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Chapter 22 - Investors and The Investment Process
CHAPTER 22
INVESTORS AND THE INVESTMENT PROCESS
1.
a. Mature pension fund:
Investment Objectives
Return requirement: Return must exceed the fund’s actuarially assumed rate of
return based in part on the anticipated 5% rate for wage cost increases.
Risk tolerance: Proximity of payouts limits tolerance for risk taking. As a
result, the portfolio’s asset mix should lean toward intermediate-maturity fixed-
income assets of relatively high quality.
Investment Constraints
b. Conservative endowment fund:
Investment Objectives
Return requirement: Return must meet or exceed 5% spending rate with 3%
inflation rate. Return can be from income or capital gains but budget
requirements would place the emphasis on income. Inflation considerations
require some consideration of long-term growth.
Investment Constraints
Liquidity: Budget needs will require some liquidity to meet expenses; this may
limit returns.
Chapter 22 - Investors and The Investment Process
Tax considerations: Non-taxable.
c. Life insurance company specializing in annuities:
Investment Objectives
Return requirement: Return should exceed new money rate by sufficient
margin to meet expenses and profit objectives. Lower minimum accumulation
rate tempers return objective.
Tax considerations: A minor factor because competition will require a high
rate of return, most of which will accumulate for the policyholder and thus not
be subject to tax.
Regulatory and legal: Significant state regulation will affect asset mix and
quality.
Chapter 22 - Investors and The Investment Process
CFA 1
1. The investment objectives of the Masons should be expressed in terms of return and
risk. These return and risk preferences should be portrayed in terms of the Mason’s
preferences, their current financial status, and the stage in their life cycle.
Investment Objectives
Return Requirement: Dr. Mason is nearing retirement. Therefore, the overriding
objective is to provide the Masons with sufficient retirement income. This objective
should be easily satisfied by investing the original $1,000,000 payment from ACS to
provide a moderate current income level. This income, combined with the Masons’
Social Security and pension benefits, will provide sufficient retirement income.
Risk Tolerance: Given the substantial size of the Masons’ assets, this portfolio can
tolerate a larger amount of risk than is normal for a family in the later stage of their
life cycle. Coupled with the Masons’ retirement benefits, a moderate income from the
Investment Constraints
Liquidity: The substantial size of the Masons’ assets and the prospects for continued
high royalty income lessen the importance of the liquidity constraint. A major portion
of the portfolio should be invested in relatively non-liquid assets in order to achieve
long-term capital growth.
Time Horizon: Because the Masons are in the later part of their life cycle, one would
ordinarily expect them to have a relatively short time horizon. The size of the Masons’
assets, however, and the objectives of providing for the education of their
grandchildren and for scholarships, dictate that a substantial portion of the portfolio be
invested for the longer term. Common stocks and real estate would be appropriate.
Regulatory and Legal: Since this is a personal portfolio, regulatory and legal
constraints are not important.
Chapter 22 - Investors and The Investment Process
property, provides tax deductions that might also be desirable, and rental income would
supplement common stock dividends to provide the moderate current income required.
Investment Policy
Given the Masons’ substantial assets, the investment policy should emphasize capital
appreciation and provide moderate current income. The large size of the portfolio allows
the purchase of growth-oriented common stocks while providing sufficient retirement
CFA 2
CFA 8
Answer:
Investment Objectives
Return Requirement: Often, the return is stated in terms of minimum levels required to
fund a specific liability or budget requirements, as indicated by the Wood Museum
Chapter 22 - Investors and The Investment Process
Risk Tolerance: This section specifies the client’s willingness or ability to bear risk in
the pursuit of specified return requirements. For Wood Museum, the tight budget
position and the trustees’ fears of a financial crisis indicate a low tolerance for risk.
Investment Constraints
Liquidity Requirements: The client’s need for cash or cash availability from securities
that can be sold quickly and without substantial price risk (concessions). Wood
Museum’s liquidity needs are a significant factor given the budget considerations.
Unique Needs and Circumstances: Particular conditions or requirements that reflect
the discretion of the fund trustees. For example, social factors might be a concern of
the Museum that the trustees want reflected in the types of investment deemed
appropriate for the fund.
CFA 9
Answer:
The most important area of change concerns taxes. Mrs. Atkins pays income tax, but
the endowment fund will be free of taxes.
