Last Revised: 08/13/2021

Level III - Section 4

Readings Page

Hedge Fund Strategies 2

Asset Allocation to Alternative Investments 13

Overview of Private Wealth Management 27

Topics in Private Wealth Management 39

Risk Management for Individuals 57

Review 75

This document should be used in conjunction with the corresponding readings in the 2022 Level III CFA® Program
curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2022, CFA Institute. Reproduced and
republished with permission from CFA Institute. All rights reserved.

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OID100851170.

© markmeldrum.com. All rights reserved.

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Hedge Fund Strategies

a. discuss how hedge fund strategies may be classified;

b. discuss investment characteristics, strategy implementation, and role in a

portfolio of equity-related hedge fund strategies;

c. discuss investment characteristics, strategy implementation, and role in a

portfolio of event-driven hedge fund strategies;

d. discuss investment characteristics, strategy implementation, and role in a

portfolio of relative value hedge fund strategies;

e. discuss investment characteristics, strategy implementation, and role in a

portfolio of opportunistic hedge fund strategies;

f. discuss investment characteristics, strategy implementation, and role in a

portfolio of specialist hedge fund strategies;

g. discuss investment characteristics, strategy implementation, and role in a

portfolio of multi-manager hedge fund strategies;

h. describe how factor models may be used to understand hedge fund risk
exposures;

i. evaluate the impact of an allocation to a hedge fund strategy in a traditional

investment portfolio.

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Hedge Fund Strategies

Page 1
- The Investment Thesis: additional alpha + diversification LOS a
benefits - discuss
Common Characteristics
1/ Legal/Regulatory – accredited investors only (min. income/net worth)
- liquid alts. ➞ MF/ETF structures for the more liquid HF
strategies, retail investors
2/ Flexible mandates – Few Investment constraints
3/ Large Investment Universe – traditional assets + private securities, HY debt,
distressed securities, derivatives
4/ Aggressive Investment Style – shorting, concentration, leverage
5/ Liberal use of Leverage – loans and derivatives
6/ Liquidity Constraints – lock-up periods, liquidity gates, exit windows
7/ Relatively high fee structure – mgmt. + incentive fees
1-2% 10-30%

Page 2
➞ Classification/ LOS a
- discuss

single manager funds (i.e. one strategy or style)

Equity - equity market return and risk characteristics
Event-Driven – corporate events (governance, M&A, bankruptcy)
Relative-Value – relative valuation between two or more securities,
exposed to credit & liquidity risk
Opportunistic – top-down approach, multi-asset opportunity set
Specialist - strategies that require specialized skill or knowledge of
a specific market

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➞ Equity Strategies/ Long-Short Equity LOS b
- discuss
- reliance on fundamental
research
- most managers specialize in a
specific geography, sector or style
- some are more generalist
and avoid complex sectors

➞ strategy is a mix of extracting alpha

on long and short side from single-
name stock selection combined with
some net long embedded beta

the less risk factor exposure, the

more leverage risk exposure

Page 4
➞ Equity Strategies/ Dedicated Short/Bias LOS b
- discuss
+ activist short
selling
➞ take a short position then
present research publicly
➞ reputation effect may help

increasing returns when the

market declines, 𝐫𝐟 or decreasing
returns when the market rises
- bottom-up approach (deep-dive)
- difficult to get mgmt. cooperation
- flawed business models, high &
unsustainable debt levels, poor
governance, questionable actg.
etc.

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Page 5
➞ Equity Strategies/ Equity Market Neutral LOS b
- discuss
➞ 𝐄(𝛃𝐏 ) = 𝟎
➞ typically try to be sector and
industry neutral as well
(pairs trading, stub trading, multi-class
➞ more diverse holdings trading)
- adjusted often (daily, hourly)
must balance
neutrality with the costs
of rebalancing
often seen as preferred
replacements for FI during
low return periods or YC is
flat
➞ since 𝛃 = 𝟎, require leverage to
generate meaningful returns

Equity Strategies
Page 6
Short bias L/S
LOS b
Dedicated Market long-only - discuss
Short neutral (100% +)
(60%-120%)
Leverage low high low
Volatility high low high
𝛃 exposure negative neutral positive
Return Correlation negative zero positive
Orientation deep. fund. quantitative fundamental
Valuation approach absolute relative absolute
Position sizing concentrated diverse concentrated

Long/Short ➞ 𝛂 – stock picking, market timing (factor tilts)

➞ return – equivalent to long only
➞ risk – ½ of long only

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Dedicated Short/Short Bias LOS b
𝛂 – stock picking, some market timing - discuss
return – lower than other HFs, but negative correlation
risk – more volatile than typical L/S benefit

Market Neutral
𝛂 – security selection, market timing
return – steadier than other equity hedge strategies
risk – less volatility, but leverage risk creates tail
risk

Page 8
Event-Driven Strategies/ Merger Arbitrage LOS c
- discuss
- soft-catalyst ED approach
- trade in anticipation of an
event
- hard-catalyst ED approach - trade
in reaction to an event
(less volatile/risky)
- cash-for-stock deal, buy target
stock
- Stock-for-stock deal, buy T and sell
A in same ratio as the offer
(contrarian approach - sell T, buy A)
uncorrelated source of alpha
- trades typically done using common
stock, but may include preferred,
or junior/senior debt

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Event-Driven Strategies/ Distressed Securities LOS c
- in bankruptcy, potential bankruptcy, - discuss
or financial distress

may take several years

to resolve

➞ long lock-up periods

➞ liquidation - assets are

sold and paid out
based on capital structure
priority
best context for
or/ reorganization
reorganization
(capital structure arb.)
i.e. buy senior debt
may be
sell junior debt
a fulcrum
or equity
security

Event-Driven Strategies
Page 10
Merger Arbitrage: LOS c
𝛂 – specific deal selection - discuss
return – 7 - 12% range, low correlation to market return
risk – low, single digit s.d.
- market sensitivity in times of market stress
∴ left-tail risk
Distressed Securities
𝛂 – deal selection, capital structure decisions
return – higher end of event-driven strategies
risk – higher volatility than other event-driven strategies

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Page 11
Relative Value Strategies/ Fixed-Income Arbitrage LOS d
- discuss

- valuation differences
between securities due to
credit quality, and/or implied
volatility spreads

- pricing inefficiencies are

quite small, but high
correlations between securities
∴ high levels of
leverage

Page 12
Relative Value Strategies/ Convertible Bond Arbitrage LOS d
- discuss

➞ embedded option trades at

relatively low implied vol.
levels compared to the
underlying - makes the call
cheap
- must accept or hedge away
interest rate, credit and
market risk
- if realized equity vol. is
greater than the IV of
the convertible’s option - overall
gain is achieved

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Opportunistic Strategies
Page 13
- wide range of markets and securities LOS e
- discuss
region and asset-class level (vs. individual securities)
- broad themes, global relationships, market trends, cycles
- generally divided by:
technical fundamental
relies on mgr. skill, subject
discretionary to behavioral biases
rules-based algorithms, may
systematic fail in new contexts
(subject to herding effects)
use statistical methods use economic data and focus
to predict relative price on fair valuation of securities,
movements based on past sectors, markets
price trends

Page 14
➞ Global Macro ➞ wide range of asset classes LOS e
➞ focus on themes or regions - discuss
➞ top-down, typically fundamental

- tend to be anticipatory, often contrarian, but some follow momentum

- fairly heterogeneous as a group
∴ not as consistent a source of alpha compared
to systematic, trend-following managed futures
- common theme ➞ use of leverage (6 - 7x)
- mean-reverting, low volatility markets offer few opportunities
𝛂 – correctly discerning and capitalizing on trends in global markets
return – produce lumpier and more uneven return streams than other
hedge fund strategies
risk – higher levels of volatility

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Page 15
➞ Managed Futures LOS e
uncorrelated with stocks and bonds - discuss
returns tend to be positively skewed
- since funds only acquire asset exposure (not assets), the
majority of capital (85% - 90%) is invested in short-term
government debt
- tend more towards systematic trading with a quantitative
driven approach to trend identification

① TSM – time series momentum trend following

(long assets that are rising in price, short
assets that are falling in price)
② CSM – cross-sectional momentum
- same as TSM, but a group of long
positions against a group of short positions

Page 16
Opportunistic Strategies/ Global Macro LOS e
Managed Futures - discuss

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Page 17
Specialist Strategies/ Volatility Trading LOS f
- discuss

Relative Value
volatility arbitrage
- buy cheap vol. and
sell more expensive vol.
Long/Short vol.
- VIX futures
- options
- swaps
(watch term structure
of vol., skew & smile)

Specialist Strategies Page 18

LOS f
- Reinsurance/Life Settlement: - discuss

catastrophe rather than policyholders surrendering their

insurance policies to the insurer when no longer wanted,
uncorrelated they often realize more by selling the policy
with other to a fund
asset classes - fund continues to pay the premiums, collects
payout upon death
catastrophe bonds
catastrophe risk futures uncorrelated with other HF strategies
and with other asset classes

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Page 19
Multi-Manager Strategies/ FoF, Multi-Strategy HF
LOS g
- discuss
FoF ➞ fees
fees

fund 1 … … … fund n
FoF manager allocates to
uncorrelated strategies
- more diversification
- less extreme risk exposure
- lower realized volatility
fees
Multi-strategy

strategy 1 … … … strategy n

fee netting at fund level

Hedge Fund Strategies

Page 20
Conditional Factor Risk Model LOS h, i
One factor ➞ CAPM dummy variable = 1 in - describe
&𝐑 𝐇𝐅𝐢 (𝐭 = 𝛂𝐢 + 𝛃𝐢 (𝐄𝐑𝐏)𝐭 + 𝐃𝐭 𝛃𝐢 (𝐄𝐑𝐏)𝐭 period 𝐭 - evaluate

factor risk model conditional

Multi-factor: exposure to 𝐅𝟏 for 𝐇𝐅𝐢 in period 𝐭 (normal times)

&𝐑 𝐇𝐅𝐢 (𝐭 = 𝛂𝐢 + 𝛃𝐢,𝟏 (𝐅𝟏 )𝐭 + 𝛃𝐢,𝟐 (𝐅𝟐 )𝐭 + ⋯ + 𝛃𝐢,𝐤 (𝐅𝐤 )𝐭

+ 𝐃𝐭 𝛃𝐢,𝟏 (𝐅𝟏 )𝐭 + 𝐃𝐭 𝛃𝐢,𝟐 (𝐅𝟐 )𝐭 + ⋯ + 𝐃𝐭 𝛃𝐢,𝐤 (𝐅𝐤 )𝐭

+ (𝐞𝐫𝐫𝐨𝐫)𝐢,𝐭 incremental exposure to 𝐅𝐤 for 𝐇𝐅𝐢
in period 𝐭 (financial crisis period)

factors: SNP500 - monthly return to index USD - monthly return on USD index
CREDIT - (Baa - Aaa) bond yields VIX - (𝐕𝐈𝐗 𝐭 − 𝐕𝐈𝐗 𝐭$𝟏 )𝐄𝐎𝐌

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Asset Allocation to Alternative Investments

a. explain the roles that alternative investments play in multi-asset portfolios;

b. compare alternative investments and bonds as risk mitigators in relation to a

long equity position;

c. compare traditional and risk-based approaches to defining the investment

opportunity set, including alternative investments;

d. discuss investment considerations that are important in allocating to different

types of alternative investments;

e. discuss suitability considerations in allocating to alternative investments;

f. discuss approaches to asset allocation to alternative investments;

g. discuss the importance of liquidity planning in allocating to alternative

investments;

h. discuss considerations in monitoring alternative investment programs.

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Asset Allocation to Alternative Investments

LOS a
➝ Roles in a multi-asset portfolio/ -explain
Pg-1
AI - private equity, hedge funds, real assets, commercial real estate,
commodities private credit

- common functional roles:

1/ Capital growth (CG) ➝ long-term horizon, relatively high return target
2/ Income generation (I)
3/ Risk diversification (RD)
4/ Safety (S)
A/ Role of Private Equity ➝ CG, I
- generally a return enhancer ➝ return premium over public
equities due to illiquidity risk
- limited diversification benefits vs public equity
- volatility not directly observable ➝ true picture of risk not
captured by indexes

➝ Roles in a multi-asset portfolio/ LOS a

B/ Role of Hedge Funds ➝ RD to return enhancer (CG) -explain
↙ ↘ Pg-2
Short bias arbitrage long/short equity global
event-driven macro managed futures

low, no or negative higher volatilities or higher

correlations w/ eq. correlations w/ eq.

