QUESTION 13, INCLUDING GUIDELINE ANSWER, 1996 CFA LEVEL III EXAMINA...

3. Question 13, including Guideline Answer, 1996 CFA Level III Examination

Purpose:

To test the candidate’s ability to critique and existing institutional asset allocation and create and

justify a revised allocation.

LOS: The candidate should be able to

“Asset Allocation” (Session 12)

• explain how an asset allocation process can reconcile investment opportunities with investor

preferences and support the explanation.

Cases in Portfolio Management (Session 22)

• discuss the overall portfolio management process leading to the asset allocation decision,

including the stage devoted to investor information requirements (i.e., objectives and

constraints) and the stage devoted to analyzing capital market expectations;

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

1996 CFA Level III Examination (Session 22)

• critique an existing investment policy statement and its associated asset allocation;

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

Guideline Answer:

A. Template for Question 13A

Assessment of Allocation for Mountaintop College Endowment Fund

Asset Class and

Current Allocation Circle Change (Lower/Same/Higher) and Justify your response.

STATE YOUR ASSUMPTIONS CLEARLY.

Same

There is a small ongoing need for liquidity (only for operating expenses).

Cash

Using a total return approach, spending requirements can be met by income

2%

and capital gain flows.

Lower

Assuming that about 30 percent of the portfolio in total should be allocated

U.S. Bonds

to medium- to long-term investment grade bonds, the allocation to domestic-

30%

only bonds should be less than 30 percent. This is based on both domestic

bonds’ expected US$ return and standard deviation tradeoff relative to

international bonds and the endowment’s need to conduct substantial current

and future operations in currencies other than US$. Portfolio risk reduction

can be achieved by shifting to international bonds, if their returns are

relatively uncorrelated with domestic returns.

Higher

A substantially higher allocation should be made to international bonds, both

International Bonds

because of their more favorable expected US$ return and standard deviation

0%

tradeoff relative to domestic bonds and because of the endowment’s need to

conduct substantial current and future operations in currencies other than

US$. International bonds may also provide portfolio risk reduction if their

returns are relatively uncorrelated with domestic returns.

Assuming that about 65% of the portfolio in total should be allocated to

U.S Equities

equities, a lower allocation to U.S. equities may be appropriate. This is based

60%

on U.S. equities’ expected US$ return (lower), standard deviation (lower)

and lack of non-U.S. diversification as compared to international equities

(such as EAFE equities).

A higher allocation should be made to EAFE equities, because of their more

EAFE Equities

favorable expected US$ return and less than perfect positive correlation with

8%

U.S. equity returns. But the higher allocation should be moderated by the

higher expected standard deviation of EAFE equity returns. So a modestly

higher allocation to EAFE equities is warranted.

B. Template for Question 13B

Assessment of Allocation for Lindsay Corporation Pension Plan

A higher allocation to cash will be required to meet substantial and

increasing cash outflow needs that result from the large number of retired

lives pension recipients and substantial number of new retirees over the next

several years.

Given the need for substantial, steady, and growing cash outflow, a sizable,

stable source of cash generation is needed.

Unless large risk reduction benefits are assumed for international bonds, the

pension plan has little need to take the potential additional risks involved,

even in view of the additional expected return.

Because of the cash flow needs and preservation of capital needs of the

U.S. Equities

pension fund and its fully funded status, a lower allocation to equities is

warranted. If part of this lower allocation is reallocated to EAFE equities, the

allocation to U.S. equities would be even less.

Potential diversification benefits resulting from an assumption regarding

relatively low correlations with U.S equities may warrant an overall portfolio

allocation of 8 percent. But if equities are de-emphasized relative to bonds

and cash, as recommended, the justifiable portfolio allocation to EAFE

equities would remain unchanged.

Level III: Question 14

Topic: Portfolio Management: Execution and Monitoring

Minutes: 6

Reading References: