17 May night study
Last updated
Last updated
Rebecca Mayer is an asset management consultant for institutions and high-net-worth individuals. Mayer meets with Sebastian Capara, the newly appointed Investment Committee chairman for the Kinkardeen University Endowment (KUE), a very large tax-exempt fund.
Capara and Mayer review KUE’s current and strategic asset allocations, which are presented in Exhibit 1. Capara informs Mayer that over the last few years, Kinkardeen University has financed its operations primarily from tuition, with minimal need of financial support from KUE. Enrollment at the University has been rising in recent years, and the Board of Trustees expects enrollment growth to continue for the next five years. Consequently, the board expects very modest endowment support to be needed during that time. These expectations led the Investment Committee to approve a decrease in the endowment’s annual spending rate starting in the next fiscal year.
Q.
The change in the annual spending rate, in conjunction with the board’s expectations regarding future enrollment and the need for endowment support, could justify that KUE’s target weight for:
A.infrastructure be increased.
B.investment-grade bonds be increased.
C.private real estate equity be decreased.
Solution
A is correct. A lower annual spending rate, in addition to the board’s expectations of rising enrollment and minimal need for endowment support over the next five years, indicates a decreased need for liquidity. Therefore, KUE could justify an increase in the strategic allocation to less liquid asset classes (such as private real estate equity and infrastructure) and a decrease in the strategic allocation to liquid assets (such as investment-grade bonds).
As an additional source of alpha, Mayer proposes tactically adjusting KUE’s asset-class weights to profit from short-term return opportunities. To confirm his understanding of tactical asset allocation (TAA), Capara tells Mayer the following:
Statement 1
The Sharpe ratio is suitable for measuring the success of TAA relative to SAA.
Statement 2
Discretionary TAA attempts to capture asset-class-level return anomalies that have been shown to have some predictability and persistence.
Statement 3
TAA allows a manager to deviate from the IPS asset-class upper and lower limits if the shift is expected to produce higher expected risk-adjusted returns.
Q.
Which of Capara’s statements regarding tactical asset allocation is correct?
A.Statement 1
B.Statement 2
C.Statement 3
Solution
A is correct. The Sharpe ratio is suitable for measuring the success of TAA relative to SAA. Specifically, the success of TAA decisions can be evaluated by comparing the Sharpe ratio realized under the TAA with the Sharpe ratio that would have been realized under the SAA.
Capara and Mayer review KUE’s current and strategic asset allocations, which are presented in Exhibit 1. Capara informs Mayer that over the last few years, Kinkardeen University has financed its operations primarily from tuition, with minimal need of financial support from KUE. Enrollment at the University has been rising in recent years, and the Board of Trustees expects enrollment growth to continue for the next five years. Consequently, the board expects very modest endowment support to be needed during that time. These expectations led the Investment Committee to approve a decrease in the endowment’s annual spending rate starting in the next fiscal year.
Exhibit 1:
Kinkardeen University Endowment—Strategic Asset Allocation Policy
Asset Class
Current Weight
Target Allocation
Lower Policy Limit
Upper Policy Limit
Developed markets equity
30%
30%
25%
35%
Emerging markets equity
28%
30%
25%
35%
Investment-grade bonds
15%
20%
15%
25%
Private real estate equity
15%
10%
5%
15%
Infrastructure
12%
10%
5%
15%
Capara asks Mayer to recommend a TAA strategy based on excess return forecasts for the asset classes in KUE’s portfolio, as shown in Exhibit 2.
Exhibit 2:
Short-Term Excess Return Forecast
Asset Class
Expected Excess Return
Developed markets equity
2%
Emerging markets equity
5%
Investment-grade bonds
–3%
Private real estate equity
3%
Infrastructure
–1%
Q.
Based on Exhibits 1 and 2, to attempt to profit from the short-term excess return forecast, Capara should increase KUE’s portfolio allocation to:
A.developed markets equity and decrease its allocation to infrastructure.
B.emerging markets equity and decrease its allocation to investment-grade bonds.
C.developed markets equity and increase its allocation to private real estate equity.
Solution
A is correct. The forecast for expected excess returns is positive for developed markets equity and negative for infrastructure. Therefore, to attempt to profit from the short-term excess return forecast, KUE can overweight developed markets equity and underweight infrastructure. These adjustments to the asset-class weights are within KUE’s lower and upper policy limits.
In Koval’s country, interest income is taxed at progressively higher income tax rates. Dividend income and long-term capital gains are taxed at lower tax rates relative to interest and earned income. In taxable accounts, realized capital losses can be used to offset current or future realized capital gains. Koval is in a high tax bracket, and his taxable account currently holds, in equal weights, high-yield bonds, investment-grade bonds, and domestic equities focused on long-term capital gains.
Q.
Given Koval’s current portfolio and the tax laws of the country in which he lives, Koval’s portfolio would be more tax efficient if he reallocated his taxable account to hold more:
Solution
C is correct. As a general rule, the portion of a taxable asset owner’s assets that are eligible for lower tax rates and deferred capital gains tax treatment should first be allocated to the investor’s taxable accounts. Assets that generate returns mainly from interest income tend to be less tax efficient and in Koval’s country are taxed at progressively higher rates. Also, the standard deviation (volatility) of after-tax returns is lower when equities are held in a taxable account. Therefore, Koval’s taxable account would become more tax efficient if it held more domestic equities focused on long-term capital gain opportunities.
Koval asks Mayer about adding new asset classes to the taxable portfolio. Mayer suggests emerging markets equity given its positive short-term excess return forecast. However, Koval tells Mayer he is not interested in adding emerging markets equity to the account because he is convinced it is too risky. Koval justifies this belief by referring to significant losses the family trust suffered during the recent economic crisis.
Q.
Koval’s attitude toward emerging markets equity reflects which of the following behavioral biases?
Solution
B is correct. Availability bias is an information-processing bias in which people take a mental shortcut when estimating the probability of an outcome based on how easily the outcome comes to mind. On the basis of the losses incurred by his family trust during the recent economic crisis, Koval expresses a strong preference for avoiding the emerging markets equity asset class. Such behavior is consistent with availability bias, where investors who personally experience an adverse event are likely to assign a higher probability to such an event occurring again.
Mayer also suggests using two mean–variance portfolio optimization scenarios for the taxable account to evaluate potential asset allocations. Mayer recommends running two optimizations: one on a pre-tax basis and another on an after-tax basis.
Q.
In both of Mayer’s optimization scenarios, which of the following model inputs could be used without adjustment?
Solution
B is correct. After-tax portfolio optimization requires adjusting each asset class’s expected return and risk for expected taxes. The correlation of returns is not affected by taxes and does not require an adjustment when performing after-tax portfolio optimization.