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CFA Level 3 > Private Wealth Management > Flashcards

Private Wealth Management Flashcards

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1
Q

How does the source of wealth affect an individual investor’s risk tolerance?

A

Active wealth creation probably indicates investor knowledge and experience with risk-taking decisions.

Passive wealth creation may indicate an individual who has less familiarity with risk-taking activity.

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2
Q

How does a client’s measure of wealth affect an individual investor’s risk tolerance?

A

A positive correlation exists between the perception of portfolio size and the level of risk tolerance (i.e., willingness to take risk).

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3
Q

How does the stage of life affect an individual investor’s risk tolerance?

A

Foundation phase - Can typically tolerate higher levels of risk due to the long time horizon, though they may not have the assets necessary which could reduce their ability to take risk.

Accumulation phase - Still has a long time horizon. Can still tolerate risk, but may become less aggressive and exhibit somewhat more conservative characteristics.

Maintenance or distribution phases - Will exhibit a lower tolerance for risk.

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4
Q

What is the role of situational profiling in understanding an investor?

A

Situtaional profiling should be considered only a first step in understanding an individual’s preference, economic situation, goals, and desires. It investigates an investor’s source of wealth, measure of wealth, and stage of life.

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5
Q

What are the major characteristics traditional finance assumes all investor exhibit?

A
  1. Risk aversion
  2. Rational expectations
  3. Asset integration
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6
Q

What are the major characteristics behavioral finance assumes all investors exhibit?

A
  1. Loss aversion
  2. Biased expectations
  3. Asset segregation
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7
Q

What are the four investor personality types?

A
  1. Cautious investor
  2. Methodical investor
  3. Individualistic investor
  4. Spontaneous investor
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8
Q

What are the characteristics of a cautious investor?

A

Focus on minimizing risk. Have difficulty making investment decisions and exhibit low portfolio turnover.

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9
Q

What are the characteristics of a methodical investor?

A

Have a conservative nature combined with a focus on gathering as much data as possible. They are constantly on the lookout for new and better information.

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10
Q

What are the characteristics of an individualistic investor?

A

Have confidence in their investment decision making and are willing to do investment research. They are self-assured investors.

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11
Q

What are the characteristics of a spontaneous investor?

A

Exhibit high portfolio turnover. Fear not reacting to changing market conditions, including the latest investment fads.

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12
Q

What are the benefits of having an IPS to the clients?

A
  • Objectives and constraints are considered in formulating investment decisions that benefit the client.
  • The process is dynamic and allows changes in circumstances to be incorporated.
  • A well-written IPS represents the long-term objectives of the investor.
  • Subsequent managers should be able to implement decisions congruent with the individual’s goal.
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13
Q

What are the benefits of having an IPS to the advisor?

A
  • The IPS can be consulted for clarification as to the appropriateness of specific investment decisions.
  • Most IPSs contain a stated review process, indicate dispute resolutions, and identify potential problems.
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14
Q

Compare Monte Carlo and traditional deterministic approaches to retirement planning and explain the advantages of a Monte Carlo approach.

A

Monte Carlo techniques take into account distributions and associated probabilities for input variables and generate a probabilistic forecast of retirement period values. Instead of seeing one singe outcome, the investors can see a range of possibilities for the future.

  • Probabilistic forecast give both the client and manager a better indication of the risk/return trade-off in investment decisions.
  • Monte Carlo simulations explicitly show the trade-offs of short-term risks and the risks of not meeting goals.
  • Monte Carlo is better able to incorporate tax nuances.
  • Monte Carlo can better the complications associated with future returns by more effectively incorporating the compounding effect of reinvestment.
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15
Q

What is the most common global tax regime?

A

Common Progressive

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16
Q

For each tax regime, give the ordinary income tax structure, and whether there is favorable tax treatment for interest, dividend, or capital gains.

A

Common Progressive - Progressive & Favorable Interest, Dividend, and Capital Gains.
Heavy Dividend Tax - Progressive & Favorable Interest, and Capital Gains.
Heavy Capital Gains - Progressive & Favorable Interest, and Dividends
Heavy Interest - Progressive & Favorable Dividends, and Capital Gains.
Flat and Light - Flat & Favorable Interest, Dividend, and Capital Gains.
Flat and Heavy - Flat & Favorable Interest.

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17
Q

Considering investment income tax, what are the relationships with tax drag and the tax rate, time horizon, and investment returns.

