Question 1

Jack Mercer and June Seagram are investment advisors for Northern Advisors. Mercer graduated from a

prestigious university in London eight years ago, whereas Seagram is newly graduated from a mid-western

university in the United States. Northern provides investment advice for pension funds, foundations,

endowments, and trusts. As part of their services, they evaluate the performance of outside portfolio managers.

They are currently scrutinizing the performance of several portfolio managers who work for the Thompson

University endowment.

Over the most recent month, the record of the largest manager. Bison Management, is as follows. On March 1,

the endowment account with Bison stood at $ 11,200,000. On March 16, the university contributed $4,000,000

that they received from a wealthy alumnus. After receiving that contribution, the account was valued at $

17,800,000. On March 31, the account was valued at $16,100,000. Using this information, Mercer and

Seagram calculated the time-weighted and money-weighted returns for Bison during March. Mercer states that

the advantage of the time-weighted return is that it is easy to calculate and administer. Seagram states that the

money-weighted return is, however, a better measure of the manager's performance.

Mercer and Seagram are also evaluating the performance of Lunar Management. Risk and return data for the

most recent fiscal year are shown below for both Bison and Lunar. The minimum acceptable return (MAR) for

Thompson is the 4.5% spending rate on the endowment, which the endowment has determined using a

geometric spending rule. The T-bill return over the same fiscal year was 3.5%. The return on the MSCI World

Index was used as the market index. The World index had a return of 9% in dollar terms with a standard

deviation of 23% and a beta of 1.0.

The next day at lunch, Mercer and Seagram discuss alternatives for benchmarks in assessing the performance

of managers. The alternatives discussed that day are manager universes, broad market indices, style indices,

factor models, and custom benchmarks. Mercer states that manager universes have the advantage of being

measurable but they are subject to survivor bias. Seagram states that manager universes possess only one

quality of a valid benchmark.

Mercer and Seagram also provide investment advice for a hedge fund, Jaguar Investors. Jaguar specializes in

exploiting mispricing in equities and over-the-counter derivatives in emerging markets. They periodically engage

in providing foreign currency hedges to small firms in emerging markets when deemed profitable. This most

commonly occurs when no other provider of these contracts is available to these firms. Jaguar is selling a large

position in Mexican pesos in the spot market. Furthermore, they have just provided a forward contract to a firm

in Russia that allows that firm to sell Swiss francs for Russian rubles in 90 days. Jaguar has also entered into a

currency swap that allows a firm to receive Japanese yen in exchange for paying the Russian ruble.

Regarding their statements about manager universes, determine whether Mercer and Seagram are correct or

incorrect.

Options :

A :

Only Mercer is correct.

B :

Only Seagram is correct.

C : Both are correct.

