Category Archives: Level III

CFA Level 3 Emergency Preparation

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What if you were dramatically unprepared for the CFA Level 3 exam and needed to focus on the most important information for the upcoming test. What would you study over the next nine days?

Whatever the reason, many candidates find themselves unprepared at this point whether it be real for a lack of studying or imagined from simple anxiety. While I wouldn’t think it’s possible to do all your studying in just the next week and a half, there are some sections you can focus on to get the most points and have a chance at passing the exam.

The topic weights for the CFA Level 3 exam doesn’t really help like it may for the other two exams. We see that each of the asset classes are worth between 5% and 15%, with the exception of fixed income which is weighted a little more heavily. Beyond these four topics, we’re only told that the rest of the exam, between 45% and 55%, is wrapped up into portfolio management.

We do know that the exam is divided into an essay section in the morning and a item-set section in the afternoon. Since the afternoon item-set section isn’t really any different than that seen in the CFA Level 2 exam, the best use of your time might be to focus on the morning essay section.

There are a couple of reasons for this. First, there is a lot that goes into the morning section that just knowing the material. You need to be able to write for upward of three hours without getting tired and knowing the format of the exam helps a lot. Some questions can be answered directly under the problem while others are answered in a special template box.

Another reason to focus on the morning section for your last minute studying is that your performance on the essays can really help set the tone for your mood in the afternoon. Don’t underestimate the confidence boost from getting max points on the essays, in particular the first couple of portfolio management essay questions.

Fortunately, practicing the morning section is made easier by the Institute. You’ll find the last three years’ worth of essay questions along with guideline answers on the CFA Institute website. Using these helps to get a sense of what you might see on this year’s exam as well as how to approach it. Studying the last few years can also give you a sense of the topics that most frequently show up on the morning section, discussed in a previous post here.

If I had just one week to study for the Level 3 exam, I would focus first on the individual and institutional management questions in the last three years’ exams. These will be the first questions you get in the morning.

Remember, there are two primary types of return questions you will get for individual portfolio management, a single-period return calculation or a required return (multi-period) calculation. We’ve worked both of these in previous posts here on the blog. You also need to know the five portfolio constraints for the IPS and how they relate to the risk tolerance and return objectives.

We’ve reviewed each study session and several of the previous years’ essay questions in our 21-week study program, so you might want to start there as a quick review. If you do decide to just focus on the prior essay questions, you may want to review some material from the topics that do not typically appear in the morning section like: Financial Reporting & Analysis, Corporate Finance, and Quantitative Methods.

‘til next time, happy studyin’
Joseph Hogue, CFA

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CFA Level 3 Essay #9 2012

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The material on derivatives is worth between 5% and 15% of your overall score and last year (2012) was the first time in four years that it appeared in the morning section. This might have thrown some candidates if they were not expecting an essay question, so I thought I would go over one of the questions in this week’s post.

The essay questions, along with the guideline answers, are available on the Institute’s website for your practice.

Together, questions #8 and #9 were worth 25 points or about 7% of the overall exam. Problem #8 covered the use of equity futures in changing a portfolio’s beta, using equity and bond futures to adjust portfolio allocation, and pre-investing with futures. Problem #9 covered options with delta hedging and some conceptual material on how gamma changes closer to expiration. These are formula intensive sections but the calculations really are not that hard once you work through them.

The first thing you should notice when starting #9 is that the three parts (A,B,C) are worth 12 points. Unless you have saved some time elsewhere in the morning, you should try to get through these in no more than 10-15 minutes. Don’t spend 30 minutes on a question that is only worth 12 points! Use your time wisely.

You may want to underline or highlight key figures as you’re reading to make it easier to pick out data when you come to questions. Here things that jump out to me are 2,000 shares of equity, x-price of 1,300 Euros, premium of E19.09, etc.