A
  1. Tax drag > tax rate.
  2. As the investment horizon increases => the tax drag increases.
  3. As the investment return increases => the tax drag increases.
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18
Q

Considering deferred capital gains tax, what are the relationships with tax drag and the tax rate, time horizon, and investment returns.

A
  1. Tax drag = tax rate.
  2. As the investment horizon increases => the tax drag is unchanged.
  3. As the investment return increases => the tax drag is unchanged.
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19
Q

Considering wealth-based taxes, what are the relationships with tax drag and the tax rate, time horizon, and investment returns.

A
  1. Tax drag > tax rate.
  2. As the investment horizon increases => the tax drag increases.
  3. As the investment return increases => the tax drag decreases.
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20
Q

What are the risks associated with a concentrated position in a single asset?

A

The asset may not be efficiently priced and, therefore, not generate a fair risk-adjusted return. Illiquid assets can be difficult and costly to exit or non-incoming producing.The risk in such assets is both systematic and company specific or property-specific.

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21
Q

What are the common objectives and constraints to consider when managing a concentrated position?

A
  1. Reduce the risk caused by the wealth concentration.
  2. Generates liquidity to meet diversification or spending needs.
  3. Optimize tax efficiency to maximize after-tax ending value.
    Constraints:
    *Restrictions on sale.
    *A desire for control.
    *To create wealth. An entrepreneur may assume high specific risk in expectation of building the value of the business and his wealth.
    *The asset may have other uses. (e.g., Real estate owned personally could also be a key asset used in another business of the owner)
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22
Q

What are the common cognitive biases that may make an investor reluctant to reduce his or her exposure to a concentrated position?

A

Confirmation bias, Illusion of control, Anchoring & Adjustment, Availability bias

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23
Q

What are the common emotional biases that may make an investor reluctant to reduce his or her exposure to a concentrated position?

A

Overconfidence bias, Familiarity bias, Illusion of Knowledge, Status quo bias, Endowment bias, Loyalty bias

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24
Q

How do advisers use goal-based planning in managing concentrated positions?

A

The portfolio is divided into tiers of a pyramid, or risk buckets, with each tier or bucket designed to meet progressive levels of client goals.

  1. Personal risk bucket - Protect the client from poverty or a drastic decline in lifestyle. Safety is emphasized.
  2. Market risk bucket - Maintain the client’s existing standard of living. Portfolio allocated to stocks and bonds earning an expected market return.
  3. Aspirational risk bucket - Holding positions such as private businesses, concentrated stock holdings, real estate, and other riskier positions.
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25
Q

What is the estate tax freeze strategy?

A

A strategy to transfer future appreciation and tax liability to a future generation. This partnership usually involves a partnership or corporate structure. A gift tax would be due on the value of the asset when the transfer is made; however, the asset (including any future appreciation in value) will be exempt from future estate and gift taxes in the givers’ estate. Any tax owed is “frozen,” meaning paid or fixed near an initial value.

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26
Q

What are the three broad techniques that can be used to manage concentrated positions?

A
  1. Sell the asset.
  2. Monetize the asset.
  3. Hedge the asset value.
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27
Q

What is the two-step process for the monetization of a concentrated position?

A
  1. Hedge a large part of the risk in the positions.

2. Borrow using the hedged position as collateral.

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28
Q

What are the four tools for hedging the concentrated position while during monetization?

A
  1. Short term sale against the box.
  2. Equity forward sale contract.
  3. Forward conversion with options.
  4. Total return equity swap.
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29
Q

What is a Prepaid variable forward (PVF)?

A

PVFs are economically similar to a collar and loan in one transaction. A loan is given for a specified price per share. At a future date the loan will be paid by delivering the shares. If the share price at the due date is below the loan amount all of the shares are given as payment, however if the price is higher fewer shares will be need to be delivered.

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30
Q

What is a mismatch in character for a hedging strategy of a concentrated position?

A

Two items in a strategy that trigger different tax treatments.

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31
Q

What are two tax-optimization equity strategies that combine tax planning with investment strategy?

A
  1. Index tracking with active tax management.

2. A completeness portfolio.

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32
Q

What are some strategies for managing a private business position?

