CHARTERED WEALTH MANAGER QUALIFICATION

SUMMER 2015CHIEF EXAMINER’S REPORT-

PORTFOLIO CONTRUCTION THEORY

IntroductionThe task of this exam is to assess knowledge and understanding of portfolio

construction within wealth management against the unit syllabus. Occasionally the exam may draw on a small number of low mark questions from the Financial Markets syllabus or the level assumed to enter for the Chartered qualification. This will be to a very minor extent. The exam does not test the Applied Wealth Management syllabus.

On successful completion of this exam candidates will have demonstrated strong conceptual and applied knowledge and understanding of the principal analytical tools of portfolio construction, familiarity and comfort with the application of quantitative and qualitative problems in portfolio construction, and an ability to rigorously analyse problems in portfolio construction. Up-to-date knowledge and understanding of significant financial events and developments may be examined.

Exam compositionQuestions on taxation will tend to comprise 10% to 30% of the exam, either

stand-alone or integrated within another question. This exam sitting had 20% of the total mark allocated to questions on taxation. Questions will continue on tax issues relevant to major asset classes, securities, funds and strategies. The focus is taxation of the portfolio/fund/strategy rather than taxation of the individual. There may occasionally be a question concerning CGT or IHT. Where there are a low number of marks is likely to be allocated and this is more likely to appear as an MCQ. Questions on tax in the exam focused on VAT of different parts of the investment process, taxation of shares on AIM, taxation of Gilts, stamp duty reserve tax, and on Reporting funds and Non-Reporting funds. Numerical questions will tend to comprise 30% to 50% of the exam. Questions that examine charts and tables will tend to comprise 5% to 20% of the exam. Interpretative questions will tend to comprise 20% to 50% of the exam. The last three of three of these have long applied.

Advice for exam successBe neat. Help the examiner to be able to read the paper. Being untidy with

poor handwriting can only lose you marks for the examiner is so busy making out

each word that the meaning of the answer can become lost. Underline or highlight key points if you wish. If the examiner cannot find or read your answers marks cannot be given. A poorly ordered script may lead to lower marks if the examiner becomes distracted looking for the answer. Do not split your answer to a question by entering parts of the answer in different parts of the answer book.

Be precise, succinct and efficient in your word use. At Chartered level the examiner expects to see descriptive, explanatory, discursive, analytical and critical skills in use. Demonstrate excellent critical and appraisal skills on interpretive questions.

If the question involves a calculation, make sure the final answer is clear. Ensure the workings can be followed so that marks for correct procedure can be given. It can sometimes help to set out the formula you intend to use

Ability to tackle interpretative questions well is important to passing the exam and a major reason for low scores. Interpretative questions often elicit a range of answers and candidates can and do score high marks with very different answers. Set out reasoning, assumptions, choices made, and justify decisions taken within the answer. The policy and process is at least as important as the delivery solution. Answers that dive straight into a solution tend not to score high answers. An answer that nothing should change, if strongly reasoned and justified, can score high marks.

Competence with both numerical and narrative questions are needed in the exam. The exam board often looks for demonstration of good numeracy and preponderance of marks i.e. no zero marks, when setting grade boundaries. Preponderance exists when there is a run of good marks - numerical and narrative, theoretical and applied, across the various sections.

Candidates are expected to think and reason beyond standard workbook narratives if they are to be successful in the exam. Candidates should remain mindful that the exam’s remit is to test the syllabus. The workbook is an important but ultimately incomplete interpretation of the syllabus. Do not expect exam questions that look for answers straight from the workbook and do presume high predictability of exam questions based on the past. Expect to use three quarters to a whole of a workbook.

Interpretation of overall mark70 percent or more in the exam demonstrates very good knowledge of the

material, critical ability, an ability to rigorously analyse problems and to correctly structure answers. 70 or more is obtained by achieving a preponderance of high marks across the entire paper. Scripts will have high quality narrative and numerical answers, are succinct and well argued, and set out in an informed and clear style. An exam mark between 60 and 69 percent demonstrates good working knowledge of the material and a good level of competence in its critical assessment. An exam mark between 50 and 59 percent will demonstrate adequate working knowledge of the material and evidence of some analysis. Candidates obtain low marks for a range of reasons including; limited knowledge of the core material, omitted questions, poor quality answers to quantitative questions and an inability to apply theoretical material to practical settings.

