Schweser’s Secret Sauce®
Level III CFA®
2022
SCHWESER’S SECRET SAUCE®: 2022 LEVEL III CFA®
©2022 Kaplan, Inc. All rights reserved.
Published in 2022 by Kaplan, Inc.
Printed in the United States of America.
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ISBN: 978-1-0788-1864-3
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Reproduced and republished from 2022 Learning Outcome Statements, Level I, II, and III
questions from CFA® Program Materials, CFA Institute Standards of Professional Conduct, and
CFA Institute’s Global Investment Performance Standards with permission from CFA Institute.
All Rights Reserved.”
Disclaimer: The SchweserNotes should be used in conjunction with the original readings as set
forth by CFA Institute in their 2022 Level III CFA Study Guide. The information contained in
these Notes covers topics contained in the readings referenced by CFA Institute and is believed
to be accurate. However, their accuracy cannot be guaranteed nor is any warranty conveyed as
to your ultimate exam success. The authors of the referenced readings have not endorsed or
sponsored these Notes.
CONTENTS
Foreword
Behavioral Finance: SS 1
Capital Market Expectations: SS 2
Asset Allocation and Related Decisions in Portfolio Management (1, 2): SS 3
Derivatives and Currency Management: SS 4
Fixed-Income Portfolio Management (1, 2): SS 5 & 6
Equity Portfolio Management (1, 2): SS 7 & 8
Alternative Investments for Portfolio Management: SS 9
Private Wealth Management (1, 2): SS 10 & 11
Portfolio Management for Institutional Investors: SS 12
Trading, Performance Evaluation, and Manager Selection: SS 13
Cases in Portfolio Management and Risk Management: SS 14
Ethical and Professional Standards: SS 15 & 16
Essential Exam Strategies
Index
FOREWORD
The Secret Sauce is a summary of the high points of the Level III SchweserNotes™, which
are based on the 2022 Level III CFA® Curriculum. The Secret Sauce is meant to be used
as a review tool after having read the SchweserNotes or thoroughly studying the
curriculum in some other manner. The Secret Sauce is a phenomenal way to review the
whole curriculum in a relatively short period of time in the last week or two before
the exam. I recommend that you read the Essential Exam Strategies section near the end
of this book irst as soon as possible to incorporate these into your inal month of
studying.
Candidates who study and practice the material have every reason to do well on the
exam. But don’t fall into the trap of expecting exam questions to be exactly like practice
questions. Learn the underlying concepts, apply the concepts in practice questions, and
expect surprises on exam day. CFA Institute always inds a way to throw in a few twists.
At Level I, you largely memorized facts and equations and simply applied them to short
multiple-choice questions on the exam. At Level II, the topical coverage was more
technically dif icult with the concepts from within a topic area tested in a stand-alone
item set. At Level III, you could be expected to integrate multiple concepts from different
parts of the curriculum and apply them to a 4- or 6-part multiple choice item set or
constructed response (essay type) question.
Which is the other major challenge at Level III—the constructed response (essay) irst
section of the exam. You must know the material and directly answer the question asked
using an appropriate amount of verbiage. CFA Institute does not award points for a
general display of knowledge. Our coaching using the old CFA exam questions and Mock
Exams illustrate how to answer constructed response questions in suf icient depth.
Answering constructed response questions is a skill acquired through learning the
curriculum and a lot of practice writing short answers to open-ended questions.
Level III provides its own unique challenges. Through proper preparation and suf icient
practice, you will succeed!
I wish you all the best on exam day.
Kurt Schuldes, MBA, CFA, CAIA
Senior Content Specialist
Kaplan Schweser
BEHAVIORAL FINANCE
Study Session 1
Expect behavioral inance to make up approximately 5% of the exam. Item set questions
and material integrated into IPS constructed response questions are equally probable.
Behavioral inance concepts are not complicated but there is a lot of overlapping
terminology in other areas such as capital market expectations and asset allocation.
Because of the extensive amount of terminology, some candidates have found lashcards
to be an effective study tool to help with differentiating between some of the terms.
THE BEHAVIORAL BIASES OF INDIVIDUALS
Cross-Reference to CFA Institute Assigned Reading #1
Emotional biases are caused by individuals’ psychological predispositions. Emotional
bias is not deliberate; it is more of a spontaneous reaction and it is more dif icult to
overcome.
Cognitive errors are the result of mechanical or physical limitations; they result from
the inability to analyze all information or from basing decisions on incomplete
information. Cognitive errors are easier to overcome than emotional biases and respond
to education.
Cognitive errors stemming from belief perseverance:
Conservatism bias. An initial view is rationally formed based on initial
information and then maintained.
– Implications: Investors are to slow to update views and may hold securities
too long. To mitigate, seek new information and alternative views.
Con irmation bias. Only information that supports the initial view is sought or
considered.
– Implications: Can lead to under-diversi ication and over concentration in
employer stock. To mitigate, seek out contrary information and alternate
methods of analysis.
Representativeness bias. Once a classi ication is made, the accuracy of the
classi ication is not considered. Base-rate (the assumed probability of the
classi ication) and sample-size (the amount of initial data) neglect are forms of
representativeness.
– Implications: Overemphasizing data covering short time periods and reacting
too quickly to new information. To mitigate, understand statistical analysis
and develop a suitable long-term strategic asset allocation for the portfolio.
Illusion of control bias. Individuals assume they can in luence the outcome even
when they cannot.
– Implications: Trade too quickly and under-diversify. To mitigate, apply
probabilistic analysis, consider alternative views and worst case scenarios.
Hindsight bias. Selectively remembering what was known or done in the past.
– Implications: Taking too much risk or clients who unfairly blame their
manager. To mitigate, keep and review records to determine successes and
failures. Don’t confuse value added with an up market.
Cognitive errors stemming from processing errors:
Anchoring and adjustment. Similar to conservatism except changes are made
from the initial conclusion point.
– Implications: Failing to make a large enough adjustment from the initial
anchor point. To mitigate; consider what would happen if a new analysis were
made instead of starting from the initial anchor.
Mental accounting bias. Funds are categorized and the categorization determines
how the funds are treated (the layers in BPT).
– Implications: Ignores correlation causing risk to be overstated. Incorrectly
shifts portfolio focus from total return to income received. To mitigate, look
at the total return and risk of the overall portfolio.
Framing bias. How information is presented changes the decision made (perceived
gain versus loss).
– Implications: Short-term trading and sub-optimal asset allocation. To
mitigate, focus on expected return and risk, not perceived gain or loss from a
past value.
Availability bias. Confusing what is easy to recall with what is important.
– Implications: Making choices based on irrelevant information and inadequate
diversi ication. To mitigate, follow a disciplined research process and an
investment policy statement.
Emotional Biases
Loss aversion bias. See prospect theory. Investors feel the pain of realized losses
more than the pleasure of realized gains and are, therefore, likely to sell winners
and hold losers. Myopic loss aversion postulates that many investors will under
invest in riskier equities, keeping equity prices too low and subsequent equity
returns too high.
– Implications: Selling winners may reduce upside and holding losers may
increase risk. To mitigate, objectively forecast expected return and risk.
Overcon idence bias. Also referred to as illusion of knowledge. People feel they are
smarter or know more than they do.
– Implications: Underestimate risk and overestimate return, under diversify,
and trade too much. To mitigate, maintain and review records of what works
and what does not.
Prediction overcon idence is the tendency to overestimate accuracy. Certainty
overcon idence refers to con idence increasing faster than accuracy. Self-attribution
bias refers to claiming credit for success and blaming others for failure.
Self-control bias. See consumption and savings model. Lack of self-discipline.
Individuals fail to balance the need for short-term satisfaction with long-term
goals.
– Implications: Save too little and then take too much risk in an effort to
compensate. Hold too many bonds to generate higher current income. To
mitigate, establish and follow a budget and an investment policy statement.
Status quo bias. Feeling comfortable with what currently exists and therefore not
making changes.
– Implications: Inappropriate risk and return. This is a hard bias to overcome;
try to educate the client.
Endowment bias. Feeling what is owned is more valuable (better) than what could
replace it, leading to status quo bias.
– Implications: Holding what is owned leading to inappropriate asset
allocation. If the bias imperils the ability of the client to meet critical goals,
mitigation becomes essential. This may have to be done in stages.
Regret-aversion bias. Do nothing to avoid the mental anguish of making an error
of commission, leading to status quo bias.
– Implications: Portfolios that are too conservative or aggressive. Mitigation
requires educating the client on what combinations of return and risk are
reasonable.
Investment Policy and Asset Allocation: Behaviorally
Modified Asset Allocation
Applying goals-based investing, the investor builds a portfolio one layer at a time. Each
layer of the portfolio consists of assets used to meet individual goals or subsets of goals.
The bottom layer of the pyramid is constructed irst and is comprised of assets
designated to meet the investor’s most important goals. Each successive layer consists of
increasingly risky assets used to meet less and less important goals. This allows the
investor to see risk more clearly.
The layered portfolio is probably not ef icient from a traditional inance perspective, but
the investor is comfortable with it and will, thus, be more likely to adhere to the strategy.
The construction of the modi ied portfolio considers the investor’s emotional and
cognitive behavioral biases and current wealth.
Allowable deviations from a traditional inance ef icient portfolio depend on whether the
client’s biases are more emotional or cognitive and the client’s standard of living risk
(SLR). Clients with high wealth to needs have low SLR.
Higher deviations are acceptable for clients with low SLR and emotional biases.
Lower deviations are necessary and possible for clients with high SLR and cognitive
biases.
