer, 1996 CFA Level III Examination (AIMR), 2002
CFA Level III Candidate Readings
Purpose:
To test the candidate’s ability to: 1) critique an individual investor’s existing investment policy
statement and asset allocation, and 2) recommend a new investment policy statement and asset
allocation that reflects the investor’s objectives, constraints, and circumstances.
LOS: The candidate should be able to
“The Importance of the Investment Policy Statement” (Study Session 9)
a) explain the principal contents of a typical written investment policy statement and discuss
their implications for portfolio management
b) explain the importance of an investment policy statement
“Individual Investors” (Study Session 9)
c) analyze the objectives and constraints of an individual investor and use this information to

formulate an appropriate investment policy by taking into consideration the investor’s
psychological characteristics, position in the life cycle, long-term goals, liquidity constraints,
and any special circumstances such as taxes, gifts, and estate planning
“Tax Considerations in Investing” (Study Session 9)
a) explain the importance of taxation for investment policy and discuss taxes as an investment
expense
b) differentiate between capital gains and dividends and compare the taxation of each
c) analyze the impact of turnover on after-tax portfolio returns
e) discuss the benefits of deferring capital gains taxes
h) discuss the advantages and disadvantages of realizing losses

2002 Level III Guideline Answers
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Cases in Portfolio Management (Study Session 9)
d) recommend and justify an asset allocation that would be appropriate for an individual
investor
Questions 1 and 2, including Guideline Answers, 1995 (Study Session 9)
a) prepare an investment policy statement that clearly states the investment objectives and
constraints for an individual investor
b) justify all recommendations and statements included in an investment policy statement
c) criticize an investment policy statement and identify key investment constraints and
objectives not included in the statement
d) recommend and justify an asset allocation
Question 1, including Guideline Answer, 1996 (Study Session 9)
a) prepare and justify a well-organized investment policy statement
b) recommend and justify an asset allocation and clearly state any assumptions made in
preparing the recommendation, especially with respect to the risk tolerance of the client
c) criticize an investment policy statement and judge whether the policy statement will meet the

stated goals of the client

Guideline Answer:
A. Return Requirement
New objective. A total return objective of 7 percent before tax is sufficient to meet Claire
Pierce’s educational, housing, and retirement goals.* If the portfolio earns total return of 7
percent annually, the value at retirement ($3.93 million) should be adequate to meet ongoing
spending needs then ($180,000 after tax = $257,143 before tax = 6.6 percent spending rate)
and fund all Pierce’s extraordinary needs (college and homebuilding costs) in the meantime.
The million dollar gifts to her children represent unrealistic goals that she should be
encouraged to modify or drop.
*The following calculations are not required, but provide the basis for the statement that a
return of 7 percent before tax is sufficient to generate a retirement portfolio that will support
the desired retirement spending level (at a reasonable retirement spending rate).
Current portfolio (gross)
$2,200,000
Less college cost (daughter)
$25,714 before tax
Less college cost (son)
$130,000 before tax
Less housing cost
$535,714 before tax
Current portfolio (net)
$1,508,572
After-tax return = Before-tax return (1–T) = 7.00% (0.7) = 4.90%
Years = 20
Retirement portfolio (at t + 20)
$3,927,134
Retirement spending (after tax)
$180,000

Retirement spending (before tax)
$257,143
Spending rate (before tax)
6.55%

2002 Level III Guideline Answers
Morning Session - Page 16

Calculations:
$18,000 after tax / 0.7
$91,000 after tax / 0.7
$375,000 after tax / 0.7