Answer: C

Question 2

Dynamic Investment Services (DIS) is a global, full-service investment advisory firm based in the United States. Although the firm provides numerous investment services, DIS specializes in portfolio management for individual and institutional clients and only deals in publicly traded debt, equity, and derivative instruments. Walter Fried, CFA, is a portfolio manager and the director of DIS's offices in Austria. For several years, Fried has maintained a relationship with a local tax consultant. The consultant provides a DIS marketing brochure with Fried's contact information to his clients seeking investment advisory services, and in return. Fried manages the consultant's personal portfolio and informs the consultant of potential tax issues in the referred clients' portfolios as they occur. Because he cannot personally manage all of the inquiring clients' assets, Fried generally passes the client information along to one of his employees but never discloses his relationship with the tax accountant. Fried recently forwarded information on the prospective Jones Family Trust account to Beverly Ulster, CFA, one of his newly hired portfolio managers. Upon receiving the information, Ulster immediately set up a meeting with Terrence Phillips, the trustee of the Jones Family Trust. Ulster began the meeting by explaining DIS's investment services as detailed in the firm's approved marketing and public relations literature. Ulster also had Phillips complete a very detailed questionnaire regarding the risk and return objectives, investment constraints, and other information related to the trust beneficiaries, which Phillips is not. While reading the questionnaire, Ulster learned that Phillips heard about DIS's services through a referral from his tax consultant. Upon further investigation, Ulster discovered the agreement set up between Fried and the tax consultant, which is legal according to Austrian law but was not disclosed by either party Ulster took a break from the meeting to get more details from Fried. With full information on the referral arrangement, Ulster immediately makes full disclosure to the Phillips. Before the meeting with Phillips concluded, Ulster began formalizing the investment policy statement (IPS) for the Jones Family Trust and agreed to Phillips' request that the IPS should explicitly forbid derivative positions in the Trust portfolio. A few hours after meeting with the Jones Family Trust representative, Ulster accepted another new referral client, Steven West, from Fried. Following DIS policy, Ulster met with West to address his investment objectives and constraints and explain the firm's services. During the meeting, Ulster informed West that DIS offers three levels of account status, each with an increasing fee based on the account's asset value. The first level has the lowest account fees but receives oversubscribed domestic IPO allocations only after the other two levels receive IPO allocations. The second-level clients have the same priority as third-level clients with respect to oversubscribed domestic IPO allocations and receive research with significantly greater detail than first-level clients. Clients who subscribe to the third level of DIS services receive the most detailed research reports and are allowed to participate in both domestic and international IPOs. All clients receive research and recommendations at approximately the same lime. West decided to engage DIS's services as a second-level client. While signing the enrollment papers, West told Ulster, "If you can give me the kind of performance I am looking for, I may move the rest of my assets to DIS." When Ulster inquired about the other accounts, West would not specify how much or what type of assets he held in other accounts. West also noted that a portion of the existing assets to be transferred to Ulster's control were private equity investments in small start-up companies, which DIS would need to manage. Ulster assured him that DIS would have no problem managing the private equity investments. After her meeting with West, Ulster attended a weekly strategy session held by DIS. All managers were required to attend this particular meeting since the focus was on a new strategy designed to reduce portfolio volatility while slightly enhancing return using a combination of futures and options on various asset classes. Intrigued by the idea, Ulster implemented the strategy for all of her clients and achieved positive results for all portfolios. Ulster's average performance results after one year of using the new strategy are presented in Figure 1. For comparative purposes, performance figures without the new strategy are also presented.

At the latest strategy meeting, DIS economists were extremely pessimistic about emerging market economies and suggested that the firm's portfolio managers consider selling emerging market securities out of their portfolios and avoid these investments for the next 12 to 15 months. Fried placed a limit order to sell his personal holdings of an emerging market fund at a price 5% higher than the market price at the time. He then began selling his clients' (all of whom have discretionary accounts with DIS) holdings of the same emerging market fund using market orders. All of his clients' trade orders were completed just before the price of the fund declined sharply by 13%, causing Fried's order to remain unfilled. Does the referral agreement between Fried and the tax consultant violate any CFA Institute Standards of Professional Conduct?

Options :

A : No

B : Yes, because client confidentiality is being undermined by the arrangement.

C : Yes, because it involves non-monetary compensation with no observable cost.

Answer: B

Question 3

Geneva Management (GenM) selects long-only and long-short portfolio managers to develop asset allocation

recommendations for their institutional clients.

GenM Advisor Marcus Reinhart recently examined the holdings of one of GenM's long-only portfolios actively

managed by Jamison Kiley. Reinhart compiled the holdings for two consecutive non-overlapping five year

periods. The Morningstar Style Boxes for the two periods for Kiley's portfolio are provided in Exhibits 1 and 2.

Exhibit 1: Morningstar Style Box: Long-Only Manager for Five-Year Period 1

Exhibit 2: Morningstar Style Box: Long-Only Manager for Five-Year Period 2

Reinhart contends that the holdings-based analysis might be flawed because Kiley's portfolio holdings are

known only at the end of each quarter. Portfolio holdings at the end of the reporting period might misrepresent

the portfolio's average composition. To compliment his holdings-based analysis, Reinhart also conducts a

returns-based style analysis on Kiley's portfolio. Reinhart selects four benchmarks:

1. SCV: a small-cap value index.

2. SCG: a small-cap growth index.

3. LCV: a large-cap value index.

4. LCG: a large-cap growth index.

Using the benchmarks, Reinhart obtains the following regression results:

Period 1: Rp = 0.02 + H0.01(SCV) + 0.02(SCG) + 0.36(LCV) + 0.61(LCG)

Period 2: Rp = 0.02 + 0.01(SCV) + 0.02(SCG) + 0.60(LCV) + 0.38(LCG)

Kiley's long-only portfolio is benchmarked against the S&P 500 Index. The Index's current sector allocations are

shown in Exhibit 3.

