2020 Level 1 Mock exam B Morning

CFA Level I Ethics
#1

Bailey Watson, CFA, manages 25 emerging market pension funds. He recently
had the opportunity to buy 100,000 shares in a publicly listed company whose
prospects are considered “above industry norm” by most analysts. The company’s shares rarely trade because most managers take a “buy and hold” strategy due to the company’s small free float. Before placing the order with his dealer, Watson allocated the shares to be purchased according to the weighted value of each of his clients’ portfolios. When it came time to execute the trades,
the dealer was only able to purchase 50,000 shares. To prevent violating Standard Bailey Watson, CFA, manages 25 emerging market pension funds. He recently
had the opportunity to buy 100,000 shares in a publicly listed company whose
prospects are considered “above industry norm” by most analysts. The company’s shares rarely trade because most managers take a “buy and hold” strategy due to the company’s small free float. Before placing the order with his dealer, Watson allocated the shares to be purchased according to the weighted value of each of his clients’ portfolios. When it came time to execute the trades,
the dealer was only able to purchase 50,000 shares. To prevent violating Standard III(B)–Fair Dealing, it would be most appropriate for Watson to reallocate the 50,000 shares purchased by:
A. reducing each pension fund’s allocation proportionately.
B distributing them equally amongst all the pension fund portfolios.
C allocating randomly but giving funds left out priority on the next similar
type trade.

So the answer says: the most appropriate way to handle the reallocation of an illiquid share is to reduce each client’s proportion on a pro rata, or weighted basis.

  1. I don’t understand why it says is “illiquid share”?
  2. How exactly does “reduce each client’s proportion on a pro rate, or weighted basis” work? Shouldn’t the principle always be “allocating based on pro-rata order size”?

Thanks so much!

#2

Greetings, I think - if I understand you correctly - that you are saying answer A is correct.

And answer A is in fact correct.

If the original allocation was supposed to be 10,000 shares to client X, 40,000 shares to client Y and 50,000 shares to client Z in the above example… But then when the trade actually happens the portfolio manager can only get 50,000 shares and not 100,000 as planned, then the allocation would look like this given the facts above:

5,000 shares to client X
20,000 shares to client Y
25,000 shares to client Z

You are allocating each of them 50% of their originally planned allocation, according to the number of shares they were originally supposed to receive. Another way to look at it is on a weighted basis:

Client X receives a 10% allocation of the portfolio manager’s total received shares.
Client Y receives a 40% allocation.
Client Z receives a 50% allocation.

If you apply these percentages to 50,000 shares you get the same numbers. They say “illiquid shares” because they explain in the problem above that the shares have a small free float and do not trade much. They are describing a lack of liquidity.

The general thing they’re testing on here is the concept that if the portfolio manager receives half the planned amount of shares, unless all clients signed contracts with him saying certain types of clients receive allocation preferences above others (and it is not said that way here), then ALL clients should receive the same consistent percentage amount compared to their original allocation percentage in such case. Just applied to fewer shares. This avoids prejudicing some clients.

Cheers you got this :+1:

#3

Hello @Greybeard_The_Elder Yes answer is A, I should have put that on.
Thank you very much for the detailed explanations, this helps A LOT. I got it! Thanks!

1 Like
#4

Cheers and good luck! You got this :+1: