3. Questions 1 and 2, including Guideline Answers, 1995 Level III Examination (AIMR)
Purpose:
To test the candidate’s ability to develop a long-term investment policy statement for a family with
changing resources and return needs over time. Specific tax and unique circumstances are included
for consideration.
LOS: The candidate should be able to
“Individual Investors” (Session 13)
• analyze the objectives and constraints of a particular individual investor and use the investor’s
psychological characteristics, position in the life-cycle, long-term goals and particular
constraints (such as liquidity, taxes, gifts and estate planning) to formulate appropriate
investment policies for the investor;
• create a set of portfolio policies that is based on a multi-asset, total return approach to individual
investing.
Cases in Portfolio Management (Session 22)
• create a formal investment policy statement for an investor.
1995 CFA Level III Examination (Session 22)
• prepare an investment policy statement that clearly states the investment objectives and
constraints of a client;
• justify all recommendations and statements included in the investment policy statement.
Guideline Answer:
The objectives and constraints portion of the Muellers’ investment policy statement should include
the following objectives and constraints:
Objectives:
i. Return Objective. The Muellers’ return objective should be a total return approach that is a
combination of capital appreciation and capital preservation. After retirement, they will need
approximately $75,000 (adjusted for inflation) annually to maintain their current standard of
living. Given their limited needs and asset base, preserving their financial position on an
inflation-adjusted basis may be a sufficient objective. However, their long life expectancy and
undetermined retirement needs lead to the likely need for some growth of assets over time, at
least to counter any effects of inflation.
Although the Muellers wish to exclude the future trust distribution from their current planning,
that distribution will substantially increase their capital base and dramatically alter the return
objective of their future investment policy statement, primarily by reducing their needed return
level.
ii. Risk Tolerance. The Muellers are in the middle stage of their investor life cycle. Their
relationship of income to expenses, total financial resources, and long time horizon give them
the ability to assume at least an average, if not an above average, level of risk in their
investments. However, their stated preference of “minimal volatility” investments apparently
indicates a below average willingness to assume risk. The large realized losses incurred in
previous investments may be a contributing factor to their desire for safety. Also, their need for
continuing cash outflow to meet their daughter’s college expenses may temporarily and slightly
reduce their ability to take risk.
Two other issues affect the Muellers’ ability to take risk. First, the holding of Andrea’s company
stock represents a large percentage of the Muellers’ total investable assets and thus is an
important risk factor for their portfolio. Reducing the size of this holding or otherwise reducing
the risk associated with a single large holding should be a priority for the Muellers. Second, the
future trust distribution will substantially increase their capital base and therefore increase their
ability to assume risk. However, the larger capital base would reduce their need for higher
returns, and the corresponding higher risk levels.
Constraints:
iii. Time Horizon. Overall, the Mueller’s ages and long life expectancies indicate a long time
horizon. However, they face a multi-stage time horizon because of their changing cash flow and
resource circumstances. Their time horizon can be viewed as three distinct stages: the next five
years (some assets, negative cash flow because of their daughter’s college expenses), the
following five years (some assets, positive cash flow), and beyond ten years (increased assets
from a sizable trust distribution, decreased income because they plan to retire).
iv. Liquidity. The Muellers need both immediate liquidity and ongoing funds over the next five
years. They need to have $50,000 available now for the contribution to the college’s endowment
fund. Alternatively, they may be able to contribute $50,000 of Andrea’s low cost basis stock to
meet the endowment obligation. In addition, they expect the regular annual college expenses to
exceed their normal annual savings (combined incomes minus usual living expenses) by
approximately $15,000 for each of the next five years. This relatively low cash flow
requirement of 2.7 percent ($15,000/$550,000 asset base after $50,000 contribution) can be
substantially met through income generation from their portfolio, further reducing the need for
sizable cash reserves. Once their daughter has completed college, their liquidity needs should be
minimal until retirement because their income more than adequately covers their living
expenses.
v. Taxes. The Muellers are subject to a 30 percent marginal tax rate for ordinary income and a 20
percent rate for realized capital gains. The difference in the rates makes investment returns in
the form of capital gains preferable to equivalent amounts of taxable dividends and interest.
While taxes on capital gains would normally be a concern to investors with low cost basis stock,
this is not a major concern for the Muellers because they have a tax loss carry forward of
$100,000. The Muellers can offset up to $100,000 in realized gains with the available tax loss
carry forward without experiencing any cash outflow or any reduction in asset base.
vi. Unique Circumstances. The large holding of the low-basis stock in Andrea’s company, a
“technology firm with a highly uncertain future,” is a key factor to be included in the evaluation
of the risk level of the Mueller’s portfolio and the future management of their assets. In
particular, the family should systematically reduce the size of the investment in this single stock.
Because of the existence of the tax loss carry forward, the stock position can be reduced by at
least 50 percent (perhaps more depending on the exact cost basis of the stock) without reducing
the asset base to pay a tax obligation.
In addition, the trust distribution in 10 years presents special circumstances for the Muellers,
although they prefer to ignore these future assets in their current planning. The trust will provide
significant assets to help meet their long term return needs and objectives. Any long-term
investment policy for the family must consider this circumstance and any recommended
investment strategy will need to be adjusted before the distribution takes place.
Level III: Question 2
Topic: Investment Policy Statements
Minutes: 6
Reading references:
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