Exhibit 3: S&P 500 Index Sector Allocations

GenM strives to select managers whose correlation between forecast alphas and realized alphas has been

fairly high, and to allocate funds across managers in order to achieve alpha and beta separation. GenM gives

Reinhart a mandate to pursue a core-satellite strategy with a small number of satellites each focusing on a

relatively few number of securities.

In response to the core-satellite mandate, Reinhart explains that a Completeness Fund approach offers two

advantages:

Advantage 1: The Completeness Fund approach is designed to capture the stock selecting ability of the active

manager, while matching the overall portfolio's risk to its benchmark.

Advantage 2: The Completeness Fund approach allows the Fund to fully capture the value added from active

managers by eliminating misfit risk.

Which one of the following statements about Kiley's long-only portfolio is most correct1? Kiley's portfolio:

Options :

A : is only exposed to systematic risk.

B :

is only exposed to unsystematic risk.

C : attempts to earn a positive alpha through security selection.

Answer: C

Question 4

Rowan Brothers is a full service investment firm offering portfolio management and investment banking services. For the last ten years, Aaron King, CFA, has managed individual client portfolios for Rowan Brothers, most of which are trust accounts over which King has full discretion. One of King's clients, Shelby Pavlica, is a widow in her late 50s whose husband died and left assets of over $7 million in a trust, for which she is the only beneficiary. Pavlica's three children are appalled at their mother's spending habits and have called a meeting with King to discuss their concerns. They inform King that their mother is living too lavishly to leave much for them or Pavlica's grandchildren upon her death. King acknowledges their concerns and informs them that, on top of her ever-increasing spending, Pavlica has recently been diagnosed with a chronic illness. Since the diagnosis could indicate a considerable increase in medical spending, he will need to increase the risk of the portfolio to generate sufficient return to cover the medical bills and spending and still maintain the principal. King restructures the portfolio accordingly and then meets with Pavlica a week later to discuss how he has altered the investment strategy, which was previously revised only three months earlier in their annual meeting. During the meeting with Pavlica, Kang explains his reasoning tor altering the portfolio allocation but does not mention the meeting with Pavlica's children. Pavlica agrees that it is probably the wisest decision and accepts the new portfolio allocation adding that she will need to tell her children about her illness, so they will understand why her medical spending requirements will increase in the near future. She admits to King that her children have been concerned about her spending. King assures her that the new investments will definitely allow her to maintain her lifestyle and meet her higher medical spending needs. One of the investments selected by King is a small allocation in a private placement offered to him by a brokerage firm that often makes trades for King's portfolios. The private placement is an equity investment in ShaleCo, a small oil exploration company. In order to make the investment, King sold shares of a publicly traded biotech firm, VNC Technologies. King also held shares of VNC, a fact that he has always disclosed to clients before purchasing VNC for their accounts. An hour before submitting the sell order for the VNC shares in Pavlica's trust account. King placed an order to sell a portion of his position in VNC stock. By the time Pavlica's order was sent to the trading floor, the price of VNC had risen, allowing Pavlica to sell her shares at a better price than received by King. Although King elected not to take any shares in the private placement, he purchased positions for several of his clients, for whom the investment was deemed appropriate in terms of the clients* objectives and constraints as well as the existing composition of the portfolios. In response to the investment support, ShaleCo appointed King to their board of directors. Seeing an opportunity to advance his career while also protecting the value of his clients' investments in the company, King gladly accepted the offer. King decided that since serving on the board of ShaleCo is in his clients' best interest, it is not necessary to disclose the directorship to his clients or his employer. For his portfolio management services, King charges a fixed percentage fee based on the value of assets under management. All fees charged and other terms of service are disclosed to clients as well as prospects. In the past month, however. Rowan Brothers has instituted an incentive program for its portfolio managers. Under the program, the firm will award an all-expense-paid vacation to the Cayman islands for any portfolio manager who generates two consecutive quarterly returns for his clients in excess of 10%. King updates his marketing literature to ensure that his prospective clients are fully aware of his compensation arrangements, but he does not contact current clients to make them aware of the newly created performance incentive. According to the CFA Institute Standards of Professional Conduct, which of the following statements is correct concerning King's directorship with ShaleCo?