$1,508,572 × (1.049)20
$100,000 × (1.03)20
$180,000 / 0.7
$257,143 / $3,927,134


Weakness of old objective. The current policy, as written, is vague and states only a low
return requirement, which contradicts the aggressive, unrealistic goal of gifting $2 million to
her children. The current policy focuses on the latter goal without considering her retirement
needs or her plan to build a house. Thus it does not take a total return-based, comprehensive
approach to the return objective.
Risk Tolerance
New objective. Pierce has explicitly stated her limited (below average) willingness to take
risk. After losing a substantial amount in the last two years, she does not want her assets to
drop more than 10 percent in any subsequent year. After considering her goals, Pierce would
seem to have an average ability to take risk. Her portfolio has some flexibility, as her
expected return objective of 7 percent will meet her goals of funding her children’s

education, building her “dream house,” and funding her retirement. Taken together, however,
her risk tolerance is below average. Pierce should be helped to understand that she has more
ability to take risk than she believes.
Weakness of old objective. Although the current IPS indicates her desire to invest
conservatively, it does not address her ability to take risk.
B. Time Horizon
New constraint statement. Her time horizon is multi-stage. The time horizon could
effectively be described as:
• two-stage (the next 20 years, pre-retirement; and beyond 20 years, post-retirement),
• three-stage (the next 15 pre-retirement years defined by work/housing and college costs;
the subsequent 5 pre-retirement years defined by work; and beyond 20 years postretirement), or
• three-stage (the next five pre-retirement years defined by work/housing costs; the
subsequent 15 pre-retirement years defined by work/college costs; and beyond 20 years
post-retirement).
Weakness of old constraint statement. The current IPS does not recognize the multi-stage
time horizon issues.
Liquidity
New constraint statement. There is only a minor liquidity need ($18,000 in present value
terms) to provide for education expenses for her daughter next year. After that there is no
liquidity need for the next five years. Only then ($375,000 in present value terms, for home
construction) and in years 11 through 14 ($91,000 in present value terms, for son’s
education) are there significant liquidity concerns. The portfolio need not consider possible
liquidity concerns with respect to the million-dollar gift for each child, because this is not a
realistic goal.

2002 Level III Guideline Answers
Morning Session - Page 17


Weakness of old constraint statement. The current policy overstates the liquidity needed to

fund the educational expenses. These expenses are either minor relative to the size of the
portfolio or not a current liquidity concern.
Taxes
New constraint statement. Taxes are a critical concern, for two reasons. First, taxes are an
important consideration in her retirement planning, because post retirement expenditures are
after tax. Second, taxes are an important consideration in her investment strategies because
taxes are a potential drag on performance. Potential strategies to mitigate this second issue
include employing a low turnover approach to equity investment and utilizing municipal
bonds (income exempt from income taxes).
Weakness of old constraint statement. The current policy only superficially addresses her tax
status by suggesting that she hold only assets that generate little or no taxable income, as
opposed to considering tax minimization strategies or assets that provide good after-tax total
returns. The current policy is also inconsistent with her stated desire to assume that all returns
are fully taxable.
Unique Circumstances
New constraint statement. A significant unique circumstance is the large concentration (50
percent of her assets) in Spencer Design stock. Diversifying the portfolio, in a tax-aware
manner, should be strongly considered. Another factor is her desire to build a new home in
five years, yet incur no debt. Also, she would “like” to give each child one million dollars,
but this is not a realistic goal and should not drive portfolio decisions.
Weakness of old constraint statement. The current policy fails to address the concentration in
Spencer Design stock.
C. Portfolio B is most appropriate for the balance of Pierce’s assets.
Pierce has a $2,200,000 portfolio including the Spencer Design company stock. The three
portfolios in Exhibit 5-1 do not include the Spencer Design stock, but this holding must be
considered in determining which portfolio is appropriate for Pierce.
The first consideration should be return. All three portfolios appear to exceed Pierce’s
apparent 7 percent before-tax return requirement. Including the Spencer stock, the expected
return for Portfolio A is 8.8 percent, for B is 8.2 percent, and for C is 7.6 percent.

