Olivinia Heritage Case Scenario

CFA Level III Portfolio Management
#1

Bit confused about this question on practice exam. This has to with
" Olivinia Heritage Case Scenario" The final query is on the exhibit below and the answer is 1. Aren’t we comparing the current portfolio to the taa portfolio. Why is the comparion with policy portfolio?

Exhibit 3

Efficient Frontier from Assets Utilized by OHF

Exhibit 3

Question

The most appropriate conclusion that can be drawn from Exhibit 3 is that:

  1. management’s risk–return objectives may not have been achieved with the TAA portfolio.
  2. the current portfolio is a corner portfolio.
  3. the Sharpe ratios for the policy portfolio and the TAA portfolio are the same.
#2

What, exactly, are “management’s risk-return objectives”?

Clearly, #2, and #3 are wrong.

#3

Hi Bill why is 2 and 3 obviously wrong? If I thought that the current portfolio was what we are comparing the taa portfolio to then doesn’t the taa portfolio do a better job than the current portfolio? I just can’t understand why we are comparing the taa portfolio to the policy portfolio?

#4

#2 is wrong because a corner portfolio, by definition, is on the efficient frontier.

#3 is wrong by inspection: the slope of the line through RF and the Policy Portfolio is greater than the slope of the line through RF and the TAA Portfolio.

#5

That depends intimately on how you measure “better”.

By any reasonable measure, it does.

#6

Are you able to answer my original question?

#7

Icombed through the passage and I am not seeing this. This was also what tripped me up. I see what you mean by why number 2 is wrong.

Olivinia is an oil-rich state in the country of Puerto Rinaldo, which uses the US dollar as its official currency of exchange. In 1981, the state’s legislature created the Olivinia Heritage Fund (OHF) to collect a portion of the state’s non-renewable resource revenue and invest it on behalf of future generations. James Lafferty, the managing director of the fund, is one of the keynote speakers at the Global Wealth Creation Conference. He begins his presentation with a brief overview of OHF’s history (Exhibit 1).

Exhibit 1

An Overview of the Olivinia Heritage Fund

  • Phase 1 (1981–1991)The fund was given an initial allocation of $1 billion by the state. The fund was to receive 10% of all state revenues arising from taxes on oil and gas production and extraction. The fund was given a 20-year accumulation period over which no distributions were allowed and the fund was forecasted to grow to $10 billion. Income earned following the accumulation period was to be used to provide for public works and other public infrastructure within the state. Investments were restricted to cash and investment-grade bonds.
  • Phase 2 (1991–2001)By 1991, after being in existence for 10 years, the fund value had grown to $2.2 billion. At this time, transfers of state revenues from taxes on oil-related resources was halted and the government began to use income generated by the fund for direct economic development and social investment purposes. In addition to cash and investment-grade bonds, the investment mandate for the fund was expanded to include investments in private and public companies, real estate, and infrastructure investments. Management of cash and bond investments was performed in-house. For the higher-risk component of the portfolio, the fund hired external managers in an effort to increase return and correspondingly lower the incidence of negative performance. These managers were hired or retained if they had outperformed other active managers in their sectors in at least the prior two years. The fund value at the end of this period was $6 billion.
  • Phase 3 (2001–2014)Strong reform legislation related to the original intent of the fund was introduced in 2001. It reinstated transfers of oil-related taxes to the fund, increasing them to 35% of oil- and gas-related state revenues. In addition, the fund was mandated to have 50% in public equities through passive index funds and 10% in cash and investment-grade bonds. The remainder was to be divided equally between high-yield bonds, real estate, private equity, and hedge funds and would continue to be managed externally. All investments were to be made outside the country to avoid overheating the national economy. Investments managed by individual external managers was limited to approximately $75 million. A two-thirds majority in both the upper and lower legislative bodies was required to change any future legislation related to the fund. By the end of this phase, the fund was worth $28 billion.
  • Phase 4 (2014–Present)The fund’s management felt that the significant decline in oil prices since mid-2014 and lowered production levels were likely to persist through several business cycles, requiring a change in strategy to maintain the long-term objectives of the funds. They sought government approval for lower withdrawals from the fund, higher equity exposure, and the flexibility to vary asset class policy weights by as much ±5% for each asset class from the static weights that had previously existed. The government reaffirmed its commitment to the fund given in Phase 3, and legislative approval was received for these changes, including the ability to increase public equity exposure to 65% and reduce investment-grade bond exposure to as little as 7.5%. Of the remaining authorized assets, no one asset class could have a weight in excess of 10%.

Lafferty states that ever since the fund was given the authority to vary asset class policy weights from their strategic levels, it has actively engaged in tactical asset allocation (TAA) using a variety of proprietary short-term forecasting tools that have been developed in-house. He provides the data in Exhibits 2 and 3 to illustrate the results of one such shift in the fund’s asset allocation following a signal from its TAA model.

Exhibit 2

Example of a Short-Term Shift in Asset Allocation

Asset Class Current Weights* Policy Weights TAA Weights Period Returns
Investment-grade bonds 12% 15% 10% 1.75%
High-yield bonds 8 6.25 10 3.0
Public equity 63 60 65 7.0
Private equity 5 6.25 6.25 4.5
Real estate 6.25 6.25 2.5 –4.0
Infrastructure 6.25 6.25 6.25 2.5