  1. A put is a right to sell while a call is a right to buy, so being on the other side of the transaction (the writer of the option) would be the obligation to do the reverse (i.e. put is obligation to buy while call is obligation to sell). Knowing your ultimate exposure, you can figure out how to hedge it through an equity position. In this case you need to create an offsetting short position so you take the number of shares times the option delta times the current price.
  2. You need more in-depth knowledge of how options price here with the convex relationship between price and the underlying. You’ve seen this concept with mortgage-backed securities in the fixed income topic area so it shouldn’t be totally new. Remember, delta is the change in option price relative to stock price while gamma is the change in delta relative to the underlying. Long options (calls) have positive gamma (change in price is less for a decrease in underlying than the change for an increase in the underlying) while short options (puts) have negative gamma (change in option price will be greater for a decrease in underlying equity relative to the change from an increase in the underlying).
  3. The toughest part here is continuous compounding and the fact that you need to do six calculations for just five points. Don’t stare at the problem too long if you do not know it. Just get something down and move on to make sure you get the easy points in the exam. You will get partial credit if you hit on some of the points for which the graders are looking, so write something down!
    1. First, start with the trader’s net cash position which is the number of shares long times the price, minus the premium collected for the options sold.
    2. Even if you can’t remember how to do the continuous compounding, do the equation anyway and move on to the next steps. You can still get credit for doing the remaining calculations even if the result is off because of a prior mistake (and here the difference between continuous compounding is only $0.05).
    3. From here it’s just a matter of subtracting the short call position from the long equity position and finding the relative return.

 Of the 12 total points, you could have gotten 6 or 7 easily by just knowing the conceptual material and working through the equations quickly. The remaining points would have been a little harder and may have taken more time than they were worth if you really didn’t know the material. This is a great example of making sure you get the easy points and not spending too much time where it’s not going to pay off.

If you know that you don’t know something or it’s going to take a while to figure it out, move on and come back to it if you have time.

Two more weeks to the exam. Make sure you are ready for the first two questions (individual and institutional portfolio management) and get a few mock exams done.

‘til next time, happy studyin’
Joseph Hogue, CFA

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CFA Level 3 Review GIPS

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The last study session you’ll ever need in the CFA curriculum is the reading on the Global Investment Performance Standards (GIPS) for study session 18.

The basic concept behind GIPS is:

  • GIPS applies to firms, not individuals. An analyst cannot be “GIPS compliant”
  • The goal is fair representation and disclosure across investment opportunities for the public
  • It fosters the notion of “self regulation” within the industry
  • Each section includes “requirements” and “recommendations” for compliance. I would focus on the requirements if time is limited.
  • All actual, fee-paying, discretionary portfolios must be included in at least one composite
  • No non-discretionary portfolios, but non-fee paying portfolios may be included
  • Must calculate time-weighted total portfolio returns with external cash flows using daily weighting
  • Only actual assets, no model portfolios or simulations

The material on disclosures is easily testable along with some of the differences between the real estate and private equity sections.

Firms must disclose:

  • If they have met all requirements using the appropriate compliance statement (verbatim!)
  • Definition of the firm and description of composites (with creation date) and benchmarks
  • If they are presenting gross of fees and any fees deducted
  • If presenting net of fees, if model or actual management fees are deducted
  • Currency used in presentation
  • Measure of internal dispersion
  • Fee schedule
  • Use and extent of leverage, derivatives and short positions
  • Date, description and reason for redefinition of firm or composites
  • Minimum asset levels for composites
  • Treatment of withholding taxes, dividends, interest and capital gains
  • Bundled fees and the types of bundled fees
  • Sub-advisors and the period in which they were used
  • Any portfolios that were not valued at month end or last business day
  • Use of subjective unobservable valuation inputs
  • If no benchmark is used and why
  • Custom benchmarks used; description, date of creation, components, weights and rebalancing process
  • Whether the performance of a past firm or affiliation is linked (only appropriate if substantially all decision makers came over to new firm, the process remains substantially the same, and the firm has documentation of the performance history).

The guidelines on presentation and reporting are also important:

  • Total benchmark return for each period must be presented
  • Composite assets at the end of each year
  • Total firm assets or % of firm assets in each composite
  • Returns of less than one year cannot be annualized
  • % of composite in non-fee paying portfolios
  • % of composite in bundled fee portfolios
  • Five years of GIPS compliant performance or since inception if 5-years not available
  • Firms must add one year each year until at least ten years of data is reported

Be able to calculate the income return and capital return for real estate funds

Remember the valuation hierarchy for GIPS if the asset’s actual market value is not available

  • prices of similar assets in active markets
  • prices of similar assets in inactive markets
  • observable market inputs other than prices such as dividends, cash flows for pricing models
  • subjective or unobservable inputs like discount rates and projections  

Wow, we’ve made it through the entire curriculum. Hopefully, you have been able to keep up and have been doing well on practice problems and using other resources. You’re not done just yet. There’s still three weeks left to the exam and they can be the most important three weeks of your preparation. We’ll cover what to expect on test day in Friday’s post and other tips and strategies in subsequent posts all the way up to test day.