C/ Role of Real Assets - physical asset with high degree of correlation

with inflation
i) Timber ➝ CG, I, RD ➝ inflation hedging
land trees
ii) Commodities ➝ RD - hedge against inflation (core) as well as a
differentiated source of alpha
iii) Farmland ➝ CG, I, RD ➝ inflation hedging
land crops, rent

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➝ Roles in a multi-asset portfolio/ LOS a

-explain
C/ Role of Real Assets
Pg-3
iv) Energy investments ➝ RD ➝ inflation hedging
v) Infrastructure ➝ CG, RD, I
- illiquid, ∴ very long holding periods (20 yrs. or more)
- stable/modest growing income
- high correlation with overall inflation
D/ Role of Commercial Real Estate ➝ CG, I, RD
- provides protection against unanticipated increases in inflation
-rents, property value
(I) (CG)
E/ Role of Private Credit ➝ I ➝ direct lending (no secondary market)
➝ CG ➝ distressed investing

➝ Diversifying Equity Risk/ LOS b

- notion of risk is related to time horizon -compare
Pg-4
- short-term ➝ volatility
- long-term ➝ underperformance (not meeting LT return targets)
➝ Volatility reduction over a short time horizon
- technical challenge ➝ reported return for many AI classes are
calculated from appraisal-based valuations
- typically result in volatility and correlation estimates that are
too low
- need an adjustment called ‘unsmoothing’
- most AI categories have positive but less than perfect correlations
with equities
- versus bonds with negative correlations (but inflation risk remains)
(Exhibit #6/7)

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LOS b
➝ Diversifying Equity Risk/ -compare
• Risk of not meeting investment goals over a long-time horizon Pg-5
- Bonds may reduce volatility but come at the cost of lower returns
- Over long time periods, may not be able to meet return targets
(Example #1)
➝ Investment Opportunity Set/
• Traditional Approach ➝ the usual ➝ growth, income, safety, LOS c
diversification -compare
also: 1/ Liquidity – Exhibit #10
2/ Expected Performance under distinct macroeconomic regimes
- e.g. high/low growth
vs.
inflation expectations (Exhibit #11)

➝ Investment Opportunity Set/ LOS c

-compare
2/ Risk-Based Approaches ➝ exposure to risk factors
Pg-6
(equity market risk, size, value, liquidity, duration, inflation,
credit spread, currency, etc….) (Exhibit #14)
Traditional approach/ strengths
• easy to communicate ➝ familiarity
• relevance for liquidity management and operational considerations

IPS constraint • Implementation

• Investment manager
identification and allocation
Limitations/
• over-estimation of portfolio diversification

risk diversification vs. asset class diversification

• obscured primary drivers of risk
- grouping distinct investments in the same asset class category
(IG and HY both as Fixed Income)

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LOS c
➝ Investment Opportunity Set/ -compare
• risk-based approach/ strengths Pg-7
• common risk factor identification
• integrated risk framework (more reliable risk quantification)
• limitations
• sensitivity to the historical look-back period
- sensitivities calculated with regression
• implementation hurdles
- converting risk factor targets to actual investment
mandates ➝ manager selection, rebalancing

➝ Investment Considerations/ LOS d

-discuss
1/ Risk Considerations – s.d. is a poor representation of the risk
Pg-8
characteristics of AI
(illiquidity, subjective valuations, chunky/non-normal return distributions)
- allocation may fully invest only over time (vs. immediately with
traditional inv.)
∴ actual allocation may not mirror the modelled allocation used to
arrive at the SAA
2/ Return expectations - lack of historical record will produce a
much more variable long-term trend (i.e. wider confidence
intervals for any estimate of E(R))
- rather than asset class history, can look at risk factor history
- build an E(R) based on 𝐑 𝐟 + risk premiums

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➝ Investment Considerations/ LOS d

-discuss
3/ Investment Vehicle
Pg-9
a) Direct investment in a limited partnership - requires scale
and expertise!
scale ➝ mgr. and strategy diversification
expertise ➝ mgr. selection/evaluation
b) Fund-of-funds– get diversification and operational efficiency
- due diligence expertise as well
- suitable for smaller funds
But/added mgmt. fees and lack of flexibility to
customize exposures

c) SMA/Fund-of-one - very high minimum investments

- greater operational challenges for both manager
and investor
- may be disadvantage if GP has other funds with higher fees
competing for the same limited investment opportunity

LOS d
➝ Investment Considerations/ -discuss
3/ Investment Vehicle VCITS Pg-10
d) Mutual funds/VCITS/publicly traded funds • Undertakings
- allow smaller investors access for collective
investments in
- often operate with regulatory restrictions that
transferable
limit investment strategies securities
(watered down or strategically incomplete version of sponsor’s
primary investment vehicle)
4/ Liquidity
a) liquidity risks ➝ Investment Vehicle - most common vehicle is
the limited partnership
Hedge funds: Subscription - accept capital monthly or quarterly
Redemption - quarterly or annual, 30-90 days’ notice
- maybe gates ➝ limits on fund or investor
assets redeemed

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➝ Investment Considerations/ LOS d

4/ Liquidity -discuss
Pg-11
a) Liquidity risks ➝ Investment Vehicle
Hedge funds: Lock-up - typically 1 yr. US (shorter Europe)
- redemption prior permitted but penalized (10%)
Private Equity: Subscription - multiple closes
- committed capital called over 3-yr period
- not just capital out, but capital in requires liquidity
planning
- capital calls may fall short of committed capital
Redemption - no redemption provisions
- interest may be sold on secondary market with
GP approval (sig. discounts to NAV)
- distributions over the life of the fund
Lock-up – typically 10-year life, option to extend 1-2 yrs.

LOS d
➝ Investment Considerations/
-discuss
4/ Liquidity Pg-12
a) Liquidity risks ➝ Underlying investments
• Holdings may be liquid with liquid strategy ➝ managed futures
• Holdings may be liquid with illiquid strategy ➝ distressed,
event-driven, some equity
• Holding may be illiquid - relative value
- leverage can de-liquify a liquid portfolio during drawdowns
- margin calls usually met by selling in order of liquidity
5/ Fees/Expenses - mgmt. + incentive fees
- fees on committed versus called capital
- extra pass-through fees

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➝ Investment Considerations/ LOS d

6/ Tax considerations – must consider the tax efficiency of -discuss
Pg-13
the strategy ➝ may be a tax strategy misalignment
- investor has no control over timing of taxable events
(e.g. Short-term gains)
7/ Other considerations ➝ outsource or in-house expertise?
- function of size and access to expertise LOS e
Investment Horizon real estate -discuss
• < 15-year investment horizon ➝ avoid private real assets
- take 5-7 years to capitalize/develop equity
- another 10-12 years to unwind
- public equity HF, managed futures ➝ 3 mos. -1 yr. lockups only

LOS e
Expertise – need to understand the risks & complexity of strategies
-discuss
Governance – investors without a strong governance program are Pg-14
less likely to develop a successful alt. Inv. program
Transparency - must be comfortable with less than 100% transparency
- real estate, private equity, real assets ➝ investor is buying
into as-of-yet-unidentified assets
- reporting for AI fund generally less transparent
- no legal requirements mandating frequency, timing or details of
reporting

➝ Asset Allocation Approaches/ LOS f

➝ Including AI – 3 primary approaches -discuss
Pg-15
1/ Monte Carlo Simulation – may be used to:
a) generate return scenarios that deviate from normality
- returns now ready for MCVaR optimization
b) estimate long-term risk profile & return potential of an MVO
allocation
2/ Optimization techniques – MVO will typically over allocate to AI due
to underestimation of risk (stale or infrequent pricing)
or assumption of normality of returns
∴ can a) establish limits on AI allocations
b) use optimization methods that incorporate downside
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➝ Asset Allocation Approaches/ LOS f

3/ Risk-factor based approaches -discuss
- but first ➝ issues with AI Asset Returns/ Pg-16
1/ Stale pricing and unsmoothing ➝ due to appraisal-based valuations
- gives the illusion of lower volatility
Common in private real estate
- detect smoothing by testing for SC
and private equity
(serial correlation)
- higher the SC, larger the difference between
smoothed vs. unsmoothed volatility
- one method: 𝐫𝐭 − 𝐬𝐫𝐭+𝟏 r = return
𝟏−𝐬 s = serial correlation measure
e.g./ HY Credit .34
US equities .03 HF Distressed .36
Broad Fixed Income .02 Private Real Estate .85
HF Macro .08 Private Equity .38

➝ Asset Allocation Approaches/ LOS f

-discuss
2/ Skewness and Fat Tails – skewness and kurtosis lead to
Pg-17
underestimated downside risk measures
- non-normality more severe in private AI and some HF return series
- pos. skew ➝ smaller downside risk
- neg. skew, excess kurtosis ➝ both have longer downside risk
(vs. normal assumption)
- leads to actual CVaR estimates > normal dist. - based CVaR
estimates
So: if SC Significant ➝ unsmooth
• if return series normal ➝ MVO
else MCVaR optimization

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➝ Asset Allocation Approaches/ LOS f

1/ Monte Carlo Simulation – 2 applications -discuss
a) simulate risk factor or asset returns that exhibit skew Pg-18

and kurtosis – use a regime switching model

𝐫𝐄 ∼ (𝐍|𝐬𝐭𝐚𝐭𝐞 𝟏) ➝ low vol. state w/ P(E)
𝐫𝐑 ∼ (𝐍|𝐬𝐭𝐚𝐭𝐞 𝟐) ➝ high vol. state w/ P(R)
but 𝐄(𝐑 𝐄.𝐑 ) is not ∼ N
b) simulate risk and return analytics over a long-time horizon
based on a MVO or MCVaR opt. allocation
- requires an SAA and asset class expected returns

critically important
- simulate outcomes to capture the probability of not meeting long-term
return targets

➝ Asset Allocation Approaches/ LOS f

2/ Portfolio Optimization -discuss
a) MVO with/without constraints Pg-19

- unconstrained MVO tends to over allocate to AI given

higher E(R) and understated vol.
- can impose min. and max. allocation constraints to compensate
- leads to constrained portfolios that appear inefficient
b) Mean - CVaR optimization
- when concern is about downside risk of a proposed SAA, risk
objective may be to minimize CVaR rather than volatility for a given
return target
- if portfolio contains asset classes/investment strategies
with neg skew/pos K., CVaR min can have significant effect
on optimal SAA (Example # 6)

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➝ Asset Allocation Approaches/ LOS f

3/ Risk Factor-based optimization -discuss
- factors may be defined differently among investors Pg-20

- correlations among risk factors may dramatically shift

under changing market conditions
- some factor sensitivities are stable, others are not
➝ Liquidity Planning/ - focus is on multi-year liquidity LOS g
planning for private investments -discuss
Issue #1 ➝ how to achieve and maintain the desired allocation
- key challenge
- use of a liquidity forecasting model
- capital is called over a number of years (raises allocation)
- NAV of investment grows as well (raises allocation)
- distributions occur in mid-later yrs. (lowers allocation)

➝ Liquidity Planning/ LOS g

Issue #1 ➝ how to achieve and maintain the desired allocation -discuss
Pg-21
simple model
C - capital contribution
𝐂𝐭 = 𝐑𝐂𝐭 × (𝐂𝐂 − 𝐏𝐈𝐂𝐭 ) RC - Rate of contribution
𝐃𝐭 = 𝐑𝐃𝐭 [ 𝐍𝐀𝐕𝐭$𝟏 × ( 𝟏 + 𝐆)]
CC - committed capital
Example 𝐍𝐀𝐕𝐭 = [𝐍𝐀𝐕𝐭$𝟏 × ( 𝟏 + 𝐆)] + 𝐂𝐭 − 𝐃𝐭
#8 PIC - paid-in-capital
full allocation D - Distributions
RD - rate of distributions
C + G - D G - D G - growth rate of PE fund
Challenge: (assume 20%
building
to a full allocation
diminishing allocation target)
allocation
- getting to and maintaining
target allocation of 20%
AUM

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➝ Liquidity Planning/ LOS g

Issue #1 ➝ how to achieve and maintain the desired allocation -discuss
Pg-22
example: $1B fund, 20% PE allocation, G = 6%
- based on C, G, & D ➝ $100M committed capital will
be $110M NAV in 5 years
∴ target allocation of 20% in 5 year
𝑨𝑼𝑴𝟓 = 𝟏𝑩 × (𝟏. 𝟎𝟔)𝟓 = 𝟏. 𝟑𝟑𝟖 𝑩
20% of 𝑨𝑼𝑴𝟓 = 𝟐𝟔𝟕. 𝟔 𝑴
- if 100M commitment = 110M NAV in 5 years ➝ ratio of
𝐍𝐀𝐕 𝟏𝟏𝟎
= = 𝟏. 𝟏
𝐂𝐨𝐦𝐦𝐢𝐭𝐭𝐦𝐞𝐧𝐭 𝟏𝟎𝟎
𝟐𝟔𝟕.𝟔 𝐌
∴ target commitment = = 𝟐𝟒𝟑. 𝟑𝐌
𝟏.𝟏

➝ Liquidity Planning/ LOS g

Issue #1 ➝ how to achieve and maintain the desired allocation -discuss
➝ 243M Capital Commitment ➝ 20% allocation in 5 years Pg-23

but/ results in a concentrated PE investment in one vintage yr.

➝ after allocation reached, NAV begins to drop (D > G)
but AUM continues to grow
- 20% allocation drops quickly
- better allocation ➝ over 4 years (multi-year commitment schedule)
➝ diversified over 4 funds (4 vintage years)
➝ as fund 1 reaches full capital and D > G, drop in
NAV offset by increases in fund 2, 3, 4
➝ as fund 1 drops off, bring on fund 5
➝ laddered investment strategy
- leads to a more stable NAV over time

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➝ Liquidity Planning/ LOS g

Issue #2 - managing the capital calls -discuss
Pg-24
- not practical to keep the committed but not yet
called capital in liquid reserves
- often invested in public equities (as a proxy for private equity)
Issue #3 – preparing for the unexpected
- assumptions of RC and RD may be wrong
- capital calls may be faster in bear markets, distributions
may be slower
- GP may extend life of fund if public markets are performing poorly
➝ investor’s portfolio may be dropping resulting in an
over allocation to PE

➝ Monitoring/ LOS h
1/ Investment Program -discuss
- specific goals are associated with any investment in AI Pg-25

- investment program should be monitored relative to

those goals (CG, RD, I, S)
➝ AI program likely to take several years to reach fully invested status
- during this time, should monitor relevant markets
to ensure investment thesis is still intact
- gives time to adjust course if CG, I, RD or S appear less likely
or/ investor goals, objectives or circumstances may change
2/ Performance Evaluation
a) proper benchmarking is a challenge
• custom index proxies – unlikely to match realized risk, return,
and liquidity characteristics of actual PE program

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LOS h
➝ Monitoring/
-discuss
2/ Performance Evaluation Pg-26
a) proper benchmarking is a challenge
• peer group - varying benchmark definitions, high level
of idiosyncratic risk across funds
b) timing/nature of reported returns
- illiquid ➝ use IRR ➝ sensitive to the timing of cash flows
FVAI + D
➝ if funds are returned more quickly ➝ may want
IC
to use MOIC (multiple on invested capital)
- strong/weak performance may be due to a strong/weak economy
3/ The firm and the Investment Process
a) key person risk – departure may negatively affect the
investment process
b) alignment of interests - money manager’s interests should
remain aligned with investors

➝ Monitoring/ LOS h
3/ The firm and the Investment Process -discuss
Pg-27
c) is there style drift
d) is the fund abiding by risk management processes
e) client/asset turnover – a significant gain or drop in
either could be a sign of an underlying problem
f) client profile – long-term investors or likely to redeem at
first sign of stress
g) service providers – independent 3rd party administrators,
custodians, and auditors

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Overview of Private Wealth Management

a. contrast private client and institutional client investment concerns;

b. discuss information needed in advising private clients;

c. identify tax considerations affecting a private client’s investments;

d. identify and formulate client goals based on client information;

e. evaluate a private client’s risk tolerance;

f. describe technical and soft skills needed in advising private clients;

g. evaluate capital sufficiency in relation to client goals;

h. discuss the principles of retirement planning;

i. discuss the parts of an investment policy statement (IPS) for a private client;

j. prepare the investment objectives sections of an IPS for a private client;

k. evaluate and recommend improvements to an IPS for a private client;

l. recommend and justify portfolio allocations and investments for a private

client;

m. describe effective practices in portfolio reporting and review;

n. evaluate the success of an investment program for a private client;

o. discuss ethical and compliance considerations in advising private clients;

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

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Overview of Private Wealth Management

LOS a
⇒ Private client investment concerns/ -contrast
1/ Investment objectives - Financial security during retirement Pg-1

- Provide financial support to family members

- Philanthropic goals

- May not be clearly defined or quantified

- May compete with one another
- Change over time
Vs. institutional clients/
- More clearly defined objectives (typically related to a spending
or liability stream)
- Unlikely to change materially over time

2/ Constraints
• Time horizon: → Shorter horizon – lower risk tolerance, higher
liquidity requirements
→ Different horizons for different objectives
Inst. Inv. → long horizon, single stage, single investment objective

LOS a
⇒ Private client investment concerns/
-contrast
2/ Constraints Pg-2
• Scale → portfolios are smaller in size – limitations with
respect to certain asset classes
• Taxes → many institutional portfolios may be wholly
tax-exempt, individuals are not

3/ Other Distinctions
• Investment governance – no formal governance structure
• Investment sophistication – more vulnerable to emotional
or biased investment decisions
• Regulation – regulatory environment may be different for
individual and inst. inv. (i.e. different regulators)
or/ same regulator but different regulations
• Uniqueness & complexity – private clients with similar sets of
financial considerations and objectives may pursue different
investment strategies (less likely w/ Inst. Inv.) OID100851170.

