Exam

Question 1

Pros & Cons of compulsory annuitisation (PROS)

Answer 1

Pros:

• Pooled longevity risk makes cost of offering the annuity cheaper for all
• Provides longevity hedge for individuals
• Certainty of income, peace of mind

Question 2

Pros & Cons of compulsory annuitisation (CONS)

Answer 2

• Women / higher socio economic live longer. Would poor / men subsidising the rich.
• Guaranteed rate of income may be lower due to low prevailing interest rates
• Early death -> will not get full benefit
• give up some upside of being exposed to markets

Question 3

Two approaches to portfolio rebalancing; TAA and SAA. Pros & Cons?

Answer 3

SAA: main risk control tool. Designed to achieve objective. Keep control of risk/return tradeoff. Countercyclical discipline. Rebalance as risky asset classes outperform and increase as a proportion. WATCH: costs of trading/tax.
If SAA was right for the client at the start, why would you deviate.

Question 4

4 Conflicts of Interest

Answer 4

1. Different trails between internal & external products. Mitigate: review for client suitability, ensure adequate product review to justify. Manage: still need firm revenue. Manage fees different. eg fee for service. Improve efficiencies, stay abreast of industry best practice
2. Entertainment: mitigate by maintaining entertainment register and set guidelines on what is acceptable.
3. Brokerage: review portfolios for excessive turnover
4. Volume bonuses” peer review of product allocation processes and system monitoring

Question 5

Pros / Cons of including alternative assets (client perspective)

Answer 5

+ perception of being smart money
+ perceived diversification (though in reality, correlations, risk/return can vary markedly)
+ access to investments not available in other formats
- liquidity
- cost (of external managers)
- incorporating from risk / return perspective, alt assets have unique characteristics, so how should they be modelled

Question 6

Pros / Cons of including alternative assets (firm perspective)

Answer 6

\+ fees / revenue generally high
\+ perception of being on cutting edge
\+ placement fees
- hard to model/hard to incorporate into SAA.  incorporating from risk / return perspective, alt assets have unique characteristics
- costly to review & monitor
- low transparency

Question 7

Possible services for UHNW from US IB

Answer 7

1. ascertain client needs first
2. standard offering: tax, super, estate planning, insurance, investments, managing longevity risk)
3. other offerings that may suit: tax specific advice for company, financial structuring of business, trusts,
4. access to exclusive entertainment, etc (eg art), philanthropic desires, trust set up.

Question 8

Discuss challenges of managing advisers

Answer 8

Key: business drivers, power of advisers, management techniques
Challenge; reputational risk; revenue stream dependent advisers and their relationships (may take clients when leave).
Keep PWMs engaged with firm: titles, bonuses, need to be heard etc
Need to build brand loyalty to engender loyalty
Get advisers to work in teams.

Question 9

Is behavioural finance relevant?

Answer 9

1. BF is based on the idea that people are not rational
2. PWM recognise individuals are more important than the aggregate when creating IP
3. PWM need to protect clients from themselves - use BF
4. List examples of BF (heuristics etc)

Question 10

Pros & Cons of life cycle (aka target date funds) (PROS)

Answer 10

+ age cohorts are a good starting point
+ useful for managing longevity risk in the absence of a deep annuities market
+ even if not perfectly suited to client, may be good enough

Question 11

Pros & Cons of life cycle (aka target date funds) (CONS)

Answer 11

• being prescriptive on date of AA change can be detrimental if market has just fallen materially
• Different firms offer different fund allocations - which is correct?
• Later in life funds may be too conservative, giving up growth

Question 12

What is Human Capital

Answer 12

1. HC is a person’s skills, training etc used to generate wealth and income.
2. Not generally tradeable.
3. The ability to earn a salary
4. Major proportion of wealth for most

Question 13

Human Capital: How can you value it?

Answer 13

HC can be modelled as the NPV of future income payments discounted at appropriate rate.

Question 14

What is the relationship between HC and FC

Answer 14

HC declines over time as individuals approach retirement.
FC increases over time as assets build up in prep for retirement.
HC falls because there are less future pay packets to be discounted by the discount rate

Question 15

How would you increase the value of HC

Answer 15

education
training
ability to work harder

Question 16

How would you protect HC

Answer 16

Insurance - eg income protection, TPD, life insurance, training
Annuities - longevity risk

Question 17

Portfolio rebalancing is important because:

Answer 17

• ensure risk/return accords with SAA. If drift is too far from SAA, no longer appropriate
• after AA is set, weights will drift over time. need to rebalance
• Significant time/resources spent agreeing to SAA based on risk/return profile.
• Adjustments can be made based on periodicity or bands. Note if a partic asset class is more expensive to trade, bands may be wider

Question 18

Lessons learned from Madoff

Answer 18

1. Due diligence is critical (as a PWM seek info from feeder funds, check independent service providers are used and DD is conducted by auditors & asset consultants before products are placed on APL.
2. Be alert to warning signed: unusual fee structures; strong family structure, inadequate staffing, non-registration with authorities, access to records

Question 19

Madoff - behaviours of the rich

Answer 19

1. feeling of exclusivity and being part of the club
2. desire to feel special & smart
3. endorsement by high profile people
4. emotional issues are critical

Question 20

STrategies to prevent PWMs leaving

Answer 20

• allow them to let off steam, allocate bonuses, stroke egos
• market directly to clients, try to build brand loyalty, have PWMs sell firm specific products
• Get advisers to work in teams

Question 21

Issues with simulation techniques and models

Answer 21

• sensitivity of assumptions can materially alter results
• generally MVO based. New paradigm models tend to produce AA close to standard approach
• difficulty of estimating expected returns and risk
• how diff would end AA be if used new vs standard approach
• MVO & Monte Carlo simns can be useful to prompt invstors to change savings plans or attitudes

Question 22

Sophisticated PWM firm must offer TAA discuss

Answer 22

• Mkts hard to beat; but clients believe mkts not hard to beat
• Clients expect it (profits, marketing for firm)

Question 23

Growing focus on AT investing - discuss (6)

Answer 23

• final AA should be based on AT
• asset location - eg hold in a trust, in a super fund etc for different tax rate. Optimise AA and Asset Location.
• t/o generally hurts AT returns (though can harvest losses to advantage)
• note bonds taxed as income, shares are CG and income.
• tax inefficiencies of managed funds
• SMAs

Question 24

Impact of estimation error: 2 common approaches

Answer 24

1. Black Litterman model
2. Re-sampled efficient frontiers (reseample historical data & create efficient frontier. Repeat multiple times, rank #1 portfolios, #2 portfolios etc. Plot to est eff frontier