A
  1. Strategic buyer - buy and hold buyer
  2. A financial buyer or financial sponsor - buy, restructure, and sell
  3. Recapitalization - Sell shares back to company
  4. Sale to (other) management or key employees
  5. Divestiture, sale, or disposition of non-core business assets.
  6. Sale or gift to family members
  7. Personal line of credit secured by company shares.
  8. Initial Public Offering (IPO)
  9. Employee stock ownership plan (ESOP)
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33
Q

Skipping a generation increases the future value a gift by a factor of __.

A

1/(1-t)

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34
Q

When considering a client’s tax liability, what is the credit method?

A

The credit method provides complete resolution of the residence-source conflict.Under the credit method, the residence country allows the individual to take a tax credit for taxes paid to a source country. T_credit = Max(T_residence, T_source)

35
Q

When considering a client’s tax liability, what is the exemption method?

A

The exemption method provides complete resolution of the residence-source conflict. Under the exemption method, the country of residence charges no income tax on income generated in a foreign country that enforces source jurisdiction. T_exemption = T_source.

36
Q

When considering a client’s tax liability, what is the deduction method?

A

The deduction only provides only partial resolution of the residence-source conflict. Under the deduction method, the individual pays the full tax of the source country, and is only allowed to deduct the amount of taxes paid to the source country.

37
Q

What is the primary objective of estate planning?

A

The primary objectives of estate planning are to minimize taxes and to facilitate the tax efficient transfer of assets to heirs or recipients of charitable bequests.

38
Q

Individuals must generally be concerned with tax planning on:

A

Four levels. Income, assets held, assets transferred, and expenditures.

39
Q

What is the capitalized value of the core spending needs over a given period?

A

The capitalized value of the core spending needs is the sum of the product of the joint probability of survival and the real spending needs discounted by the real risk free rate. The real risk free rate is calculated as: (1 + nominal risk-free rate)/(1 + inflation rate) - 1.

40
Q

What is a short sale against the box?

A

A short sale against the box is a hedging technique then allows a loan equal to most of the value of the company to be taken out. It requires borrowing and shorting the company stock. It is more suited to a company with public shares.

41
Q

What are two factors that contribute to shifting the financial capital curve up when an individual’s savings rate is increased?

A
  1. Financial capital grows more quickly when contributions are increased.
  2. Additionally increasing the savings rate now puts more financial capital to work sooner and this capital starts earning investment returns sooner than originally planned.
42
Q

What is the primary use of life insurance?

A

The primary use of life insurance is to replace lost human capital. When human capital falls to zero upon death, the payoff on the life insurance replaces the lost income (human capital).

43
Q

What are the factors that affect the risk tolerance of a defined benefit plan?

A

Plan surplus: The greater the surplus, the greater the risk tolerance.
Financial status and profitability: The greater the strength of the sponsor, the greater the plan’s risk tolerance.
Correlation between firm profitability and the value of the plan assets: The higher the correlation, the less the plan’s risk tolerance.
Plan features: Provisions that increase liquidity needs or reduce time horizon reduce risk tolerance. (e.g., early retirement and lump-sum withdrawals).
Workforce characteristics: The lower the average workforce, the longer the time horizon and, other things equal this increases the plan’s risk tolerance. The higher the active to retired lives, higher the plan’s risk tolerance.

44
Q

What is shortfall risk?

A

The probability that the assets will be below some specific level or have returns below some specific level over a given time horizon.

45
Q

What are two ways that risk should be measured for a defined benefit plan?

A

Asset/liability management (ALM) or shortfall risk.Under ALM risk is measured by the variability of plan surplus. Shortfall risk may be estimated for a status at some future date of fully funded.

46
Q

In regards to a DB plan’s return objective, what is the goal of a pension plan and it’s minimum return objective.

A

The goal of a pension plan is to have pension assets generate return sufficient to cover pension liabilities. The minimum return objective is the discount rate used to compute the present value of the future benefits, or the actuarial rate.

47
Q

What factors affect the liquidity constraint of a DB plan?

A

The number of retired lives.
The amount of sponsor contributions: The smaller the firm contributions relative to retirement payments, the greater the liquidity needs.
Plan features.

48
Q

What are the two factors that affect the time horizon of a DB plan?

A

If the plan is terminating the time horizon is the termination date.
If the plan is ongoing, the time horizon depends on the characteristics of the plan’s participants.

49
Q

Give is the tax constraint of a DB plan?

A

Tax-exempt

50
Q

What are the the legal and regulatory factors of a DB plan?

