2011 Essay Question #2 Individual Portfolio Management

Question #2 on the 2011 Level 3 CFA exam (really a continuation of the Individual Portfolio Management questions in #1) is extremely important. The question was worth 23 points (12.8% of total essay points) and combined with #1 made individual portfolio mgmt more than 10% of the total level 3 exam. The essay along with guideline answers is available on the CFA Institute’s website. Please download a copy to follow along.

** Pay attention** The first question on the essay section will always be individual portfolio management and it will be one of two types of calculations…

  • Single-period return like 2011: Look for clues like, “first year of retirement,” or, “cash flow required one-year from now.”  As with both types, SHOW ALL STEPS OF YOUR CALCULATIONS!
     – Make sure you include all cash inflows: pension, salary
    – Minus all cash outflows: living expenses, mortgage (have you already tried Imbrex? It should be a sensation in a modern real estate market data!); debt repay, gifts
    – Investable assets: (do NOT include primary residence unless otherwise instructed)
    – When the time period is in one year and nominal:  Add the rate of inflation to the real return as in guideline answer (should be geometrically but graders usually give credit for added as well). Remember “real” return is without inflation.

** Pay attention to the question– “After-tax nominal return” means you do NOT gross up for    taxes (as in last year’s question), “Pre-tax nominal return” means you need to account for the tax rate by grossing up the required cash flows. Example: If the Beckers had needed a pre-tax return (assuming 35% tax rate) à yr 1 required cash flow $209,500/(1-tax rate)= $322,307 à $322,307/$4.35 million= 7.4% plus inflation= 10.4% pre-tax nominal rate of return

– Rates of return on these questions are usually within the realm of reason (around 4-6% real, 6-10% nominal) so if you work the problem and get something like 15% or more, go over your calculations because you might have something wrong

  • Multi-period required return like 2010 essay: (we’ll cover this next week when we do the problem)

These questions will also include questions on the IPS statement.

** Though 2011 does not ask for it, many years will ask you to, “State the return objective portion of the IPS.” A lot of candidates miss easy points because they either forget this or think that the return calculation will do satisfy it. NO! YOU MUST STATE A RETURN OBJECTIVE! Easy points, most of the objective is just copying from the vignette. Example: The Beckers’ objective is to retire at the end of one year and live off of investments after paying debts.
– Include in return objective: the investor’s age and stage of life, inflation concerns, needed % required, other relevant facts of the case
– Do the return calculation before the return objective, as this will help with numerical requirements of return objective

Part B: Remember risk tolerance has two components (ability and willingness)

Factors affecting ability: long-term versus short-term (long-termà higher ability to TOLERATE RISK), Importance of goals (high importanceà lower ability), size of income needs to portfolio size (very high % à lower ability)

Factors affecting willingness: These are usually statements in vignette (past losses and fear of future loss, desire a conservative approach)

** Remember: When the ability and willingness to tolerate risk are in conflictà go with less overall risk tolerance. Example: high willingness but low abilityà investors have low overall portfolio risk tolerance.

Part C: Remember TUTLL

Time– length of life stages is important as well as children’s ages, explicitly write how many stages and whether long-term or short-term (usually long-term)

Unique– large stock holdings or insider positions, client behavioral characteristics (socially responsible investing), any contradictions in the case

Taxes- tax-free investments, types of taxes (wealth, capital gains, income, estate)

Legal- Trusts, prudent investor rules

Liquidity- short-term living expenses, emergency cash, plans to pay off debt

Part D: Choosing a portfolio

– Choose from the portfolios that will satisfy minimum return requirements first (in this case, portfolio B has a chance of falling to 0 so is inappropriate)

We’ll cover more on individual portfolio management in other posts, but be sure to study the old exams on the Institute’s website.

Let me know if you have any questions,

Joe Hogue, CFA

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