54 RELATE TO ASSET ALLOCATION. THE AZUR FUND IS A SOVEREI...

Questions 49-54 relate to Asset Allocation.

The Azur fund is a sovereign wealth fund valued at USD792 billion located in the country of

Azurbikan. Azurbikan is a member of OPEC petroleum exporting countries with the main

funding source of the fund being oil exports.

Noir Rashwan, CFA, is the managing director of the fund and is currently meeting with the

board of directors of the fund, consisting of representatives from various government

departments, business leaders, and other stakeholders. Her agenda is to discuss concerns

regarding low oil prices and how that affects the country's wealth in its concentrated position

in oil, a proposed change to the fund's strategic asset allocation to increase the overall return

of the fund in response to the low price of oil, and divestiture of some real estate assets to

capture gains. Rashwan first presents the current and proposed asset allocations shown below.

Current Asset Allocation Proposed asset allocation

Cash 4%

Domestic government bonds 20% 1%

Domestic corporate bonds 10% 2%

Global bonds 10% 2%

Domestic equity 35% 9%

Global equities 10% 12%

Real estate 15% 10%

Infrastructure 10%

Hedge funds 17%

Private equity 33%

She explains to the board of directors that since the fund has low liquidity needs the proposed

strategic asset allocation will allow the skilled sub-managers to add value through active

management of the non-traditional assets.

In 2008, many of the fund's foreign investments that were purchased at the peak of the real

estate market lost substantial amounts of value. Some of those real estate values have since

rebounded and are currently above the purchase price. Rashwan proposes to sell the fund's

USD100 million stake in a hotel located in the United States in South Beach Miami. Zein

Minkara, president of a major pharmaceutical company, states, "We should sell now to lock

in the gains, avoiding the substantial and painful losses that many of our real estate holdings

experienced during the last global recession." The hotel property value has a pre-tax standard

deviation of 13% and would be subject to a 20% capital gains tax.

Regarding the low price of oil, Jamal Zayat, Sultan of Azurbikan, states, "Since we're part of

OPEC, a consortium of oil exporting nations, we should agree to restrict the world supply of

oil, thus propping up its price as we've been able to do in the past." Siham Atallah, chairman

of the central bank of Azurbikan, discusses changes in the economic environment of oil

production putting downward pressure on oil prices. These changes include reduced demand

in gasoline through greater fuel efficient cars, weak economies of Europe and developing

countries, and the development of new technologies allowing countries to extract oil and

natural gas from areas that were once unprofitable.

Atallah ends with a summary of short-term capital market expectations:

 "Overall global GDP is expected to grow at a moderate pace,

 the yield curve is expected to flatten with short-term rates increasing while long-term

rates remain steady,

 yield spreads are exceedingly high, and

 global real estate values are showing signs of overvaluation in some markets."

...

Which of the following statements regarding the proposed change in strategic asset allocation

for the Azur fund is least accurate?

A) Due to the large size of the fund, it may not be possible to find enough alternative investments to

meet the proposed strategic asset allocation.

B) The percent allocated to alternative investments is acceptable given the low liquidity needs, long

time horizon, and desire for increased return.

C) The proposed asset allocation is too heavily weighted towards non-traditional assets with not

enough exposure towards more traditional bond and equity investments.

Explanation

For institutional investors like a large sovereign wealth fund with a long time horizon and

little liquidity needs, a portfolio comprised largely of non-traditional investments where

manager skill and an illiquidity premium can be earned is acceptable. The problem large

institutional investors may run into is not enough alternative investments available to invest

in, like hedge funds, to meet their target asset allocation.

For Further Reference:

Study Session 8, LOS 17.n

SchweserNotes: Book 3 p.130

CFA Program Curriculum: Vol.3 p.306

Study Session 9, LOS 18.a

SchweserNotes: Book 3 p.140

CFA Program Curriculum: Vol.3 p.322

Question #50 of 60

The behavioral bias displayed by Minkara, the president of the pharmaceutical company,

is most likely described as:

A) recency bias.

B) loss aversion.

C) mental accounting.

Minkara is displaying recency bias (also referred to as representative bias) when investors

attach more importance to more recent data. In this case, he is placing more emphasis on the

recent run up in real estate prices and equating that with similar events that led to the last

global recession. Loss aversion is when the utility given up from a loss is greater than the

utility derived from achieving a gain on an investment. In loss aversion, the investors sell

winners too soon and hold onto losers too long in hope of gaining back some of their losses.

Mental accounting is when assets (or liabilities) are separated into different buckets based on

subjective criteria. There is no evidence of mental accounting in this particular situation.

Study Session 9, LOS 18.e

SchweserNotes: Book 3 p.153

CFA Program Curriculum: Vol.3 p.361

Question #51 of 60

The after-tax standard deviation on the sale of the USD100 million stake in the hotel

is closest to:

A) 10.4%.

B) 13.6%.

C) 16.3%.

The after-tax standard deviation = pre-tax standard deviation (1 - t) = 13%(1 - .2) = 10.4%.

After-tax risk and return can significantly impact the efficient frontier; therefore, the post-tax

standard deviation should be used as an input into the asset allocation process.

Study Session 9, LOS 18.b

SchweserNotes: Book 3 p.146

CFA Program Curriculum: Vol.3 p.340

Question #52 of 60

After implementing the new strategic asset allocation, the pre-tax rebalancing range for real

estate is now 5% to 15%. The after-tax rebalancing range for the sovereign wealth fund's

allocation to real estate is closest to:

A) 7.25% to 12.75%.

B) 5.00% to 15.00%.

C) 3.75% to 16.25%.

Pre-tax allowable deviation is 15% - 10% = 5% or 10% - 5% = 5%.

Post-tax deviation = 5% /(1 - t) = 5% / (1 - .2) = 6.25% for a range of 3.75% to 16.25%

Question #53 of 60

The statements made by the Sultan regarding reducing the supply of oil reflect which

behavioral bias?

A) Framing.

B) Home bias.

C) Illusion of control.

He is exhibiting illusion of control in that he believes OPEC can control the world supply of

oil. Changes in the economic environment can lead to major changes for optimization of asset

allocation as changes in oil and gas production have significantly changed over the last

decades. Home bias has to do with a preference to invest in securities listed on the exchanges

of your home country. Framing bias has to do with answering a question differently

depending upon how it is asked.

Study Session 9, LOS 18.c, e

SchweserNotes: Book 3 p.149, 153

CFA Program Curriculum: Vol.3 p.350, 361

Question #54 of 60

Based on the short-term capital market expectations, which of the following tactical asset

allocations would least likely be implemented?

A) Increase high yield bonds and reduce real estate.

B) Decrease long-term bonds and reduce real estate.

C) Increase equities and increase corporate bonds.

Since long-term rates are not projected to increase, there would be no need to decrease the

allocation to long-term bonds. The increase in short-term rates will make cash instruments

like money market funds more attractive; high yield spreads means corporate bond prices are

undervalued, allowing for opportunities to invest in investment grade and high yield bonds.

Study Session 9, LOS 18.d

SchweserNotes: Book 3 p.151

CFA Program Curriculum: Vol.3 p.356

Question #55 of 60