Private Wealth Management, Institutional Investors

Question 1

Contrast private client and institutional client investment concerns.

Answer 1

Investment Objectives:
Private clients:
1. May not be precisely defined
2. Can change over time
3. May be difficult to reconcile

Institutional clients have more stable, clearly defined objectives.

Constraints:
Private clients have:
* Shorter time horizons or different time horizons for different objectives
* Portfolios tend to be smaller
* Tax planning is an important consideration

Other Considerations:
Private clients have:
* Lesser investment sophistication
* Investor uniqueness

Question 2

Discuss the personal information needed in advising private clients.

Answer 2

Personal information that should be gathered for a private client includes:
* Family circumstances
* Employment
* Retirement plans
* Sources of wealth
* Investment objectives
* Risk tolerance
* Investment preferences
* Wills and trust documents
* Insurance policies
* Service guidelines
* Portfolio reporting requirements

Financial information gathering should include the client’s personal balance sheet, annual income and expenses, and sources of cash flows.

Question 3

Discuss the financial information needed in advising private clients.

Answer 3

Financial information gathering should include:
* the client’s personal balance sheet
* annual income and expenses
* sources of cash flows

Question 4

Identify tax considerations affecting a private client’s investments.

Answer 4

**Taxes on individuals include: **
* income tax
* wealth-based taxes
* consumption tax

**Tax-efficient strategies include: **
* legal tax avoidance
* tax reduction
* tax deferral

Question 5

Identify and formulate client goals based on client information.

Answer 5

Planned goals: are those that can be reasonably estimated within a specified time horizon.

Unplanned goals: are related to unexpected financial expenditures.

Private wealth managers can assist in:
* quantifying
* prioritizing
* reevaluating
* changing

Question 6

What is Risk Tolerance?

Answer 6

Risk tolerance is dependent on both the willingness and ability to take risks.

Question 7

What is Risk Capacity?

Answer 7

Risk capacity is based on the ability to take financial risks and is a more objective measure of risk compared to risk tolerance.

Question 8

What is Risk Perception?

Answer 8

Risk perception is a subjective measure of risk and is affected by the way risk questions are framed.

Question 9

Describe technical skills needed in advising private clients.

Answer 9

Technical skills include:
* proficiency in financial planning
* capital markets and asset classes
* portfolio construction and monitoring
* technology skills
* multiple languages

Question 10

Describe soft skills needed in advising private clients.

Answer 10

Soft skills include:
* communication
* social skills
* education skills
* business development
* sales skills

Question 11

Evaluate capital sufficiency in relation to client goals.

Answer 11

Capital sufficiency analysis: is used to determine the likelihood of clients being able to meet their objectives.

Deterministic forecasting assumes that a private client’s portfolio will achieve a single compound annual growth rate across the investment horizon.

Question 12

Discuss the principles of retirement planning.

Answer 12

A key challenge in retirement planning is determining a sustainable rate at which distributions can be made from a client’s portfolio for the rest of the client’s lifetime.

A client’s retirement goals can be analyzed using:
* mortality tables
* annuities (reduce longevity risk)
* Monte Carlo simulation (probability of success for goals but does not consider shortfall)

Question 13

What are some Behavioral biases exhibited by retirees?

Answer 13

Behavioral biases exhibited by retirees include:
* increased loss aversion
* consumption gaps
* the annuity puzzle
* lack of self-control

Question 14

Discuss the parts of an investment policy statement (IPS) for a private client.

Answer 14

Client Background and Investment Objectives:
* A client’s background details are obtained from personal, financial, and tax information.
* Investment objectives may be planned, unplanned, ongoing, or a one-off.

Key Investment Parameters:
* Low risk tolerance is usually associated with high-priority goals and near-term goals.
* Time horizon is described as a range (>15 years for a long horizon and < 10 years for a short horizon).
* asset class preferences
* liquidity preferences
* unique investment preferences
* constraints

Asset Allocation:
* Strategic asset allocation: indicates a long-term target allocation for each asset class
* Tactical asset allocation: is an active management strategy

Portfolio Management and Implementation:
This covers wealth manager guidelines in relation to
* discretionary authority
* portfolio rebalancing
* tactical asset allocation changes
* acceptable investment vehicles

Wealth Manager Duties and Responsibilities:
* formulating and reviewing the client’s IPS
* constructing the portfolio
* monitoring and rebalancing the portfolio
* monitoring portfolio costs and third-party providers
* reporting portfolio performance.

