Level III Review, Private Wealth Management

Private wealth management, along with the next study session on institutional management, is probably the single most important portion of the CFA Level III exam. The first questions in the morning are ALWAYS Individual followed by Institutional portfolio management. Learn these sections, be ready for them on the exam and finish your first two questions with confidence!

Practice is really the key with the essay questions. Working through old exams, you get a sense of how the Institute frames scenarios and questions. The old exams released by the Institute also have the guideline answer (max points) so you get an idea of what the graders want.  Being able to practice how you are going to BRIEFLY get your answer across is a huge help. I worked through seven years of old exams and had no trouble with the morning section.

** Practicing old exams will also help you get in the habit of writing again. If you haven’t hand-written anything in a while, you do not want to wait for the 3-hour exam to see how much your hand starts hurting!!
We posted the link to the Institute’s site last week to access the last three years’ essay questions and guideline answers. Make sure you click through to download the exams. We will cover as many of the questions as we can before June. ** Click on “Level III” in the Finquiz Blog menu above and scroll down for the essay questions we covered last year.

Managing Individual Investor Portfolios

The first question on the essay section will always be individual portfolio management and it will be one of two types of calculations, a single period return or a multi-period return. We’ll cover the keywords to watch out for and how to work through each calculation in subsequent posts.
Some of exams specifically ask you to state a return objective:
– 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
Remember the constraints!

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

The reading can get pretty detailed but I would concentrate on the conceptual material and the basic equations. Understand the different tax regimes and the treatment of different gains (interest, dividend and cap gains).
Be able to do the basic calculations like accrual taxes, deferred cap gains, accrual equivalent rate and returns.
The differences and advantages between the different tax-advantaged accounts is important so be able to tell where an asset should be placed and calculate basic returns.

Estate Planning
A few terms are important to remember like testament, probate, forced heirship, claw-back, safety reserve, and the different types of trust (revocable, irrevocable, fixed, discretionary, spendthrift).
Be able to calculate the relative after-tax value between a tax-free and a taxable gift as well as the value from generation skipping. As with many of the equations here, the mathematical representation is more intimidating than the concept. Try to talk through what is happening (i.e. capital is growing for n years then taxes are coming off the total) and many of the problems will become clearer.
Understand the difference between the credit, exemption and deduction methods under the residence/source conflicts. The credit method allows for a complete reduction of taxes paid while the deduction method only allows the taxes paid to come off of income.
Be able to work with the information from a mortality table to calculate core and excess capital. Remember, the probability of joint survival equals Prob(husband survival) plus Prob(wife survival) minus the product of each survival.

Low-basis Stock
The reading on psychological considerations and risk, investor stages and attitudes is strictly conceptual. Make a brief outline of the concepts with definitions and be able to reproduce a one or two sentence reasoning on the exam. *Again, looking over past exams will help tremendously in seeing the depth of understanding that the Institute is expecting.
The rest of the reading basically a comparison of the advantages/disadvantages between the different diversification/sale techniques. A table listing these for sale, public exchange funds, private exchange funds, completion portfolio, and hedging should give you the basic idea.

  • Sale: max flexibility but possibly highest taxes
  • Exchange funds: diversifies portfolio without recognizing gains but include mgmt. fees, lockup period and may not be able to adjust holdings
  • Completion portfolios: diversifies holdings, provides cash without recognizing gains to the extent of loss harvesting but the investor may need considerable other assets and take a lot of time to reach goal
  • Hedging: fast and can monetize the position but the upside may be limited and their may be regulatory risk on a constructive sale

Human Capital, Asset Allocation and Insurance
Don’t get bogged down with the few equations in the reading. Instead understand the meaning behind the equations and the models.
Understand the difference between human capital as a risk-free asset and a risky asset and its impact on the investment decision (i.e. stability of future income and whether the financial assets should be in risky investments or stable investments)
Understand longevity risk (risk of ruin) is the risk of outliving your assets and the differences between fixed-payout and variable-payout annuities. The fixed-payout risks losing purchasing power from inflation over time and locks in the rate.

Study session five in the CFA Level III curriculum covers institutional portfolio management and will be the second essay question on the morning section of the exam. We will cover the key concepts and formulas in next week’s post and then hit some past essays in subsequent posts on the blog.

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

CFA Program 2020/2021 - Levels I, II and III

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