Level III 2023 Practice Exam

2 ⅕ Hours (132 Minutes)

Session 2 of the 2023 Practice Exam has 11 question sets. The format consists of
either a free form constructed response question set (essay), or a question set
consisting of a vignette or a short case followed by four multiple choice questions based
on the vignette. Each question set is allocated 12 minutes for a total of 132 minutes.

Question Set Topic Minutes

1 Portfolio Management – Performance Evaluation 12
2 Portfolio Management – Performance Evaluation 12
3 Portfolio Management – Private Wealth 12
4 Portfolio Management – Institutional 12
5 Ethical and Professional Standards 12
6 Portfolio Management – Private Wealth 12
7 Ethical and Professional Standards 12
8 Portfolio Management – Trading 12
9 Equity Investments 12
10 Equity Investments 12
11 Alternative Investments 12

Total 132

© 2023 CFA Society Boston 2

 QUESTION SET 1
TOPIC: PORTFOLIO MANAGEMENT – PERFORMANCE EVALUATION
TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Andrea Freedman is the CIO at Dartmore Investments. To determine annual

performance, investment managers serving Dartmore are evaluated on several
qualitative and quantitative factors that align with the firm’s investment policy. Freedman
has identified two funds that had significant underperformance last year. She hires
Vision Consultants (Vision) to find suitable investment managers to replace the two
underperforming managers.

Victor Bieler, a senior specialist at Vision, identified three potential active investment
managers for Dartmore. The managers were identified based on past performance,
qualitative factors, and fee schedule. The fee schedules are summarized in Exhibit 1.
Note: The sharing fee is applied on active return above the base fee.

Exhibit 1
2021 Performance
Maximum Compared to
Manager Base Fee Sharing Annual Fee Benchmark
Lake Management 2.50% 20% 5.50% Inline
River Management 2.00% 22% N/A Outperform
Ocean Management 2.25% 25% 5.75% Underperform

Bieler makes the following statements.

Statement 1: If River Management underperforms expectations, Dartmore would be

at risk of making a Type I error in hiring River Management because of
its recent outperformance.

Statement 2: If Ocean Management outperforms expectations, Dartmore would be

at risk of making a Type II error in hiring Ocean Management, due to
its recent underperformance.

Freedman mentions to Bieler that she expects the current market volatility to stabilize
and that investors will subsequently increase their allocation to equities. Freedman
presents the expected gross active returns for the market and the benchmark over the
next three years in Exhibit 2.

Exhibit 2
Year 1 Year 2 Year 3
Gross active return 16.25% 18.75% 18.50%
Benchmark return 11.75% 12.50% 11.25%

A. Identify which of Bieler’s statements is most likely correct. Justify your

response.

© 2023 CFA Society Boston 3

B. Identify which manager in Exhibit 1 will have the lowest investment management
fees in Year 2. Justify your response.

C. Calculate the net active return for Ocean Management in Year 3.

© 2023 CFA Society Boston 4

QUESTION SET 2
TOPIC: PORTFOLIO MANAGEMENT – PERFORMANCE EVALUATION
TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Alex Fisher, Vice President of Quantitative Research & Investments at Capwan

Partners (Capwan), is preparing materials for the annual fund performance presentation
to the executive management of the firm. Fisher is working with two analysts, Tim
Zlotnikov and Chris Hamilton, to create the presentation. Fisher explains that the
presentation must contain materials that will help the audience understand performance
evaluation, including measurement, attribution, and appraisal.

Hamilton is a recent hire at Capwan and asks Zlotnikov the best attribution process to
accurately generate the reports. Zlotnikov makes the following statements.

Statement 1: Returns-based attribution is more reliable as it uses total portfolio

returns and is not subject to data manipulation.

Statement 2: Holdings-based attribution yields accurate results for both shorter and
longer measurement periods as it eliminates the trading effect.

Statement 3: Transaction-based attribution is the most accurate as it uses both

holdings of the portfolio and transactions during the evaluation period
but is very difficult and time consuming to implement.

Fisher has concerns about the effects of macroeconomic factors on the portfolios and
requests Zlotnikov and Hamilton to analyze returns for the Europe Sector Diversified
Fund (Exhibit 1) and the Energy Fund (Exhibit 2).

