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.
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
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
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
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
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 Level III CFA Program 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