QUESTION 1, INCLUDING GUIDELINE ANSWER, 1996 CFA LEVEL III EXAMINAT...

4. Question 1, including Guideline Answer, 1996 CFA Level III Examination (AIMR)

Purpose:

To test the candidate’s ability to select appropriate asset allocation strategies for various clients’

objectives and constraints.

LOS: The candidate should be able to

“Asset Allocation” (Session 12)

• formulate major steps in the asset allocation process.

Cases in Portfolio Management (Session 22)

• recommend and justify a general asset allocation that would be appropriate for an investor.

1995 CFA Level III Examination (Session 22)

• recommend an asset allocation and justify the recommendation;

• justify the use of specific asset classes and relate the asset allocation to the investment policy

statement.

1996 CFA Level III Examination (Session 22)

• recommend and justify an asset allocation and clearly state any assumptions, especially

regarding the risk tolerance of the client, that contributed to the recommendation.

Guideline Answer:

A. Personal Portfolio

Portfolio A is the most appropriate portfolio for the Muellers. Because their pension income will

not cover their annual expenditures, the shortfall will not likely be met by the return on their

investments so the 10 percent cash reserve is appropriate. As the portfolio depletes over time, it

may be prudent to allocate more than 10 percent to cash equivalents. The income deficit will be

met each year via a combination of investment return and principal invasion.

Now that their daughter is financially independent, the Mueller’s sole objective for their

personal portfolio is to provide for their living expenses. Their willingness and need to take on

risk is fairly low. Clearly, there is no need to expose the Muellers to the possibility of a large

loss. Also, their time horizon has been shortened considerably because of their health situation.

Therefore, a 70 percent allocation to intermediate term high grade fixed income securities is

warranted.

The income deficit will rise each year as the Muellers’ expenses rise with inflation but their

pension income need remains constant. The conservative 20 percent allocation to equities

should provide diversification benefits and some protection against unanticipated inflation over

the expected maximum 10-year time horizon.

Portfolio B, the second best portfolio, has no cash reserves so the Mueller’s liquidity needs

would not be met. Also, although it has a higher expected return, Portfolio B’s asset allocation

results in a somewhat higher standard deviation of returns than Portfolio A.

Portfolios C and D offer higher expected returns but at markedly higher levels of risk and with

relatively lower levels of current income. The Mueller’s large income requirements and low risk

tolerance preclude the use of Portfolios C and D.

B. Trust Distribution Portfolio

Portfolio B is the most appropriate portfolio for the trust assets. Portfolio B’s expected return of