BEHAVIORAL FINANCE AND INVESTMENT
PROCESSES
Cross-Reference to CFA Institute Assigned Reading #2
One of the goals of BF is to help managers better understand clients and tailor
investment plans in a way the client can understand and stick with. Classifying client
characteristics is one tool to assist the manager in understanding the client.
Classi ication models include the following:
1. The Barnewall two-way behavioral model1 classi ies investors as passive or
active. Passive investors have not had to risk their own capital to gain wealth. Active
investors have risked their own capital to gain wealth and usually take an active
role in investing their own money.
2. The Bailard, Biehl, and Kaiser (BB&K) ive-way model2 classi ies investors into
ive categories along two dimensions, con idence (con ident is low risk aversion
versus anxious is high risk aversion) and method of action (bases decisions on
thinking versus emotion and feeling).
3. The Pompian behavioral model3 classi ies the investor as active (more willing to
take risk) or passive (less willing to take risk) and classi ies the client’s biases as
cognitive or emotional to identify four behavioral investor types (BITs):
– Passive Preserver: Emotional biases with higher risk aversion.
– Friendly Follower: Cognitive biases with higher risk aversion.
– Independent Individualist: Cognitive biases with lower risk aversion.
– Active Accumulator: Emotional biases with lower risk aversion.
Limitations of Classifying Investors Into Behavioral Types
1. Individuals may simultaneously display both emotional biases and cognitive errors;
the key issue is determining how to help the client accomplish her goals.
2. An individual might display traits of more than one behavioral investor type.
3. As investors age or circumstances change, they will most likely go through
behavioral changes resulting in decreased or changing risk tolerance.
4. Even though two individuals may fall into the same behavioral investor type, the
individuals should not be treated the same due to their unique circumstances and
psychological traits.
5. Individuals tend to shift unpredictably between rational to irrational behavior.
The Client/Adviser Relationship
Behavioral inance insights help the manager build a stronger business:
1. Understand the “why” behind a client’s goals to build a stronger relationship.
2. Applying BF insights allows the manager to present advice the client can accept.
3. Applying BF insights allows the manager to meet and satisfy the client’s
expectations.
4. A stronger manager/client bond results in better business for the manager.
Risk Tolerance Questionnaires
Questionnaires are often used to classify clients but these questionnaires have
limitations:
The same questionnaire can produce different results if the structure of the
questions is changed.
Investor biases are often ignored.
Since the client’s IPS should be analyzed annually for appropriateness, the
questionnaire should also be administered annually.
Advisers may interpret what the client says too literally; client statements should
be indicators.
Risk tolerance questionnaires are probably better suited to institutional investors,
where less interpretation is required.
– Institutional investors are generally more pragmatic and tend to approach
investing from a thinking/cognitive approach with a better understanding of
risk and return.
Defined Contribution Plans and Employer Stock
Recognizing participants’ lack of investing knowledge and tendency toward a status quo
bias, many de ined contribution pension plans have begun offering target date funds.
Target date funds, however, do not consider the individual’s personal characteristics or
assets held outside the plan. Individuals are also likely to utilize naïve diversi ication.
Reasons why employees have a tendency to invest in their company’s stock:
1. Familiarity and overcon idence.
2. Representativeness; naı̈vely extrapolate past good performance into expectations.
3. Framing; employer’s contribution in stock instead of cash is seen as an implicit
recommendation of the quality of the stock as an investment.
4. Loyalty; hold the stock in an effort to help the company.
5. Financial incentives; tax incentives or allowed to purchase the stock at a discount.
Retail Clients
In contrast to the behavioral traits of DC plan participants, some retail investors trade
their brokerage accounts excessively. Excessive trading is thought to be caused by
overcon idence based on a false sense of insight into the investment’s future performance.
The typical result is lower overall returns due to trading costs and the disposition effect,
selling winners too soon and holding losers too long. Home bias is the behavioral trait of
investors placing a high proportion of their assets in the stocks of irms in their own
country.
Analyst Forecasts and Behavioral Finance
There are three primary behavioral biases that can affect analysts’ forecasts:
overcon idence; the way management presents information; and biased research.
Overconfidence
Overcon idence is undue faith in their own forecasting abilities caused by an in lated
opinion of their own knowledge, ability, and access to information. Tend to remember
previous forecasts as being more accurate than they really were (a form of hindsight
bias).
Factors contributing to overcon idence:
Illusion of knowledge bias: They think they are smarter than they are, and forecasts
are more accurate than the evidence indicates. Fueled by collecting a large amount
of data.
Representativeness: Incorrectly combining the probability that the information its
a certain information category and the probability that the category of information
its the conclusion.
Availability bias: Undue weight given to more readily accessible, recently recalled
data.
Ego defense mechanisms:
– Self-attribution bias. Analysts take credit for their successes and blame
others or external factors for failures.
– Hindsight bias. Selectively recall the forecast or reshape it in such a way that
it its the outcome. By making their prior forecasts it outcomes, they fail to
properly recalibrate their models when making future forecasts.