IPS Appendix:
* modeled portfolio performance
* capital market expectations.

Question 15

Prepare the investment objectives section of an IPS for a private client.

Answer 15

Client Background and Investment Objectives:
A client’s background details are obtained from relevant personal, financial, and tax information.

Investment objectives may be planned, unplanned, ongoing, or a one-off. Multiple objectives should be prioritized into primary and secondary objectives.

Key Investment Parameters:
Low risk tolerance is usually associated with high-priority goals and near-term goals.

Time horizon is described as a range (e.g., in excess of 15 years for a long horizon and less than 10 years for a short horizon). When a client has multiple objectives, there may be different time horizons for each objective.

Other investment parameters include asset class preferences, liquidity preferences (including a cash reserve), unique investment preferences, and constraints restricting investments for a client’s portfolio.

Asset Allocation:
Strategic asset allocation indicates a long-term target allocation for each asset class, with the portfolio being rebalanced periodically to maintain the target allocation.

Tactical asset allocation is an active management strategy that normally specifies a range for each asset class rather than a specific target allocation percentage.

Portfolio Management and Implementation:
This covers wealth manager guidelines in relation to discretionary authority, portfolio rebalancing, tactical asset allocation changes, and acceptable investment vehicles that can be used to implement a client’s investment strategy.

Wealth Manager Duties and Responsibilities:
These include formulating and reviewing the client’s IPS; constructing the portfolio; monitoring and rebalancing the portfolio; monitoring portfolio costs and third-party providers; and reporting portfolio performance.

IPS Appendix:
This section includes modeled portfolio performance and capital market expectations.

Question 16

Evaluate and recommend improvements to an IPS for a private client.

Answer 16

Client Background and Investment Objectives:
A client’s background details are obtained from relevant personal, financial, and tax information.

Investment objectives may be planned, unplanned, ongoing, or a one-off. Multiple objectives should be prioritized into primary and secondary objectives.

Key Investment Parameters:
Low risk tolerance is usually associated with high-priority goals and near-term goals.

Time horizon is described as a range (e.g., in excess of 15 years for a long horizon and less than 10 years for a short horizon). When a client has multiple objectives, there may be different time horizons for each objective.

Other investment parameters include asset class preferences, liquidity preferences (including a cash reserve), unique investment preferences, and constraints restricting investments for a client’s portfolio.

Asset Allocation:
Strategic asset allocation indicates a long-term target allocation for each asset class, with the portfolio being rebalanced periodically to maintain the target allocation.

Tactical asset allocation is an active management strategy that normally specifies a range for each asset class rather than a specific target allocation percentage.

Portfolio Management and Implementation:
This covers wealth manager guidelines in relation to discretionary authority, portfolio rebalancing, tactical asset allocation changes, and acceptable investment vehicles that can be used to implement a client’s investment strategy.

Wealth Manager Duties and Responsibilities:
These include formulating and reviewing the client’s IPS; constructing the portfolio; monitoring and rebalancing the portfolio; monitoring portfolio costs and third-party providers; and reporting portfolio performance.

IPS Appendix:
This section includes modeled portfolio performance and capital market expectations.

Question 17

Recommend and justify portfolio allocations and investments for a private client.

Answer 17

The traditional approach: to portfolio construction consists of:
* identifying appropriate asset classes
* developing capital market expectations
* determining asset class weights
* assessing constraints
* implementing the portfolio
* choosing asset location

Goals-based investing: follows the same steps as the traditional approach but creates separate portfolios for each of the client’s goals.

Question 18

Describe effective practices in portfolio reporting.

