Question 10

Michelle Wolf, CFA, owns Wolf Pack Investments, a regional money-management firm that focuses on clients in the Western United States. Wolf is preparing an investment policy statement for a new client. She believes investment policy statements (IPS) are crucial to developing a good adviser-client relationship.

For Wolf, the IPS serves several purposes.

Purpose 1:   The IPS lists the risk and return characteristics of each investment in the portfolio.

Purpose 2:   The IPS communicates investors’ needs and preferences to herself and future investment advisers.

Purpose 3:   The IPS provides guidance in the event of changes in the market environment.

Purpose 4:   The IPS defines the responsibilities of the investment adviser.

Wolf meets with Fred Francis, a 48-year-old professor at an elite private college. Francis has four teenage children and his wife is a homemaker. He likes managing his own money, but his work responsibilities now require enough time that he can no longer keep track of his investments. In her interview with Francis, Wolf collects the following data for use in constructing an appropriate investment policy statement:

• Francis and his wife live comfortably on his $95,000/year salary and plan to maintain the same lifestyle after Francis retires.

• For his age, Francis is very healthy.

• Francis’ retirement portfolio contains $1,600,000, the result of a large inheritance and 20 years of living below his means. He currently contributes $20,000 a year to his retirement accounts. Most of the money is in taxable accounts.

• All four of Francis’ children plan to attend the college where he works – they will receive free tuition but must pay room and board.

• Francis is a conservative investor, with 60 percent of his portfolio in corporate and municipal-bond funds and the rest in large-cap stock funds.

• Francis believes financial markets are very efficient, and market prices reflect everything that is known about a security. Francis is skeptical about managers’ ability to add value.

• As a tenured professor, Francis expects to work until age 65, the college’s mandatory retirement age. After retirement, Francis will collect a pension worth 50 percent of his base salary annually, adjusted for inflation.

• Francis hopes to retire with $3,000,000, of which $500,000 will be used to set up a self-sustaining foundation to support cardiac research. His wife is a heart-attack survivor.

After constructing an IPS for Francis, Wolf considers four possible asset allocations for the Francis portfolio:

Allocation 1: Index funds, 60 percent bonds and 40 percent stocks, mostly broad market funds with a few sector funds concentrated in areas Wolf believes this allocation offers the best value.

Allocation 2: A mix of 30 percent bonds, 30 percent large-cap stocks, 30 percent small-cap stocks, and 10 percent hedge funds.

Allocation 3: 50 percent of the portfolio in intermediate-term investment-grade bonds and 50 percent in a Wilshire 5000 index fund.

Allocation 4: A market-neutral portfolio of long and short positions designed to limit exposure to market movements.

Part 1)

In order to craft a comprehensive IPS, which one of the following additional pieces of information provided by Francis is least important?

A)   How often he wants Wolf to review the portfolio.

B)   His expectations for interest rates.

C)   His comfort level with active management.

D)   An estimate of his children’s college expenses.

Part 2)

Based on the information gathered in Wolf’s interview with Francis, Francis is least likely to be concerned with:

A)   liquidity.

B)   taxes.

C)   time horizons.

D)   return objectives.

Part 3)

Based on the data Wolf collected, which of the following classifications of Francis’ risk tolerance is most appropriate?

A)   Low, because he is financially conservative.

B)   High, because he can afford to take risks in order to boost returns.

C)   Moderate, because despite his conservatism, Francis should take more risk in an effort to meet his long-term goals.

D)   It is impossible to classify without more information.

Part 4)

Which of the following is least likely to be a common role of the IPS?

A)   Purpose 1.

B)   Purpose 4.

C)   Purposes 2 and 4.

D)   Purposes 1 and 3.

Part 5)

Based on the information Francis provided, which of the following investment mixes is most appropriate for Francis’ portfolio?

A)   Allocation 1.

B)   Allocation 2.

C)   Allocation 3.

D)   Allocation 4.

Part 6)

The last step in the planning stage of the portfolio-management process is:

A)   crafting an asset-allocation strategy.

B)   evaluating portfolio performance.

C)   developing an IPS.

D)   purchasing securities.

Question 10

Michelle Wolf, CFA, owns Wolf Pack Investments, a regional money-management firm that focuses on clients in the Western United States. Wolf is preparing an investment policy statement for a new client. She believes investment policy statements (IPS) are crucial to developing a good adviser-client relationship.

For Wolf, the IPS serves several purposes.

Purpose 1:   The IPS lists the risk and return characteristics of each investment in the portfolio.

Purpose 2:   The IPS communicates investors’ needs and preferences to herself and future investment advisers.

Purpose 3:   The IPS provides guidance in the event of changes in the market environment.

Purpose 4:   The IPS defines the responsibilities of the investment adviser.

Wolf meets with Fred Francis, a 48-year-old professor at an elite private college. Francis has four teenage children and his wife is a homemaker. He likes managing his own money, but his work responsibilities now require enough time that he can no longer keep track of his investments. In her interview with Francis, Wolf collects the following data for use in constructing an appropriate investment policy statement:

• Francis and his wife live comfortably on his $95,000/year salary and plan to maintain the same lifestyle after Francis retires.

• For his age, Francis is very healthy.

• Francis’ retirement portfolio contains $1,600,000, the result of a large inheritance and 20 years of living below his means. He currently contributes $20,000 a year to his retirement accounts. Most of the money is in taxable accounts.

• All four of Francis’ children plan to attend the college where he works – they will receive free tuition but must pay room and board.

• Francis is a conservative investor, with 60 percent of his portfolio in corporate and municipal-bond funds and the rest in large-cap stock funds.