Overall PerformanceOverall, and as a percent of 100, 19% of candidates achieved a mark below

50%, 28% were awarded a mark of 50-59%, 28% a mark of 60-69%, 21% a mark of 70-79%, and 4% a mark of 80-89%. The mean exam mark for Sections A, B and C taken together was 62% with a standard deviation of 13 marks. The maximum mark was 85% and the minimum 24%.

Performance on the SectionsSection A comprised 20 MCQs worth 20 marks. 27% of candidates obtained

less than 50%. 27% obtained 50-59%, 29% obtained 60-69%, and 17% obtained70%-79%.

Section B comprised short answer questions worth 40 marks. 33% of candidates obtained below 50%. 15% obtained 50-59%, 17% obtained 60-69%, 16%obtained 70%-79%, 13% obtained 80-89%, 16% obtained 70%-79%, and 6% obtained 90% or more.

Section C comprised three case study questions of 20 marks each. Each candidate is to answer any 2 of the 3 questions. 11% of candidates obtained below 50%. 21% obtained 50-59%, 33% obtained 60-69%, 33% obtained 70-79%, and 2% obtained 80% or more. In Section C, Q14 on behavioural finance was most popular, with 74% of candidates selecting it. Q15 on valuation, the security market line, and risk free rate was least popular, with 59% of candidates attempting it. 66% of candidates attempted Q13 on constructing a portfolio for a very low risk investor in receipt of a lump sum, life-long personal injury settlement. In Section C, Question 15 was the least well answered, and Question 13 best answered.

Specific Issues and Answers to Each Question

Section ASection A of the paper assesses candidates’ broad knowledge of the syllabus.

Marks in Section A often predict how well a candidate will score across other sections. This being the case an effective spread of knowledge is important for a good overall exam mark.

Question 1There were 20 multiple choice questions worth one mark each. The mean

median and modal mark was 11, 11 and 12 out of 20 respectively. The standard deviation of marks was 2 marks. The maximum mark was 16 and the minimum 5. The 20 parts to question 1 are as follows:

The correct answer to each multiple choice question was (a) B, (b) C, (c) A, (d) D, (e)D, (f) B, (g) B, (h) B, (i) A, (j) B, (k) D, (l) A, (m) C, (n) D, (o) B, (p) C, (q) D, (r) C,(s) D, and (t) C. Candidates tended to correctly answer (c), (d), (e), (j), (k), (l), (m).

Section BSection B of the paper tested candidates’ knowledge and ability to appraise

specific parts of the syllabus via questions that require short to medium length answers. There were eight, 2 mark numerical questions. The mean, median, and modal mark was 23, 25 and 36 out of 40 respectively. The standard deviation of marks was 9 marks. The maximum mark was 40 and the minimum 5.5. The average mark on the eight, 2 mark numerical questions was 9 out of a possible 16. Many candidates remain underprepared to answer numerical questions. Answers to the 11 questions in section B are as follows:

Question 2This question asked for candidates’ understanding of compounding and

annualised numbers, an area that is regularly tested. Overall the question had a mean, median and modal mark of 1.5, 2 and 2 respectively. The standard deviation was 1 mark. The maximum mark was 2 and the minimum 0.

Annualised total return is ((1+(1.5%+1.6%))^2)-1= 6.3%

Question 3The question asked candidates to calculate the annualised standard deviation

of returns. The mean, median and modal mark was 1, 2 and 2 respectively. The maximum mark was 2 and the minimum 0.

Annualised, standard deviation of returns is 6% x sqrt(12) = 20.8%

Question 4The question asked candidates to calculate the Sharpe ratio. The mean,

median and modal mark was 1, 0.5 and 0.5 respectively. The maximum mark was 2 and the minimum 0.

This is the annualised return (from Q1) minus the risk free rate (1%), divided by the annualised standard deviation of returns (from Q2).

Sharpe ratio is (6.3% - 1%) / 20.8% = 0.25

Question 5The question asked candidates to calculate the beta. The mean, median and

modal mark was 1, 1.5 and 2 respectively. The maximum mark was 2 and the minimum 0.

Beta is 0.60 x (6% / 3.2%) = 1.125.