Exhibit 1
Europe Sector Diversified Fund
Portfolio Benchmark Portfolio Benchmark
Sector Weight Weight Return Return
Agriculture 35% 25% 28% 16%
Defense 25% 30% 15% 11%
Finance 20% 15% 4% 7%
Energy 20% 30% –6% –1%
Total 100% 100% 13.15% 8.05%

Exhibit 2
Energy Fund
Portfolio Benchmark Portfolio Benchmark
Segment Weight Weight Return Return
Exploration 10% 15% 5% 3%
Refining 35% 20% 7% 4%
Storage 30% 35% 8% 6%
Transportation 25% 30% 4% 7%
Total 100% 100% 6.35% 5.45%

© 2023 CFA Society Boston 5

1. Which of Zlotnikov’s statements is most likely correct?

A. Statement 1
B. Statement 2
C. Statement 3

2. Based on a Brinson–Hood–Beebower attribution analysis of the Europe Sector

Diversified Fund, the manager’s selection decisions were better in:

A. Energy than in Defense.

B. Defense than in Finance.
C. Finance than in Agriculture.

3. The Brinson–Fachler allocation effect for the Energy sector in the Europe Sector
Diversified Fund is closest to:

A. 0.15%.
B. 0.80%.
C. 0.91%.

4. Based on a Brinson-Fachler attribution analysis of the Energy Fund, which of the

following conclusions is most likely correct?

A. The allocation effect is positive for the Storage segment

B. The allocation effect is negative for the Exploration segment
C. The allocation effect is negative for the Transportation segment

© 2023 CFA Society Boston 6

QUESTION SET 3
TOPIC: PORTFOLIO MANAGEMENT – PRIVATE WEALTH
TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Robert Robertson, age 56, had a successful career in the solar energy industry. He
plans to work as a consultant for nine more years and now does consulting work. The
consulting income allows Robertson to cover all current living expenses and to
contribute approximately $100,000 annually to his investment portfolio. He meets with
his new wealth manager to discuss his portfolio and future financial plans and to create
an IPS.

Robertson’s current balance sheet is shown in Exhibit 1.

Exhibit 1
Investment Account Type Value
Liquid securities Taxable $ 5,000,000
Retirement plan (moderate risk allocation) Qualified $ 2,000,000
Diversified domestic equities Taxable $ 2,500,000
Diversified international equities Taxable $ 1,500,000
Real estate (investment properties) Taxable $ 4,000,000
Municipal bonds Taxable $ 1,000,000
Total – $16,000,000

Robertson is preparing the oldest of his three children to begin a four-year program at a
local university next year. His other two children are 14 and 16 years old, and he
expects them to attend universities with similar costs. The cost per child will be
approximately $75,000 (in today’s dollars) over the course of their four-year
enrollments.

Robertson discusses goals for his investment portfolio, which include ensuring that his
children’s college educations are fully paid and that he is able to generate income of
approximately $150,000 per year from his portfolio in retirement. In addition, Robertson
would like to begin purchasing and renovating sports cars as a hobby when he retires
and to leave as much as possible to charity upon his death. Robertson has no major
debts.

Robertson wants to increase his real estate investments to generate passive income
during retirement by purchasing his dream investment property upon reaching age 65.
He estimates this property will cost approximately $2,000,000 (in today’s dollars).
Robertson believes he is a better-than-average real estate investor. He currently owns
four investment properties and needs access to funds equal to 25% of their value at any
given time for unexpected repairs and improvements. He tells the wealth manager that
he will manage his current real estate portfolio himself and wants the wealth manager to
only consider investments outside of real estate.

Given his previous work in the solar energy industry, Robertson would prefer to buy
stocks of environmentally friendly companies. While he is open to opportunities in
traditional energy companies if the market provides good value, he asks to review any
such companies prior to investing.

© 2023 CFA Society Boston 7

A. Describe four of Robertson’s liquidity needs from his investment portfolio.

B. Evaluate Robertson’s degree of risk capacity (higher than average, lower than
average) associated with each of the following goals. Justify each response.

• Children’s college education

• Sports cars
• Charitable bequest

C. Identify one of Robertson’s investment constraints.

© 2023 CFA Society Boston 8

QUESTION SET 4
TOPIC: PORTFOLIO MANAGEMENT – INSTITUTIONAL
TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Eve Harlow, the owner of restaurant chain Burger Shack, meets with financial advisor
Neil Almond to review the company’s defined benefit pension plan. Currently, the plan’s
assets equal the plan’s liabilities. The plan’s objective is to maintain a 100% funded
ratio using publicly traded investment vehicles. The plan’s portfolio has not been
reviewed since the plan was established seven years ago.

Almond gathers statistics on company characteristics and determines that the workforce
is young and there are no major upcoming liquidity needs. Almond concludes that the
Burger Shack pension plan has a high risk tolerance. The plan’s actuaries determine
that a 7% annual return for plan assets will keep pace with the liabilities.

Almond begins drafting an IPS to share with Harlow. In addition, he obtains the most
recent statements and begins reviewing the current asset allocation. He creates a new
proposed asset allocation, as shown in Exhibit 1.

Exhibit 1
Expected
Long-Term Current Proposed
Asset Class Annual Return Allocation Allocation
Passive domestic equities 8% 45% 10%
Active domestic equities 10% – 15%
Passive international equities 10% 15% 10%
Active international equities 12% – 10%
Passive domestic fixed income 3% 40% 10%
Active domestic fixed income 5% – 10%
International fixed income 7% – 5%
Hedge funds 13% – 20%
Real estate 10% – 10%
Total – 100% 100%

A. Formulate the investment objective for Burger Shack’s pension plan.

B. Identify both the current investment approach and the proposed investment
approach for the Burger Shack pension plan.

(Canada model, Endowment model, Liability-Driven Investment model, Norway

model)

List one drawback of each approach identified.

C. Demonstrate whether the return of the proposed portfolio would be sufficient to

meet Burger Shack’s actuarial rate.
© 2023 CFA Society Boston 9
QUESTION SET 5
TOPIC: ETHICAL AND PROFESSIONAL STANDARDS
TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Nancy Bates, CFA, is a vice president in the operations department of ACME

Investment Management. Her team supports the firm’s investment-related systems.

Bates is required to complete her quarterly online compliance training by the end of the
current month. Her training focuses exclusively on the potential misuse of company
data, such as front-running and the disclosure of investment decisions and strategies.

ACME’s compliance manual discusses the firm’s procedures for reporting and analyzing
material nonpublic information (MNPI) obtained outside of the firm. The manual states
that employees have a duty to report MNPI immediately to the designated contact in the
legal department. If MNPI is deemed present, the securities of the firm involved are
placed on a restricted list and ACME employees are blocked from trading these issues
until the information in question becomes public. Bates has not reviewed the
compliance manual since it was last updated more than a year ago.

The following weekend, Bates has dinner with her brother, Aaron Dugan, CFA, an
analyst in the internal audit department of Hampshire Construction, Inc. (HCI). HCI is a
privately owned corporation that specializes in the design and construction of oil
refineries for several global clients. Dugan is concerned about his job, as he explains in
Statement 1.

Statement 1: I think HCI is about to be purchased by EuroFabrik (EUF), a large, publicly

owned European conglomerate that wants to expand its footprint in the
energy infrastructure space. The tip-off was when I received requests from
the legal folks for specific internal audit working papers. I did some
freelance research and figured out what was going on. I am pretty sure at
this point that the sale will go through and the Europeans will take over all
the administrative roles. I am going to be out of a job and might need
some of your industry contacts to help me with my job search.

Bates is worried about Dugan and shares her concerns with her administrative
assistant, Amy Tamworth, in Statement 2.

Statement 2: My brother works for a large, private construction company and believes
that they are about to be bought out by a big global firm looking to expand
operations. He is not part of the negotiations, which are confidential, but
he is in the internal audit department and has access to enough
information that he was able to deduce what was happening.

Tamworth has just finished her first quarterly compliance training and urges Bates to
report her conversation with Dugan to the appropriate contact in the legal department.

© 2023 CFA Society Boston 10

Bates is unsure about whom that is and is advised to look at the appendix in the Code
of Ethics training handbook. Bates finds the contact information and subsequently
meets with the lawyer to report her information.

