17 May midnight study

Elsbeth Quinn and Dean McCall are partners at Camel Asset Management (CAM). Quinn advises high-net-worth individuals, and McCall specializes in retirement plans for institutions.

Quinn meets with Neal and Karina Martin, both age 44. The Martins plan to retire at age 62. Twenty percent of the Martins’ $600,000 in financial assets is held in cash and earmarked for funding their daughter Lara’s university studies, which begin in one year. Lara’s education and their own retirement are the Martins’ highest-priority goals. Last week, the Martins learned that Lara was awarded a four-year full scholarship for university. Quinn reviews how the scholarship might affect the Martins’ asset allocation strategy.

Q.

Given the change in funding of Lara’s education, the Martins’ strategic asset allocation would most likely decrease exposure to:

1. A.cash.

2. B.bonds.

3. C.equities.

Solution

A is correct. The changing character of liabilities through time affects the asset allocation to fund those liabilities. The Martins’ investment horizon for some of their assets has changed. The amount of liquidity needed for Lara’s near-term education has been greatly reduced owing to the receipt of the scholarship. The Martins will likely still have to pay for some university-related expenses; however, a large part of the $120,000 in cash that is earmarked for Lara’s expenses can now be allocated to the Martins’ long-term goal of early retirement. Retirement is 18 years away, much longer than the one- to five-year horizon for university expenses. Therefore, the Martins’ allocation to cash would likely decrease.

The Martins have assets in both taxable and tax-deferred accounts. For baseline retirement needs, Quinn recommends that the Martins maintain their current overall 60% equity/40% bonds (± 8% rebalancing range) strategic asset allocation. Quinn calculates that given current financial assets and expected future earnings, the Martins could reduce future retirement savings by 15% and still comfortably retire at 62. The Martins wish to allocate that 15% to a sub-portfolio with the goal of making a charitable gift to their alma mater from their estate. Although the gift is a low-priority goal, the Martins want the sub-portfolio to earn the highest return possible. Quinn promises to recommend an asset allocation strategy for the Martins’ aspirational goal.

Q.

The most appropriate asset allocation for the Martins’ new charitable gift sub-portfolio is:

1. A.40% equities/60% bonds.

2. B.70% equities/30% bonds.

3. C.100% equities/0% bonds.

Solution

C is correct. The Martins’ sub-portfolio is aspirational and a low priority. Investors are usually willing to take more risk on lower-priority, aspirational portfolios. The charitable gift will be made from their estate, which indicates a long time horizon. In addition, the Martins want the highest return possible. Therefore, the highest allocation to equities is most appropriate.

Next, Quinn discusses taxation of investments with the Martins. Their interest income is taxed at 35%, and capital gains and dividends are taxed at 20%. The Martins want to minimize taxes. Based on personal research, Neal makes the following two statements:

Statement 1	The after-tax return volatility of assets held in taxable accounts will be less than the pre-tax return volatility.
Statement 2	Assets that receive more favorable tax treatment should be held in tax-deferred accounts.

Q.

Which of Neal’s statements regarding the taxation of investments is correct?

1. A.Statement 1 only
2. B.Statement 2 only
3. C.Both Statement 1 and Statement 2

Solution

A is correct. Taxes alter the distribution of returns by both reducing the expected mean return and muting the dispersion of returns. The portion of an owner’s taxable assets that are eligible for lower tax rates and deferred capital gains tax treatment should first be allocated to the investor’s taxable accounts.

Next, Quinn discusses taxation of investments with the Martins. Their interest income is taxed at 35%, and capital gains and dividends are taxed at 20%. The Martins want to minimize taxes. Based on personal research, Neal makes the following two statements:

The equity portion of the Martins’ portfolios produced an annualized return of 20% for the past three years.

As a result, the Martins’ equity allocation in both their taxable and tax-deferred portfolios has increased to 71%, with bonds falling to 29%.