2002 Level III Guideline Answers
Morning Session - Page 18


Asset
Money Market
Bonds
Equities
Spencer Stock
TOTAL

Expected
Returns
4.2%
6.4%
10.8%
9.0%

Portfolio A
Weights Weighted
Returns
0.023
0.097%
0.223
1.427%
0.254
2.743%
0.500
4.500%
8.767%

Portfolio B
Portfolio C
Weights Weighted Weights Weighted
Returns
Returns
0.023
0.097%
0.250
1.050%
0.360
2.304%
0.150
0.960%
0.117
1.264%
0.100
1.080%
0.500
4.500%
0.500
4.500%
8.165%
7.600%

Therefore, the appropriate portfolio is more directly determined by risk and liquidity issues.
Portfolio A initially appears to be a reasonable asset mix. Cash is 5 percent, bonds 45
percent, and equities 50 percent. However, when the Spencer Design stock is included in the
portfolio, the mix changes to 2.3 percent cash, 22.3 percent bonds, and 75.4 percent equities.
The cash reserve level is appropriate given her low short-term liquidity needs. However,

given her overall risk tolerance (especially her low willingness to assume risk), having 75
percent of her assets in equities, even given her long time horizon, is too aggressive and
leaves her inadequately diversified with respect to other asset classes.
Portfolio C is overly conservative, with 50 percent cash, 30 percent bonds, and only 20
percent equities. When the Spencer stock is added, the mix appears more reasonable, with 15
percent bonds and 60 percent equities, but the remaining 25 percent cash is still excessive.
Even considering her plan to build her “dream house” in five years (not a short-term liquidity
need), it is inappropriate to hold this level of reserves and forego the additional return
potential in the meantime.
Portfolio B initially appears to be very conservative with 5 percent cash, 72 percent bonds,
and only 23 percent equities, but only if the Spencer Design stock is not considered. When
the Spencer stock is incorporated, the asset mix is 2 percent cash, 36 percent bonds, and 62
percent equities. The level of cash reserves is appropriate, given the minimal near-term
liquidity needs, which are only her daughter’s upcoming final year of college (present value
of $18,000). Given that Portfolio B earns more than a sufficient expected return, the cash
reserve level in Portfolio B is more appropriate than in Portfolio C and the equity exposure
and diversification in Portfolio B are more appropriate than in Portfolio A, especially given
Pierce’s overall risk tolerance (ability and willingness taken together). All these factors
considered together strongly suggest that Portfolio B is the most appropriate choice.
D. Because of Pierce’s tax circumstances and the fact that each of the managers is expected to
have very similar average market returns, standard deviation characteristics, and fees, the
primary differentiating factor for Pierce should be the tax implications of the portfolio
turnover that results from each manager’s investment approach. On that basis, Manager H is
most appropriate for Pierce.
Manager H would likely experience the lowest turnover. H is an active manager whose
average holding period of seven years equates to an annual turnover of only 14.3 percent.

2002 Level III Guideline Answers
Morning Session - Page 19

With low annual turnover, capital gains are deferred and most often are long-term in nature
and therefore taxed at a lower rate than would be the case for short-term gains. Also, as an
active manager, the portfolio manager can focus on after-tax return strategies, including
selling stocks at a loss to offset gains, reducing Pierce’s tax obligation further.
Manager F holds a portfolio of stocks that is equally weighted. Therefore, at the end of each
quarter the manager will reduce the positions of stocks that outperformed the overall
portfolio and purchase the stocks that underperformed. These sales and purchases will likely
result in numerous rebalancing transactions each quarter.
Although G manages a market-weighted value index portfolio, which would seemingly imply
low turnover, G tracks the half of the index with the lowest price-to-book ratios. As relative
price-to-book ratios change, the index will be rebalanced quarterly. In so doing, G’s strategy
may cause significant turnover to accommodate the addition and deletion of stocks in the
value portion of the index.
Both Managers F and G will incur significant quarterly rebalancing costs. Also, as F and G
sell the outperforming stocks as the portfolios are rebalanced, they will tend to realize gains.
It is likely that many of these gains will be taxed at the higher short-term capital gain rates
rather than the lower long-term capital gain rates. In addition, neither manager will be able to
pursue any after-tax return maximization strategy, such as loss harvesting to offset gains,
because this would increase tracking error relative to the respective indexes.

