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:
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