‘til next time, happy studyin’
Joseph Hogue, CFA

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Which topics usually show up on the CFA Level 3 Essay Section?

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While I’m generally not one to recommend ‘gaming’ the CFA exams, knowing which topic areas and material has a better chance at showing up on the essay section of the Level 3 exam can help out big time. The afternoon section is worth just as many points and you still need to master all of the curriculum, but the morning section can make or break your day.

First, a disappointing experience in the morning can devastate your confidence and ruin your concentration during the afternoon. You need to go into the exam feeling like you’re going to pass and carry that optimism all the way through. Secondly, there are questions that are more suitable and do show up in the essays. Preparing for these through practicing old exams will put you way ahead anyone on test day.

Your first question on the exam will always be an individual portfolio management question. The individual management question is usually around 12% of the exam (44 points) and will either be a multi-period return or a single-period return. Within the question you’ll often see questions on taxes, investor behavior and estate planning but the core is built around the return objective, risk tolerance and the five constraints. We’ve covered a few of these in the past, linked here and here for review.

An institutional portfolio management question usually follows directly but last year it didn’t come until #6, but you will always see one. It is usually around 36 points (10% of the total exam) but ranges from 24 to 49 points. There’s really no way of knowing which institution type will show up but make sure you know the basic comparisons between them all for the IPS components. We’ve done a couple of past questions, linked here.

Practicing several (at least) old individual and institutional questions from past exams will make your day on that first Saturday of June. Imagine starting the exam being totally confident and easily completing the first two questions and knowing you’ve just aced about 20% of the exam!

Economics has been in the morning section in each of the last four years and has been worth an average of 11% of your morning score. Biases and sources of error in data is a popular topic along with one of the economic measurement tools  (tobin’s q, fed model, cobb douglas, h-model, yardeni ). We ran through the 2011 Economics question here.

Risk management is often in the morning section, though it skipped last year. The question is usually about 10% of your morning score and often has a question about hedging with options, forwards, futures or swaps.

Asset allocation is another that usually shows up but was skipped last year. Some will say that this makes it more likely to show up in an essay this year but there’s no real proof of it (though I would agree from what I’ve seen in the past tests). The question is around 15 points (about 8% of your morning score) and will often be a selection of an appropriate portfolio or calculation of corner portfolios. The basic concepts, differences and advantages/disadvantages of the portfolio techniques is also something that has come up in the past (Black-Litterman, Mean Variance Opt., resampled efficient frontier, Monte Carlo). Linked here is the 2011 Asset Allocation Question.

Performance evaluation and the material on monitoring/rebalancing are also frequent essay questions. Each has had a question in three of the last four years with an average of about 15-17 points. Make sure you can do a micro- and macro-attribution for performance evaluation as well as breaking total return down into its components. The buy/hold, constant mix, and cppi methods of rebalancing often show up as questions so make sure you spend some time there as well.

The material on fixed income and equity investments also frequently find themselves into an essay question though no specific formulas or processes jump out as regulars. Even if you receive a question in the morning section, the topics are a fairly large percent of your total score so you may get a question in the afternoon as well.

The material in corporate finance, financial reporting & analysis, and quantitative methods don’t usually show up in the morning section. The material in alternative investments shows up only rarely, with a question on swaps and futures in 2009 (question #8).

We cover study session 18 next week and will spend the last few weeks reviewing and talking about test day. Let me know if you have any questions,

‘til next week, happy studyin’
Joseph Hogue, CFA

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CFA Level 3 Review, Portfolio Evaluation

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Study session 17 in the CFA Level 3 curriculum concludes the portfolio management topic area with two readings (41-42) on performance evaluation and attribution.

Evaluating Portfolio Performance
The curriculum gives several ways to calculate the rate of return on an account depending on if and when cash flows occur. Don’t try to memorize each individual method, instead think about it intuitively to work through the problem. If cash flows happen at the beginning of the period, then they should be included in the return metrics because it is money that was/wasn’t in the account for the entire period. If cash flows happen at the end of the period, they should not be included.

Understand the difference between time-weighted and money-weighted returns. The money-weighted return is the IRR and is only appropriate when the manager has discretion over deposits/withdrawals.

