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 knowledge of asset allocation issues by using a common example of

investors, who have built up a collection of assets over time, seeking advice from a portfolio

manager on the strengths and weaknesses of their portfolio asset allocation.

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 the risk

tolerance of the client, that contributed to the recommendation.

Guideline Answer:

The Muellers’ portfolio can be evaluated in terms of the following criteria:

i. Preference for “Minimal Volatility.” The volatility of the Muellers’ portfolio is likely to be

much greater than minimal. The asset allocation of 95 percent stocks and 5 percent bonds

indicates that substantial fluctuations in asset value will likely occur over time. The asset

allocation’s volatility is exacerbated by the fact that the beta coefficient of 90 percent of the

portfolio (i.e., the four growth stock allocations) is substantially greater than 1.0. Thus the

allocation to stocks should be reduced, as should the proportion of growth stocks or higher beta

issues. Furthermore, the 5 percent allocation to bonds is in a long-term zero coupon bond fund

that will be highly volatile in response to long-term interest rate changes; this bond allocaton

should be exchanged for one with lower volatility (perhaps shorter maturity, higher grade

issues).

ii. Equity Diversification. The most obvious equity diversification issue is the concentration of 35

percent of the portfolio in the high beta small cap stock of Andrea’s company, a company with a

highly uncertain future. A substantial portion of the stock can and should be sold, which can be

done free or largely free of tax liability because of the available tax loss carry forward. Another

issue is the 90 percent concentration in high beta growth stocks, which contradicts the Muellers’

preference for minimal volatility investments. The same is true of the portfolio’s 45 percent

allocation to higher volatility small cap stocks. Finally, the entire portfolio is concentrated in the

domestic market. Diversification away from Andrea’s company’s stock, into more value stocks,

into more larger cap stocks, and into at least some international stocks is warranted.

iii. Asset Allocation (including cash flow needs). The portfolio has a large equity weighting that

appears to be much too aggressive given the Muellers’ financial situation and objectives. Their

below average risk tolerance and limited growth objectives indicate that a more conservative,

balanced allocation is more appropriate. The Muellers are not invested in any asset class other

than stocks and the small bond fund holding. A reduction in equity investments, especially

growth and small cap equities, and an increase in debt investments is warranted to produce more

consistent and desired results over a complete market cycle.

In addition, the Muellers have no cash reserve or holdings of short-term high grade debt assets.

In the very near future, the Muellers will need $50,000 (up front payment) and at least part of

$40,000 (first year’s tuition and living expenses) for their daughter’s college education, as well

as some reserve against normal expenses. In addition, they expect to have negative cash flow

each year their daughter is in college, which should lead them to increase their cash reserves.

The current portfolio is likely to produce a low level of income because of the large weighting

in growth stocks and because the only bond holding is a long-term zero coupon fund. Also, the

marketability of Andrea’s company stock is unknown and could present a liquidity problem if it

needs to be sold quickly. After their immediate cash needs are met, the Muellers will need a

modest, ongoing allocation to cash equivalents.

Level III: Question 4

Topic: Tax/Mutual Fund Issues

Minutes: 16

Reading References: