Question #1 was, as always, an individual portfolio management question. In 2009 it was worth 26 points, or about 7.2% of your total exam points. Download the exam and guideline answers from the CFA Institute to follow along with the discussion.
We’ve covered the individual and institutional portfolio management essay questions in the 2011 and 2010 Level III exams already. See prior posts for practice and a general strategy.
Skimming over the questions, I know that I need to look for:
Ai. Don’t forget to explicitly write out a return objective! Look for copy/paste stuff from the vignette like estate gifts, funding expenses and preserving capital after inflation, and any special inflows/outflows mentioned. The objective is anything the investor wants or needs to do with their money. When I took the exam, I did this one after the return calculation so I could also put in the relevant figures (i.e. total assets, return % needed, expenses, etc.), it’s not always required in the guideline answer but it can’t hurt.
Aii. A few clues should jump out in the question, ‘pre-tax nominal’ and ‘first year’. Pre-tax means you are going to need to gross up the net income needed for taxes. The tax rate is always given so just divide income needs by (1-tax rate).
‘First year’ signals one of two questions you will definitely be getting on the exam, a one-year return needed for retirement. The other question is the multi-year return needed for retirement in the future and one where you will use your calculator (covered in previous essay posts).
Do Not Forget to Show Your Calculations!! Don’t throw away easy partial credit! Even if you miss the final answer, you will still get some points for having: Cash Inflows, Outflows (expenses), Investable Assets (minus debt payoff), Return Calculation (with inflation). Of the twelve points available for Part A, I would guess about 3 points are for the return objective and nine are for the return calculation (but only 3-5 are for the correct final answer, meaning you may still get 4-6 points even with a wrong return).
Practice setting your calculations up exactly as they are shown in the guideline answer, with headings and format.
Bi. Ability to take risk is usually going to be more quantitative information. What is proportion of expenses to total assets? (Around 5% or less will be higher tolerance). Will they have any other funds besides investments? How important are planned spending needs? (They don’t necessarily NEED that vacation home in Malibu, so higher tolerance). Is retirement within a couple of years?
Bii. Willingness to take risk is usually explicit statements by the participants in the vignette. Look for past experiences that might make them fearful of losses, conservative or risk-taking behavior, attitude toward loss.
Ci. Liquidity constraints are debt and/or expenses stated in the vignette. The typical needs are paying off home-mortgage and paying for children’s tuition.
Di. Always talk of time horizon in ‘stages’ separated by significant life and spending events. Events that usually delineate stages are: working career (accumulation), paying for tuition, and retirement. Always list out the relevant time in years for each stage as shown in guideline answer (retirement is usually set at 25 or more years, we don’t need to put an explicit time on their death).
We’ve now covered the last three years essay questions for individual portfolio management. I would recommend working through them one more time along with making sure you understand the key concepts for the topic area. This first question on the exam can be EASY POINTS! The range of questions is fairly limited to return objective statements, calculating returns, and describing risk tolerance and constraints. There may be some tax or wealth transfer stuff thrown in for good measure, but you should be able to pick up some good points here. BE READY!
Please let me know if you have any questions. This is important stuff and can be some seriously easy points! ‘til next time, happy studyin’
Joseph Hogue, CFA