The material on benchmarks is fairly testable, make sure you know the types of benchmarks and advantages/limitations.

  • Absolute is the return objective or a minimum return target on the portfolio. It is simple and straightforward but not investable.
  • Manager universe  is usually the median manager or fund from a broad list. It is measureable but not investable, specified in advance, and is ambiguous.
  • Broad market is the comparison to a market index like the S&P500. The benchmark method is easy to understand, widely available and unambiguous, investable and measurable but there may not be an index appropriate for the manager’s investment style.
  • Factor model based uses models to relate systematic sources of returns to the account through  a regression model. It can be modeled to the manager’s specific style but may be difficult to use, ambiguous, and may not be investable.
  • Returns based benchmarks are constructed using the series of account returns and the series of style index returns over a period to make allocation weights. The method is intuitive and simple, unambiguous, investable and specified in advance but may not be matched to the manager’s actual style and require detailed data points.

Understand the basic steps to creating a custom security-based benchmark and its advantages/limitations.

Question #9 in the morning section of the 2010 and 2011 Level 3 exams was an attribution problem. I highly recommend that you download the test and the guideline answers to work through the problems. You need to be able to do both a macro-attribution and a micro-attribution analysis. The past three years of essay questions and guideline answers are available here.

Understand the objectives and basic process for a manager continuation policy.

Global Performance Evaluation
The reading revolves around breaking a total return out into its three components: capital gain (in the local currency), yield, and currency return.

Example: If you invest $100 in the Mexico index on January 1 2013 and by the end of the year the index has increased by 10% with a depreciation of 3% in the peso against the dollar, what is the return of the investment in dollars? (no dividends paid)

The return to currency is (% change in currency)(1+return +yield) = -.03(1+0.10+0)= -0.033
The return in the domestic currency is (cap gain)+(yield)+(currency)= 0.10+0+-0.033 = 6.7%
**Note it isn’t as simple as reducing the overall gain by the 3% depreciation

You will also need to be able to break the total portfolio return down further to its returns from market selection, security selection, yield and currency. The market selection return is that which would have been achieved with a passive investment in the local market index. The security selection component is made by the manager’s individual selections, in the local currency and compared to the market index.

Beyond the two types of global attribution analysis, the material on active and passive currency management is fairly testable. Passive currency management can be fully hedged to the exposure or selectively hedging some currencies but not others. Active currency management is a strategy that differs from the benchmark and creates different exposures. Currency management is usually done by futures or forwards as seen in the prior topic area.

Be sure to catch Friday’s post where we’ll look at what topics typically show up in the Level 3 morning essay section. We’ll cover study session 18 in the CFA Level 3 curriculum next week, which consists of one reading on the Global Investment Performance Standards (GIPS).

‘til next time, happy studyin,
Joseph Hogue, CFA

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CFA Level 3 Review, Monitoring and Rebalancing

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Study session 16 in the CFA Level 3 curriculum covers execution of portfolio decisions with two readings (39-40) on monitoring and rebalancing. The material is part of the large Portfolio Management topic area which is worth approximately half of your total test score.

Execution of Portfolio Decisions
Know the basic types of orders (market, limit, participate, portfolio, reserve) and what each means for price, timing, and liquidity.

Understand the basics for the type of markets (crossing networks, auction, dealer, and automated auctions). Don’t confuse electronic crossing networks (automated markets for institutionals that match buy and sell orders at specific times during the day) and Electronic communications Networks (ECN, computer-based auctions that operate throughout the day.

Understand the differences and roles of brokers and dealers. The relationship between the trader and dealer is adversarial while the broker represents the trader. Brokers help to find the opposite side of a trade, can supply market information, provide discretion and secrecy, and can provide other supporting investment services.

The material on transaction costs is the most testable portion of the reading and often shows up on the essay portion. Make sure you can work through an implementation shortfall problem and calculate explicit costs, realized profit/loss, delay costs, and the missed trade opportunity costs.

Be able to calculate the volume-weighted average price and describe differences between the two approaches.

Understand the motivations for each of the different types of traders (informational, value, liquidity, and passive) and what it means for timing and liquidity.

Monitoring and Rebalancing
The material on monitoring is basically understanding the constraints on the IPS and being able to see when an investor’s situation changes materially enough to take action. The curriculum is fairly basic and you should be able to work through it if you’ve spent the time on the individual/institutional management portions.