Question 6The question asked candidates to calculate the required return. The mean,

median and modal mark was 1, 0.5 and 2 respectively. The maximum mark was 2 and the minimum 0.

Required return is: 1% + 1.125 x (4.5% - 1%) = 4.94%.

Question 7The question asked candidates to calculate the real, inflation adjusted portfolio

return. The mean, median and modal mark was 1, 0.5 and 2 respectively. The maximum mark was 2 and the minimum 0.

Real return = (159000/142000) / (1+3%)-1= 8.7%

Question 8The question asked candidates to calculate a portfolio return in a foreign

currency. The mean, median and modal mark was 1.3, 2 and 2 respectively. The maximum mark was 2 and the minimum 0.

US$ return = ((159000 x 1.55) / (142000 x 1.65)-1= 5.2%

Question 9The question asked candidates to calculate the real, inflation adjusted portfolio

return in a foreign currency. The mean, median and modal mark was 0.7, 0.5 and 0 respectively. The maximum mark was 2 and the minimum 0.

Real US$ return = ((159000 x 1.55) / (142000 x 1.65) / (1+3%)-1= 2.1%

Question 10The question asked candidates to calculate the expected return given various

exposures to return factors and the investment return earned on the factor. This is how a multi factor model works. The mean, median and modal mark was 2, 4 and 4 respectively. The maximum mark was 4 and the minimum 0.

Expected return for stock A

FactorsFactor Exposures Factor

ReturnsReturn

Contribution

Risk Free 0.01% 0.01Leverage -0.7 -0.20% 0.14Size 1.3 1.10% 1.43

Volatility -0.2 -0.80% 0.16Value 1.1 0.30% 0.33Momentum -0.8 -0.10% 0.08

2.15%

In the future fewer marks are likely to be awarded for this question.

Question 11Answers were of a poor standard to this question on after tax valuation, with a mean, median and modal mark of 0.5 out of 4. The maximum mark was 4 and the minimum 0.

Very important to the question was that neither stock was sold. They remain in the portfolio. Capital gains tax is not relevant. Based on this, no tax adjustment is required for Stock A.

Required return for Stock A = 0.5% + 0.9 x (5% – 0.5%) = 4.5%. The expected return for Stock A is 5.2%. Stock A is undervalued. This is above the SML.

Stock B pays dividends. There are two ways to calculate the after tax return:

1. There’ll be 10% dividend tax paid at source, leaving a further 25% to still pay on the net received figure. 4% x 0.75 (1 - 0.25) = 3%.The required return for Stock B is therefore 2% capital gain + 3% dividend return= 5.0%

2. Gross-up the dividend. 4% x 1.1 (10% more than the net received) = 4.4%. Next, reduce the gross dividend by the full amount of dividend tax of 32.5%. 4.4% x 0.675 (1 – 32.5%) = 3%.The required return for Stock B is therefore 2% capital gain + 3% dividend return= 5.0%

The pre-tax expected return for Stock B is 6% and after-tax expected return 5%. The expected return and required return are the same, 5%, so Stock B is correctly valued and on the SML.

Question 12Answers were of a good standard to this question on after tax valuation. The

mean, median and modal mark was 11, 12 and 16 respectively. The maximum mark was 16 and the minimum 0.

i. The efficient frontier is the upper line linking points 2 to 5 on the chart. Both risk free rates – Treasury Bill and money market are included on this chart.

ii. The question is interpretive. The money market rate could be used. One would do so because the money market rate has zero systematic risk and is the zero beta CAPM which better reflects actual practice and empirically predicts better. With the money market the 50:50 portfolio (or some combination of this with the risk- free rate) is best for Amanda. Alternatively, the Treasury Bill rate could be used. One would do so because the Treasury Bill has zero systematic and unsystematic risk – it’s default free, and this is an important factor even though it may sometimes not be risk free in real, inflation adjusted terms. With the Treasury Bill rate the 75 bond:25 equity portfolio (or some combination of this with the risk-free rate) is best for Amanda.

iii. An additional rate tax payer may prefer returns as capital gain rather than income. Amanda may want to tilt her portfolio toward growth style assets, which would be less than fully diversified. Alternatively, Amanda’s may wish to select other types of equity funds such as VCT’s, EIS, SEIS, where less tax is paid – though there is additional risk and this may not be suitable in Amanda’s case. An alternative to a diversified bond fund might be investment bonds, if delaying the incidence of taxation has merit.