• Francis believes financial markets are very efficient, and market prices reflect everything that is known about a security. Francis is skeptical about managers’ ability to add value.

• As a tenured professor, Francis expects to work until age 65, the college’s mandatory retirement age. After retirement, Francis will collect a pension worth 50 percent of his base salary annually, adjusted for inflation.

• Francis hopes to retire with $3,000,000, of which $500,000 will be used to set up a self-sustaining foundation to support cardiac research. His wife is a heart-attack survivor.

After constructing an IPS for Francis, Wolf considers four possible asset allocations for the Francis portfolio:

Allocation 1: Index funds, 60 percent bonds and 40 percent stocks, mostly broad market funds with a few sector funds concentrated in areas Wolf believes this allocation offers the best value.

Allocation 2: A mix of 30 percent bonds, 30 percent large-cap stocks, 30 percent small-cap stocks, and 10 percent hedge funds.

Allocation 3: 50 percent of the portfolio in intermediate-term investment-grade bonds and 50 percent in a Wilshire 5000 index fund.

Allocation 4: A market-neutral portfolio of long and short positions designed to limit exposure to market movements.

Part 1)

In order to craft a comprehensive IPS, which one of the following additional pieces of information provided by Francis is least important?

A)   How often he wants Wolf to review the portfolio.

B)   His expectations for interest rates.

C)   His comfort level with active management.

D)   An estimate of his children’s college expenses.

The correct answer was B) His expectations for interest rates.

The IPS should contain instructions for portfolio review, a detailed breakdown of investment constraints (including college expenses), and instructions on how Wolf will manage the portfolio. While Francis’ expectations for interest rates may be relevant to his preferred asset allocation, it is Wolf’s job to manage the portfolio, and the other pieces of information are far more relevant for the IPS.

This question tested from Session 18, Reading 72, LOS d, (Part 2)

Part 2)

Based on the information gathered in Wolf’s interview with Francis, Francis is least likely to be concerned with:

A)   liquidity.

B)   taxes.

C)   time horizons.

D)   return objectives.

The correct answer was D) return objectives.

Francis can meet his retirement goals by generating a return of about 5 percent on his portfolio, including the contributions from his salary. His portfolio is more than sufficient to meet his financial needs, so return objectives are a minor issue. While liquidity is not going to tax Francis’ portfolio, his children will be attending college soon, so he must have sufficient cash to cover their expenses. Most of Francis’ money is in taxable accounts, so he must be concerned about taxes. Francis faces two time horizons for his investments, notably the children’s college years and his retirement years. While Francis appears to have more than enough to cover the needs in each time period, he must consider those time periods in his asset-allocation decisions.

This question tested from Session 18, Reading 72, LOS d, (Part 2)

Part 3)

Based on the data Wolf collected, which of the following classifications of Francis’ risk tolerance is most appropriate?

A)   Low, because he is financially conservative.

B)   High, because he can afford to take risks in order to boost returns.

C)   Moderate, because despite his conservatism, Francis should take more risk in an effort to meet his long-term goals.

D)   It is impossible to classify without more information.

The correct answer was A) Low, because he is financially conservative.

Francis can indeed afford to take more risk. But he is financially conservative, and his financial needs do not require outsized returns. As such, Wolf should design a portfolio consistent with his willingness to accept risk.

This question tested from Session 18, Reading 72, LOS d, (Part 2)

Part 4)

Which of the following is least likely to be a common role of the IPS?

A)   Purpose 1.

B)   Purpose 4.

C)   Purposes 2 and 4.

D)   Purposes 1 and 3.

The correct answer was A) Purpose 1.

The IPS is designed to help the adviser make decisions, taking into account the client’s needs and preferences. It is not normally used to discuss individual portfolio holdings. Purposes 2, 3, and 4 each represent common roles of the IPS.

This question tested from Session 18, Reading 72, LOS d, (Part 2)

Part 5)

Based on the information Francis provided, which of the following investment mixes is most appropriate for Francis’ portfolio?

A)   Allocation 1.

B)   Allocation 2.

C)   Allocation 3.

D)   Allocation 4.

The correct answer was C) Allocation 3.

Francis believes that markets are efficient, and security prices reflect all that is known about the investment. In other words, Francis does not believe investors can beat the market through security selection. The adviser must balance the client’s desires against the client’s needs. In this case, Francis is a conservative investor who currently uses bond funds and stock index funds and does not believe he can beat the market. His return objectives are very modest, and can be met without a portfolio manager delivering any alpha, or excess return. Since Francis’ needs can be met without going beyond his current investment parameters, there is no reason for Wolf to deviate from those parameters. For that reason, a passive investment strategy is best. The market-neutral portfolio is as active as you can get, eliminating the market and depending entirely on manager-provided alpha for returns. The mix of bonds, stocks, and hedge funds is too aggressive for Francis, and small-caps and hedge funds may require too much active management. The index funds with sector concentrations represent a semi-active investment strategy, which is more appropriate than the market-neutral portfolio or the portfolio containing hedge funds. However, the intermediate term, investment-grade bonds and Wilshire 5000 stock index fund, which seeks to replicate the majority of stocks traded in the market place are appropriate for a buy-and-hold portfolio, a passive strategy.

This question tested from Session 18, Reading 72, LOS d, (Part 2)

Part 6)

The last step in the planning stage of the portfolio-management process is:

A)   crafting an asset-allocation strategy.

B)   evaluating portfolio performance.

C)   developing an IPS.

D)   purchasing securities.

The correct answer was A) crafting an asset-allocation strategy.

The final step in the planning stage is the creation of a strategic asset allocation. Purchasing and evaluation are part of the execution stage, and the IPS is developed in the planning stage, before the asset allocation is determined.

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