Answer 18

Portfolio reports should include:
* performance summary (current period)
* market commentary (current period)
* portfolio asset allocation
* detailed performance of asset classes and individual securities
* benchmark report
* historical performance of the client’s investment portfolio
* transaction details (current period)
* purchase and sale report (current period)
* impact of currency exposure and exchange rate fluctuations

Question 19

Describe effective practices in portfolio reviews.

Answer 19

Portfolio reviews should cover:
* the appropriateness of the client’s existing goals and investment parameters
* rebalancing of portfolio asset allocation to target allocation or ranges
* any changes to the wealth manager’s ongoing management of the portfolio
* any changes or updates in the wealth manager’s duties and responsibilities
* any changes to IPS and portfolio review frequency

Question 20

Evaluate the success of an investment program for a private client.

Answer 20

The success of an investment program should be evaluated in terms of:
* goal achievement
* process consistency
* portfolio performance

The investment program is successful only if it achieves success in all three criteria.

Question 21

Discuss ethical and compliance considerations in advising private clients.

Answer 21

Ethical considerations include:
* fiduciary duty and suitability
* know your customer requirements
* client confidentiality
* conflicts of interest

Compliance considerations for private wealth managers vary by jurisdiction.

Question 22

Discuss how levels of service and range of solutions are related to different private clients.

Answer 22

Mass affluent:
* a wide range of management services
* larger client-to-wealth-manager ratio
* noncustomized portfolio management approach

HNW:
* smaller client-to-wealth-manager ratio
* tailored investment solutions
* portfolios with sophisticated strategies
* alternative investments

UHNW:
* multigenerational investment horizons
* complex tax and estate planning
* comprehensive service requirements that go beyond investment planning.

Robo-advisors: service clients with small portfolios.

Question 23

Compare taxation of income, wealth, and wealth transfers.

Answer 23

The main categories of taxes are:
* income tax
* capital gains tax
* wealth/property tax
* stamp duties
* wealth transfer tax

Question 24

What is a capital gain/loss?

Answer 24

Realized capital gains: occur upon the actual disposition of an asset.

Unrealized capital gains: are “paper gains,” which represent appreciation on unsold items.

Depending on the holding period of the investments, the capital gains may be subject to a short-term (usually higher) rate or a long-term (usually lower) rate.

Some countries differentiate between investment gains (lower or no tax on capital gains) and trading gains (taxed at regular rates).

Question 25

What are the 3-main types of investment accounts:

Answer 25

1. Taxable
2. Tax deferred (TDA)
3. Tax exempt (TEA)

Question 26

Describe global considerations of jurisdiction that are relevant to taxation.

Answer 26

Tax haven: is a jurisdiction with very low or no tax rates for residents and foreign investors.

Territorial tax system: taxes only income that is earned locally (e.g., Hong Kong SAR).

Worldwide tax system: will impose taxes on all sources of income, which inevitably leads to double taxation, (taxation on the same income by more than one jurisdiction). However, relief may be provided in the form of tax credits by the home jurisdiction for taxes already paid in the source jurisdiction or bilateral tax treaties.

Question 27

What are the 4 common metrics used in examining tax efficiency?

Answer 27

There are four common metrics used in examining tax efficiency:
1. After-tax holding period return.
2. After-tax post-liquidation return.
3. After-tax excess returns.
4. Tax-efficiency ratio.

Question 28

Analyze the impact of taxes on capital accumulation and decumulation in taxable, tax-exempt, and tax-deferred accounts.

Answer 28

Taxable accounts: involve one or more tax rates on income or returns to determine R′.

TEAs: after-tax funds are deposited so no tax is due on the returns earned or on withdrawals.

TDAs: pretax funds are deposited and the investor may take a tax deduction for the amount contributed, thereby reducing taxable income and taxes due. All tax is deferred until withdrawal, allowing tax-deferred compounding.

Question 29

What is the best tax effecient allocation of assets?

Answer 29

In general, tax-efficient assets (e.g., equities that generate capital gains, which are often subject to lower tax rates) should be placed in taxable accounts.

tax-inefficient assets (e.g., taxable bonds that generate taxable interest, which is often subject to higher tax rates) should be placed in tax-exempt or tax-deferred accounts.