The rebalancing portion of the reading is the more testable. Understand the costs of rebalancing (transaction costs and taxes) and the two methods for rebalancing, calendar and percentage of portfolio.

Calendar rebalancing is simple and less costly because there is no need for monitoring but it is unrelated to market behavior so costs may outweigh benefits if the portfolio weights have not moved much. The percent-of-portfolio method requires frequent monitoring but has a relatively tighter control on allocations especially in a volatile market.

Understand the effect of transaction costs, risk tolerance, asset correlations, and volatility on the optimal corridor width.

The buy-and-hold, constant mix, and constant proportion portfolio insurance methods are also highly testable and you absolutely must understand the differences and how to calculate affect on the portfolio given different types of markets.

Study session 16 in the CFA Level 3 curriculum concludes the portfolio management topic area with two readings on performance evaluation and attribution.

‘til next time, happy studyin’
Joseph Hogue, CFA

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CFA Level 3 Review, Risk Management with Derivatives

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Study session 15 in the CFA Level 3 curriculum concludes the readings on risk management with three readings (36-38) on applications of derivatives. The last three readings are a little more quantitatively intense. Resist the temptation to skip over the difficult parts. Instead use the practice problems until you are confident that you could reproduce the concepts in an essay question.

Risk Management Applications of Forward and Futures Strategies
The number of futures contracts for a portfolio hedge is extremely testable and you need to know how to work through the calculation. Think through the formula to understand what is going on and it will become easier to remember.  # Futures contracts =

  • (desired beta minus current beta) divided by beta on futures      contracts: if you want to decrease the portfolio beta (decreasing      risk) then you will be selling futures contracts and you’re answer should      have a negative sign. Here you are taking the difference between the risk      you want and the risk you have and dividing by the riskiness of the      futures contracts to answer how much each futures contract will change the      risk of your portfolio.
  • Multiplied by (value portfolio divided by price of a futures      contract): This tells you how many futures contracts you need given      the portfolio size.
  • * A common question is to reduce beta to zero so the formula would      change to (0-portbeta)/futuresbeta * (portfolio      value/ futures contract price)
  • Pre-investing is also a common question and really just the      opposite of the above. Here you need to create index beta from 0 so it      would be (indexbeta-0/ futuresbeta)

Remember, a futures hedge on a portfolio is only a hedge for the similarity in risks between the index used for the futures contract and the portfolio. Example, the futures sold on the S&P500 would not be a good hedge on a portfolio of small-cap stocks because the index is a lg-cap index.

The formulas for creating a synthetic index fund and creating cash out of equity are also testable so do not avoid them.

Remember the advantages to using futures to manage risk (i.e. lower transaction costs, greater liquidity, provide better timing and allocation strategies, require less capital to trade).

Risk Management Applications of Options Strategies
Know the basic strategies (covered calls, protective puts, spreads, straddles, and collars) and how to figure out value at expiration. Here I think the curriculum is a little convoluted with the formulas when it is really a pretty basic concept.

Covered calls are holding a long stock position and selling calls against it to reduce some downside risk so you are going to deduct the collected premiums from your costs. Your upside is capped at the strike price plus the premium while you still risk losing everything except the premium (if the stock goes to zero).

Protective puts offer greater risk reduction and retain upside in the shares but cost more. The are formed by buying puts against a long stock position so you are going to add the cost of the puts into your costs.

Whether bull or bear, spreads involve two option strikes one higher and one lower so your costs will just be the difference in the premiums. Your risk is limited to the net difference in premiums while your upside is limited to the difference in the strike prices.

Collars involve both a call and a put option with the sell of one financing the purchase of the other. The most used example is a zero-cost collar where a call option is sold to fully finance a put option which provides downside protection at the expense of giving up upside potential.

Straddles involve buying a put and a call with the same strike and the same expiration and can be costly. The investor makes money if the shares move higher or lower than the combined price of the two options.

Risk Management Applications of Swap Strategies
For me, this was one of the most difficult readings in the curriculum. You need to be able to work through an example of a swap for interest rates, currency and equities and explain who has the risk in the transaction.

Remember, market value risk is the uncertainty associated with the value of an asset or liability while cash flow risk is the uncertainty associated with the size and timing of cash flows. Credit risk is the uncertainty that the other side of the transaction will be able to make their payment.

*Currency swaps usually involve the payment of notational principal at initiation and payments are not netted because they involve different currencies. This is different than other swaps where there is usually no initial principal exchanged and payments are netted.

