The individual and institutional questions for the level 3 CFA exam in 2010 were worth almost a quarter of the entire test! The first question, individual portfolio management, was worth about 19.4% of the essay portion while the institutional question was worth 27.2% (along with behavioral).
This is not far from the historical averages for these questions. You will get massive points on the exam if you master these two topic areas of the curriculum! We are covering some of the last three years’ essay questions here, but you need to go to the Institute’s website and download the exams to work them on your own.
Question 1 has five parts (A,B,C,D,E) for a total of 35 minutes.
You know the first two questions will be individual and institutional problems and will be fairly intense. In 2010, they totaled 84 points/minutes (that is more than an hour of intense CFA exam fun, so be ready!).
Again, I skim through the questions quickly to see what I need. For this one, we can see that we need:
- A- Liquidity and Time constraints
- B- Return objective and calculate the required annual pretax nominal rate SHOW YOUR CALCULATIONS!
- C- Two factors that increase ABILITY to take risk for each person
- D- Determine which has greater willingness to take risk with one reason
- E- How much of bonds/equities to sell or buy for tax efficiency
We won’t go over the general advice here (like paying attention to where you write your answers) so you need to check the other blog posts for the level 3 exam and the other essay questions.
This gives us a great idea of what we are looking for in the vignette.
- Liquidity constraints are almost always <1yr spending needs and planned debt/giving
- Time constraints are going to be the time horizon for any large outlays or life events (college, retirement, etc)
- MAKE SURE YOU WRITE A RETURN OBJECTIVE! This is an explicit statement of need and usually is cut and paste from vignette. You already know some of it from the next part of the question!! “earn a pretax nominal rate to retire in 25 years”
- Remember, pretax and nominal! Add inflation to your return needs and watch for tax information.
- Ability to take risk is usually things like: proportion of spending needs to assets, time horizon, importance of spending needs. You only need two for each person
- Willingness for risk is almost always explicit statements in the vignette. Things like, “I am comfortable living on less,” or “I would be really stressed if we lost any principal.” You only need one.
Now, as you are reading through the vignette you can highlight/underline any relevant information as you come to it.
A- We see that Lima wants to pay education costs in one year (large cash outlay so liquidity needs). For time constraints, always explicitly state whether it is single- or multi-stage and approximate years in each and long- or short-term. (last stage usually in retirement and just written as >25 years)
B- Objective is usually something like, “grow investments to (specific objectives like protect purchasing power in retirement and leave amount to charity)” plus any relevant numerical info like how much spending is needed on how large of an asset base.
- a. ** This is one of two types of return problems you will get. You must know both. Show all steps of calculation (as shown in guideline answer). Even if you mess up the final calculation, you will still get some credit for your work along the way. Remember: Current investable assets, cashflows, expenses & debt repayment
- b. These long-term required return calculations can be done on your calculator with the appropriate (PV), (FV), etc written on test as shown. **FOR ALL ESSAY QUESTIONS, circle and/or double underline your final answer. Make it easy for the grader to find your answer!
C- The guideline answers show four possible answers, you only need two. Factors that are going to INCREASE ability to take risk are: longer time horizon, low % of spending needs to assets, flexibility in spending needs, importance of spending needs, amount of debt
D- Factors that INCREASE willingness to take risk are usually explicit statements in vignette showing confidence or fear of investor.
E- Past essay exams have included questions like these that often hinge on taxes paid now or later and possible tax law changes. The tax section is fairly quantitatively intense but it seems like the exam tests the concepts in tax management rather than the more intense calculations. Make sure you understand the basic ideas behind deferment, taxable/non-taxable accounts, and the different types of taxes.
Other than part E, the question was fairly easy if you understand the IPS and can do basic return calculations. You need to work through the last three years’ individual and institutional essay questions at least twice before the actual exam. Doing this will not only help you to learn the material but will boost your confidence through the first (and most important) points on the exam.
‘til next time, let me know if you have any questions. Happy studyin’
Joseph Hogue, CFA