A

A DB plan is regulated under ERISA (Employee Retirement Income Security Act). Additionally, the pension plan trustee is a fiduciary and falls under the prudent expert rule.

51
Q

What is a Cash balance plan?

A

A cash balance plan is a type of plan that defines the benefit in terms of an account balance. In a typical plan the participant’s account is credited each year with a pay credit and an interest credit. The pay credit is usually based on age, salary, or length of employment, while the interest credit is based upon a benchmark such as Treasuries. The sponsor bears all of the investment risk because increases and decreases in the value of the plan’s investments do not affect the benefit amount promised to participants.

52
Q

What are Employee stock ownership plans (ESOPS)?

A

An ESOP is a type of defined-contribution benefit plan that allows employees to purchase the company stock, sometimes at a discount from market price.

53
Q

What is a foundation?

A

In general foundations are grant-making entities funded by gifts and an investment portfolio.

54
Q

What is an endowment?

A

Endowments are long-term funds owned by a non-profit institution and supporting that institution.

55
Q

What are the four types of foundations?

A
  1. Independent
  2. Company sponsored
  3. Operating
  4. Community
56
Q

What is the purpose of an independent foundation?

A

Provide grants to charities, educational institutions, social organizations, etc.

57
Q

What is the purpose of a company sponsored foundation?

A

Closely tied to the sponsoring corporation, they Provide grants to charities, educational institutions, social organizations, etc.. The grants can be used to further the corporate sponsor’s business interest.

58
Q

What is the purpose of an operating foundation?

A

Established for the sole purpose of funding an organization or some ongoing research/medical initiative.

59
Q

What is the purpose of a community foundation?

A

Publicly sponsored grant-awarding organization used to fund social, educational, religious, etc.

60
Q

What is the annual spending requirement of an independent and company sponsored foundation?

A

5% of assets; expenses cannot be counted in the spending amount.

61
Q

What is the annual spending requirement of an operating foundation?

A

Must spend at least 85% of dividend and interest income for its own operations; may be subject to spending 3.33% of assets.

62
Q

What is the annual spending requirement of a community foundation?

A

There is none.

63
Q

What is disintermediation risk and when is it likely to occur?

A

Disintermediation risk occurs during periods of high interest rates when policy holders are more likely to withdraw cash value causing increased demand for liquidity from the portfolio.

64
Q

What is the return objective for an insurance company?

A

To earn a net interest spread, which is a return higher than the actuarial assumption. This is the actuaries’ assumed rate of growth in policy holder reserves. Earn less and the surplus will decline. Consistent higher returns will grow the surplus and give the company competitive advantage in offering products to the market at a lower price (i.e., lower premiums). The general thrust is to segment the investment portfolio by significant line of business and set objectives by the characteristics of that line of business. The investments are heavily fixed-income oriented with the exception of the surplus which may pursue more aggressive objectives.

65
Q

What are the differences in the IPS between Life Insurance and Non-Life Insurance companies?

A

Overall, the operating results for non-life insurance companies are more volatile than for life insurance companies, duration is shorter, liquidity needs are both larger and less predictable.

  1. Non-life insurance companies have a more diverse product mix, but the liability durations are shorter.
  2. There is often a long tail to non-life policies. A claim could be filed today and take years to process before payout.
  3. Many non-life policies have inflation risk. The company would insure the replacement value of the item. Life insurance policies are typically for a stated value.
  4. Life insurance policies are generally very predictable in amount but hard to predict in timing. Non-life are hard to predict in both dimensions of amount and timing.
  5. Non-life insurers have an underwriting or profitability cycle which varies over a 3- to 5-year cycle. During periods of intense competition, prices are reduced to retain business and are frequently set low and lead to losses as payouts on the policies occur.
  6. Non-life business risk can be very concentrated geographically or with regard to specific events.
66
Q

What are the three bank risk measures?

A
  1. Leveraged-adjusted duration gap
  2. Value at Risk (VAR)
  3. Credit measures of risk developed both internally and commercially available.
67
Q

What is the leveraged-adjusted duration gap?

A

The duration of a bank’s assets less the leveraged duration of the bank’s liabilities, where leverage is measured as liabilities over assets. “The leverage- adjusted duration gap measures a bank’s overall interest rate exposure. For a positive interest rate shock (unexpected increase in rates), the market value of net worth will decrease for a bank with a positive gap; be unaffected for a bank with a zero gap (an immunized balance sheet); and increase for a bank with a negative gap.