Swaptions are options to enter into a swap either as payer or receiver. The payer swaption allows the holder to be a fixed-rate payer/floating-rate receiver and is similar to a bond put. The receiver swaption allows the holder to be the fixed-rate receiver/floating-rate payer and is similar to a bond call.

Study session 16 in the CFA Level 3 curriculum covers execution of portfolio decisions with two readings on monitoring and rebalancing.

‘til next time, happy studyin’
Joseph Hogue, CFA

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CFA Level 3 Review, Risk Management

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Study session 14 in the CFA Level 3 curriculum begins the readings on Risk Management with two readings (34-35). The Level 3 exam puts a lot of emphasis on the topic area and it is extremely testable. There is typically a question in the morning essay section, in fact last year was the first time since 2007 that there was no risk management essay. REVIEW THOSE PAST ESSAY QUESTIONS.

Risk Management
The reading starts of with some basic concepts and is important but secondary to the later material. Understand the advantages and disadvantages of both a centralized risk management system versus a decentralized system. A centralized system is led by a senior management employee within its own department and benefits from economies of scale and can provide an integrated picture of the company’s risks. In a decentralized system, each department handles their own risks and allows people closer to the actual risk to directly manage it.

Understand the different categories of risk: financial, non-financial, and sovereign  and the risks within each category:

Financial risks: market, credit, and liquidity
Non-financial risks: operational, model, regulatory and settlement

The measures of market risk are the more important material. You must understand standard deviation and value at risk, and the three methods of calculating value at risk.

Analytical- VAR = E® – z value (StDev)
Remember, you may need to adjust the standard deviation and expected return depending on the data provided and the question.  Daily StDev =Annual StDev/(square root of 250)
Historical Method- uses actual historical returns ranking in decending order and picks out corresponding return for the % probability. For example, if there are 100 observations and we want a 5% probability, then we would select the fifth worst return (or the average of the two closest).
Monte Carlo Simulation – generates random outcomes according to assumed probability distribution and a set of parameters to estimate the VAR.

Understand the extensions/supplements to VAR like stress testing and scenario analysis, as well as the performance measures like the Sharpe and Sortino ratios.

Currency Risk Management
The reading can get pretty detailed and quantitatively intense but you need to be able to work through all the hedging exercises. Pay attention to whether the question asks for the return in the local or domestic currency and whether the expected future value is hedged or only the principal.

Understand the differences between hedging with futures and using options. Futures are less expensive and appropriate when the investor risks volatility in rates but has a clear view of the direction of change. Options may be more expensive but provide more precision and are appropriate when exposures are uncertain with respect to timing and magnitude of exchange rate changes.

Understand the concepts behind strategic and tactical currency risk management. The three types of approaches are strategic management with a balanced mandate, currency overlay (tactical management), and treating the currency as a separate asset class.

Study session 15 in the CFA Level 3 curriculum concludes the readings on risk management with three readings on applications of derivatives.

‘til next time, happy studyin’
Joseph Hogue, CFA

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CFA Level 3 2011 Essay Question #3

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You will always have an institutional portfolio management question in the essay portion. The question from 2011 was worth 26 points (14.4% of morning session and 7.2% of total exam points) while last year’s question was worth 34 points (almost 10% of your total exam score!).

Please download the essay and guideline answers from the CFA Institute’s website here.

We covered the reading on institutional investors back in February, linked here. Each type of institution (pensions, foundations, endowments, insurance, and banks) have their own special idiosyncracies but there are some commonalities as well. As with the individual investor material, you need to understand their risk and return needs and how the five IPS constraints fit into them.

The question from 2011 had five parts, each with a couple of sub-questions. I read the questions quickly to find out the specific data for which I am looking but a lot of candidates start by reading the vignette.  You absolutely must be practicing these old essay exams to figure out what information the Institute is looking for and how you will approach the questions.

Skimming the questions, we see that we need:

  • Return objective- *** Remember, this is an explicit statement of what the investor needs or wants. Just writing out a numerical return percentage won’t cut it. These are easy points, most of the objective will be a cut and paste from within the vignette. Things like, the investor needs to grow assets at a rate sufficient enough to cover X% of the institution’s spending needs and maintain the real value of the portfolio.
  • Calculate a required return- the instructions say SHOW YOUR CALCULATIONS for a reason. Show all steps to make sure you at least get some partial credit.
  • Factors in Risk Tolerance, remember risk tolerance is compose of both willingness and ability. You need to know what factors influence each. When in doubt, go with the more risk averse objective.
  • Liquidity and Time Horizon constraints for the IPS
  • Spending rule affect on goals and funding
  • More risk tolerance factors

endowments & foundations are often tested together because they are similar but with important differences.