2002 Level III Guideline Answers
Morning Session - Page 20


LEVEL III, QUESTION 6
Topic:
Minutes:

Portfolio Management

15

Reading References:
1. “The Psychology of Risk,” Amos Tversky, Quantifying the Market Risk Premium
Phenomenon for Investment Decision Making (AIMR, 1990), 2002 CFA Level III Candidate
Readings
2. “Behavioral Risk: Anecdotes and Disturbing Evidence,” Arnold Wood, Investing Worldwide
VI (AIMR, 1996), 2002 CFA Level III Candidate Readings
3. “Behavioral Finance: Past Battles and Future Engagements,” Meir Statman, Financial
Analysts Journal (AIMR, November/December 1999), 2002 CFA Level III Candidate
Readings
Purpose:
To test the candidate’s ability to identify and contrast major principles of behavioral finance and
traditional or standard finance.
LOS: The candidate should be able to
“The Psychology of Risk” (Study Session 14)
a) contrast the assumptions of rational investment decision making and observed investor
behaviors such as loss aversion, reference dependence, asset segregation, mental accounting,
and biased expectations
“Behavioral Risk: Anecdotes and Disturbing Evidence” (Study Session 14)
a) discuss potential systematic overconfidence in analysts’ forecasts and the associated
implications, particularly for asset allocation and portfolio construction
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 14)
a) contrast the standard finance view of human investor behavior and a behavioral finance
framework

2002 Level III Guideline Answers
Morning Session - Page 21

Guideline Answer:
Identify three
behavioral finance
concepts illustrated
in Pierce’s comments
1.
Overconfidence
(Biased Expectations
and Illusion of
Control)

Describe each of the three concepts

Discuss how an investor
practicing standard or
traditional finance would
challenge each of the three
concepts

Pierce is basing her investment
strategy for supporting her parents on
her confidence in the economic
forecasts. This is a cognitive error
reflecting overconfidence in the form
of both biased expectations and an
illusion of control. Pierce is likely
more confident in the validity of those
forecasts than is justified by the

accuracy of prior forecasts. Analysts’
consensus forecasts have proven
routinely and widely inaccurate.
Pierce also appears to be overly
confident that the recent performance
of the Pogo Island economy is a good
indicator of future performance.
Behavioral investors often conclude
that a short track record is ample
evidence to suggest future
performance.

Standard finance investors
understand that individuals
typically have greater
confidence in the validity of
their conclusions than is
justified by their success rate.
The calibration paradigm,
which compares confidence to
predictive ability, suggests
that there is significantly
lower probability of success
than the confidence levels
reported by individuals. In
addition, standard finance
investors know that recent
performance provides little
information about future
performance and are not

deceived by this “law of small
numbers.”

2002 Level III Guideline Answers
Morning Session - Page 22


2.
Loss Aversion (Risk
Seeking)

3.

Pierce is exhibiting risk aversion in
deciding to sell the Core Bond Fund
despite its gains and favorable
prospects. She prefers a sure gain over
a possibly larger gain coupled with a
smaller chance of a loss. Pierce is
exhibiting loss aversion (risk seeking)
by holding the High Yield Bond Fund
despite its uncertain prospects. She
prefers the modest possibility of
recovery coupled with the chance of a
larger loss over a sure loss. People
tend to exhibit risk seeking rather than
risk averse behavior when the
probability of loss is large. There is
considerable evidence indicating that
risk aversion holds for gains and risk

seeking holds for losses and that
attitudes toward risk vary, depending
on particular goals and circumstances.

Pierce’s inclination to sell her Small
Reference Dependence Company Fund once it returns to her
original cost is an example of
reference dependence. Her sell
decision is predicated on the current
value as related to original cost, her
reference point. Her decision does not
consider any analysis of expected
terminal value or the impact of this
sale on her total portfolio. This
reference point of original cost has
become a critical but inappropriate
factor in Pierce’s decision.