Tamworth’s position is clerical with no access to investment recommendations. She is

nevertheless required to request permission for personal trades through the compliance
system. Tamworth is a CFA candidate currently enrolled for the Level I exam.

Tamworth does some online research, looking for the overlap of “large, private
construction company” and “big global firm looking to expand operations.” She identifies
HCI and EUF as the likely companies. Based on a quick reading of some internet
articles, Tamworth believes that the purchase will have a positive impact on EUF’s stock
price. Because of her research, Tamworth believes that she can rely on the mosaic
theory to defend any subsequent trading activity. She requests permission for the trade
in ACME’s compliance system, and it is granted.

1. According to the Standards, which of the following best describes ACME’s

compliance training and procedures?

A. The training is inadequate; the procedures for reporting and analyzing

MNPI incidents are reasonably designed and adequate
B. The training program and the procedures for reporting and analyzing
MNPI incidents are both reasonably designed and adequate
C. The training program is inadequate as to the follow-up after MNPI
reporting. If the information is deemed material, the firm should also
publicly disclose the information

2. Which of the following best describes Dugan’s revelations in Statement 1?

A. Dugan has violated the Standards by disclosing material nonpublic

information
B. Dugan has not violated the Standards as he had no intent for his sister or
himself to profit from the information
C. Dugan has not violated the Standards because his revelations may be
unreliable as he is only “pretty sure” that the deal will happen

3. Bates’ failure to immediately report the information to ACME’s legal department

violated the Standard relating to:

A. loyalty.
B. misconduct.
C. material nonpublic information.

© 2023 CFA Society Boston 11

4. Which of the following best describes Tamworth’s reliance on the mosaic theory
to justify her decision to trade EUF stock?

A. Tamworth can rely on the mosaic theory because she had to research
whether the purchase would have a positive impact on EUF’s stock price
B. Tamworth cannot rely on the mosaic theory because it was clear from
Bates’ remarks that the information that triggered Tamworth’s research
was misappropriated
C. Tamworth can rely on the mosaic theory because Bates did not name
either of the firms and Tamworth had to piece together information from
other sources to identify the participants

© 2023 CFA Society Boston 12

QUESTION SET 6
TOPIC: PORTFOLIO MANAGEMENT – PRIVATE WEALTH
TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Thomas Morrow is an independent financial analyst. Morrow meets with a new client,
Richard Nala, to review his portfolio and financial situation. Nala has recently retired
from a full-time position but is still active as a consultant, which provides compensation
well above his current spending needs. He also donates his time to local charitable
organizations, which is important to him. He would like to benefit selected charities
following his death. Nala’s investment goal is to provide for his children in a tax-efficient
manner without gifting them a large amount of capital at once. Nala’s current investment
assets are shown in Exhibit 1.

Exhibit 1
Account Cost Present Percent
Investment Type Basis Value of Assets
ABC stock Taxable $50,000 $1,250,000 38.4%
Taxable fixed income Qualified $0 $750,000 23.1%
International stocks Qualified $0 $500,000 15.4%
US large-cap stocks Qualified $0 $500,000 15.4%
Cash Taxable $250,000 $250,000 7.7%
Total – $300,000 $3,250,000 100.0%

Morrow reviews the portfolio and, given the concentration risk associated with ABC
stock, recommends that Nala diversify this position. Nala is restricted from utilizing short
sales and derivative contracts in his jurisdiction. However, Morrow believes there are
other ways to diversify the concentration risk. Nala’s tax rate is 25% for long-term
capital gains and is expected to remain at this level. His holding period in ABC stock is
long term. ABC and the overall market are each expected to return 8% annually over
the next ten years.

A. Determine which of the following strategies would be most appropriate for Nala
to achieve his investment goals while reducing the concentration in ABC stock.
(Charitable remainder trust, Covered call writing, Equity monetization)
Justify your response. Explain why each of the other two strategies would be
less appropriate.

B. Calculate the difference in final value at the end of 10 years between

contributing the ABC stock to an exchange fund today and an outright sale of the
ABC stock today with the net proceeds reinvested in the market.