68
Q

In general, what is the risk tolerance for a bank’s IPS and why?

A

Below average because they cannot let losses in the security portfolio interfere with their ability to meet their liabilities.

69
Q

What is the return objective for a bank’s IPS?

A

To earn a positive interest spread. The interest spread is the difference between the bank’s cost of funds and the interest earned on loans and other investments.

70
Q

What is the liquidity for a bank’s IPS?

A

Short and liquid, driven by deposit withdrawals and demand for loans as well as regulation.

71
Q

What is the time horizon for a bank’s IPS?

A

Short and linked to the duration of the liabilities.

72
Q

What is the tax constraint for a bank’s IPS?

A

Taxable entity

73
Q

What is the legal and regulatory objective for a bank’s IPS?

A

Must meet regulatory requirements for liquidity, reserves, and pledging. Usually short-term treasuries.

74
Q

What are commodity pools?

A

Commodity pools invest in commodity-related futures, options contracts, and related instruments.

75
Q

Contrast the assumptions concerning pension liability risk in asset-only and liability-relative approaches to asset allocation.

A

Pension liability risk is due to pension liabilities subject to market related risk such as interest rate risk, inflation risk, or exposure to economic growth. Under an asset-only approach, a pension fund focuses on selecting efficient portfolios. It does not attempt to explicitly hedge the risk of the liabilities. The liability-relative approach to asset allocation is chosen for its ability to mimic the liability (i.e., the portfolio will have a high correlation with the liability). In the asset-only approach, the risk-free investment is the return on cash. In a liability-relative approach, the risk-free investment is a portfolio that is highly correlated with and mimics the liability in performance.

76
Q

Explain measurement of pension liabilities through duration management versus the liability-relative approach.

A

The duration management approach focuses on short-term changes in liability relative to changes in interest rates. This approach is valid when pension risk is short-term, as in the case of firms near bankruptcy. For ongoing plans, it is superior to asset-only, but liability-relative management is better because it captures the risk of not satisfying short-term obligations and long-term liabilities.

77
Q

How can the market exposures due to accrued benefits in pension plans be hedged?

A

If accrued benefits are fixed, nominal bonds is the optimal benchmark.
If accrued benefits are indexed to inflation, real rate (real return) bonds such as TIPS is the optimal benchmark.

78
Q

What are the components of future benefits and how can the market exposures due to future benefits in pension plans be hedge?

A
  1. Wages to be earned in the future, nominal bonds is the optimal benchmark.
    2a. Growth in future wages due to inflation, real rate (real return) bonds such as TIPS is the optimal benchmark.
    2b. Growth in future wages due to economic growth above inflation (e.g., wage growth above COLA), equities is the optimal benchmark.
79
Q

In general for pensions, how would a portfolio constructed using an asset-only approach differ from a portfolio using a liability-relative approach?

A

In an asset-only approach, the portfolio is usually composed of 60-70% equities with the rest in short- and medium- duration nominal bonds. In a liability-relative approach, the portfolio is typically composed of derivatives, long duration bonds, inflation-indexed bonds, and equities, as well as other components dedicated to generating an efficient return.

80
Q

What are the responsibilities of the firm for a defined contribution plan (DCP)?

A
  1. Must offer sufficient choices to facilitate diversification.
  2. Must provide the ability for participants to switch funds across choices.
  3. Must keep contributions of company stock at a level that will not overweight the participant portfolios and reduce the benefits of diversification.
81
Q

What is the IPS of a defined benefit plan (DCP)?

A

Because in a DCP the firm (sponsor) is not associated with the investments, per se, the benefits, the IPS is more of a set of guidelines. The sponsor must oversee and hlep employees/participants in their retirement planning.

82
Q

What is the responsibility of the board or committee established to oversee the defined benefit plan (DCP)?

A
  1. See that participants have sufficient educational opportunities to facilitate investment decisions.
  2. Provide descriptions of all investment opportunities.
  3. Select and periodically evaluate fund mangers.
  4. Generally oversee the plan and its participants.
83
Q

Correlations are important in both the asset-only approach and the liability-relative approach to investing for pensions, but they are used differently in each approach. Discuss the differences.

A

In an asset-only approach, investments are chosen to have a low correlation with firm assets. In a liability-relative approach, the focus is on hedging the pension liabilities, so investments are chosen to have a high correlation with the liabilities.

CFA Level 3 (17 decks)

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