Investment Objectives
Return Requirement: The fund should strive to provide a predictable stream of income
growing in line with the rising costs. An initial income target of 6% of portfolio assets
should enable the fund to support the hospital’s operating budget, while still favoring
future growth.
Chapter 22 - Investors and The Investment Process
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Time Horizon: Endowment funds typically have very long time horizons and there is
no reason to believe that the current case is any exception. Certainly the time horizon
extends well beyond normal market cycles.
Tax Considerations: Since endowment funds are normally free from taxes, with the
exception of minimal estate taxes, taxes would not be a meaningful constraint for this
fund.
Legal: Most endowment funds are governed by state regulations, and since most states
have moved to a “prudent man” standard, regulatory and legal constraints should not
be significant investment factors (certainly no more so than during the time that Mrs.
Atkins is alive).
Unique Needs: Although the details provided concerning Good Samaritan are
somewhat sketchy, and additional information might be appropriately requested, it
would appear that this hospital is experiencing financial difficulties which have been
characteristic of this industry for several years. The existence of an operating deficit,
and the possibility that this deficit may grow, suggest that a slightly more conservative
posture relative to other endowment funds might be appropriate.
CFA 10
Answer:
a. An appropriate investment policy statement for the endowment fund will be
organized around the following major and specific aspects of the situation:
i. The primacy of the current income requirement;
ii. The inability to accept significant risk as to 85% of the original capital;
A proposed IPS might be:
“The endowment fund’s investment assets shall be managed in a Prudent Man
context to provide a total return of at least 8% per year, including an original
$500,000 (5%) current income component growing at 3% annually. Meeting
Chapter 22 - Investors and The Investment Process
b. The account circumstances will affect the initial asset allocation in the
following major ways:
i. The aggregate portfolio will have much larger than normal holdings of
U.S. Treasury and Treasury-related securities. Maximum use will be
made of discount Treasuries and related zero-coupon securities in order
to minimize the risk and the amount of total assets that must be “frozen”
in order to assure the availability of $8,500,000 on June 30, 2020.
iv. The aggregate portfolio risk level will be well below average. The 2020
payout requirement dictates a zero risk posture on a large part of the total
while the prudent man environment will act to prevent overzealous risk
taking in the “remainder” portion.
v. The fund’s tax-exempt status maximizes allocation flexibility, both as to
income aspects and as to planning for future capital growth.
CFA 11
Answer:
a. Investment objectives are goals; investment constraints are the limits within
which the responsible party must operate in order to achieve the objectives;
investment policies define the ways in which the effort to achieve the
objectives will be undertaken.
Chapter 22 - Investors and The Investment Process
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
“a target total return of 3% per annum greater than the rate of inflation with a
standard deviation no greater than that of the S&P 500 in the post-World War
II period.”
An investment constraint is a limitation on the investment decision-making
which can be identified as a requirement in terms of liquidity, time horizon, tax
considerations, legal or regulatory considerations and unique needs. The
realism of both the investment objectives and the practical policies adopted for
managing the account must be tested against any investment constraints. For
example: an investment advisor to an ERISA plan is legally constrained by
virtue of inclusion as a fiduciary under the law, and cannot purchase for the
plan portfolio more than 10% of the common stock of the plan sponsor.
An investment policy is an operational statement or guideline that specifies the
actions to be taken in order to achieve the investment objective within the
constraints imposed.
b. Investment Objectives
Return: Total return equal to or greater than the foundation’s annual spending
plus the rate of inflation.
c. Investment Policies
A portfolio balance, to be averaged over time, of a maximum position of 67%
in equity-type investments and a minimum position of 33% in fixed income
type investments.
Qualified equity and fixed income investments to consist of the following:
Equity Related
Fixed Income
Common stocks and warrants
Government and agency obligations
Convertible securities
Corporate obligations
Option writing
Real estate mortgages
Chapter 22 - Investors and The Investment Process
In the case of convertible securities, corporate obligations and preferred stocks
carrying a credit rating, qualifying for purchase are securities rated no less than
BBB (“regarded as having an adequate capacity to pay interest / dividends and
repay principal”) as defined by S&P, or its equivalent as defined by other
recognized rating agencies. Stocks are to be of high quality with betas not to
exceed 1.2 for portfolio as a whole.