The Martins want to keep the strategic asset allocation risk levels the same in both types of retirement portfolios. Quinn discusses rebalancing; however, Neal is somewhat reluctant to take money out of stocks, expressing confidence that strong investment returns will continue.

Q.

Given the Martins’ risk and tax preferences, the taxable portfolio should be rebalanced:

1. A.less often than the tax-deferred portfolio.
2. B.as often as the tax-deferred portfolio.
3. C.more often than the tax-deferred portfolio.

Solution

A is correct. The Martins wish to maintain the same risk level for both retirement accounts based on their strategic asset allocation. However, more frequent rebalancing exposes the taxable asset owner to realized taxes that could have otherwise been deferred or even avoided. Rebalancing is discretionary, and the Martins’ also wish to minimize taxes. Because after-tax return volatility is lower than pre-tax return volatility, it takes larger asset-class movements to materially alter the risk profile of a taxable portfolio. This suggests that rebalancing ranges for a taxable portfolio can be wider than those of a tax-exempt/tax-deferred portfolio with a similar risk profile; thus, rebalancing occurs less frequently.

Q.

During the rebalancing discussion, which behavioral bias does Neal exhibit?

1. A.Framing bias
2. B.Loss aversion
3. C.Representativeness bias

Solution

C is correct. Representativeness, or recency, bias is

the tendency to overweight the importance of the most recent observations and information relative to a longer-dated or more comprehensive set of long-term observations and information.

Return chasing is a common result of this bias, and it results in overweighting asset classes with strong recent performance.

Framing bias is that the decision differs based on how questions are framed, which is irrelevant.

Loss aversion is reluctant of taking loss, but... here is reluctant of taking gains due to momentum, i.e. return chasing

Quinn’s CAM associate, McCall, meets with Bruno Snead, the director of the Katt Company Pension Fund (KCPF). The strategic asset allocation for the fund is 65% stocks/35% bonds. Because of favorable returns during the past eight recession-free years, the KCPF is now overfunded. However, there are early signs of the economy weakening. Since Katt Company is in a cyclical industry, the Pension Committee is concerned about future market and economic risk and fears that the high-priority goal of maintaining a fully funded status may be adversely affected. McCall suggests to Snead that the KCPF might benefit from an updated IPS. Following a thorough review, McCall recommends a new IPS and strategic asset allocation.

The proposed IPS revisions include a plan for short-term deviations from strategic asset allocation targets. The goal is to benefit from equity market trends by automatically increasing (decreasing) the allocation to equities by 5% whenever the S&P 500 Index 50-day moving average crosses above (below) the 200-day moving average.

Q.

Given McCall’s IPS recommendation, the most appropriate new strategic asset allocation for the KCPF is:

1. A.40% stocks/60% bonds.
2. B.65% stocks/35% bonds.
3. C.75% stocks/25% bonds.

Solution

A is correct. McCall recommends a new IPS. Changes in the economic environment and capital market expectations or changes in the beliefs of committee members are factors that may lead to an altering of the principles that guide investment activities.

Because the plan is now overfunded, there is less need to take a higher level of equity risk. The Pension Committee is concerned about the impact of future market and economic risks on the funding status of the plan. Katt Company operates in a cyclical industry and could have difficulty making pension contributions during a recession.

Therefore, a substantial reduction in the allocation to stocks and an increase in bonds reduce risk. The 40% stocks/60% bonds alternative increases the allocation to bonds from 35% to 60%. Increasing the fixed-income allocation should moderate plan risk, provide a better hedge for liabilities, and reduce contribution uncertainty.

Chose B (maintaining current allocation), but A makes perfect sense sense to decrease stocks on the view of weakening economy and company being under a cyclical industry

Q.