© 2023 CFA Society Boston 13

QUESTION SET 7
TOPIC: ETHICAL AND PROFESSIONAL STANDARDS
TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Cheryl LaPoint is a CFA candidate who has passed the Level II exam. She works as a
commercial real estate broker in the Boston office of Trans Continental Properties
(TCP), a publicly traded company with offices around the US. Along with brokering
office, warehouse, and manufacturing space, TCP has a small relocation services unit
that brokers residential home sales as a value-add to their commercial work. Lately, the
firm has been struggling.

LaPoint typically commutes to work with friend and neighbor Andrew Saltzman, CFA,
who works as a portfolio manager for a large investment firm. One Monday as they
depart for work, LaPoint turns the radio to a national business news channel. One of the
top stories is the announcement of major layoffs in a number of TCP’s offices. She tells
Saltzman:

Statement 1: I have known about this for several weeks but I couldn’t tell you because
of your job. I have no idea how large the layoff will be or if my job is
vulnerable. The press release went out at 7:00 AM, and I checked online
before I left home to make sure it was already in the news.

As the story unfolds, it becomes clear that TCP is closing a number of offices. The
Boston office is among them, and its operations will be transferred to the TCP office in
New York City (NYC).

When LaPoint arrives at work, she learns that only a few of the senior staff in Boston
will be retained and reassigned to positions in NYC. The remaining staff, including
LaPoint, will be laid off. Emails have already been sent to all clients of the Boston office,
announcing the closure and layoffs. Contact information about who will be handling their
business out of the NYC office was included, with a promise of more information to
come.

Later that day, LaPoint meets with the human resources department. She is offered a
generous severance package contingent on her signing a six-month non-compete
agreement, which includes a clause forbidding her to solicit any business from TCP
clients.

The next few days are spent preparing the site for closure. The IT department removes
all company applications and data from the personal laptops of the staff. The facility will
be officially closed by Friday when the staff terminations become effective.

LaPoint has maintained separate personal and professional social media accounts.
Prior to her official termination, she updates all of her social media accounts with the
pending change in her employment status. She adds a message to her professional
social media accounts that these accounts will be shut down within two weeks. Many of
these platforms generate an automatic update to all of the members of LaPoint’s
networks, alerting them to the changes in her profile.

© 2023 CFA Society Boston 14

After her termination, LaPoint realizes that she still has a remote hard drive used for
backups. The drive contains both personal files and work files from her former
company. LaPoint does a full backup of her personal laptop, which has had all company
files removed. Previous backups, which contain company files, remain on the drive. Not
wanting to lose the backup history for her personal files, LaPoint ponders how to handle
the disposition of the drive.

A competitor of TCP contacts LaPoint and offers her a temporary position in the
residential brokerage operations of the firm. The position would not require LaPoint to
compete with TCP’s commercial business. The hiring manager assures LaPoint that
she would not be given any assignments that would put her in competition with TCP’s
relocation services unit.

1. LaPoint’s statement to Saltzman:

A. violated the Standard relating to loyalty.

B. violated the Standard relating to material nonpublic information.
C. did not violate the Standards relating to loyalty or to material nonpublic
information.

2. Which of the following best describes LaPoint’s handling of her social media
presence?

A. Her handling of her social media presence complied with the Standards
B. She violated her non-solicitation agreement and the Standard relating to
loyalty by not deleting her professional accounts immediately upon
termination
C. She violated her non-solicitation agreement and the Standard relating to
loyalty as the automatic updates that some accounts generate are a form
of solicitation

3. Regarding the backup drive, according to the Standards LaPoint should:

A. return the drive to her former employer.

B. keep the drive but never restore any of her former employer’s data.
C. contact her former employer, explain the situation with her personal files,
and keep the drive.

© 2023 CFA Society Boston 15

4. According to the Standards, which of the following should be the principal
consideration for LaPoint in deciding whether to accept the temporary position?

A. LaPoint’s experience is in commercial, and not residential, real estate,

no non-compete violation is likely to occur
B. Accepting this position would be a violation of LaPoint’s non-compete
agreement and the Standard relating to loyalty
C. The assurances given to LaPoint by the hiring manager would allow her to
conform with the non-compete agreement and the Standard relating to
loyalty

© 2023 CFA Society Boston 16

QUESTION SET 8
TOPIC: PORTFOLIO MANAGEMENT – TRADING
TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Mark Miller is the CIO at Bulls and Bears Investment Management (BBIM). At the
beginning of every quarter, Miller performs an extensive review of portfolio holdings to
find rebalancing opportunities. His analysis focuses primarily on changes in
macroeconomic factors. He prefers to execute all rebalancing trades within a month
after the rebalancing opportunities are identified.