Section CThe aim of Section C is to test depth of knowledge through three long answer

case study questions, as well as to test candidates applied skills.

Question 13The question was the best answered in section C. The mean, median and

modal mark was 14 out of 20. The maximum mark was 16 and the minimum 4.

i. Samantha’s not taxed. The lump sum is paid tax-free. Samantha is treated as a non-income tax payer. Once Samantha’s invested part or all the lump sum there’s tax to pay on the investment returns.

ii. The answer is interpretive. Samantha has no human capital so no means of replacing investment losses through earned income. This makes Samantha wholly dependent on the lump sum. This suggests the investment must have a

lowish level of risk a high level of certainty of outcome, and a low risk of shortfall. At the same time Samantha wishes to be tax efficient. The investment problem is that capital gains type of investments have an annual allowance but tend to be more risky, which takes us away from what Samantha desires. The solution might tend to lead us away from a large allocation to bonds where there’s no annual allowance to use up and income is taxed at 20%.

The question is how to invest with a (very) low risk appetite and be tax efficient if you are a non-income tax payer but liable to pay tax on investment income and on capital gains. The investment return needs to make somewhere around ILGs + 2.5%, so perhaps 5% long-run annual average.

High scoring scripts included an asset allocation that was explained and fully justified. High scoring scripts also discussed some tax efficient vehicles, including:

Gross yield on ISA: From 6 April 2015 can put £15,240 in ISA and choose how you split this between stocks & shares and cash ISAs, or whether to split it at all. This is likely to be only a very small part of the lump sum award.

Gross yield on deposits: Interest on deposit account will be taxed as income but Samantha is non-income tax payer so can complete forms and receive gross. But gross yield will not make 5% so can only be a small part of the investment solution.

Gross yield in pension environment (except for div withholding tax): Samantha is a non-earner so can receive 20% tax relief even though she doesn’t pay tax on the lump sum. The maximum Samantha can contribute tax efficiently each year is £3,600 gross - a payment of £2,880 to which the taxman adds £720. Dividends, except for withholding tax, and capital gains are tax free in the pension environment. This is likely to be only a very small part of the lump sum award.

Tax efficient funds such as VCTs, EIS, SEIS, were considered unsuitable given the low risk tolerance. Samantha is wholly dependent on the lump sum and needs to investment with low risk of shortfall.

Good answers suggested low risk, low shortfall solutions that avoided, as far as is practical, tax on investment income.

iii. The £35,000 is a hypothecated amount for the provision of a private pension. It’s equivalent to pension contributions Samantha would likely have made had she’d received a work income, discounted back to today’s money. Most likely these contributions would’ve been into her employer’s defined contribution workplace pension scheme. Doing nothing workplace pensions’ autoenrolment would have probably led Samantha to be enrolled into a defined contribution pension scheme and into the scheme’s default fund. Usually this is around 80% growth assets with a target investment volatility of 10 – 15%. This will not be as low risk as how the discount rate was applied

i.e. ILGs + 2.5%. It will probably target something like 5 to 6% per annum. This suggests that the pension piece of the overall lump sum is probably best invested on a moderate investment risk. Investment would likely be in a diversified growth fund and de-risked close to retirement, assumed to be State Pension Age. High scoring scripts also discussed the asset allocation and differences to the answers above.

Question 14The question was the best answered in section C. The mean, median and

modal mark was 13, 13, and 14 out of 20 respectively. The maximum mark was 17 and the minimum 2. Very good answers elaborated on the following:

Many investment decisions are influenced by the context of the decision. People deploy short cuts & rules of thumb when making investment decisions. Decisions and behaviours often therefore come about rather than being analysed though-out.

4 main types of bias suggest a role for behavioural science in investment decisions and communication.

1. Social biases include herd instinct, conformity, extreme aversion

People often conform because they want to fit in with the group and/or because they believe the group is better informed than they are.

As a result, we often do or want to observe other’s actions before we make our own decision.Practical outcome – Behavioural scientists wanting to influence consumer decision and choice would point out how others like us are already behaving. Point to statistics about popularity, take-up, consumer satisfaction.