Mitigating overcon idence:
Self-calibrate; analyze forecasts in relation to the actual outcome. Getting prompt
feedback through self-evaluations, colleagues, and superiors, combined with a
structure that rewards accuracy should lead to better self-calibration.
Seek at least one counterargument for why the forecast may not be accurate. The
analyst should also consider sample size. Basing forecasts on small samples can lead
to unfounded con idence in unreliable models.
Utilize a Bayesian framework to re-estimate probabilities.
Influence by Company Management
The way a company’s management presents (frames) information can in luence how
analysts interpret it and include it in their forecasts. The problem stems from company
managers themselves being susceptible to behavioral biases. There are three cognitive
biases exhibited by management when reporting company results:
1. Framing: Analysts should be aware that the typical management report presents
accomplishments irst.
2. Anchoring and adjustment: Anchored to the previous forecast; the analyst is not
able to fully incorporate the effect of new information.
3. Availability: The enthusiasm with which managers report operating results and
accomplishments makes the information very easily recalled.
Managers are also susceptible to self-attribution bias; inclined to over-emphasize the
positive as well as the extent to which their personal actions in luenced the operating
results. Self-attribution leads to excessive optimism (overcon idence).
Analysts must be wary of restated earnings because management compensation is based
largely on operating results. To help avoid the undue in luence in management reports,
analysts should focus on veri iable quantitative data rather than on subjective
information provided by management.
Analyst Biases in Research
Overcon idence: Usually related to collecting too much information, which leads
to the illusions of knowledge and control and to representativeness, all of which
contribute to overcon idence.
Con irmation bias: Tendency to view new information as con irmation of an
original forecast.
Gambler’s fallacy: Thinking there will be a reversal to the long-term mean more
frequently than actually happens. An example is incorrectly increasing the odds of
heads on the next toss (greater than 50%) because tails has come up several times
in a row.
Representative bias: Inaccurately extrapolate past data into the future. For
example, classifying a irm as a growth irm based solely on recent high growth.
Preventing Bias in Research
Analysts should be aware of the possibility of anchoring and adjustment when they
recalibrate forecasts. Take a systematic approach with prepared questions and gather
data before forming any opinions or making any conclusions.
The analyst should use a structured process by incorporating new information,
sequentially assigning probabilities using Bayes’ formula to help avoid conclusions with
unlikely scenarios. He should seek contradictory evidence formulating a contradictory
opinion instead of seeking more information that proves his initial hypothesis. He should
get prompt feedback that allows him to re-evaluate his opinions and gain knowledge for
future insight, all along documenting the whole process.
Investment Committees
In a group setting, individual biases can be either diminished or ampli ied with additional
biases being created.
Social proof bias: Following the beliefs of a group (i.e., groupthink). Decision
making in a group setting is notoriously poor. Committees do not learn from past
experience because feedback from decisions is generally inaccurate and slow;
systematic biases are not identi ied. The remedy is for committees to consist of
individuals with diverse backgrounds, members who are not afraid to express their
opinion.
Market Behavior
When a pattern emerges in which mispricing seems to persist and even be predictable,
we call this an anomaly.
Momentum effect: A pattern of returns that is correlated with the recent past
(i.e., trend); caused by investors following others. Forms include the following:
– Herding: Investors trade in the same direction or in the same securities.
Makes investors feel more comfortable because they are trading with the
consensus of a group. Two behavioral biases associated with herding are the
availability bias, also known as the recency bias, or recency effect. Recent
information is given more importance because it is most vividly remembered.
The recent data is extrapolated by investors into a forecast.
– Regret: The feeling that an opportunity has passed by; a hindsight bias.
Regret can lead investors to buy investments they wish they had purchased,
which in turn fuels a trend-chasing effect. Chasing trends can lead to excessive
trading, resulting in short-term trends.
Financial Bubbles and Crashes
Unusual positive or negative returns caused by panic buying and selling; a period of
prices two standard deviations from their mean. A crash can also be characterized as a
fall in asset prices of 30% or more over a period of several months; bubbles usually take
longer to form.
Behavior during bubbles:
Overcon idence: Excessive trading, underestimating risk, concentrated portfolios,
rejection of contradictory information.
Con irmation bias: Investors acknowledge evidence that con irms their beliefs
and ignore evidence that contradicts their beliefs.
Self-attribution bias: Take personal credit for successes without attempting to
link performance to strategy.
Hindsight bias: Tendency to see outcomes as expected based on the past; link
outcomes to forecasts.
Regret aversion: Investors do not want to miss the gains everyone else is enjoying.
Disposition effect: Investors are more willing to sell winners and hold onto losers,
leading to the excessive trading of winning stocks.
As the bubble unwinds in the early stages, investors are anchored to their beliefs, causing
them to underreact as they are unwilling to accept losses. As the unwinding continues,
the disposition effect dominates as investors hold onto losing stocks in an effort to
postpone regret.
Value vs. Growth
Researchers4 found that value stocks outperformed growth stocks in 12 of 13 markets
over a 20-year period from 1975 to 1995. Small-cap stocks outperformed large-caps in
11 of 16 markets. They contend that the relative performance is due to risk exposures of
companies with a particular size and book-to-market value being more vulnerable during
economic downturns.
In the halo effect, the investor transfers favorable company attributes into thinking the
stock is a good buy. A company with a good record of growth and share price
performance is seen as a good investment with continued high expected returns. This is a
form of representativeness in which investors extrapolate past performance into future
expected returns, leading growth stocks to become overvalued (poor investments
relative to value stocks).
The most persistent market anomalies that challenge the ef icient market hypothesis are
the momentum effect, bubbles, and crashes. Most anomalies start out as individual
emotional and cognitive biases causing over- or underreaction, which turns into
irrational group behavior.
1. Barnewall, Marilyn. 1987. “Psychological Characteristics of the Individual Investor.” Asset Allocation for
the Individual Investor. Charlottesville, VA: The Institute of Chartered Financial Analysts.
2. Bailard, Brad M., David L. Biehl, and Ronald W. Kaiser. 1986. Personal Money Management, 5th ed.
Chicago: Science Research Associates.
3. Pompian, Michael. 2008. “Using Behavioral Investor Types to Build Better Relationships with Your
Clients.” Journal of Financial Planning, October 2008:64-76.
4. Fama, Eugene F. and Kenneth R. French, 1998. “Value versus Growth: The International Evidence.”
Journal of Finance, vol 53, no. 6:1975–1999.
CAPITAL MARKET EXPECTATIONS
Study Session 2
The economics material here is applied in nature and therefore, a big departure from the
technical nature of economics testing at Levels I and II even though many of the concepts
are the same (e.g., economic growth, monetary and iscal policy, and international
economics). In order to be successful in economics at Level III, you must be able to go
beyond the mere technical aspects and be able to apply the concepts (e.g., forecasting).
There is some overlap of material here with behavioral inance, quantitative methods
(from Level II), and foreign currency, for example. Based on history, expect Study
Session 2 to be closer to 10% of the exam and to appear in a combination of item set and
constructed response questions.
CAPITAL MARKET EXPECTATIONS, PART 1:
FRAMEWORK AND MACRO CONSIDERATIONS
Cross-Reference to CFA Institute Assigned Reading #3
To formulate capital market expectations, the analyst should use the following sevenstep process.
Step 1: Determine the speci ic capital market expectations needed according to the
investor’s tax status, allowable asset classes, and time horizon.
Step 2: Investigate assets’ historical performance as well as the determinants of
(i.e., factor affecting) their performance.
Step 3: Identify the valuation model used and its requirements.
Step 4: Collect the best data possible.
Step 5: Use experience and judgment to interpret current investment conditions.
Step 6: Formulate capital market expectations.
Step 7: Monitor performance and use it to re ine the process.
Problems in Forecasting
Nine problems encountered in producing forecasts are: (1) limitations to using economic
data; (2) data measurement error and bias; (3) limitations of historical estimates; (4) the
use of ex post risk and return measures; (5) non-repeating data patterns; (6) failing to
account for conditioning information; (7) misinterpretation of correlations;
(8) psychological biases; and (9) model uncertainty.
Analysts are susceptible to six psychological biases:
1. Anchoring bias.
2. Status quo bias.
3. Con irmation bias.
4. Overcon idence bias.
5. Prudence bias.
6. Availability bias.
Trend Rate of Growth
Economic growth trend rates are subject to unexpected surprises or shocks that are
exogenous to the economy and cannot be predicted.
Exogenous shocks are caused by numerous factors:
Changes in government policies.
Political events.
Technological progress.
Natural disasters.
Discovery of natural resources.
Financial crises.
Overall, the trend rate of growth is more (less) stable in developed (emerging)
economies.
A basic model for forecasting the economic growth rate is the sum of three components:
Labor input (based on growth in the labor force and labor participation).
Capital per worker (which increases labor productivity).
Total factor productivity (which is re lected in technological progress and changes
in government policies).
Market Forecasting
Econometric analysis uses statistical methods to explain economic relationships and
formulate forecasting models. Structural models are based on economic theory, while
reduced-form models are compact versions of structural approaches.
Economic indicators include leading indicators that move ahead of the business cycle
with a reasonably stable lead time. They also include coincident and lagging indicators
that move with and after changes in the business cycle and can be used to con irm what
is happening in the economy.
A checklist approach is more subjective and considers a series of questions. Judgment and
perhaps some statistical modeling is used to interpret the answers and formulate a
forecast.
The Business Cycle
Understanding business cycle phases is important for forming capital market
expectations, but there are some limitations to business cycle analysis:
Business cycles vary in duration and intensity, and their turning points are dif icult
to predict.
It can be dif icult to distinguish which effects result from shorter-term factors that
arise from the business cycle and which are related to longer-term factors that
affect the trend rate of economic growth.
Returns in the capital market are strongly related to activity in the real economy,
but they also depend on factors such as investors’ expectations and risk tolerances.
The longer-term business cycle can be subdivided into ive phases: the initial recovery,
early expansion, late expansion, slowdown, and contraction.
Initial Recovery
Duration of a few months.
Business con idence is rising.
Government stimulation is provided by low interest rates and/or budget de icits.
Falling in lation.
Large output gap.
Low or falling short-term interest rates.
Bond yields are bottoming out.
Rising stock prices.
Cyclical, riskier assets such as small-cap stocks and high yield bonds do well.
Early Expansion
Duration of a year to several years.
Increasing growth with low in lation.
Increasing con idence.
Rising short-term interest rates.
Output gap is narrowing.
Stable or rising bond yields.
Rising stock prices.
Late Expansion
High con idence and employment.
Output gap eliminated and economy at risk of overheating.
In lation increases.
Central bank limits the growth of the money supply.
Rising short-term interest rates.
Rising bond yields.
Rising/peaking stock prices with increased risk and volatility.
Slowdown
Duration of a few months to a year or longer.
Declining con idence.
In lation is still rising.
Short-term interest rates are at a peak.
Bond yields have peaked and may be falling, resulting in rising bond prices.
Yield curve may invert.
Falling stock prices.
Contraction
Duration of 12 to 18 months.
Declining con idence and pro its.
Increase in unemployment and bankruptcies.
In lation tops out.
Falling short-term interest rates.
Falling bond yields, rising prices.
Stock prices increase during the latter stages anticipating the end of the recession.
Inflation
In lation means generally rising prices and is measured most frequently by consumer
price indices. In lation peaks in the latter stages of economic expansion and falls during a
recession and the initial stages of recovery.
A decline in the level of in lation (but not negative in lation) is called disin lation.
De lation refers to generally decreasing prices (i.e., a negative rate of in lation). Such a
general decline in prices discourages all economic activity, encourages default on loans,
and produces very low or negative interest rates. Following the inancial crisis of 2007–
09, some central banks adopted quantitative easing (an announced long term policy of
wide spread purchase of both shorter- and longer-term inancial assets in an effort to
stimulate the economy). The detrimental effects of de lation cause central banks to
prefer some level of (positive) in lation.
In lation Expectations and Asset Classes
Monetary Policy
The latter stages of an economic expansion are often characterized by increased in lation.
As a result, central banks usually resort to restrictive policies towards the latter part of
an expansion.
To spur growth, a central bank will cut short-term interest rates. This results in greater
consumer spending, greater business spending, higher stock prices, and higher bond
prices. Lower real interest rates also usually result in a lower value of the domestic
currency, which is thought to increase exports. The equilibrium interest rate in a country
(the rate that produces a balance between growth and in lation) is referred to as the
neutral rate.
The Taylor rule determines the target interest rate using the neutral rate, expected GDP
relative to its long-term trend, and expected in lation relative to its targeted amount. It
can be formalized as follows:
ntarget = rneutral + iexpected + [0.5 (GDPexpected − GDPtrend) + 0.5 (iexpected − itarget)]
Negative Interest Rates
A negative rate is de ined as a net payment made to keep money on deposit at a inancial
institution or payment of a net fee to invest in short-term instruments.
Essentially the implicit advantages of being able to quickly transfer large amounts of
money held on deposit to settle transactions outweighed the explicit cost of holding
those deposits at negative rates. In other words, negative interest rates did not cause the
expected large move into physical cash (which would have a more favorable interest rate
at zero percent).
Fiscal Policy
If the government wants to stimulate the economy, it can decrease taxes and/or increase
spending, thereby increasing the budget de icit. If they want to rein in growth, the
government does the opposite.
There are two important aspects to iscal policy. First, it is not the level of the budget
de icit that matters, it is the change in the de icit. For example, a de icit by itself does not
stimulate the economy, but increases in the de icit are required to stimulate the
economy. Second, changes in the de icit that occur naturally over the course of the
business cycle are not stimulative or restrictive.
The Yield Curve
When both iscal and monetary policies are simulative, the yield curve is sharply upward
sloping (i.e., short-term rates are lower than long-term rates), and the economy is likely
to expand in the future.
When iscal and monetary policies are restrictive, the yield curve is downward sloping
(i.e., it is inverted as short-term rates are higher than long-term rates), and the economy
is likely to contract in the future.
When iscal and monetary policies are in disagreement, the implications for the economy
are less clear.
If monetary policy is stimulative while iscal policy is restrictive, the yield curve
will be upward sloping, though it will be less steep than when both policies are
expansive (i.e., moderately steep).
If monetary policy is restrictive while iscal policy is stimulative, the yield curve
will be lat.