BBIM employs Morgan Traders as a prime broker to execute large orders. Miller meets
with Jack Farina, a senior trader at Morgan, to discuss trading strategies. To be
consistent with the firm’s investment objective, Miller mentions that he would like to
integrate trade execution with the portfolio management process. Farina makes the
following statements about advanced trading strategies that may align with Miller’s
interests.

Statement 1: To avoid adverse price movements and realize alpha on the

rebalancing trades, you should implement an arrival price strategy.

Statement 2: To avoid information leakage and significant market impact, you should
use dark aggregator algorithms for large rebalancing orders.

Statement 3: To achieve best execution for the rebalancing trades without market
impact, you should use smart order routers to electronically send large
market orders.

After reviewing his research and analysis, Miller decides to reduce his position in
Schwingate Materials (SM), one of the largest holdings in the portfolio. SM is currently
trading at $71.00/share. Miller sends a sell order for 100,000 shares of SM to Morgan
Traders with a limit price of $68.25. The arrival price when the order was submitted to
the market by Morgan was $70.75. Order execution details are summarized in Exhibit 1.
SM closed the trading day at $67.25/share.

Exhibit 1
Trade Shares Executed Execution Price
Trade 1 24,000 $70.60
Trade 2 31,000 $69.60
Trade 3 20,000 $69.40
Trade 4 25,000 $68.80

Miller then turns his attention to trade governance, including trading policy, procedures,
processes, disclosures, and record keeping. He understands the importance of having a
trade policy document that clearly and comprehensively articulates the firm’s trading
policies and escalation procedures. He requests that the investment committee include
the following recommendations when formulating the trading policy.

© 2023 CFA Society Boston 17

Recommendation 1: Ensure that partially executed orders are fairly allocated on a
pre-trade and post-trade basis to individual clients with similar
investment goals.

Recommendation 2: Use the same broker and trading venues for all asset classes
to consistently achieve best execution for all trades.

1. Which of Farina’s statements about advanced trading strategies is least likely

correct?

A. Statement 1
B. Statement 2
C. Statement 3

2. The trading cost component of the expanded implementation shortfall for the sale
of 100,000 SM shares is closest to:

A. $102,000.
B. $115,000.
C. $140,000.

3. The arrival cost for the sale of 100,000 SM shares is closest to:

A. 35 bps.
B. 163 bps.
C. 197 bps.

4. Which of Miller’s recommendations is(are) most likely consistent with good trade
governance?

A. Recommendation 1 only
B. Recommendation 2 only
C. Both Recommendations 1 and 2

© 2023 CFA Society Boston 18

QUESTION SET 9
TOPIC: EQUITY INVESTMENTS
TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Calvin Pine is a vice president at Great Funds Advisors, LLC, (GFA), a San Francisco-
based registered investment advisor and manager of the Great Shares family of ETFs.
GFA has an existing suite of products that includes a series of fixed income and
commodity ETFs with a combined $25 billion in assets under management. The firm
has hired Pine to lead the launch of a new series of equity ETFs, which GFA’s executive
committee believes will drive the next leg of GFA’s growth. One of Pine’s first meetings
is with GFA’s president, Cam Beale, to discuss the firm’s product development strategy
for the new equity ETFs.

Pine and Beale begin the meeting with a discussion regarding the passive-active
spectrum. Beale feels strongly that passive management is the most appropriate
approach for the new ETFs as demand from GFA’s clients is likely to be higher. Pine
agrees with Beale’s thinking but adds that, given the growing interest in ESG strategies,
it makes sense to offer some ETFs with exclusionary screening. After agreeing in
principle on positioning, Pine presents Beale with two options for the firm’s first US
equity ETF. Exhibit 1 provides information on the benchmark and factor exposures for
each option.