Question 30

Discuss risk and tax objectives in managing concentrated single-asset positions.

Answer 30

The following factors should be considered:
* Level of concentration
* Tax basis and tax rate
* Liquidity
* Time horizon
* Investor restrictions
* Nonfinancial matters

Question 31

Describe strategies for managing concentrated positions in public equities.

Answer 31

Strategies for managing a concentrated position in public equities include the following:
* Staged diversification strategy: over multiple years to spread out tax liability
* Completion portfolio: using other assets to complement/complete the concentrated position
* Equity monetization: by hedging a large part of the risk in the position using derivatives and then borrow using the hedged position as collateral
* Zero-cost collars: used to lower initial cost by giving up some stock upside; the put premium paid and call premium received are equal
* Covered call: writing can be a staged diversification assuming the share price appreciates sufficiently
* Exchange fund: with a pooling of investments on a tax-free basis
* Charitable remainder trust: to benefit both beneficiaries and a designated charity

Question 32

Explain portfolio tax management strategies and their application.

Answer 32

Tax management strategies can be classified as follows:
* Investments held in a manner to minimize taxes: tax-exempt accounts, lower long-term capital gains tax rate
* Deferring income recognition: limiting dispositions, waiting for tax rates to fall, tax loss harvesting

4-common investment vehicles include:
1. Partnerships
2. Mutual funds
3. Exchange-traded funds (ETFs)
4. Separately managed accounts (SMAs)

Question 33

What is Tax loss harvesting?

Answer 33

Tax loss harvesting: involves the sale of securities with embedded losses to offset gains, which will lower the tax liability for the current year.

Many tax authorities allow a form of tax lot accounting. When an investor makes a partial sale and has acquired the stock on different dates, each at a different cost, the investor may select which tax lots applied to the sale. Here are some possibilities:
* Highest in, first out (HIFO) is generally optimal.
* In case future tax rates are expected to be higher than current tax rates, first in, first out (FIFO) may be better.
* In case future tax rates are expected to be lower than current tax rates, last in, first out (LIFO) may be better.

Question 34

Describe strategies for managing concentrated positions in privately owned businesses.

Answer 34

Strategies for managing concentrated positions in privately owned businesses include the following:
* IPO
* Direct sale to another investor
* Sale of non-essential business assets
* Personal line of credit secured by company shares
* Leveraged recapitalization (private equity firm)
* Sale to employee stock ownership plan

Question 35

Describe strategies for managing concentrated positions in privately owned real estate.

Answer 35

Strategies for managing concentrated positions in real estate include the following:
* Mortgage financing (enonrecourse loan)
* Donor-advised fund or charitable trust

Question 36

Discuss objectives—tax and non-tax—in planning the transfer of wealth.

Answer 36

An individual’s estate is everything that is owned by the individual. Estate planning is the planning process associated with transferring the estate to others during an individual’s lifetime or at death so the assets go to the individuals or entities intended and in the most efficient way.

Key objectives in gift and estate planning include the following:
* Ensuring adequate liquidity and ongoing income
* Control over assets
* Asset protection
* Tax-effective transfer of assets
* Maintain family wealth
* Business succession
* Charity

Question 37

There are 3-benefits of charitable gifts.

Answer 37

There are 3-benefits of charitable gifts:
1. The donor usually does not have to pay gift tax.
2. The donor receives an immediate tax deduction for the gift, which reduces the donor’s current year tax liability.
3. The charity is usually tax exempt, so it can invest the funds and there will be tax-free compounding.

Question 38

Describe considerations related to managing wealth across multiple generations.

Answer 38

Common estate planning tools:
* Trusts
* foundations
* life insurance
* companies

Other important issues to anticipate include:
* business succession/disposition
* divorce
* incapacity.

Question 39

What are trusts and what are some examples of trusts?

Answer 39

Trusts: are used mainly for control, asset protection, and tax management reasons.

Types of trusts:
* testamentary versus inter vivos trusts
* revocable versus irrevocable trusts
* fixed versus discretionary trusts.

Question 40

What is Family Governance?