  • Know the spending rules: volatility/riskiness in funding and why would you choose each
    • A simple spending rule is just a percentage rate times the portfolio’s market value. This rule can lead to volatile spending and would necessitate a lower risk tolerance to avoid volatility in the portfolio value.
    • A rolling three-year average rule is the percentage rate times the portfolio’s average value over the last three years. The rule helps to decrease volatility and can increase risk tolerance.
    • A geometric smoothing rule is the weighted average of the prior year’s spending (adjusted for inflation) and the product of the percentage rate times the portfolio’s market value. This rule also increases risk tolerance but places more emphasis on the recent market value of the portfolio.
  • Difference between endowments/foundations. A foundation may be the sole source of funding whereas endowments are usually a smaller part of overall funding. Foundations may have a limited time horizon whereas endowments are usually indefinite. Endowments do not have legally required spending levels.

Part A-

i. Most endowments and foundations, unless explicitly stated in vignette, are going to want to maintain REAL VALUE OF ASSETS. This means they must earn a return high enough to satisfy spending needs and inflation. The first two points in the vignette give you everything you need for the objective (maintain real value, long-term, fund 25% of annual op expenses)

ii. The institute will give you points for a geometric or arithmetic return (but you should know how to do the geometric return because it is technically correct).

Required return is going to be= spending rate * inflation rate * management expenses.

                * remember- the correct inflation rate is that applicable to spending (this case higher education) not necessarily general inflation = (1+ spending rate)*(1+inflation rate)*(1+mgmt. expense rate)
   * Know how to calculate your spending rate from the three spending rules

Part B-

Worth six points: one point for circling the correct answers in middle box, two points for ONE REASON stated in third column. ** Remember- graders are only going to look at your first response. Don’t waste your time putting down more than one response.

The guideline answer shows two possible responses, only one was asked for.

- For endowments, generally as funding increasesà risk tolerance increases because spending needs are lower proportion of total assets.

- As inflation increases, risk increases as well because it becomes harder to protect REAL VALUE of assets in portfolio and also satisfy spending needs

Part C-

Remember TUTLL, IPS constraints are just as important for institutionals as for individuals

Time- will generally be infinite for most institutional types or the vignette will say otherwise
Unique- usually explicit in case as well (endowments and foundations often have prohibitions against investing in ‘vice’ stocksà Socially-Responsible Investing)
Taxes- Endowments/Foundations are tax exempt, Banks and Insurance are Taxable
Liquidity- Annual spending needs for Endowment/Foundations, Very important for Banks/Insurance to fund claims and withdrawals.
Legal- UMIFA for Endowments/Foundations, Highly-regulated Banks/Insurance on the state level

Part D-

i. primary goal for endowment is usually spending with protection of real value- reducing portfolio risk will also reduce expected return and make it harder to cover spending and inflation

ii. LEARN THE SPENDING RULES! Three-year average rule will smooth needs thus lowering volatility

Part E-

Again, ONLY WRITE WHAT IS ASKED FOR. The questions asks for 3 factors (don’t write six and hope the grader will look for the best 3, they don’t do this)

For differences in risk tolerance, think about the IPS constraints that affect tolerance.

  • Time – Longer or infinite horizons will have longer to make up portfolio shortfalls
  • Liquidity – The need to fund a larger percentage of total institutional spending is an important one and makes for lower ability to tolerate risk. Spending rules that lower volatility (smoothing or the 3-yr average rule) will increase ability to tolerate risk.
  • Legal – remember foundations must spend a certain percentage to maintain tax status while endowments do not have this requirement
  • Additionally, other sources of funding and the yearly increase (inflationary or otherwise) in operating expenses are always important to needs

Guideline answer provided by Institute shows 7 possible answers, you only need 3

We’ll cover study session 14 in the CFA Level 3 curriculum next week. The readings start Risk Management, an extremely important topic in the Level 3 exam and definitely worth a couple of questions on the test.

‘til next time, happy studyin’
Joseph Hogue, CFA

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