Exhibit 1
Great Shares R1 ESG ETF Great Shares R1 Value ETF
Ticker GESG GROV
Russell 1000 ESG
Benchmark Enhanced® Index Russell 3000 Value® Index
Benchmark HHI 0.00125 0.0016
Benchmark reconstitution Monthly Quarterly
Factor exposures Growth, Quality Value, Yield

Beale reviews the information and states that GESG should be the first equity ETF that
GFA offers to clients. He concludes that GESG will have greater diversification, be less
likely to experience periods of underperformance when value is out of favor, and
experience less frequent portfolio turnover relative to GROV.

Pine is excited by Beale’s feedback and quickly offers some initial thoughts on how
GFA’s portfolio management team should handle portfolio construction. Pine also
suggests steps the portfolio management team can take to limit tracking error,
presented in Statements 1 and 2.

Statement 1: Full replication of the benchmark does not make sense for GESG. One
reason is that the Russell 1000 ESG Enhanced® Index has a large
number of constituents. Another reason is that it is unlikely that the ETF
will have sufficient assets, at least initially, to fully replicate the index.
Instead, I suggest our portfolio management team utilize an optimization
approach. While we could use stratified sampling, optimization is
preferable as it will result in a lower tracking error.

© 2023 CFA Society Boston 19

Statement 2: If our portfolio management team can keep GESG’s tracking error low, it
will indicate that they are doing an excellent job of replicating the return of
the Russell 1000 ESG Enhanced® Index. We can easily measure the
tracking error of GESG by calculating the standard deviation of the excess
return of GESG versus the index. Since GESG’s benchmark has fewer
constituents than the Russell 1000® Index, GESG should have a lower
tracking error than it would if it were tracking that index.

With Beale’s support, Pine and GFA’s portfolio management team launch GESG. One
year later, Pine decides to evaluate the sources of the ETF’s returns since its inception.
Given GESG’s exposure to the growth factor, Pine decides to run a portfolio attribution
analysis that ranks the constituents of the Russell 1000 ESG Enhanced® Index from
highest to lowest based on earnings growth. Exhibit 2 provides the results of that
analysis. All figures shown are expressed as percentages.

Exhibit 2
Russell 1000 ESG
GESG
Enhanced® Index
Return Weight Contribution Weight Contribution Difference
Total 11.02 100.00 11.03 100.00 11.02 +0.01
4th quartile 15.50 41.30 6.40 41.00 6.36 +0.04
3rd quartile 9.80 24.80 2.43 25.00 2.45 –0.02
2nd quartile 7.20 19.90 1.43 20.00 1.44 –0.01
1st quartile 5.50 13.80 0.76 14.00 0.77 –0.01
Cash 2.50 0.20 0.01 0.00 0.00 +0.01

After reviewing these results, Pine concludes that GESG slightly outperformed its
benchmark.

1. Which of the following should least likely have been a relevant consideration for
positioning GFA’s new equity ETFs along the passive-active spectrum?

A. Forecasted future returns for the relevant equities

B. Availability of a suitable benchmark for the new equity ETFs
C. Confidence in GFA’s ability to outperform a suitable benchmark

2. Beale’s conclusions regarding GESG are most likely correct regarding:

A. diversification and performance.

B. performance and portfolio turnover.
C. diversification and portfolio turnover.

© 2023 CFA Society Boston 20

3. Which of Pine’s statements related to limiting tracking error is(are) most likely
correct?

A. Neither Statement 1 nor Statement 2

B. Statement 1 only
C. Both Statement 1 and Statement 2

4. Which of the following is an incorrect explanation for GESG’s relative

performance versus its benchmark? GESG had a higher-than-benchmark
contribution from:

A. cash holdings.
B. the fastest-growing constituents.
C. the slowest-growing constituents.

© 2023 CFA Society Boston 21

QUESTION SET 10
TOPIC: EQUITY INVESTMENTS
TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

Tsu-Jui Cheng is considering four market cap-weighted indices as the benchmark for an
equity fund. Information regarding the indices is shown in Exhibit 1.

Exhibit 1
Index Stocks in Index Herfindahl-Hirschman Index (HHI)
Index 1 10 0.2000
Index 2 20 0.0680
Index 3 50 0.0660
Index 4 60 0.0167

Index 1 is reconstituted according to objective criteria while Index 2 is reconstituted by

vote of a committee. Indices 3 and 4 are fixed and not reconstituted, but they are
rebalanced periodically. Index 3 is rebalanced quarterly and Index 4 is rebalanced semi-
annually.