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LOS b
⇒ Understanding private clients/ – information needed -contrast
a) Personal info: - Family situation – marital status Pg-3
- children/grandchildren, ages/plans
- proof of client identification
- Employment/career – future career/business/retirement
aspirations
- Source of client’s wealth
- Explicit return objectives – minimum absolute or
relative return targets?
- meet specific goals?
- Investment preferences – liquidity, ESG
- Financial objectives (goals) and risk tolerance
b) Financial info: - Assets, liabilities and cash flows
- Projection of expenses, planned disbursements
c) Other relevant info: Wills, trust documents, life & disability insurance
- Decision-making parameters (i.e. who can approve or
change IPS, approve trades, etc…)
- Service needs and expectations

LOS b
-contrast
⇒ Understanding private clients/ – information needed
LOS c
d) Tax considerations/ - Cap. gains -identify
• Common tax categories - Taxes on income - Div., int., income Pg-4
- Wealth-based taxes → property, gifts
- Consumption/spending taxes
• Basic tax strategies - Tax avoidance → tax free accounts
→ tax free gifts
- Tax reduction – tax efficient strategies
(i.e. tax-exempt bonds, low turnover funds)
- Tax deferral → defer gains, retirement
accounts

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LOS d
⇒ Client goals/ -identify
• Planned goals – can be reasonably estimated or -formulate
quantified within an expected time horizon Pg-5

e.g.
• retirement
• specific purchases
• education – for children
• family events – weddings
• wealth transfer – lifetime or estate
• philanthropy

Unplanned goals/ unforeseen financial needs (more challenging to

estimate amount & timing)
e.g. - property repairs - medical expenses - others (funeral, elder care)

→ Wealth Manager’s Role:

• Goal quantification
• Goal prioritization (what is more important, critical)
• Goal changes (Example #3)

LOS e
-evaluate
⇒ Risk Tolerance
Pg-6
describes a set of risk-related concepts
• Risk tolerance - Level or risk an individual is willing and able
to bear
- Opposite of risk aversion (high RA = lower RT)
• Risk capacity - Ability to accept financial risk
- Determined by wealth, income, investment time
horizon, liquidity needs
- Clients with greater risk capacity can tolerate greater
financial losses without compromising goals
• Risk perception - The subjective assessment of the risk
involved in the outcome of an investment decision
(use of risk tolerance questionnaires, conversations with client)
→ Risk tolerance may also vary for different goals
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⇒ Technical skills/ Specialized knowledge and expertise LOS f

necessary to provide investment advice -describe
Pg-7
- Some jurisdictions regulate minimum qualifications
e.g.
• Capital market proficiency - Generalist understanding of
markets and asset classes
• Portfolio construction ability - That are appropriate for each client
- Understanding of each asset class risks/returns,
correlations, investment vehicles, managers, strategies, etc.
• Financial planning knowledge - Working knowledge of estate law,
taxation and insurance
• Quantitative skills
• Technology skills - Portfolio optimization software, simulation tools,
PM software, etc.
• Language fluency

LOS f
⇒ Soft skills – the ability to effectively interact with others
-describe
• Communication skills - Active listening, effective verbal Pg-8
& written communication skills, presentation skills
• Social skills - Ability to understand & relate to others
- Empathy
• Education and coaching skills
• Business development and sales skills

⇒ Capital sufficiency analysis/ (capital needs analysis) LOS g

-evaluate
- Process to determine if a client has, or is likely
Pg-9
to accumulate, sufficient financial resources to meet objectives
Methods/
1/ Deterministic forecasting – straight-line manner Requires return
Simple but e.g. 6% compounded return for 15 years
assumption, PVp,
unrealistic 𝑷𝑽𝒑 (𝟏. 𝟎𝟔)𝟏𝟓 = 𝑭𝑽 anticipated future
contributions/withdrawals
2/ Monte Caro simulation – allows for the uncertainty of key variables
- Use simple average return + s.d. of year-to-year returns

Taken from this distribution each year

- Inputs may also require assets class assumptions
plus taxes, inflation, mgmt. fees avg. ret., s.d., correlations
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LOS g
⇒ Capital sufficiency analysis/ (capital needs analysis)
-evaluate
2/ Monte Caro simulation Pg-10

1. 75% of the portfolios

3.
had a FV > $765,821

2. Number of portfolios
in which FV > 0
1.
3. 5% of the portfolios
had a FV > $3,651,264
2.

When capital will not be sufficient to meet goals/objectives:

(Example #5)
1/ Contributions must increase
2/ Goals must become more modest
3/ Goals must be delayed
4/ Higher expected returns (within risk tolerance) must be pursued

LOS h
⇒ Retirement Planning/ -discuss
• Retirement Stage of Life Pg-11

Convert human capital to financial capital, accumulate other

benefits, reduce financial liabilities

Education Early Career Peak Pre- Early Late

Career Development Accumulation Ret. Ret. Ret.

Developing Begin to Retirement planning takes Begin to draw from -Reduce

human accumulate on greater importance financial resources expenses
capital assets for and other incomes -Health
retirement (e.g. pensions) issues

Determine sustainable rate of

distribution from inv. portfolio

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LOS h
⇒ Retirement Planning/ -discuss
• Analyzing retirement goals → 3 common methods Pg-12
1/ Mortality tables → indicates life expectancies at specified ages
e.g.

Plan YR Client age Life Survival Spending Prob. × Sp.

Expectancy Probability PV/ 5%
0 72 12 100% 50k 50k 47.61k
1 73 11.4 97% 51.5k 49.96k 45.31k
2 74 10.8 93% 53.045k 49.33k 42.613k
3 75 10.2 90% 54.64k 49.176k 40.45k

20 92 3.3 14% 87.675k 12.28k 4.63k

(+3%/annum) ΣPV
2/ Annuities → Provide a series of fixed payments (may be for life or
in exchange for a lump sum payment
for a specified period
• Immediate annuity → begins right away
of time)
• Deferred annuity → begins at some later date
3/ Monte Carlo simulation - Uses actual portfolio to estimate retirement needs
- Produces a prob. of reaching a goal, but not a
shortfall measure

LOS h
⇒ Retirement Planning/ -discuss
• Behavioral Considerations Pg-13
a) Heightened loss aversion → As clients age
→ Implications for asset classes used, weights,
return assumptions
b) Consumption gaps - Retirees spend less than expected
c) The annuity puzzle - Individuals tend not to prefer annuities
d) Preference for investment income over capital appreciation

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LOS i
⇒ IPS/ written planning document – objectives and risk -discuss
tolerance over a relevant time horizon (+ constraints) Pg-14
+/
• Encourages investment discipline
• Reinforces client’s commitment to follow the strategy
• Focuses on long-term goals
• Evidence of a client-focused inv. mgmt. process

Parts of the IPS/ philanthropy

1. Background and investment objectives - ongoing retirement funding
- one-time
family needs
Detailed and quantified
second home
whenever possible
- Also details of any cash flows → further contributions
→ required liquidity events
- Where there are multiple objectives, which is/are primary
SAA + CME + Inv. obj. → capital sufficiency analysis → are the objectives
supported?

LOS i
Parts of the IPS/
-discuss
1. Background and investment objectives Pg-15
- MVp + relevant accounts (taxable, tax-exempt)
- Any other investment assets outside the portfolio + any
cash flows from external sources
2. Investment parameters
a) Risk tolerance - ability + willingness (+process used for assessment)
b) Investment Time Horizon → range i.e. long → > 15yrs
short → < 10yrs
- multiple goals may have multiple time horizons
c) Asset classes used
d) Other investment preferences - i.e. ESG, legacy holdings, non-advised
holdings
e) Liquidity preferences - Cash reserves, pending liquidity needs
f) Constraints - Restrictions on investments and strategies

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Parts of the IPS/ LOS i

-discuss
3. Portfolio asset allocation
Pg-16
- Target allocation for each asset class
- SAA → target + upper/lower bounds (for rebalancing)
- TAA → asset class target ranges
4. Portfolio Management
a) Discretionary authority - Ability of manager to act without
client approval
b) Rebalancing - Methodology & frequency of reviews
time-based or threshold-based
c) Tactical changes - If allowed, when and to what degree
d) Implementation - Types of investment vehicles (MF, ETFs,
- Use of outside managers proprietary
investments)

LOS i
Parts of the IPS/
-discuss
5. Duties and responsibilities: Pg-17
a) Wealth manager responsibilities
- Developing the SAA, investment recommendations, monitoring,
rebalancing, cost management, the use of derivatives and leverage,
drafting/maintaining the IPS, performance reporting, voting proxies
- Perhaps 3rd party responsibilities (e.g. custodian)

b) IPS Review – how frequently

6. IPS Appendix
a) Modelled portfolio behavior E(Rp)
b) Capital market expectations

MVp
Range of
possible outcomes
-

5yrs 10yrs 20yrs

(Exhibit #5)
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LOS l
⇒ Portfolio allocations & investments/ -recommend
→ Portfolio construction/ -justify
a) Traditional approach → Identify asset classes Pg-18

→ Develop CMEs (E(r), s.d., corrx,y)

→ Determine portfolio allocation (typically MVO)
→ Asset constraints active or passive
→ Implement the portfolio manager selection
security type
→ Determine asset location factor focus

(tax exempt, taxable, tax deferred)

b) Goals-based investing approach
determine - Same process as above but:
portfolio - Align investments with goals (assign investments to goals)
allocations - Preform MVO for each sub-portfolio
- Goals stated as max volatility or min. probability of success
(Example #10, 11)

LOS m
⇒ Portfolio reporting and review/
-describe
1/ Reporting → Asset allocation report Pg-19
→ Performance summary by asset class
→ Detailed performance by individual securities (perhaps)
→ Historical performance (since inception)
→ Contributions/withdrawals
→ Purchases/sales
→ Currency exposure
- Wealth manager may add economic/market commentary letter
- If goals-based investing is used → reporting may focus on progress
towards the goals (vs. performance of asset classes/securities)
→ Benchmark reports → performance by asset class relative to the benchmark

2/ Review - Actual meeting with client → review the investment plan, ask
about changes in investment objectives, risk tolerance, time
horizon, circumstances, comparisons of asset allocation vs. target

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LOS n
⇒ Evaluating success/ -evaluate
1. Goal achievement - do not ask if investment strategy Pg-20
succeeded during last period, but whether it is likely
to succeed in meeting client goals without requiring
meaningful adjustments

2. Process consistency - has the plan been followed with respect to

3rd party managers, rebalancing, tax considerations, unique
circumstances, tactical allocations

3. Portfolio performance - absolute and relative risk & return

- downside risk consistent with risk tolerance

4. Definitions of success - manager and client should have the same

definition of what success looks like

LOS o
-discuss
⇒ Ethical consideration/
Pg-21
1. Fiduciary Duty & suitability → given client circumstances

- Obligation to deliver a high

standard of care when acting for
the benefit of another party

2. Know your client (KYC) – obtain essential facts about every client
for whom they open and maintain an account

3. Confidentiality

4. Conflicts of interest - Investment product commissions

- Fees based on activity or AUM

⇒ Compliance considerations/
- Regulatory requirements for dealing with clients
- Varies by jurisdiction

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LOS p
-discuss
⇒ Private Client Segments/ Pg-22
a) Mass affluent → Financial planning, risk management, retirement planning
→ Non-customized solutions
- High client/manager ratio
- Commissions structure to fee-based
- Can be discretionary or not

b) High net worth segment → Lower client-to-manager ratio

- Customized investment management, tax planning,
wealth transfer issues
- Less liquid investments (due to higher wealth), more
sophisticated portfolios, requirement for stronger
product knowledge

c) Ultra-high net worth segment ( >50M)

- Multi-generational time horizons, highly complex tax
and estate-planning considerations
- Few clients/ manager

LOS p
⇒ Private Client Segments/ -discuss
c) Ultra-high net worth segment Pg-23

- Other services → bill payment, travel planning, advice on

acquiring assets such as artwork, wine, etc.
- Typically, multiple family members – family governance issues
- Services usually takes a team approach
- Even may involve a ‘family office’ – dedicated advisors

d) Robo-advisors - Primarily digital client interface/experience

- Gathers info, uses MVO to recommend portfolio
allocation, implements w/ MFs & ETFs
- Will also monitor and rebalance as needed
- Provide regular reporting

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Topics in Private Wealth Management

a. compare taxation of income, wealth, and wealth transfers;

b. describe global considerations of jurisdiction that are relevant to taxation;

c. discuss and analyze the tax efficiency of investments;

d. analyze the impact of taxes on capital accumulation and decumulation in

taxable, tax-exempt, and tax-deferred accounts;

e. explain portfolio tax management strategies and their application;

f. discuss risk and tax objectives in managing concentrated single-asset

positions;

g. describe strategies for managing concentrated positions in public equities;

h. describe strategies for managing concentrated positions in privately owned

businesses and real estate;

i. discuss objectives - tax and non-tax - in planning the transfer of wealth;

j. discuss strategies for achieving estate, bequest, and lifetime gift objectives in
common law and civil law regimes;

k. describe considerations related to managing wealth across multiple

generations.

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Topics in Private Wealth Management

LOS a (4.5p) Taxation of Components of Return - compare

LOS b (6.5p) Tax Jurisdictions - describe

LOS c (9p) Tax Efficiency - discuss

LOS d (5.5p) Impact of Taxes - analyze

LOS e (10p) Tax Mgmt. Strategies - explain

LOS f (3p) Risk/Tax Objectives of Managing CPs - discuss

LOS g (7p) CPs in Public Equities - describe

LOS h (3p) CPs in Private Businesses and RE - describe

LOS i (4.5p) Transferring Wealth - discuss

LOS j (6p) Estate/Bequest/Gift Strategies - discuss

LOS k (13p) Managing Wealth Across Multiple Generations

Page 1
in managing assets for private clients ➞ objective should LOS a
be to maximize after-tax return for a given level of risk - compare

Taxation of the components of return:

tax what 1/ Income Tax - wages, rent, dividends, interest
they make
2/ Gains Tax - capital gains
tax what
they own 3/ Wealth or Property Tax
tax what
4/ Stamp Duties - a tax on the purchase of shares or real estate
they buy
tax what 5/ Wealth Transfer Tax - estate or inheritance tax, gift taxes
they give
away
- may be imposed on the donor or recipient, or both

Interest/Dividends/Withholding Taxes
interest ➞ taxed as ordinary income OID100851170.

- some forms may be exempt (i.e. Municipal Bonds)

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Page 2
Interest/Dividends/Withholding Taxes LOS a
Dividends ➞ paid out of after-tax corporate earnings - compare

➞ taxed again as investor income (double taxation)

- some countries therefore tax dividends favourably
- either (personal tax rate) - (Corporate tax rate)
or lower overall tax rate
Cross-border income (interest/dividends/royalties)
withholding taxes ➞ by the jurisdiction in which the
income was earned
(may be a lower rate if a tax treaty is in place)
Capital gains tax basis = cost basis
- typically (price paid per share x # of shares/units
+ commission/costs)
- if dividends include ‘return of capital’, cost basis is
reduced

Page 3
Interest/Dividends/Withholding Taxes LOS a
Capital gains - compare

taxable gain(loss) = (selling price - comm./costs) - cost basis

- only realized gains/losses are taxable
- losses can only be used to offset gains
short-term capital gain - taxed as income
long-term capital gain - taxed at a lower rate (but must not be
in the business of generating capital gains)

Real Estate Taxes - principal residence usually exempt from cap. gns.
RE Investments - net income is taxed (after dep., int. exp.,
maintenance, etc.)
- Dep. lowers cost basis (BV)
- recaptured on sale
- may be able to roll over one property for another and
defer tax on gain
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Page 4
Tax Status of the Account/ LOS a
- compare
taxable
tax-deferred - contributions reduce income, but all
withdrawals are taxed as income (pre-tax contributions)
tax-exempt - contributions do not reduce income and no taxes
on withdrawals (post-tax contributions)
See exh. #2

LOS b
Tax havens - countries with no or very low tax rates
- describe
for foreign investors (e.g. Cayman Islands, Bahamas)

Territorial tax system - only locally sourced income is taxed

(Philippines, Singapore)

Worldwide tax system - tax on all income regardless of its source

- may result in double taxation (tax treaties may exist
or tax credits may be available)

Page 5
LOS b
Worldwide Tax system - tax applies to residents - describe
- definition of resident usually based on ‘time spent’ in the
country
Ex. #3 - some countries tax citizens regardless of residence (e.g. U.S.)
LOS c
Tax efficient strategy - one that gives up very little of
- discuss
its return to the friction of taxes
- analyze
- generally equities are more tax efficient
dividends often receive preferential tax treatment
cap. gains generally taxed at lower rates than income
investor retains control over timing of realized gains
higher yield, higher turnover strategies tend to be less tax efficient
momentum ➞ more tax efficient - sell losers early (tax loss), let winners run
style funds ➞ less tax efficient - sell holdings if they drift out of
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Page 6
Calculating After-Tax Returns: LOS c
(𝐯𝐚𝐥𝐮𝐞𝐓 − 𝐯𝐚𝐥𝐮𝐞𝟎 ) + 𝐢𝐧𝐜𝐨𝐦𝐞 - discuss
pre-tax HPR: 𝐑= - analyze
𝐯𝐚𝐥𝐮𝐞𝟎
(𝐯𝐚𝐥𝐮𝐞𝐓 − 𝐯𝐚𝐥𝐮𝐞𝟎 ) + 𝐢𝐧𝐜𝐨𝐦𝐞 − 𝐭𝐚𝐱
after-tax HPR 𝐑𝟏 =
𝐯𝐚𝐥𝐮𝐞𝟎
𝐧

or 𝐑 = 𝐑 − 𝐭𝐚𝐱Y𝐯𝐚𝐥𝐮𝐞
𝟏
where tax = d 𝐭𝐫𝐚𝐧𝐬𝐚𝐜𝐭𝐢𝐨𝐧𝐢 × 𝐭𝐚𝐱 𝐢
𝟎
𝐢8𝟏
𝟏4 div./int./net cap. g.
𝐧
annual 𝐑𝟏𝐆 ≈ [&𝟏 + 𝐑𝟏𝟏 (&𝟏 + 𝐑𝟏𝟐 ( … (𝟏 + 𝐑𝟏𝐧 )] −𝟏
- if cap. losses > cap. gains
quarterly or monthly
➞ may not be a
taxes are not paid monthly or quarterly current period benefit
- tax remittances from an inefficient year
will be a tax cash outflow drag on the next year

Page 7
Calculating After-Tax Returns: LOS c
- discuss
after-tax post liquidation return - analyze
(for MFs and comingled funds (final value - tax basis) x
𝟏4 cap. gains
𝟏 𝟏
𝐥𝐢𝐪𝐮𝐢𝐝𝐚𝐭𝐢𝐨𝐧 𝐭𝐚𝐱 𝐧
𝐑 𝐏𝐋 = ^&𝟏 + 𝐑 𝟏 (&𝟏 + 𝐑 𝟐 ( + ⋯ (𝟏 + 𝐑 𝐧 ) − b −𝟏 tax rate
𝐟𝐢𝐧𝐚𝐥 𝐯𝐚𝐥𝐮𝐞
assumes all holdings sold as of period end date and all resulting
cap. gains taxes are paid and deducted from ending portfolio value
Ex. #4
index if passive
After-tax excess return: 𝐑𝟏 − 𝐁 𝟏index or strategy portfolio if
benchmark active
may include
tax alpha 𝛂𝐭𝐚𝐱 = 𝐗 𝟏 − 𝐗
pre-tax excess effects of tax
after-tax excess return mgmt.
return (𝐑𝟏 − 𝐁𝟏 ) (𝐑 − 𝐁)
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𝟏
Page 8
Tax efficiency ratio: 𝐓𝐄𝐑 = 𝐑 (not useful if LOS c
𝐑 returns are < 0) - discuss
- analyze
- help assess which funds/strategies are more
appropriate for taxable accounts for a private client Ex. #5

LOS d
Capital Accumulation:
- analyze
tax-exempt FV = (𝟏 + 𝐑)𝐧
taxable FV = (𝟏 + 𝐑𝟏 )𝐧
ordinary tax rate on full FV
tax-deferred FV = (𝟏 + 𝐑) 𝐧 (𝟏
− 𝐭)
Ex. #6
Asset Location: tax efficient assets in taxable accounts
- must also consider the liquidity needs of the accounts
exh. #6/7 + Ex. #7

Page 9
Decumulation: withdraw from taxable accounts first LOS d
- analyze
or// in progressive tax regimes ➞ withdraw from tax-deferred
accounts until lowest tax bracket has been hit, then
from taxable accounts
- mandatory withdrawals from a tax-deferred account may be required
(e.g. Canada ➞ 5%/yr. of asset value)

Charitable Giving: gift appreciated securities in taxable accounts

(if tax benefits exist ➞ gift may be seen as a ‘deemed
Ex. #8 disposition’)
LOS e
Tax avoidance - a legal activity to avoid taxes
- explain
(e.g. tax-free accounts, tax-exempt investments, delay sales)

Tax evasion - illegal concealment of income and non-payment of

taxes

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Basic Tax Management Strategies/ LOS e
1/ Structuring investments in a legitimate manner to reduce - explain

the amount of taxes owed

e.g./ tax-free/tax-deferred accounts vs. taxable accounts
tax-exempt securities
long-term capital gains (vs. short-term)
qualifying dividends

2/ Deferring recognition of taxable income returns compound

pre-tax
limit portfolio turnover
tax loss harvesting - selling securities at a loss to offset
any capital gains
Application of Tax Mgmt. Strategies/ see exh. #10
A/ Investment Vehicle

Partnership ➞ all tax liabilities passed through to partners

(e.g. HF/PE)

Page 11
Application of Tax Mgmt. Strategies/ LOS e
- explain
Mutual Funds - income passed through as earned + capital
gains (∆NAV) on redemption of units
(int./div., may be
- losses typically used to offset gains in the cap. gains)
fund only, not distributed
- when new unitholders buy into a MF, they are also buying a
share of the unrealized capital gains

potential capital gains exposure = 𝐧𝐞𝐭 𝐠𝐚𝐢𝐧𝐬(𝐥𝐨𝐬𝐬𝐞𝐬)

𝐭𝐨𝐭𝐚𝐥 𝐧𝐞𝐭 𝐠𝐚𝐢𝐧𝐬
ETFs - sponsor delivers low cost-basis shares to the AP during
the redemption phase
- investor only pays cap. gains tax when they, and they alone,
sell their ETF shares
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Application of Tax Mgmt. Strategies/ LOS e
B/ Tax-loss harvesting - realizing losses to offset gains - explain

tax-lot accounting ➞ each purchase has its own cost basis

tax-lot FIFO LIFO HIFO

methods first last highest

or/ specified lot method ➞ PM identifies which

tax lots to use
Ex. #10
C/ Quantitative Tax Mgmt./ use of an optimization technique (algo.)
that will: minimize tracking error
maximize realized losses
minimize realized gains
minimize trading costs

Page 13
Concentrated Positions/ 3 types LOS f
- discuss
1/ publicly-traded equity
2/ privately-owned business
3/ commercial and investment real estate
Risks and Tax Considerations/
company-specific risks
reduction in portfolio efficiency (lack of diversification)
liquidity risk of privately held or large block equity securities
outsized tax bill due to low cost basis
Factors to consider/
a) degree of concentration vs. rest of portfolio
- larger %’age requires attention
b) volatility/downside risk of the position
- higher ➞ greater benefit from diversification
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Page 14
Factors to consider/ LOS f
c) tax basis lower = higher tax liability - discuss
d) tax rate of investor higher = higher tax liability
e) time horizon of investor longer = better ability to offset
the tax impact of a sale on total asset value
f) restrictions on the investor (regarding sale)
g) emotional attachment or desire to maintain voting control

Approaches/
1/ Sell and diversify ➞ easiest, but not always most tax efficient
2/ Staged diversification ➞ sell and diversify over time
3/ hedging and monetization strategies - hedge the position to create
a risk-free asset - borrow against the position, use
the funds to create a diversified portfolio
some
4/ tax-free exchanges - trade illiquid asset for a liquid one
jurisdictions

Page 15
LOS f
Approaches/ - discuss
5/ Charitable giving - gift the appreciate assets (if a tax benefit
exists)
6/ Tax avoidance/tax deferral - some jurisdictions offer a
step-up in basis at death ➞ asset value becomes
new cost basis for recipient
- tax-loss harvesting in other parts of the portfolio can be
paired with a staged diversification strategy
LOS g
1/ Staged Diversification and completion portfolio
- describe
partial individual stocks ∴ underweight
sale position factor
more sold
exposures
↓ tracking risk position + completion = Benchmark (ETF won’t offer
↑ tax liability portfolio
that)
higher tracking risk

- max. realized losses in the CP, match against St. Div. in position OID100851170.

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Page 16
LOS g
1/ Staged Diversification and completion portfolio
- describe
- use of quantitative tax mgmt. ➞ min. active risk but//
max. after-tax return

2/ Equity Monetization ➞ receive cash without an outright sale

- also used when: sales are restricted

maintaining control is important
maintain the position but create short-term
2-step process: short sale liquidity
1/ hedge position risk total return swap
options, collars, futures, forwards
2/ borrow against the position - high LTV ratio can be
achieved
- invest proceeds in a diversified portfolio

Page 17
LOS g
2/ Equity Monetization
- describe
- some jurisdictions may see this as a ‘constructive sale’
- triggers a tax liability
∴ hedges can be constructed to retain some economic
risk of the position
Ex. #12
Issues ➞ tax treatment of gains/losses from the hedge

3/ Tax-free exchanges e.g. exchange fund in US.

Partnership
𝐌𝐕𝐂𝐏𝟏
𝐂𝐏𝟏 ➞ pooled ➞ ownership %𝟏 k n∑𝐌𝐕 o
𝐂𝐏
𝐂𝐏𝟐 ➞ fund ➞ ownership %𝟐 7 year min.
holding period
𝐂𝐏𝐧 ➞ ➞ ownership %𝟑

investor gets basket of securities

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Page 18
4/ Charitable Remainder Trust/ LOS g
- describe
CP sell CP tax exempt, invest in 𝛒𝐃𝐈𝐕.

Investor trust charity

- when last beneficiary dies any
tax
Income remaining assets distributed
benefit
to charity
Beneficiaries

Strategies for Private Business/ LOS h

- discuss
IPO Sale to a 3rd party sale to an insider
divest non-core assets (typically RE)
personal line of credit - against company shares
- typically will include a put (borrower can put the loan to the
company)
- invest in 𝛒𝐃𝐈𝐕. possible
- interest on loan offset by portfolio income constructive sale

Page 19
Strategies for Private Business/ LOS h
Leveraged Recapitalization - discuss

cash PE
CP
Debt partial exit only
minority tax deferred
continues to grow
Employee Stock Ownership Plan (ESOP) business

- type of pension plan that is allowed to buy some or

all of a company’s shares (only some jurisdictions)
- sale over time
- partial diversification - maintain control over time
Strategies for Real Estate
1/ Mortgage financing
- sale generates after-tax funds
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Strategies for Real Estate LOS h
1/ Mortgage financing - set LTV ratio at a point where - discuss
net rental income after tax = Principal pmt. + 𝐈(𝟏 − 𝐭)
𝐍𝐑𝐈𝐀𝐓 + 𝐈𝐭 = 𝐏 + 𝐈
𝐍𝐑𝐈𝐀𝐓 = 𝐏 + 𝐈 − 𝐈𝐭 = 𝐏 + 𝐈(𝟏 − 𝐭)
- use loan proceeds to invest in 𝛒𝐃𝐈𝐕.
- net result ➞ lower risk
➞ portfolio income + cap. app. - int. exp.
➞ RE capital appreciation
- may also use interest only loan + balloon payment
- higher LTV ratio based on servicing ability
or/ after-tax property cash flow added to 𝛒𝐃𝐈𝐕.

Page 21
Strategies for Real Estate LOS h
2/ Charitable donation ➞ Donor-advised fund - discuss

Property DAF make charitable

𝛒𝐃𝐈𝐕. donations
tax
deduction for
full amt.
Sell
RE (tax-exempt)
LOS i
Objectives of gift and estate planning/
- discuss
- transferring assets to the next generation or to a
charity during or after one’s life
estate - all property a person owns or controls
1/ maintain sufficient income and liquidity - for donors lifestyle
- ability to pay taxes on the part of beneficiaries

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2/ Decide on control of assets - retain or relinquish LOS i
- discuss
3/ Asset protection - from creditors, to bypass forced heirship,
to protect from spendthrifts
forced heirship ➞ a requirement that a certain proportion of
assets must pass to specified family members
(primarily civil law countries)

4/ transferring assets in a tax aware manner

- may be: gift taxes
estate (donor) or inheritance tax (recipient)
- even a generation-skipping tax

5/ Preservation of family wealth

6/ Business succession

7/ Achieving charitable goals - typically qualifies for gift/estate

tax deduction
- lifetime gifts may also qualify for tax deduction

Page 23
will (testament) - outlines rights others will have LOS j
over one’s property after death - discuss

testator - person who authorized the will and whose property is

being disposed of
common law - free choice
civil law - restrictions on choice (may use offshore trust governed
by a different domicile over gifting/donating assets to
circumvent forced heirship rules)

Probate - legal process to confirm the validity of the will

Intestate - dying without a valid will or one that does not dispose
of their property (court decides)

- country’s legal system determines which estate planning tools are

available
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Lifetime gratuitous gifts and Testamentary gratuitous LOS j
bequests - discuss
gifts - may be able to transfer tax free
below some annual threshold to family members
- appreciation of gifted assets avoids estate tax
- charitable gift transfers ➞ typically not subject to gift tax
➞ earns an income tax deduction
bequests - estate or inheritance tax (not always)
- may be flat or progressive
- usually some statutory allowance (taxes above this
amount only)
- may also depend on the relationship to the recipient
(e.g. spouse)
Efficiency of gifts vs. bequests/

[𝟏 + 𝐫𝐠 &𝟏 − 𝐭 𝐠 (]
𝐧 if 𝐫𝐠 = 𝐫𝐜 , 𝐭 𝐠 = 𝐭 𝐜
𝐅𝐕𝐠𝐢𝐟𝐭
𝐑𝐕𝐭𝐚𝐱 𝐟𝐫𝐞𝐞 𝐠𝐢𝐟𝐭 = =
𝐅𝐕𝐛𝐞𝐪𝐮𝐞𝐬𝐭 [𝟏 + 𝐫𝐜 (𝟏 − 𝐭 𝐜 )]𝐧 (𝟏 − 𝐓𝐜 ) RV = 𝟏Y(𝟏 − 𝐓 )
𝐜

Page 25
Efficiency of gifts vs. bequests/ LOS j
- discuss
𝐧
𝐅𝐕𝐠𝐢𝐟𝐭 [𝟏 + 𝐫𝐠 &𝟏 − 𝐭 𝐠 (] &𝟏 − 𝐓𝐠 ( paid by the
𝐑𝐕𝐭𝐚𝐱𝐚𝐛𝐥𝐞 𝐠𝐢𝐟𝐭 = = recipient
𝐅𝐕𝐛𝐞𝐪𝐮𝐞𝐬𝐭 [𝟏 + 𝐫𝐜 (𝟏 − 𝐭 𝐜 )]𝐧 (𝟏 − 𝐓𝐜 )

&𝟏 − 𝐓𝐠 (
- if 𝐫𝐠 = 𝐫𝐜 , 𝐭 𝐠 = 𝐭 𝐜 , RV = n
(𝟏 − 𝐓𝐜 )
Ex. #18

Estate Planning Tools/

1/ Trusts (common law) - legal relationship
grantor holds assets for
assets trustee individual the benefit of
trust company the beneficiaries
grantor trust (owns the assets)

beneficiaries
(beneficial, not legal, owner
of the assets)
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1/ Trusts LOS j
- discuss
Revocable - settlor retains the right to rescind the trust
and regain title to the assets
∴ retains tax liability of gains/income
- not creditor protected
Irrevocable - no right to rescind the trust
- trustee pays taxes
- creditor protected
Fixed - distributions to beneficiaries occur at certain times and in
certain amounts
Discretionary - trustee decides timing and amount of distribution
- beneficiaries have no legal right to income or assets
∴ neither do creditors of beneficiaries
- reasons for using a trust/
Control - make resources available to benefit members without
ceding control

Page 27
1/ Trusts - reasons for using a trust/
LOS j
- discuss
Asset protection - from creditors
- protects family assets from divorce
- can avoid probate (and probate fees)
Tax-related considerations - trust pays lower tax rate on
income/gains (if trust set up in lower tax jurisdiction)
- beneficiary pays lower tax rate

2/ Foundations - legal entity

- hold assets for a specific charitable purpose
- set up and funded by an individual or family (private foundation)
- tax deduction when assets are transferred in
- no tax if minimum spending requirement met
- asset protection

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3/ Life Insurance - premiums paid to insurer LOS j
- death benefits paid to beneficiary (tax free) - discuss
- bypasses probate
- assets belong to insurance company

4/ Companies - corporation may have a lower tax rate

- distributions can be deferred
e.g. CFC - controlled foreign corporation - located in another country
- tax on earnings may be deferred until distributed
LOS k
Family governance - a system to generate, transition,
- discuss
preserve, and grow wealth over time
- a process for a family’s collective communication
and decision-making
- can consist of formal legal documents
non-binding family agreements
list of goals/values defined and agreed on collectively

Page 29
Family governance LOS k
- essential factors/ - discuss

focusing on human/social/intellectual capital of the family

recognizing importance of goals of each family member
defining mission/vision
educating younger generations to be responsible with wealth

common governance entities for HNW families/

1/ Board of Directors - when family business reaches a mature stage,
external members (experts) added
2/ Family Council - selected family members
- represent the family in dealing with the board
3/ Family Assembly - gathering of all family members
- meets at least annually to discuss the business
direction of the family-owned company

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Page 30
common governance entities for HNW families/ LOS k
- discuss
4/ Family Office - investment and administrative center
5/ Family Foundation - platform for philanthropy

Family conflict resolution/ family constitution - non-binding agreement

that sets forth an agreed on set of rights, values and responsibilities

Family dynamic in the context of business exit/

transition to a new generation - founders may allocate
shares to the next generation during their lifetime
or after death
- if during lifetime ➞ founder may keep voting shares and
transfer non-voting shares
sale of the business - possible endowment bias
- taxable event
- may impact other objectives

Page 31
Timing of sale ➞ business transferred to a trust well LOS k
in advance of a sale - discuss

- future appreciation removed from the estate of the

business owner

Selection of trustees individual vs. corporate trustees

- better suited to ensure
typically close to the
continuity for multigenerational
family and has knowledge of
wealth
circumstances
- lower admin. costs
broader range of skills/resources

- some jurisdictions allow private trust companies

- trust company established for the use of a single family

Post-sale consideration - where does the money go

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- Planning for the Unexpected/ LOS k
- discuss
anti-avoidance rules allow a tax authority to deny
tax benefits if// there is no commercial purpose to an
arrangement other than to achieve tax benefits

Divorce/ - protect family assets

pre-nuptial agreement - before
post-nuptial agreement - after
trust structure ➞ may require pre-nup. as a condition
of the trust benefit
medical care
Incapacity - power of attorney
financial
- long process after the fact if none exists
- difficult to challenge after the fact if one does exist
- living will - legally binding
- wishes regarding medical care in the event of incapacitation

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Risk Management for Individuals

a. compare the characteristics of human capital and financial capital as

components of an individual’s total wealth;

b. discuss the relationships among human capital, financial capital, and

economic net worth;

c. discuss the financial stages of life for an individual;

d. describe an economic (holistic) balance sheet;

e. discuss risks (earnings, premature death, longevity, property, liability, and

health risks) in relation to human and financial capital;

f. describe types of insurance relevant to personal financial planning;

g. describe the basic elements of a life insurance policy and how insurers price
a life insurance policy;

h. discuss the use of annuities in personal financial planning;

i. discuss the relative advantages and disadvantages of fixed and variable

annuities;

j. analyze and critique an insurance program;

k. discuss how asset allocation policy may be influenced by the risk

characteristics of human capital;

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

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Human vs. Financial Capital

⇒ Human Capital/ - PV of future earnings & wages LOS a, b

- often the dominant asset on a household -compare
-discuss
economic balance sheet
Pg-1
- some professions will receive higher wages, and some
will be more or less sensitive to the business cycle
- the discount rate used should be consistent with the
risk of wage growth and consistency
N
𝑝(𝑠K )𝑤K+L (1 + 𝑔K ) 𝐰𝐭 = 𝐰𝐭+𝟏 (𝟏 + 𝐠 𝐭 ) ⇒ wage in time
𝐻𝐶J = d K
O8L &1 + 𝑟M + 𝑦( period t = wage in previous period
+ growth rate
- discount rate = 𝐫𝐟 + premium for 𝐩(𝐬𝐭 ) – probability of surviving in
occupational year t
income volatility

- assumptions required/ 𝒑(𝒔𝒕 ), 𝒘𝒕 , 𝒈𝒕 , 𝒓𝒇 , 𝒚, 𝑵

(Extended example; Pg. 385)

⇒ Financial Capital/ - personal vs. investment assets LOS a, b

-compare
- consumed- held for their potential to -discuss
increase in value Pg-2
- intangible & tangible
a) personal assets/ - autos, clothes, furniture
- not expected to increase in value
- derive personal worth from their value-in-use
b) mixed assets/ - residence, artwork, collectibles
- aspects of personal & investment asset characteristics
c) investment assets/ - stocks, bonds, accrued pension plan
⇒ Publicly traded marketable assets
⇒ Non-publicly traded marketable assets - real estate,
annuities, cash-value life insurance, business
assets, collectibles

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⇒ Financial Capital/ LOS a, b

-compare
c) investment assets/
-discuss
⇒ Non-marketable assets – vested employer pension Pg-3
plans, government pensions
𝑵
𝒑(𝒔𝒕 )𝒃𝒕 𝐛𝐭 - benefit in yr t
𝒎𝑵𝑷𝑽𝟎 = d
(𝟏 + 𝒓)𝒕 𝐫 - discount rate (lower for gov’t
𝒊8𝟏
plans)

⇒ Net worth/ traditional assets – liabilities

⇒ Net wealth/ human capital + investment asset

(Economic Net + PV future pension benefits
Worth) less: liabilities + PV future consumption

needs

Financial Stages

⇒ Financial Stages of Life/ LOS c

-discuss
1) Education phase - development of human
Pg-4
capital (i.e. investing in education)
- little/no focus on saving & risk mgmt.
2) Early Career → generally, lasts to mid 30s
- significant family & housing expenses
- human capital most likely largest asset
3) Career Development → 35-50
- upward career mobility & income growth
- retirement savings begin to accumulate at a
rapid pace
4) Peak accumulation → 51-60
- reached or are moving towards maximum earnings
- begin to reduce investment risk, stress income objectives
- high career risk

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⇒ Financial Stages of Life/ LOS c

5) Pre-retirement → 61-65 -discuss
Pg-5
- risk reduction, tax planning
- less volatile investments
- retirement plan distribution options
6) Early retirement → first 10 yrs
- most active period of retirement
- period of comfortable income & sufficient assets
- some seek new career or jobs w/ less stress
7) Late retirement → length of time unpredictable (longevity risk)
- health issues could impact financial position
- cognitive decline raises issues of trustees, POAs

Economic Balance Sheet

- more comprehensively represents assets available LOS d

to fund life-cycle consumption & for wealth -describe
Pg-6
preservation
- helps illustrate the magnitude of risk exposures of an individual

⇒ Traditional Balance Sheet

Assets – Liabilities = Net Worth
- for individuals in the early life cycle stages, net worth
may be negative but// human capital may be large
- traditional B.S. ignores these

⇒ Economic Balance Sheet

PV (all available marketable - PV (all current +
& non-marketable assets) implied liabilities)
- Net Wealth (economic net
worth)

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Value Human Value Pension LOS d

Capital Wealth -describe
Pg-7

- at 25, human
capital dominates
assets

- at 50-55,
25 65 95 25 65 95 person wealth,
financial capital
Value Financial Value Real Estate
+ real estate
Capital
dominate

- as retirement
continues, assets
Inversely are typically
related
drawn down.
over
time

25 65 95 25 65 95

LOS d
-discuss
Pg-8
- at 25: income = £ 40,000/yr after-tax
gw = 1%
savings = 10%/yr
disc. r = 8% 𝝅 = 3%
financial capital = £ 10,000
gfc = 3%
- at 30: purchase home for £ 100,000
10% down, 30 yr mortgage
@ 5%
ghome = 1%
- at 65: £ 20,000 outflow/yr
gp = 𝝅, discount rate = 5%/yr
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LOS d
allocation of different -discuss
asset types changes over the Pg-9
life-cycle

- message:
- 2 individuals with the same
net worth may not have the same
net wealth (economic net worth)
∴ should invest differently

e.g./ Ind. A $1M human capital

Ind. B $3M human capital
45 yrs old ⇒ $1.5M 45 yrs old
$500 fin. capital $500k fin. capital

- expects to spend $38k/yr to 85

- expects to spend $88k/yr to 85
40% loss in portfolio will lead to a
40% loss in portfolio will lead to a
13.2% loss in expected spending 5.7% decrease in expected spending

Individual Risk Exposures

1/ Earnings Risk/ - events that could negatively LOS e

-discuss
affect human and financial capital
Pg-10
- health risks (some are a function of the job)
- unemployment & underemployment
- loss of job later in life
- inadequate human capital investment/development
- affects financial capital – ability to earn excess income to save
- ability to maintain reserves
2/ Premature Death Risk/ mortality risk
- affects the ability of the family to meet
financial needs/desires (death of primary income earner)
- may affect earnings of surviving spouse due to the
added (i.e. non-shared) responsibilities
- financial drains- death exp., transition exp., estate settlement exp.

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LOS e
3/ Longevity risk/ - risk of outliving one’s assets
-discuss
Pg-11
4/ Property risk/ - damaged, destroyed, stolen, lost

5/ Liability risk/ - legal liability for property damage or

physical injury
- needing legal defense by association
6/ Health risk/ - risks and implications associated with illness
or injury (individual, family member, children)
- reduces human capital and may drain financial capital
- long-term care costs of aging parents

Insurance

⇒ Life insurance/ LOS f, g

• Uses - a hedge against the risk of premature -describe
Pg-12
death of an earner
- can also provide liquidity to a beneficiary without the delay
of probate (fund the probate process, cover estate tax on
illiquid assets)
- may also be used as a tax-sheltered savings instrument (U.S)
• Types - temporary (or term) - only for a specified period of time
- cost is lower than permanent life ins.
- no cash value
- premiums remain fixed over the term or may increase
as mortality risk increases
- permanent - provides lifetime coverage (as long as premiums
are paid over the entire period)
- premiums are usually fixed
- usually some cash value

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⇒ Life insurance/ LOS f, g

-describe
• Types – permanent
Pg-13
• Whole life - remains in force for insured’s entire life
- requires ongoing fixed premiums
- generally a cash value that may be accessed
- non-cancelable (by the insurance company)
- may be participating – value may grow
- non-participating – fixed value
• Universal life - more flexible
- policy holder can pay higher or lower premium
payments, more options for investing the cash value
- insurance stays in force as long as premiums are
paid, or the cash value can cover the policy expenses
- riders can be added to both types – adds some risk mitigation
beyond the basic policy (i.e. accidental death &
dismemberment)

⇒ Life insurance/ LOS f, g

-describe
• Types – riders/
Pg-14
- accelerated death benefit – collect early
if diagnosed as terminal
- guaranteed insurability – right to purchase more coverage
at predefined intervals
- waiver of premium – if policy holder becomes disabled
- can also sell the policy to a 3rd party
• Basic Elements/
• term and type
• amount of benefits
• limitations under which benefits could be withheld
• contestability period (insurance company can investigate
and deny claims)
• identity of insured must have an
• policy owner insurable interest
• beneficiaries
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⇒ Life insurance/ LOS f, g

Pricing/ - 3 key considerations -describe
Pg-15
1. mortality expectation (how long the insured is expected to live)
- generalized tables + individual specific information
- may involve a physical examination
2. discount rate
- net premium ⇒ the discounted value of the future
death benefit .0015
$100,000
e.g./ $150k policy, term life = 1 yr In
one yr .0015 (100k) +
.15% mortality $0 .9985 (0)
.9985
disc. rate = 5.5% $142.18 = $150
,𝟏𝟓𝟎0𝟏. 𝟎𝟓𝟓1
3. loading - other factors that
add to the net premium to = gross premium
- load = other expenses + profit

(sales comm., physical exam, issuance, monitoring, verification

of claims)

⇒ Life insurance/ LOS f, g

Pricing/ · stock companies – profits accrue to -describe
Pg-16
shareholders
· mutual companies – profits accrue to policyholders
(policy dividend)
Cash Values & Policy Reserves/
premiums premiums premiums

level
premiums
Costs
of insurance

age age age

1-yr term, renewed each 10-yr term, renewed whole life
yr. every 10-yrs

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⇒ Life insurance/ LOS f, g

Cash Values & Policy Reserves/ -describe
Pg-17
- cash can accumulate within the policy
- can be withdrawn by the policy owner when the policy
endows (matures) or when policy is terminated
- can be borrowed against
• premium stays constant
• face value stays constant
• cash value increases
• insurance value decreases
- since insurance is meant to replace human
capital, may become unnecessary after
policy holders working years are over
Policy Reserves ⇒ insurance company liability
- represents the future payment to be made
- policy reserves increase to the face value over time

⇒ Life insurance/ LOS f, g

- one whole life policy may have lower premiums -describe
but faster cash value growth Pg-18
net payment cost index
- comparison facilitated by:
surrender cost index
- cost/yr for $1,000 coverage
• Calculating Life Insurance Needs:
1) Human life value method: replace the estimated net
contribution to family finances that the insured
would generate
2) Needs analysis method: meet the financial needs of
the survivors
⇒ Disability Income Insurance/ - offsets the risk of lost earnings
ability due to physical injury, disease or other
impairment

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⇒ Disability Income Insurance/ LOS f, g

-describe
defined as/ Pg-19
- best, but
1. inability to perform one’s regular occupation most expensive
2. inability to perform any regular occupation for which one
is suited by education or experience
3. inability to perform any occupation
- premium is fixed, policy is written for the health &
occupation of the insured
- available individually & through employer
- typically have provisions for partial & residual disability
cannot perform can perform all
all duties duties, but at lower
income
- coverage is only up to
a specific limit ⇒ 60-80%

⇒ Property Insurance/ – manage property risk LOS f, g

a) Homeowner policy - risks associated with personal property -describe
Pg-20
and liability
- all risks vs. named risks
- replacement cost vs. actual cash value
- deductibles (higher = lower premiums)
- underinsured = lower payouts
b) Auto insurance
- collision vs. comprehensive
- deductibles
- often mandatory
⇒ Health/Medical Insurance/ - depends on the country
- may be public – paid by tax dollars or a
- may be private (U.S.) combination

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⇒ Health/Medical Insurance/ LOS f, g

- comprehensive major medical insurance – covers -describe
Pg-21
the vast majority of health care expenses
• Deductibles – min. amount policy holder pays
• Coinsurance - %age insurance company pays above the deductible
• Copayments – fixed payments policy holder must make for particular
services
• Maximum out-of-pocket expense – total amount in a year a policy
holder would pay after which the insurance company pays 100%
• Maximum yearly benefit – max. amount of company will pay in a year
• Pre-existing condition – may not be covered

⇒ Liability Insurance/ - personal umbrella liability insurance policy

- adds to coverage in auto & home policies for personal liability

Annuities

Parties/ ➀ the insurer – generally an insurance company LOS h, i

➁ the annuitant – person who receives the benefit -discuss
Pg-22
➂ the contract owner – person who purchases the annuity
(typically the annuitant)
➃ the beneficiary – the person who would receive any
proceeds upon death of the annuitant – if any
Classification/
⇒ Immediate annuity – an amount of money is paid
to the insurance company in exchange for
specified future monthly payments over a specified
period of time (# of yrs or life of the annuitant)
⇒ Deferred annuity - the income stream begins at a later date
- annuity amount based on how much was put up
- attempts to provide protection against longevity risk

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• Classification of annuities/ LOS h, i

• fixed or variable -discuss
Pg-23
⇒ Deferred variable annuity - like a mutual fund but
structured like an insurance contract
- individual can choose an investment option (limited)
- typically higher MERs
- may include a death benefit – beneficiary would receive
100% of investment (i.e. pmt. to insurance company)
- contract holder has the right to exit the contract
with penalty
- does not guarantee lifetime income ⇒ must be converted
to an immediate payout annuity
rider = GMWB – guaranteed minimum withdrawal benefit
e.g./ 4% of invested amount/yr for life
- excess paid to beneficiary, deficiency paid by ins. co.

- Deferred Fixed Annuity/ -an annuity payout LOS h, i

-discuss
that begins at some future date
Pg-24
- at any point prior to annuitization, investor can cash
out (with penalty) no longer deferred,
cash out
- once in retirement now an immediate
begin payments
fixed annuity
- Immediate variable annuity/ - pay a sum of money for an
annuity whose payments are based on the performance
of the assets purchased

- Immediate fixed annuity/ - pay a sum today for an annuity

that promises a fixed income for life

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- Immediate Fixed Annuity/ LOS h, i

-discuss
- income yield varies based on age & gender
Pg-25

- the income yield

is determined by
estimating the
average longevity
of a given
annuitant pool

- pays as long as the - pays at least 10 yrs.

individual is alive
- no residual

- income yields will also vary based on the expected return the
insurance company can earn on the premiums
- low bond yields + longer life spans = low income yields

- Advanced Life Deferred Annuities/

LOS h, i
- hybrid between deferred & immediate -discuss
fixed annuity Pg-26
- pure longevity insurance – buy now, fixed payments
begin late in life (e.g. 80-85)
Advantages/Disadvantages
➀ Volatility of Benefit Amount
fixed – constant income stream (predictability)
variable – income stream could change considerably
➁ Flexibility
immediate ⇒ irrevocable (funds are part of the insurance
company’s overall portfolio)
variable ⇒ funds can be withdrawn – funds are in a
subaccount
(∴ guarantee of income for life + flexibility of withdrawal)

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Advantages/Disadvantages LOS h, i
➂ Future Market Expectations -discuss
Pg-27
- fixed ⇒ annuitant locks in whatever rate of return exists
at the time of purchase
- may wait until rates rise, but during that period, life
expectancies may rise, which increases the cost of
annuitization
- variable ⇒ annuitant gets higher payments as rates go higher
- may limit future growth however
- those without growth limits are likely to
outpace inflation
➃ Fees
variable > fixed
- immediate fixed annuity prices much easier to
compare vs. variable

Advantages/Disadvantages LOS h, i
➄ Inflation Concerns -discuss
Pg-28
- fixed ⇒ affects real income
- are nominal and will not change with inflation
- may be riders available tied to inflation
➅ Payment Methods
• life – payments cease at death
• period-certain - payments are for a # of periods only
• life with period-certain – payments have a minimum term
or life
- if the annuitant dies within the minimum term,
beneficiary receives the payments for the balance of the
term
• life with refund – minimum received = initial payment – fees
• joint life – payments continue until both members are no
longer living

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Advantages/Disadvantages LOS h, i
➆ Benefit Taxation -discuss
Pg-29
- tax deferred growth
- payments = growth + return of principal

(only this is taxed)

➇ Mortality Credits

fixed
payment
- self-insured would get only
interest + principal
- some individuals pass away
early, subsidizing the rest in
the pool

Advantages/Disadvantages LOS h, i
- expected benefits of an annuity are -discuss
Pg-30
generally negative (insurance always is)
- benefit of certainty regarding lifetime income
but/ · lower potential wealth at death
· lower lifetime income

- higher annuity allocation/

- longer than avg. life expectancy
- greater preference for lifetime income
- less concern for leaving money to heirs
- lower income from other sources

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An Insurance Program
LOS j
⇒ Strategies for loss control that do not involve insurance -analyze
1. Risk avoidance – don’t do certain things -critique
Pg-31
2. Loss prevention – e.g. security cameras
3. Loss reduction – e.g. sprinkler system for fire

⇒ Do not insure = risk retention

⇒ Insure = risk transfer
- Also some non-insurance risk transfers = contracts

⇒ Risk Management Techniques/

Effect of Human Capital

LOS k
⇒ Consider wage growth volatility
-discuss
- Some professions are more bond-like in volatility Pg-32
while others may be more stock-like
(Example #14)

- Most human capital volatility is difficult to hedge with insurance

- Factors contributing to riskiness
• Lower performance within any given occupation
(lack of upward mobility, first out in layoffs)
• Lack of geographical mobility
• Single source of income
• Employer specific human capital
• Routine cognitive/labor based human capital
• Human capital with rapid decay rates

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Asset Allocation & Risk Reduction

LOS l
• Identify idiosyncratic risk exposures that can be
-recommend
efficiently reduced through diversification or hedging -justify
- Strategies may be constrained by liquidity needs Pg-33
(low starting income but high expenses early in life)
- High exposure to human capital risk
- Life & disability insurance desirability high
- Later in life, higher exposure to financial capital risk
- Low need for life, disability insurance
- Health & longevity risk increase
- Reduce market risk and increase insurable risk

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REVIEW

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Investment Characteristics
Review - 1
Equity:
1/ Long/short: specialize by region/sector/style (some generalists)
typically net long (pos. market factor exposures) (40 - 60%)
heterogeneity in exposures to various equity factors
alpha through stock picking (market timing poor)
𝐄(𝐑) ~ long only, 𝐄(𝛔) = 𝟏Y𝟐 long only
liquid, average leverage
df
2/ Dedicated Short:
negatively correlated returns vs. equities and other HF
alpha through stock picking (market timing poor) strategies
60% - 120% short
𝛔𝐒 > 𝛔𝐋-
𝐒
liquid, low leverage

Review - 2
Equity:
3/ Equity Market Neutral:
high leverage, quantitative approach
steadier returns, less volatile
highly diversified, high liquidity
short IH, mean-reverting trades, higher turnover, tax
no/low beta risk issues

Event Driven:
df
4/ Merger-Arb.:
cash-for-stock ➞ long target
stock-for-stock ➞ long target, short acquirer (𝟕2 %)
cross-border M/A, vertical M/A ➞ wider spreads, more risk
friendly M/A, horizontal M/A, domestic deals ➞ smaller spreads
(3-7%)
left-tail risk due to M/A failures, market sensitivity (more deals
alpha from deal selection fail with
high leverage, 𝐄(𝐑) ~ low double digits, 𝐄(𝛔) < 𝟏𝟎% market stress)

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Review - 3
Event Driven:
5/ Distressed Securities:
very illiquid, long IH, longer lock-up periods
𝐄(𝐑) highest for event driven strategies, but higher 𝛔
typically long-biased (returns are
low diversification, concentrated positions lumpy and
best in early recovery period cyclical)
df
moderate to low leverage (1.2x – 1.7x NAV)

Relative Value:
6/ Fixed Income Arbitrage: - credit quality, liquidity, volatility premiums
reversion to the mean
net positive carry (as well)
high levels of leverage (4x – 5x)
liquidity varies by security type

Review - 4
Relative Value:
7/ Convertible Bond Arbitrage
tend to be volatility related trades
more illiquid (small issues sizes) ➞ low investment
high levels of leverage (3x) capacity
may/may not hedge credit, interest rate risk
diversification benefit, small return, risk reduction effect
df
Opportunistic:
8/ Global Macro
fundamental/technical, discretionary, some systematic
strong trends or themes (mean reverting, low vol. markets
risk factor exposure very heterogeneous, dynamic poor)
high leverage, 6x – 7x
lumpier return series, higher vol.

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Review - 5
Opportunistic:
9/ Managed Futures:
uncorrelated with stocks/bonds
cyclical return profile, range-bound, mean-reverting
markets poor
highly liquid, systematic, trend following, wide range
of risk factor exp.
positively skewed returns in stressed markets
higher volatility than most
df HFs
high leverage

Specialist:
10/ Volatility Trading - long vol. ➞ positive convexity, short equity bet
- short vol. ➞ premium income, long equity bet
- low leverage
11/ Reinsurance/Life Settlement – no asset class correlation
- very specialized skills
- low investment capacity

Review - 6
Multi-Strategy:
F-o-F: - diversification, investment access
- liquidity, manager selection expertise
- strategic, tactical, style allocation
- lower realized 𝛔, less single mgr. risk
- netting risk, added layer of fees, less transparency
- steady, low vol. returns
df
Multi-Strategy – faster tactical allocations
- GP absorbs netting risk, one layer of fees
- concentration of operational risks
- steady, low vol. returns > FoF, but more variance
- less investor liquidity than FoF
- more leverage than FoF

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Hedge Funds
Review - 7
LOS h/
Conditional Factor Risk Model
𝐑 𝐇𝐅𝐢 = 𝛂𝐢 + 𝛃𝐢,𝟏 𝐅𝟏 + ⋯ + 𝛃𝐢,𝐧 𝐅𝐧
+ 𝐃𝐭 𝛃𝐢,𝟏 𝐅𝟏 + ⋯ + 𝐃𝐭 𝛃𝐢,𝐧 𝐅𝐧
df
dummy var. ➞ incremental exposure

e.g. 𝛃𝟏 = . 𝟕𝟏 or 𝛃𝟐 = . 𝟔𝟒
𝐃𝛃𝟏 = . 𝟎𝟑 𝐃𝛃𝟐 = −. 𝟎𝟖
. 𝟕𝟒 . 𝟓𝟔

Review - 8
LOS i/
- when added to a 60/40 eq./fx-inc. port.

df

vs. 6.96 8.66 .62 1.13 14.42

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Alternative Investments
Review - 1
LOS a/
1/ capital growth
2/ Income generation
3/ Risk Diversification
4/ Safety
A/ Private equity ➞ CG, I - return enhancer, limited diversification
B/ Hedge funds ➞ RD to CG vs. equities
C/ Real Assets ➞ high correlation with inflation
timber, farmland ➞ CG, I, RD
commodities, energy investments - RD
infrastructure ➞ CG, RD, I
D/ Real Estate ➞ CG, I, RD
E/ Private Credit ➞ I - direct lending
➞ CG - distressed securities

Review - 2
LOS b/ short-term risk ➞ volatility
long-term risk ➞ underperformance (not meeting LT targets)

short-term/ AI returns generally understate volatility (private AI)

- needs to be unsmoothed
- most AI have positive (but < 1) corr. with equities
- bonds have neg. corr. w/ equities
long-term/ bonds have higher risk of not meeting LT return targets

LOS c/ Traditional approaches

Liquidity-based approach to defining the opportunity set
- first pass MVO on just liquid classes
- second pass to incorporate illiquid classes
Expected performance under distinct macro regimes
high/low growth vs. inflation expectations

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Review - 3
LOS c/
Risk-based approach - each class’s exposure to risk factors
𝐄(𝐑) = 𝛂 + 𝛃𝟏 𝐅𝟏 + 𝛃𝟐 𝐅𝟐 … + 𝛃𝐧 𝐅𝐧
- optimize over factors
traditional approach/ neg. over-estimation of diversification
obscures primary drivers of risk
risk-based/ neg. sensitivity to lookback period
implementation issues

LOS d/
1/ Risk Considerations s.d. is a poor representation of risk
allocation may fully invest only over time
2/ Return expectations lack of historical record
can use risk-factor history

Review - 4
LOS d/
3/ Investment Vehicle
Limited partnership - requires size & expertise
Fund-of-funds - easier to access, (higher fees), diversification
SMA/fund-of-one - very high minimums
Liquid alts. - mutual funds basically
- weaker versions of primary investment
4/ Liquidity ➞ liquidity risk at both
a) Investment vehicle ➞ lockups, redemption gates
➞ private funds - no redemption, 10-yrs.
b) Underlying assets ➞ illiquid holdings or liquid holdings but
illiquid strategies
5/ Fees/expenses ➞ mgmt. + incentive fees
➞ committed instead of called capital
6/ Tax Considerations ➞ turnover

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Review - 5
LOS d/
7/ Other considerations - outsource or in-house expertise
(function of size and access to experts)
LOS e/
Investment horizon < 15 yrs. - avoid private investments
HF ➞ typically 1 yr. lock-up
Expertise - risks and complexity of AI
Governance - strong system required
Transparency - lower than other investment classes (i.e. reporting)

LOS f/ 1/ Monte Carlo Simulation

- decompose a non-normal return series into 2 or more
normal return distributions (input to MVO)
- regime switching model
- estimate long-term risk profile and return potential
of a given MVO allocation

Review - 6
LOS f/
2/ Optimization - MVO will over-allocate to AI (low vol., high
- set limits on allocations returns)
or/ - mean - CVaR optimization - when concern is about
downside risk
3/ Risk-factor based approaches
a) unsmooth return series ➞ smoothed return series
will have SC ➞ the higher,
b) skew & excess kurtosis the more understated was
(neg.) (pos.) volatility
indicate left tail risk
- unsmoothed ➞ normal ➞ MVO
➞ non-normal ➞ mCVaR

LOS g/ 1. achieving and maintaining allocation

- capital is called over a number of years
- NAV of investment grows as well
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Review - 7
LOS g/ 1. achieving and maintaining allocation
➞ multiple commitments over a number of years
➞ diversification over vintage years
- leads to a more stable NAV over time
➞ managing capital calls - not practical to keep capital in liquid
reserves
- private equity ➞ public equities
credit ➞ high yield debt
real estate ➞ REITs
Bear markets ➞ faster capital calls, slower distributions, fund life
extension
LOS h/ Monitoring the
A/ Investment Program ➞ suitability, investor changes, economic
changes
B/ Performance Evaluation - may be best to wait until closer to
the end of the fund’s life

Review - 8
LOS h/
B/ Performance Evaluation
- strong/weak performance may be due to strong/weak
economy
C/ The firm and Investment Process
key person risk client/asset turnover
alignment of interests client profile
style drift service providers
risk mgmt. processes (i.e. auditor)

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Overview of Private Wealth Management

Review - 1
LOS a/
1. Investment objectives - diverse objectives, may not be clearly
(vs. clearly defined, more stable) defined

2. Constraints:
Time horizon - shorter ➞ lower risk tolerance, higher liquidity
requirements
➞ multiple horizons
Scale - smaller portfolios
Taxes - not tax-exempt

3. Others governance
sophistication - more emotional
regulation
uniqueness/complexity - variation in goals/objectives across
private wealth clients

Review - 2
LOS b/
a) Personal info.: family, career, source of wealth, financial objectives
b) Financial info.: assets, liabilities, sources of cash flow, expense
c) Other: insurance, wills, POA projections

LOS c/ d) Tax Considerations - income, wealth, consumption taxes

tax avoidance, tax reduction, tax deferral strategies

LOS d/ Client goals:

Planned ➞ reasonably estimated or quantified with an expected time
horizon
retirement, specific purchases, education, family events,
wealth transfer, philanthropy
Unplanned ➞ unforeseen, difficult to quantify or plan for
property repairs, medical expenses, elder care
PWM role ➞ goal quantification, prioritization, monitor for goal changes

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Review - 3
LOS e/risk tolerance ➞ level of risk investor is willing & able to bear

risk capacity ➞ ability to accept financial risk

(determined by wealth, income, liquidity needs, etc.)
risk perception ➞ subjective assessment of risk
- risk tolerance may vary by goal

LOS f/ Technical skills – capital market proficiency

- portfolio construction ability
- financial planning knowledge
- quantitative skills
- technology skills
- language proficiency
Soft Skills - communication skills, social skills, education and
coaching skills, business development and sales skills

Review - 4
LOS g/ Capital sufficiency analysis
1/ Deterministic forecasting - simple but unrealistic
2/ Monte Carlo Simulation
𝐌𝐕𝐏
contributions
distributions
𝐄(𝐑)
𝛔
10yrs. 15yrs. 20yrs. 50% 25yrs.
100% 99% 70% 20%

- when PoS < critical threshold level

1/ contributions must increase
2/ goals must be moderated
3/ goals must be delayed
4/ higher 𝐄(𝐑) - within risk tolerance limits

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Review - 5
LOS h/ Retirement Stage of Life - Early Career, Career Development,
Peak Accumulation, Pre-retirement

Early - Late Retirement contributions

- distributions required rate of
sustainable rate of distributions contributions

Analyzing retirement goals

Mortality Tables ➞ 𝐏𝐕 𝐨𝐟 ∑𝐭𝐢8𝟏(𝐏𝐨𝐒𝐢 × 𝐒𝐩𝐞𝐧𝐝𝐢𝐧𝐠 𝐢 )
Annuities ➞ determine the cost of an annuity that meets spending
needs
Monte Carlo simulation – simulate several possible scenarios
using actual current portfolio
Behavioral Considerations: heightened loss aversion, consumption gaps
the annuity puzzle, preference for income
over cap. apprec.

Review - 6
LOS i/ IPS - objectives and risk tolerance over a relevant time
horizon
Parts/ 1. Background and Investment Objectives ongoing
one-time
detailed and quantified
- primary vs. secondary
2. Investment parameters
Risk Tolerance Investment Time Horizon
Asset Class Preferences Other Investment Preferences
Liquidity Preferences Constraints
3. Portfolio asset allocation
Discretionary authority
4. Portfolio management
Rebalancing
Tactical changes (if TAA followed)
Implementation
5. Duties and Responsibilities
- WM responsibilities, IPS Review
6. Appendix - modelled portfolio behavior, CMEs

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Review - 7
LOS L/ portfolio construction
1/ traditional approach - identify asset classes, develop CME,
determine asset allocation (typically MVO) within
constraints, implement, asset location
2/ goals-based investing - same process but align allocations with
goals (sub-portfolios)
- MVO on each sub-portfolio

LOS m/ 1/ Reporting - delivering info. about performance ➞ progress towards

goals
2/ Review - meetings with client to discuss client’s investment
strategy
LOS n/ evaluating success
1/ goal achievement - strategy likely to meet client goals?
2/ process consistency - has the plan been followed

Review - 8
LOS n/ evaluating success
3/ portfolio performance - absolute, relative, downside risk
consistent with risk
4/ definition of success - shared by both manager tolerance
and client

LOS o/ 1/ Fiduciary Duty & Suitability - obligation to deliver a high

2/ Know Your Client standard of care when acting
for the benefit of another
3/ Confidentiality
party
4/ Conflicts of Interest

LOS p/ 1/ Mass affluent - high client/manager ratio, non-customized solutions

2/ HNW - lower client/manager ratio, customized solutions
3/ Ultra-HNW - multi-generational time horizons, few clients/mgr.
4/ Robo-advisors - primarily digital interface, ETFs/MFs

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Topics in Private Wealth Management

Review - 1
LOS a - compare/ Income:
1/ Interest ➞ taxed as ordinary income (some forms may be tax-
exempt ➞ Munic. bonds)
2/ Dividends ➞ typically taxed favourably (if qualified)
3/ Cross-border income ➞ withholding tax, may be more favourable if
a tax treaty exists
4/ Capital gains ➞ tax basis = cost basis
long-term gain ➞ lower tax rate only realized
gains are
short-term gain ➞ taxed as income taxed
- capital losses can only be used to offset cap. gains

Wealth: Real estate taxes property tax ➞ wealth tax

net rental income - income tax

Wealth transfers: estate/inheritance/gift taxes

charitable giving provides a tax benefit

Review - 2
LOS a - compare/ taxation of components of return also
depend on the tax status of the account:
taxable
tax-deferred - pre-tax contributions - withdrawals taxed
tax-exempt - post-tax contributions as income
- no tax on withdrawals

LOS b - discuss/ Tax haven - countries with low tax rates

Territorial tax system - only locally sourced income is taxed
Worldwide tax system - all income is taxed regardless of its
- tax applies to residents source

LOS c - discuss/analyze/
- tax efficiency - very little of the return is given up as tax

R = pre-tax return
𝐑𝟏 = 𝐑 − 𝐭𝐚𝐱Y𝐯𝐚𝐥𝐮𝐞
𝐑𝟏 = after-tax return

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Review - 3
LOS c - discuss/analyze/
𝟏4
𝐧
𝐑𝟏𝐆 ≈ [&𝟏 + 𝐑𝟏𝟏 (&𝟏 + 𝐑𝟏𝟐 ( … (𝟏 + 𝐑𝟏𝐧 )] −𝟏
𝐥𝐢𝐪𝐮𝐢𝐝𝐚𝐭𝐢𝐨𝐧 𝐭𝐚𝐱
𝐑𝟏𝐏𝐋 ≈ ^&𝟏 + 𝐑𝟏𝟏 (&𝟏 + 𝐑𝟏𝟐 ( … (𝟏 + 𝐑𝟏𝐧 ) − b−𝟏
𝐟𝐢𝐧𝐚𝐥 𝐯𝐚𝐥𝐮𝐞
after-tax post-liquidation return (assumes tax is paid on all embedded
capital gains)
After-tax excess return: 𝐗 𝟏 = 𝐑𝟏 − 𝐁 𝟏
- tax alpha: 𝛂𝐭𝐚𝐱 = 𝐗 𝟏 − 𝐗 ➞ pre-tax excess return
𝟏
Tax efficiency ratio: 𝐓𝐄𝐑 = 𝐑 Y𝐑 higher = more tax efficient

LOS d - analyze/
accumulation: tax-exempt FV = (𝟏 + 𝐑)𝐧 - no tax
taxable FV = (𝟏 + 𝐑𝟏 )𝐧 - annual taxes on returns
tax-deferred FV = (𝟏 + 𝐑)𝐧 (𝟏 − 𝐭) - all taxed as ordinary
income

Review - 4
LOS d - analyze/
Decumulation - withdraw from taxable accounts first
- progressive tax regimes - withdraw from tax-deferred
account until lowest tax bracket has been hit
Charitable gifting - gift appreciated securities in taxable accounts
(if tax benefit exits)

LOS e - explain/
tax avoidance - legal activity (i.e. defer cap. gains)
tax evasion - illegal concealment of income
Strategies/ 1/ Structure investments legitimately to avoid taxes
tax-exempt/tax-deferred accts.
tax-exempt securities
long-term cap. gains
2/ Defer recognition of taxable income
limit turnover
tax-loss harvesting OID100851170.