Answer 40

Family governance: can be thought of as the mechanism for families to maintain and increase their wealth over the long term.

Governing bodies may include a board of directors, a family council, a family assembly, a family office, and a family foundation. Conflict resolution begins with the family constitution.

Question 41

Compare the characteristics of human capital and financial capital as components of an individual’s total wealth.

Answer 41

Total wealth is composed of both human capital and financial capital.

Human capital (HC): is the discounted present value of expected future labor income. Estimation includes:
* the future amount
* the probability the individual will be alive to earn it
* a discount rate related to the riskiness of the amounts

Financial capital (FC): is the sum of all the other assets of an individual.

Question 42

Discuss the relationships among human capital, financial capital, and economic net worth.

Answer 42

Net wealth: is the sum of the individual’s FC and HC less any liabilities owed by the individual.

A typical individual might start an employment career with high HC and low FC.

As the individual’s remaining work career decreases with age, HC generally declines over time while FC increases as the individual saves and invests.

Question 43

Discuss the financial stages of life for an individual.

Answer 43

Generally, HC is highest in early career and declines until retirement. FC is likely to peak at retirement.

The life stages are:
* Education
* Early Career
* Career Development
* Peak Accumulation
* Preretirement
* Early Retirement
* Late Retirement

In all stages, there can be unpredicted needs for health care and/or to care for family.

Question 44

Describe an economic (holistic) balance sheet.

Answer 44

The economic (holistic) balance sheet extends the traditional balance sheet assets to include HC.

Liabilities are extended to include consumption and bequest goals.

This more complete economic view allows better planning of resource consumption to meet remaining lifetime goals.

Question 45

Discuss risks (earnings, premature death, longevity, property, liability, and health risks) in relation to human and financial capital.

Answer 45

Earnings risk: Job loss and other career disruptions can reduce HC and may even lead to the need to consume FC prematurely.

Premature death risk: Can be a serious risk early in the career when substantial HC could be lost and cause unexpected expenses that consume limited FC.

Longevity risk: Individuals who live too long are at risk of outliving their FC.

Property risk: Loss in value of physical property (FC).

Liability risk: If legally responsible for damages, leading to a reduction in FC.

Health risk: Direct loss of FC to pay illness or injury related expenses and may reduce HC through diminished ability or inability to work.

Question 46

Describe types of insurance relevant to personal financial planning.

Answer 46

Life insurance: protects the survivors from the adverse financial consequences of the insured’s premature death.

Disability income insurance: provides partial replacement of the insured’s job income if the job is lost.

Property insurance: provides compensation for losses in value of real property. Homeowners insurance: covers the home and automobile insurance covers the car.

Health and medical insurance: covers health care expenses.

Liability insurance: covers losses if the insured is found legally responsible for damages to another.

Question 47

Describe the basic elements of a life insurance policy and how insurers price a life insurance policy.

Answer 47

Temporary life insurance: is for a set period of time.

Permanent insurance: builds up value sufficient to pay for insuring the remaining lifetime of the insured.

Pricing: reflects mortality estimates that determine how many in the group are expected to die during the insurance period and allow calculating the net premium to charge to make those payouts.

Load: is an estimate of company expenses and profit that is added to determine the gross premium charged for the insurance.

Question 48

Discuss the use of annuities in personal financial planning.

Answer 48

Annuities: are the economic opposite of life insurance: pay once and receive payouts back for remaining life to insure against longevity risk.
* Immediate annuities begin payout immediately
* Deferred annuities pay out at a future time.
* Fixed annuity payouts do not change in amount
* variable payouts are linked to change in a reference asset.

Question 49

Discuss the relative advantages and disadvantages of fixed and variable annuities.

Answer 49

Fixed versus variable annuities:
* Fixed provide a known future payout
* Variable have a better chance of keeping up with inflation.
* Fixed will be priced to reflect bond market rates at the time of purchase
* Variable will perform in line with changes in the reference asset and are more likely to allow withdrawals.
* Fees for variable are generally higher.
* Both may be subject to some taxes.
* Both earn a mortality credit

Question 50

What is a mortality credit?