International Considerations
Macroeconomic links refer to similarities in business cycles across countries.
Economies are linked by both international trade and capital lows so that a recession in
one country dampens exports and investment in a second country, thereby creating a
slowdown in the second country. How the current account in luences economic activity
can be shown in the following formula:
net exports = net private saving + government surplus
Another link between economies results from exchange rates. A strong link is
established when a smaller economy pegs its currency to that of a larger and more
developed economy. Interest rates between the two economies will often re lect a risk
premium indicating the market’s con idence in the peg, with the smaller economy
generally having higher interest rates. If con idence is high (low), the interest rate
differential will be small (large).
CAPITAL MARKET EXPECTATIONS, PART 2:
FORECASTING ASSET CLASS RETURNS
Cross-Reference to CFA Institute Assigned Reading #4
Formal Tools
Statistical methods include sample statistics, shrinkage estimation, and time series
estimation.
Discounted cash low (DCF) models express the intrinsic value of an asset as the
present value of future cash lows.
A risk premium or build up model can also be used. The approach starts with a risk-free
rate and then adds compensation for priced risks. Such models include equilibrium
models, factor models, and building blocks.
Survey and Judgment
Capital market expectations can be formed using surveys. In this method, a poll is taken
of market participants such as economists and analysts as to what their expectations are
regarding the economy or capital market.
Judgment can also be applied to project capital market expectations. Although
quantitative models provide objective numerical forecasts, there are times when an
analyst must adjust those expectations using their experience and insight to improve
upon those forecasts.
Forecasting Fixed Income Returns
DCF Analysis
DCF analysis works well when future cash lows are known or when they can be
estimated reasonably accurately. Yield to maturity (YTM) is used as an estimate of
expected return.
There is the assumption of holding the bond to maturity, which does not account for
optionality, selling a bond prior to maturity, and interest rate changes (that impact bond
prices and reinvestment returns). For example, falling (rising) interest rates will decrease
(increase) reinvestment returns. For an investment horizon that is shorter than the
Macaulay duration, the capital gain/loss impact will be more dominant than the
reinvestment impact; therefore, falling (rising) interest rates will result in a higher
(lower) realized return.
Risk Premium (Building Block) Approach
The short-term default-free rate matches the forecast horizon and is calculated from the
most liquid instrument.
The term premium is driven by four primary factors: (1) in lation levels, (2) the cause of
in lation (primarily driven by aggregate demand or supply), (3) supply and demand of
short- and long-term default-free bonds, and (4) business cycles.
The credit premium compensates for the expected level of losses and for the risk of
default losses, both of which are components of the credit spread. The credit premium for
very high quality bonds is mainly driven by downgrade bias; for low(er) rated bonds,
there is much more compensation for credit risk. Credit premiums are not positively
related to maturity and tend to be higher at shorter maturities due to event risk and
illiquidity of older bonds that are not actively traded but have a short time left to
maturity.
The liquidity premium tends to be lowest at the earliest stages of a bond’s life. The
liquidity premium tend to be lower for bonds that are issued at close to par or market
rates, new, large in size, issued by a frequent and well-known user, simple in structure,
and of high credit quality.
Emerging Market Bond Risk
Key Risks
Emerging market debt offers the investor higher expected returns at the expense of
higher risk.
Credit risk is the most signi icant risk, although economic, political, and legal risks are
also important.
Assessing Health of an Emerging Market
Guidelines for bond investors to consider:
De icit-to-GDP ratio should be less than 40%; debt-to-GDP ratio should be less than
70%.
Real growth rate should be at least 4%.
Current account de icit should be less than 4% of GDP.
Foreign debt levels should be less than 50% of GDP; debt levels should be less than
200% of the current account receipts.
Foreign exchange reserves should be at least 100% of short-term debt.
Forecasting Equity Returns
Discounted Cash Flow Models
The advantage of these models is their correct emphasis on the future cash lows of an
asset, and the ability to back out a required return. Their disadvantage is that they do not
account for current market conditions, so they are viewed as being more suitable for
long-term valuation.
The most common discounted cash low model is the Gordon growth model or constant
growth model. It is most useful to value mature markets growing at a constant rate:
Grinold and Kroner (2002)1 take this model one step further by including a variable that
adjusts for stock repurchases and changes in market valuations as represented by the
price-earnings (P/E) ratio:
E(Re) ≈ D/P + (%ΔE − %ΔS) + %ΔP/E
where:
E(Re) = expected equity return
D/P = dividend yield
%ΔE = expected percentage change in total earnings
%ΔS = expected percentage change in shares outstanding
%ΔP/E = expected percentage change in the P/E ratio
Risk Premium Approach
To determine the expected return for equities, the analyst would start with the yield to
maturity on a long-term government bond and add a single-equity risk premium. In
contrast, bonds use a building block approach as discussed earlier.