Standard finance investors are
consistently risk averse and
would systematically prefer a
sure outcome over a gamble
with the same expected value.
Such investors also take a
symmetrical view of gains and
losses of the same magnitude,
and their sensitivity (aversion)
to changes in value is not a
function of some specified
value reference point.

In standard finance,
alternatives are evaluated in
terms of terminal wealth
values or final outcomes and
not in terms of gains and
losses relative to a reference
point such as original cost.
Standard finance investors
also consider the risk and
return profile of the entire
portfolio rather than
anticipated gains or losses on
any particular investment or
asset class.

2002 Level III Guideline Answers
Morning Session - Page 23


LEVEL III, QUESTION 7
Topic:
Minutes:

Portfolio Management
22

Reading References:
1. Emerging Stock Markets: Risk, Return, and Performance, Christopher B. Barry, John W.
Peavy III, and Mauricio Rodriguez (Research Foundation of the ICFA, 1997)

C. “Portfolio Construction Using Emerging Markets,” Ch. 2
D. “Investability in Emerging Markets,” Ch. 3
2. “The Importance of the Investment Policy Statement” (AIMR, 1999), 2002 CFA Level III
Candidate Readings
3. “Individual Investors,” Ch 3, Ronald W. Kaiser, Managing Investment Portfolios: A
Dynamic Process, 2nd edition, John L. Maginn and Donald L. Tuttle, eds. (Warren, Gorham
& Lamont, 1990)
4. Cases in Portfolio Management, John W. Peavy III and Katrina F. Sherrerd (AIMR, 1990)
A. “Introduction”
B. “The Allen Family (A)”; Case p. 15, Guideline Answers p. 58.
C. “The Allen Family (B)”; Case p. 18, Guideline Answers p. 62.
5. Managing Investment Portfolios: A Dynamic Process, 2nd edition, John L. Maginn and
Donald L. Tuttle, eds. (Warren, Gorham & Lamont, 1990)
B. “Monitoring and Rebalancing the Portfolio,” Ch. 13, Robert D. Arnott and Robert M.
Lovell, Jr.
Purpose:
To test the candidate’s: 1) ability to appropriately modify an individual investor’s investment
policy statement and asset allocation in response to important changes in the investor’s
circumstances, and 2) understanding of potential benefits and risks associated with investing in
emerging markets equity.
LOS: The candidate should be able to
“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

2002 Level III Guideline Answers
Morning Session - Page 24

“Investability in Emerging Markets” (Study Session 5)
a) describe the concept of “investability” in emerging markets
b) discuss performance comparisons between indexes of investable securities and indexes of all
securities in emerging markets
c) contrast the portfolio characteristics of the emerging market investable security universe and
the portfolio characteristics of all emerging market securities
“The Importance of the Investment Policy Statement” (Study Session 9)
a) explain the principal contents of a typical written investment policy statement and discuss
their implications for portfolio management
b) explain the importance of an investment policy statement
“Individual Investors” (Study Session 9)
c) analyze the objectives and constraints of an individual investor and use this information to
formulate an appropriate investment policy by taking into consideration the investor’s
psychological characteristics, positions in the life cycle, long term goals, liquidity
constraints, and any special circumstances such as taxes, gifts, and estate planning
Cases in Portfolio Management (Study Session 9)
b) contrast the investment objectives and constraints of individual investors in several different
economic circumstances
c) create an investment policy statement for an individual investor in each case, using the
concepts addressed in the readings in this study session
“Monitoring and Rebalancing the Portfolio” (Study Session 11)
a) determine whether changed asset risk and return conditions require a portfolio to be
rebalanced
b) appraise the need to rebalance under altered client circumstances, including changes in
wealth, time horizon, liquidity requirements, tax treatment, and regulatory environment
c) appraise the impact on the need to rebalance of such factors as the availability of new asset
alternatives, changes in asset class expected returns and risks, and transaction costs
d) contrast the merits and costs of rebalancing using such approaches as maintaining a 60/40
asset mix, letting an asset mix drift, and using a tactical asset allocation

2002 Level III Guideline Answers
Morning Session - Page 25