Answer 50

A mortality credit is:
* For life insurance, the ultimate cost is lower if you die and the one-time fixed payout occurs sooner, while those who live longer end up paying more for the same payout.
* For annuities, the issue reverses: annuitants who live longer end up collecting more and are subsidized by those who die sooner and collect less.

Question 51

Analyze and evaluate an insurance program.

Answer 51

Risk avoidance: Very severe & Occurs regularly

Risk transfer: Very severe & Occurs Infrequent

Risk reduction: Not severe & Occurs regularly

Risk retention: Not severe & Occurs Infrequent

Question 52

Discuss how asset allocation policy may be influenced by the risk characteristics of human capital.

Answer 52

Asset allocation should consider the investor’s total economic wealth, FC and HC.

If, an individual employed in a high-risk profession would, all else the same, choose lower risk FC.

If the HC is positively correlated with the stock market, then it will be best to select asset classes other than equity for any risky assets that are used.

Of course, the individual should try to avoid FC tied directly to her employer.

Question 53

Recommend and justify appropriate strategies for asset allocation and risk reduction when given an investor profile of key inputs.

Answer 53

Determine and take the appropriate amount of systematic (market) risk through an asset allocation of total wealth.

Reduce where appropriate idiosyncratic (non-market) risks:
* Through asset diversification.
* Use of insurance to transfer risks.

Question 54

Discuss common characteristics of institutional investors as a group.

Answer 54

The five common characteristics of institutional investors are:
* larger size
* long-term investment horizons
* regulatory frameworks
* governance frameworks
* principal-agent issues

Question 55

Discuss investment policy of institutional investors.

Answer 55

The investment policy statement (IPS) of an institution formally sets out:
* the institution’s mission and objectives
* liabilities
* investment horizon
* external constraints (regulatory, accounting, and tax)
* asset allocation
* rebalancing and reporting policies.

Question 56

What are the 4 common models used in institutional investing?

Answer 56

• the Norway model
• the endowment model
• the Canada model
• the liability-driven investing (LDI) model

Question 57

Evaluate risk considerations of private defined benefit (DB) pension plans in relation to
1. plan funded status
2. sponsor financial strength
3. interactions between the sponsor’s business and the fund’s investments
4. plan design
5. workforce characteristics

Answer 57

The risk tolerance of a defined benefit pension plan is generally higher when:
* Funded status is higher.
* The sponsor has lower debt levels and is more profitable.
* The plan is small relative to the size of the sponsor’s business.
* The correlation between the plan assets and the business of the sponsor is low.
* The plan has no provisions for early retirement or lump-sum options.
* The workforce is young and the plan has a high level of active lives.

Question 58

What is the typical asset allocation for the investment portfolio of a private DB or DC plan?

Answer 58

Asset allocation varies by country due to differences in:
* regulation
* tax constraints
* investment objectives
* risk appetite
* demographics

Question 59

What is the typical asset allocation for the investment portfolio of a sovereign wealth fund?

Answer 59

• Budget stabilization funds (mainly bonds and cash).
• Development funds (depends on socioeconomic causes supported).
• Savings and pension reserve funds (higher levels of equities and alternatives).
• Reserve funds (equities, alternatives with significant allocation to bonds).

Question 60

What is the typical asset allocation for investment portfolio of university endowment, and private foundation?

Answer 60

University endowments:
* Large U.S. endowments use the endowment model with a majority allocation to alternatives.
* Smaller U.S. endowments tend to hold more domestic equities and fixed income, with a lower allocation to alternatives.

Private foundations:
* Large foundations allocate approximately 50% to alternatives.
* Smaller foundations allocate more to public equities and fixed income.

Question 61

Describe considerations affecting the balance sheet management of banks and insurers.

Answer 61

The volatility of equity of a bank or an insurer can be lowered by:
* Reducing the volatility of assets.
* Reducing the volatility of liabilities.
* Lowering leverage.
* Increasing the correlation of assets and liabilities.
* Diversifying assets and liabilities.
* Increasing the liquidity and quality of investment assets.
* Accessing stable funding sources.