2. Decision biases include inertia, base rate neglect, bounded rationality.People tend to make a decision and then stick to it. We also tend to make the easiest, rather than best, decisions. As people inherently go for preset option, a behavioural scientist wanting to influence our decisions and choices should use defaults.

People have ‘bounded rationality’. More choice to consumers is not always helpful - it can increase procrastination. A behavioural scientist wanting to increase individual selection of choices would limit choice to up to 9. Inertia and procrastination justify autoenrolment and defaults, as well as save more tomorrow programmes.

Base-rate neglect happens when available statistical data is ignored in favour of specific data to make a probability judgment. Practical outcome: It’s easier to identify with an individual than ‘statistically average person’. Mirrors human thought where we tend to think in narrative structures. Get people to anchor on the true probability.

3. Probability and belief biases include anchoring, loss aversion, overconfidence.

People have greater aversion to losses than expected. A behavioural scientist wanting to influence our choices would use framing. People react differently to same information about risk and probability if presented in the context of success than they will if presented in the context of failure e.g. people likely to respond differently to a fund with an investment objective that has a 20% chance of success rather than an 80% chance of failure. Emotions shape actions, so to make more powerful use case studies and stories to orientate clients to the future feeling they may experience – positive or negative.

People’s preferences tend to be undefined and choice will be influenced by the order of appearance or by knowledge of the median or mean. Practical outcome – order in which funds are offered or placed likely to influence response.Individuals are too optimistic about the future so save and invest too little. Over optimism / overconfidence - leads individuals to invest with too much risk than their risk tolerance would suggest.

4. Memory biases include present bias, hindsight bias and endowment effect.

Present bias finds that people suffer temporal myopia - a tendency to discount the future in favour of the present.Practical outcome - in a retirement income setting, present bias will increase the attractiveness of the PCLS today relative to future income. May lead to demand for quick succession early lump sums to front-load consumption in retirement. Increases risk that private pension money to retire on will be spent early.

The endowment effect occurs where ownership creates satisfaction. Practical outcome is this can be used to help generate positive experience and growing attachment of risk averse people to saving through a low risk start. Initial good experience leads to reluctance to leave.

People tend to link control with certainty (even if this is not the case). Neurologists have discovered inbuilt preference for certainty. Where there is uncertainty, the brain fills the gap with fear. Link between feeling of control and perception of situation. When there’s a lack of control, e.g. risky, people tend to interpret uncertainty associated with the situation negatively, so tend to view risky investments as more risky than they are and low risk investments as more desirable than they actually are. Practical outcome: implications for people’s ability to judge investment (risk) related products against those that deliver certain and consistent outcomes i.e. safe but low return.

Question 15The question tested candidates’ knowledge of portfolio theory and multifactor models. The mean, median and modal mark was 11, 12, and 10 respectively. The maximum mark was 17 and the minimum 4. High scoring scripts included the following:

i. Y axis is return, x axis is beta. Intercept is 0.5% and market return 6% for beta of 1. Line joins the two and continues. See chart below.

All the large companies are underpriced for their level of systematic risk so are expected to outperform. They are located above the SML.

All the small companies are either correctly or overpriced so expected to perform in line with their level of systematic risk or underperform. They are located below the SML.

ii. Chart below.

SML

New SML

SML

iii. Large companies are no longer attractive and smaller companies now attractive. Large companies are now overpriced for their level of systematic risk so are expected to underperform. Expected return is less than commensurate for their level of systematic risk. These are located below the SML.Small companies underpriced so expected to outperform for level of systematic risk. Expected return is more than commensurate for their level of sys risk.These are located above the SML.

iv. High scoring scripts discussed and appraised in some detail the multi factor CAPM. One of the Fama French factors is size. The SML only considers market beta to calculate the required return. But small firms may be more risky in other ways. The shares of small size firms may have long-run returns that are higher than will be predicted given their level of systematic risk. This is the result found in the question. There is an ongoing debate about whether this is a ‘risk premium’ or whether smaller firms are more risky in other ways. Some of the more attractive or less attractive companies may have different value and growth qualities, and the multifactor CAPM can help an investor understand the reason for any extra performance and its timing.

v. Security betas are unstableRisk free rate specification problem There are other priced risk factors