Options :

A : King may not accept the directorship since it creates a conflict of interest

B : King may accept the directorship as long as it is disclosed to clients and prospects

C : King may accept the directorship as long as it is disclosed to his employer, clients, and prospects

Answer: C

Question 5

Dakota Watson and Anthony Smith are bond portfolio managers for Northern Capital Investment Advisors,

which is based in the U.S. Northern Capital has $2,000 million under management, with S950 million of that in

the bond market. Northern Capital's clients are primarily institutional investors such as insurance companies,

foundations, and endowments. Because most clients insist on a margin over the relevant bond benchmark,

Watson and Smith actively manage their bond portfolios, while at the same time trying to minimize tracking

error.

One of the funds that Northern Capital offers invests in emerging market bonds. An excerpt from its prospectus

reveals the following fund objectives and strategies:

“The fund generates a return by constructing a portfolio using all major fixed-income sectors within the Asian

region (except Japan) with a bias towards non-government bonds. The fund makes opportunistic investments

in both investment grade and high yield bonds. Northern Capital analysts seek those bond issues that are

expected to outperform U.S. bonds with similar credit risk, interest rate risk, and liquidity risk-Value is added by

finding those bonds that have been overlooked by other developed world bond funds. The fund favors nondollar, local currency denominated securities to avoid the default risk associated with a lack of hard currency on

the part of issuer."

Although Northern Capital does examine the availability of excess returns in foreign markets by investing

outside the index in these markets, most of its strategies focus on U.S. bonds and spread analysis of them.

Discussing the analysis of spreads in the U.S. bond market, Watson comments on the usefulness of the option

adjusted spread and the swap spread and makes the following statements:

Statement 1: Due to changes in the structure of the primary bond market in the U.S., the option adjusted

spread is increasingly valuable for analyzing the attractiveness of bond investments.

Statement 2: The advantage of the swap spread framework is that investors can compare the relative

attractiveness of fixed-rate and floating-rate bond markets.

Watson's view of the U.S. economy is decidedly bearish. She is concerned that the recent withdrawal of liquidity

from the U.S. financial system will result in a U.S. recession, possibly even a depression. She forecasts that

interest rates in the U.S. will continue to fall as the demand for loanable funds declines with the lack of business

investment. Meanwhile, she believes that the Federal Reserve will continue to keep short-term rates low in

order to stimulate the economy. Although she sees the level of yields declining, she believes that the spread on

risky securities will increase due to the decline in business prospects. She therefore has reallocated her bond

portfolio away from high-yield bonds and towards investment grade bonds.

Smith is less decided about the economy. However, his trading strategy has been quite successful in the past.

As an example of his strategy, he recently sold a 20-year AA-rated $50,000 Mahan Corporation bond with a

7.75% coupon that he had purchased at par. With the proceeds, he then bought a newly issued A-rated Quincy

Corporation bond that offered an 8.25% coupon. By swapping the first bond for the second bond, he enhanced

his annual income, which he considers quite favorable given the declining yields in the market.

Watson has become quite interested in the mortgage market. With the anticipated decline in interest rates, she

expects that the yields on mortgages will decline. As a result, she has reallocated the portion of Northern

Capital's bond portfolio dedicated to mortgages. She has shifted the holdings from 8.50% coupon mortgages to

7.75% coupon mortgages, reasoning that if interest rates do drop, the lower coupon mortgages will rise in price

more than the higher coupon mortgages. She identifies this trade as a structure trade.

Smith is examining the liquidity of three bonds. Their characteristics are listed in the table below:

Which of the following best describes the relative value analysis used in the Northern Capita! Emerging market

bond fund? It is a:

Options :

A : top-down approach.

B : bottom-up approach.

C : combination of a top-down approach and a bottom-up approach.

Answer: B

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