The proposal for short-term adjustments to the KCPF asset allocation strategy is known as:

1. A.de-risking.
2. B.systematic tactical asset allocation.
3. C.discretionary tactical asset allocation.

Solution

B is correct. Using rules-based, quantitative signals, systematic tactical asset allocation (TAA) attempts to capture asset-class-level return anomalies that have been shown to have some predictability and persistence. Trend signals are widely used in systematic TAA. A moving-average crossover is a trend signal that indicates an upward (downward) trend when the moving average of the shorter time frame, 50 days, is above (below) the moving average of the longer time frame, 200 days.

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https://chatgpt.com/c/4b70a263-3797-40f3-abc8-482e42ab055e (ChatGPT answered pretty well here)

Mark DuBord, a financial adviser, works with two university foundations, the Titan State Foundation (Titan) and the Fordhart University Foundation (Fordhart). He meets with each university foundation investment committee annually to review fund objectives and constraints.

Titan’s portfolio has a market value of $10 million. After his annual meeting with its investment committee, DuBord notes the following points:

• Titan must spend 3% of its beginning-of-the-year asset value annually to meet legal obligations.

• The investment committee seeks exposure to private equity investments and requests DuBord’s review of the Sun-Fin Private Equity Fund as a potential new investment.

• A recent declining trend in enrollment is expected to continue. This is a concern because it has led to a loss of operating revenue from tuition.

• Regulatory sanctions and penalties are likely to result in lower donations over the next five years.

DuBord supervises two junior analysts and instructs one to formulate new allocations for Titan. This analyst proposes the allocation presented in Exhibit 1.

Exhibit 1:

Fund Information for Titan

Fund Name	Existing Allocation	Proposed Allocation	Fund Size in Billions (AUM)	Fund Minimum Investment
Global Equity Fund	70%	70%	$25	$500,000
Investment-Grade Bond Fund	27%	17%	$50	$250,000
Sun-Fin Private Equity Fund	0%	10%	$0.40	$1,000,000
Cash Equivalent Fund	3%	3%	$50	$100,000

QuestionQ.

Discuss two reasons why the proposed asset allocation is inappropriate for Titan.

Your Answer:

Minimum Investment Requirement for Sun-Fin Private Equity Fund: The Sun-Fin Private Equity Fund has a minimum investment requirement of $1,000,000. Given Titan’s portfolio value of $10 million, allocating 10% ($1 million) to this fund meets the minimum requirement but poses significant concentration risk. The high minimum investment relative to Titan’s overall portfolio size reduces diversification and increases exposure to the risks associated with a single private equity investment. This can be particularly concerning given the illiquid nature and higher risk associated with private equity investments compared to more traditional asset classes like equities and bonds.

Financial Constraints and Liquidity Needs: Titan is facing several financial challenges, including the need to spend 3% of its beginning-of-the-year asset value annually to meet legal obligations, declining enrollment leading to reduced operating revenue, and anticipated lower donations due to regulatory sanctions. These factors suggest that Titan requires a higher level of liquidity to meet its ongoing spending needs and to cushion against potential future financial shortfalls. Allocating 10% to a private equity fund, which is typically illiquid and has a long-term investment horizon, reduces the overall liquidity of the portfolio. This could make it difficult for Titan to access funds when needed, particularly in a financial emergency or to cover the 3% spending requirement. Maintaining a more significant portion of the portfolio in liquid assets, such as investment-grade bonds and cash equivalents, would be more appropriate under these circumstances.

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Solution

The proposed asset allocation for Titan is not appropriate because:

1. Given the shift in enrollment trends and declining donations resulting from the sanctions, Titan will likely need greater liquidity in the future because of the increased probability of higher outflows to support university operations. The proposed asset allocation shifts Titan’s allocation into risky assets (increases the relative equity holdings and decreases the relative bond holdings), which would introduce greater uncertainty as to their future value.

2. Titan is relatively small for the proposed addition of private equity. Access to such an asset class as private equity may be constrained for smaller asset owners, such as Titan, who may lack the related internal investment expertise. Additionally, the Sun-Fin Private Equity Fund minimum investment level is $1 million. This level of investment in private equity would be 10% of Titan’s total portfolio value. Given Titan’s declining financial position due to declining enrollments and its resulting potential need for liquidity, private equity at this minimum level of investment is not appropriate for Titan.