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Review - 5
LOS e - explain/
Application: Investment Vehicle/
Partnerships - all tax liabilities passed through
MFs - income passed through as earned + ∆NAV cap. gains/loss
- new unitholders buy a share of the unrealized gain
𝐧𝐞𝐭 𝐠𝐚𝐢𝐧𝐬(𝐥𝐨𝐬𝐬𝐞𝐬)
𝐩𝐨𝐭𝐞𝐧𝐭𝐢𝐚𝐥 𝐜𝐚𝐩. 𝐠𝐚𝐢𝐧𝐬 𝐞𝐱𝐩𝐨𝐬𝐮𝐫𝐞 =
𝐭𝐨𝐭𝐚𝐥 𝐧𝐞𝐭 𝐚𝐬𝐬𝐞𝐭𝐬
ETFs - sponsor delivers low cost-basis shares during redemption
phase
- investor cap. gains when only they sell their shares

Tax-Loss Harvesting/ tax-lot accounting methods

FIFO LIFO HIFO (highest)
or/ may be PM choice

Quantitative Tax Mgmt./ - optimization technique

constraints: min. tracking error, max. realized losses, min. realized gains.

Review - 6
LOS f - discuss/
Risks - reduce company-specific risk - esp. if position is volatile or
has significant downside risk
- improve portfolio efficiency (risk diversification) - esp. if
position is large %’age of overall portfolio
- improve liquidity
Tax Objectives - minimize outsized tax liability due to low cost-basis
- esp. if tax basis is low or tax rate is high

LOS g - describe
1/ Sell and diversify
2/ staged diversification and completion portfolio

position + comp. port. = benchmark max. losses in

more sold:
the comp. port. to
lower TE partial factor exposures match against
higher tax sale less position gains from St. Div.
liability
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Review - 7
LOS g - describe
3. Equity Monetization: sh. sales
should leave some
1/ hedge position risk options
risk or else it may
forwards be deemed a
2/ borrow against position ➞ invest in 𝛒𝐃𝐈𝐕. ‘constructive
4. Tax-free exchanges e.g. exchange fund sale’

CP ➞ pooled
fund of ➞ exit ➞ div. portfolio of a cross-section of
other CPs the original CPs.
5. Charitable Remainder Trust
CP
Investor trust charity - when last beneficiary dies,
income remaining assets are
Beneficiaries distributed

LOS h - discuss/ IPO sale to 3rd party sale to insider

divest non-core assets personal line of credit (against company
- invest in 𝛒𝐃𝐈𝐕. shares)

Review - 8
LOS h - discuss/
Leveraged Recapitalization - sell majority to PE firm
- defer tax liability on the minority
- partial exit only, minority position continues to grow
ESOP - sale over time, staged-diversification
- employee pension play buys company shares over time
Real Estate: Mortgage Financing LTV ratio = 𝐍𝐑𝐈𝐀𝐓 + 𝐈𝐭
- use proceeds to invest in 𝛒𝐃𝐈𝐕.
- keep upside of property
Charitable donation - Donor-advised fund (e.g.)
Property ➞ DAF ➞ make donations
tax
sell property
benefit
no gains tax OID100851170.

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Review - 9
LOS i - discuss/
Objectives: transfer assets to next generation tax efficiently
- gift/estate/inheritance taxes
maintain sufficient income for current lifestyle
decide on control of assets
Asset protection - creditors, forced heirship, spendthrifts
preservation of family wealth civil law countries
business succession
achieving charitable goals - tax benefits

LOS j - discuss/ country’s legal system determines which estate planning

tools are available common law ➞ free choice
civil law ➞ restrictions on choice
Lifetime gifts - may be tax free below some threshold
- appreciation of gifted assets avoids estate tax
charitable - tax benefit

Review - 10
LOS j - discuss/
bequests - estate or inheritance tax (not always)
- usually some tax-free allowance
Efficiency of gifts vs. bequests
𝐫𝐠 = 𝐫𝐜
𝐧
𝐅𝐕𝐠𝐢𝐟𝐭 [𝟏 + 𝐫𝐠 &𝟏 − 𝐭 𝐠 (] 𝐭𝐠 = 𝐭𝐜
𝐑𝐕𝐭𝐱.𝐟𝐫𝐞𝐞 𝐠𝐢𝐟𝐭 = = 𝟏
𝐅𝐕𝐛𝐞𝐪𝐮𝐞𝐬𝐭 [𝟏 + 𝐫𝐜 (𝟏 − 𝐭 𝐜 )]𝐧 (𝟏 − 𝐓𝐜 ) 𝐭𝐡𝐞𝐧 𝐑𝐕 =
𝐧
𝟏 − 𝐓𝐜
[𝟏 + 𝐫𝐠 &𝟏 − 𝐭 𝐠 (] &𝟏 − 𝐓𝐠 (
𝐑𝐕𝐭𝐚𝐱𝐚𝐛𝐥𝐞 𝐠𝐢𝐟𝐭 =
[𝟏 + 𝐫𝐜 (𝟏 − 𝐭 𝐜 )]𝐧 (𝟏 − 𝐓𝐜 )

Estate Planning Tools/

1/ Trusts - common law - legal relationship
assets trustee indiv., grantor, trust company

grantor
trust
income

beneficiaries - beneficial, not legal, owner OID100851170.

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Review - 11
LOS j - discuss/
1/ Trusts Revocable - can rescind the trust
∴ grantor retains tax liability
- no creditor protection
Irrevocable - no right to rescind, no tax liability, creditor
protection
Fixed - distributions a legal right of beneficiary
Discretionary - distributions up to the trustee
Main motivations of a trust - Control, asset protection, tax-related
considerations
2/ Foundations - legal entity
- hold assets for charitable purposes
- asset protection
- no tax if minimum spending requirement met

3/ Life Insurance - bypasses probate, assets belong to ins. co.

- no tax on beneficiary

4/ Companies - lower corporate tax rates

Review - 12
LOS k - describe/
Family governance - process for collective communication and
decision making (system to transition and preserve wealth)
- common governance entities/
1/ Board of Directors - external members possibly
des
provi y
2/ Family Council - selected family members
inuit
cont 3/ Family Assembly - gathering of all family members
and
rchy 4/ Family Office - investment/admin. center
hiera
5/ Family Foundation - platform for philanthropy

Business exit
transition to a new generation - shares may be allocated as
sale of the business lifetime gifts
business transferred to a trust well in advance
future appreciation removed from the estate OID100851170.

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Review - 13
LOS k - describe/
pre-nuptial agreement
Divorce - protect family assets
post-nuptial agreement
- trust structure - may require pre-nup. as a condition of
trust benefit.
Incapacity
medical
POA
financial
- long process after the fact, difficult to challenge after
the fact
- living will ➞ stronger than medical P.O.A.
- legally binding

OID100851170.

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Risk Management for Individuals

Review - 1
LOS a, b - compare, discuss/
Human capital - PV of future earnings/wages
- largest asset on an economic balance sheet
𝐍
𝐏(𝐒𝐭 )𝐖𝐭$𝟏 (𝟏 + 𝐠 𝐭 ) 𝐏(𝐒𝐭 ) – prob. of survival
𝐇𝐂𝟎 = - 𝐖𝐭 = 𝐖𝐭$𝟏 (𝟏 + 𝐠 𝐭 )
(𝟏 + 𝐫𝐟 + 𝐲)𝐭
𝐭9𝟏 premium for
𝐠 = growth rate
discount rate should occupational income volatility
be consistent w/ risk of
wage growth & consistency

Financial Capital
➞ personal assets - not expected to increase in value
- worth derived from value-in-use
stocks
➞ investment assets - publicly traded marketable assets bonds
- non-publicly traded marketable assets
(real estate, annuities, cash value life ins.)
- non-marketable assets
(vested employer pension plans, gov’t. PPs)

Review - 2
LOS a, b - compare, discuss/
Net worth ➞ traditional assets - liabilities
Net wealth ➞ human capital + investment assets + PV(future
(economic net pension
worth) less: liabilities + PV(future consumption) benefits)
𝐍
𝐏(𝐒𝐭 )𝐛𝐭
LOS c - discuss/ ➞ Financial Stages of Life 𝐦𝐍𝐏𝐕 = &
(𝟏 + 𝐫)𝐭
1/ Education phase - little/no focus on saving & risk mgmt.
𝐭 $𝟏

2/ Early career - human capital largest asset

3/ Career Development - income growth, savings accumulation
4/ Peak Accumulation - begin to reduce investment risk
5/ Pre-Retirement - less volatile investments
6/ Early Retirement
7/ Late Retirement - longevity risk, health issues

LOS d - describe/ more comprehensively represents assets available

PV(all available marketable - PV(all current + = Net
& non-marketable assets) implied liabilities) Wealth OID100851170.

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LOS d - describe/ Review - 3

Financial Pension Real
human capital wealth Estate
capital

25 65 25 65 25 65 25 65

- at 25, human capital 50 - 55: pension wealth, financial

dominates capital & real estate dominate
- at 65, draw down assets
- 2 individuals with the same net worth may not have the same
net wealth ∴ should invest differently

LOS e - discuss/
1/ Earnings Risk - events that could negatively affect human &
financial capital
2/ Premature Death risk - mortality risk
- affects ability of family to meet financial needs/desires
3/ Longevity Risk - risk of outliving one’s assets
4/ Property Risk

Review - 4
LOS e - discuss/
5/ Liability Risk - legal liability
6/ Health Risk - illness/injury/long-term care costs
- reduces human capital

LOS f, g - describe/
Uses: a hedge against risk of premature death of an earner
- can also provide liquidity to a beneficiary (no probate)
- may also be used as a tax-sheltered savings instrument
Types: temporary (term) - only for a period of time, no cash value
permanent - provides lifetime coverage, usually some cash
a) whole life - remains in force for the insureds value
entire life
- ongoing fixed premiums, non-cancelable, usually a
cash value
b) universal life - variable premiums, more options for investing
cash value, stays in force as long as premiums are
paid OID100851170.
- riders can be added to both types

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Review - 5
LOS f, g - describe/
Pricing mortality expectations
discount rate – net premium
loading – add to net premium = gross premium
Stock companies ➞ profits accrue to shareholders
Mutual companies ➞ profits accrue to policyholders
⇒ Cash Values & Policy Reserves (whole life)
cash accumulation within the policy cash value increases
can be borrowed against insurance value decreases
premiums and face value stay constant
- since insurance is meant to replace human capital, may become
unnecessary after working years are over
Policy Reserves ➞ insurance company liability (increase to face value
over time)
Calculating Life Insurance needs
1/ human life value method - replace incomes
2/ needs analysis method - cover financial needs of survivor(s)

Review - 6
LOS f, g - describe/
Disability Income Insurance - offsets risk of lost earnings
1/ inability to perform regular occupation
2/ inability to perform any occupation one is suited for
3/ inability to perform any occupation
Property Insurance - all risks or named risks
(homeowner) – replacement cost vs. actual cash value
- deductibles
Auto Insurance - collision vs. comprehensive
Health/Medical Insurance - public or private
Liability Insurance - personal umbrella liability insurance policy

LOS h, i - discuss/Annuities/
insurer - insurance co.
annuitant - person who receives benefit
contract owner - person who purchased annuity
beneficiary - upon death of annuitant OID100851170.

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Review - 7
LOS h, i - discuss/Annuities/
Immediate annuity ⇒ specified amount for a specified period of
(irrevocable) payments begin right away time
Deferred annuity ⇒ annuity based on how much was put up
- attempts to provide protection against longevity
- payments begin at a later date
- both can be fixed or variable ➞ funds can be withdrawn
income based on performance of the assets
yield purchased
- will vary based on 𝐄(𝐑) insurance company
can earn ∴ low bond yields + longer life span = low income
yields
- annuitant locks in whatever rate of return
exists at time of purchase
- variable fee > fixed fees
Advanced Life Deferred Annuity - hybrid between deferred & immediate
fixed annuity (pure longevity insurance)
- buy now, payments begin late in life

Review - 8
LOS h, i - discuss/Annuities/
Taxation/payments = growth + return of principal

only this is taxed

-/ expected benefits of an annuity are generally negative
lower potential wealth at death, lower lifetime income
⇒ allocate more funds to annuities if:
- longer than average life expectancy
- less concern for leaving money to heirs

LOS j - analyze/critique/
- Strategies for loss control that do not involve insurance
1/ risk avoidance high freq. low freq.
2/ loss prevention high risk risk
3/ loss reduction severity avoidance transfer
do not insure = risk retention low risk risk
insure = risk transfer severity reduction retention
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Review - 9
LOS k - discuss/
- wage growth volatility - some professions are more bond-like
in volatility while others may be more stock-like
- most human capital is difficult to hedge with insurance
- more risky single source of income
lack of geographical mobility
employer specific human capital

LOS L - recommend/justify/
identify idiosyncratic risk exposures that can be
reduced through diversification or hedging
⇒ high exposure to human capital risk
- life/disability insurance
⇒ later in life ➞ higher exposure to financial capital risk
- low need for life/disability
- health/longevity risk increase

OID100851170.

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