Cheng also considers the following indices to use as the benchmark for another US
equity fund, Fund X:

• Index 5—a capitalization-weighted index where each constituent’s weight in the

index is the constituent’s market capitalization divided by the sum of the market
capitalization of all constituents.
• Index 6—a price-weighted index where the weight of each security is its price per
share divided by the sum of all share prices in the index.
• Index 7—a multiplicative average price index obtained by multiplying the prices
and taking the root corresponding to the number of securities.

A. Identify the index in Exhibit 1 that is most likely equally weighted. Justify your
response.

B. Identify the index in Exhibit 1 that is most likely to provide the greatest
opportunities for arbitrageurs. Justify your response.

C. Identify the equity index that is least likely to be used as the benchmark index for
Fund X. Justify your response.

© 2023 CFA Society Boston 22

QUESTION SET 11
TOPIC: ALTERNATIVE INVESTMENTS
TOTAL POINT VALUE OF THIS QUESTION SET IS 12 POINTS

James Winston and his sister in-law, Grace McGowen, plan to open their own multi-
strategy hedge fund. Winston and McGowen plan to market their first fund to both
institutions and high-net-worth individuals. Winston is an expert in publicly traded
equities and McGowen is an expert in fixed income securities. They meet to discuss
specific strategies that their new fund will pursue.

Winston states he would like to focus on short selling, relative value, and event-driven
strategies. He explains that a merger arbitrage strategy would be a great way to deliver
large returns to investors.

McGowen asks for an example of a recent transaction that could be used to implement
this strategy. Winston provides details of a potential acquisition of Discount Airways
(DA) by City Airline (CA). CA offered to acquire DA in an all-stock deal, offering one
share of CA stock for every three shares of DA. Before the offer became public, DA
stock traded at €13 per share. After the merger announcement, DA stock rose to €15
per share. CA currently trades at €46 per share, which is €3 per share lower than its
price before the offer became public. Winston also mentions that the stock of CA’s
direct competitor Big Airways (BA) gained 12% on its €48 share price when CA’s offer
for DA became public.

Winston wants to exploit the arbitrage opportunity from the offer announcement by
buying 225,000 DA shares at €15 per share and short selling 75,000 shares of CA at
€46 per share.

McGowen points out two possible outcomes of Winston’s merger arbitrage strategy:

Outcome 1: Regulators approve the deal and the stock-for-stock merger is completed
as proposed.

Outcome 2: The acquisition fails to receive approval from regulators and the market
prices revert to the levels observed before the offer was announced.

McGowen wants to pursue a strategy focused on convertible bond arbitrage. She

believes that Winston’s expertise will help implement the investments for this strategy.

McGowen and Winston both want to pursue investments in distressed securities. During
their meeting they state the following:

Statement 1: This strategy will help our new hedge fund achieve consistent returns.

Statement 2: A high interest rate environment will help us implement this strategy.

Parker Gavin, a mutual acquaintance of Winston and McGowen, learns of the new fund
and expresses his interest in alternative investments. He is deciding whether to invest in
a multi-strategy fund or a fund of funds. During Gavin’s conversation with Winston and
McGowen, the following statements are made:
© 2023 CFA Society Boston 23
Statement 3: When deciding between investing in a multi-strategy fund and a fund of
funds, an investor should base their decision solely on the average
performance of all multi-strategy and fund-of-funds managers currently
operating, as reported in published peer group indexes.

Statement 4: Multi-strategy funds are more desirable than fund-of-funds because all of
the investment decision-making is conducted in one office.

A. Calculate the payoff from each of the two possible outcomes of Winston’s
merger arbitrage strategy.

B. Identify two potential implementation issues for the bond arbitrage strategy
McGowen wants to pursue.

C. Determine whether each of Statement 1 and Statement 2 is correct. Justify

each response.

D. Discuss two drawbacks of the performance data Gavin is relying on to decide

between investing in a multi-strategy fund and a fund of funds.
.

END OF SESSION 2

© 2023 CFA Society Boston 24