Q.

The Fordhart portfolio has a market value of $2 billion. After his annual meeting with its investment committee, DuBord notes the following points:

• Fordhart must spend 3% of its beginning-of-the-year asset value annually to meet legal obligations.

• The investment committee seeks exposure to private equity investments and requests that DuBord review the CFQ Private Equity Fund as a potential new investment.

• Enrollment is strong and growing, leading to increased operating revenues from tuition.

• A recent legal settlement eliminated an annual obligation of $50 million from the portfolio to support a biodigester used in the university’s Center for Renewable Energy.

DuBord instructs his second junior analyst to formulate new allocations for Fordhart. This analyst proposes the allocation presented in Exhibit 2.

Exhibit 2:

Fund Information for Fordhart

Fund Name	Existing Allocation	Proposed Allocation	Fund Size in Billions (AUM)	Fund Minimum Investment
Large-Cap Equity Fund	49%	29%	$50	$250,000
Investment-Grade Bond Fund	49%	59%	$80	$500,000
CFQ Private Equity Fund	0%	10%	$0.5	$5,000,000
Cash Equivalent Fund	2%	2%	$50	$250,000

Discuss two reasons why the proposed asset allocation is inappropriate for Fordhart.

The proposed asset allocation for Fordhart is inappropriate for two main reasons:

1. High Minimum Investment Requirement for CFQ Private Equity Fund: The CFQ Private Equity Fund has a minimum investment requirement of $5,000,000. Allocating 10% of Fordhart's $2 billion portfolio to this fund results in a $200 million investment, which far exceeds the fund’s minimum investment requirement. This overcommitment to a single private equity fund can result in a lack of diversification within the private equity allocation itself. While Fordhart’s larger portfolio size can absorb a larger allocation to private equity compared to Titan, the excessive allocation to a single private equity fund increases the portfolio’s risk profile due to the typically higher risk and illiquidity associated with private equity investments.

2. Reduced Equity Exposure Amidst Strong Financial Health: Fordhart is experiencing strong and growing enrollment, leading to increased operating revenues from tuition. Additionally, the recent legal settlement has eliminated an annual obligation of $50 million, thereby improving the financial position and reducing the financial burdens on the portfolio.

These positive financial conditions suggest that Fordhart can afford to maintain or even increase its exposure to higher-return asset classes like large-cap equities to potentially achieve higher growth.

The proposed reduction of large-cap equity exposure from 49% to 29% is not aligned with Fordhart’s improved financial health and growth prospects. Instead, maintaining or increasing the allocation to large-cap equities would be more appropriate to capitalize on the university’s strong financial outlook and to aim for higher long-term returns.

Additionally, the increased allocation to investment-grade bonds (from 49% to 59%) reduces the potential for higher returns, which might be unnecessary given the improved financial conditions and reduced annual obligations. A balanced approach that maintains a higher equity exposure while still incorporating private equity and sufficient liquidity would be more suitable for Fordhart.

Solution

The proposed asset allocation for Fordhart is inappropriate because:

1. Given the increasing enrollment trends and recent favorable legal settlement, Fordhart will likely require lower liquidity in the future. The proposed allocation shifts Fordhart’s portfolio away from risky assets (decreases the relative equity holdings and increases the relative bond holdings).

2. The proposed 10% allocation to private equity creates an overly concentrated position in the underlying investment. A 10% allocation to the CFQ Private Equity Fund is $200 million (10% of Fordhart’s $2 billion). The CFQ Private Equity Fund has assets under management (AUM) of $500 million. Hence, Fordhart would own 40% of the entire CFQ Private Equity Fund. This position exposes both Fordhart and the CFQ fund to an undesirable level of operational risk.