Equilibrium Approach
The Singer-Terhaar model approach begins with the CAPM:
Ri = Rf + βi,M (RM − Rf), or alternatively RPi = βi,M × RPM
where:
Ri = expected return on asset i
Rf = risk-free rate of return
βi,M = sensitivity (systematic risk) of asset i returns to the global investable market
RM = expected return on the global investable market
RPi = the asset’s risk premium
RPM = the market’s risk premium
We can manipulate this formula to solve for the risk premium for debt or equity. First,
consider the formula for beta.
where:
ρi,M = correlation between the returns on asset i and the global market portfolio
σi = standard deviation of the returns on asset i
σM = standard deviation of the returns on the global market portfolio
Cov(Ri, Rm) = covariance of asset i return with the global market portfolio return
Rearranging the CAPM, we arrive at the expression for the risk premium for asset i, RPi:
The Singer-Terhaar model adjusts the CAPM for market imperfections, such as
segmentation. When markets are segmented, capital does not low freely across borders;
in integrated markets, capital lows freely. If markets are segmented, two assets with the
same risk can have different expected returns because capital cannot low to the higher
return asset. The presence of investment barriers increases the risk premium for
securities in segmented markets.
In reality, most markets are neither fully segmented nor fully integrated. To adjust for
partial market segmentation, estimate a risk premium assuming full integration and
estimate a risk premium assuming full segmentation, and then take a weighted average of
the two. Under the full segmentation assumption, the relevant global portfolio is the
individual asset as its own market portfolio, meaning that the asset is perfectly
correlated with itself.
Calculate the risk premium for asset i assuming a fully segmented market:
If no local market Sharpe ratio is given, then use the global market Sharpe ratio.
The last piece is to take a weighted average of the two risk premiums (calculated under full integration
and full segmentation) to calculate the asset’s risk premium:
RP =φRPG + (1 − φ)RPS
where φ measures the degree of the asset’s integration with the global markets, and the superscripts are G
(globally integrated) and S (segmented).
Forecasting Real Estate Returns
Real Estate Cycles
Given that supply is ixed at any given point in time, property values exhibit cyclicality,
and demand will be strongly in luenced by the quality and type of property available.
Boom is characterized by increased demand driving up property values and lease rates,
which induces construction activity.
Bust is characterized by falling demand leading to overcapacity and overbuilding, driving
property values and lease rates down.
Capitalization Rates
The capitalization rate, or cap rate, is the ratio of net operating income (NOI) over the
property value.
Assuming an in inite period:
Cap rate = E(Rre) − NOI growth rate
E(Rre) = cap rate + NOI growth rate
Assuming a inite period:
E(Rre) = cap rate + NOI growth rate − %Δcap rate
Risk Premiums on Real Estate
Term premium for holding long-term assets.
Credit premium to compensate for the risk of tenant nonpayment.
Equity risk premium for luctuations in real estate values, leases, and vacancies.
Liquidity risk premium to consider the inability of selling the asset quickly at a
reasonable price.
Public vs. Private Real Estate
Investors with less wealth can choose publicly traded real estate, including REITs, to
bene it from diversi ication. REITs are generally strongly correlated with equities in the
short term and relatively highly correlated with direct real estate over long time
horizons.
Because REITs use signi icant leverage, their returns and risks must be irst unlevered to
provide the appropriate comparison with direct real estate holdings. There are also
signi icant differences between apartment, of ice, industrial, and retail classes.
Residential Real Estate Returns
Residential real estate is the largest class of developed properties. Overall, it
outperformed equities on an in lation-adjusted basis with lower volatility.
Exchange Rate Forecasting
Trade Flows
The impact of net trade lows (gross trade lows less exports) tend to be relatively small
on exchange rates assuming they can be inanced.
Purchasing Power Parity (PPP)
PPP states that differences in in lation between two countries will be re lected in
changes in the exchange rate between them. Speci ically, the country with higher in lation
will see their currency value decline.
PPP does not hold in the short term but holds better in the long term and when in lation
differences are large and are determined through money supply.
PPP does not consider key items impacting exchange rates such as trade barriers and
capital lows.
Current Account
When restrictions are placed on capital lows, exchange rate sensitivity tends to increase
relative to the current account (trade) balance. In the absence of a trade imbalance the
current account balance should be zero.
A non-zero current account balance (i.e., imbalance) will have the largest in luence on
exchange rates when they are persistent and sustained. However, it is not the size of the
imbalance that matters as much as the length of the imbalance.
Capital Flows
The expected percentage change in the exchange rate can be computed as the difference
between nominal short-term interest rates and the risk premiums of the domestic
portfolio over the foreign portfolio:
E(%ΔSd/f) = (rd − rf) + (Termd − Termf) + (Creditd − Creditf) + (Equityd − Equityf) +
(Liquidd − Liquidf)
Adjustments to capital lows will place substantial pressure to exchange rates.
Consideration must be given to capital mobility, uncovered interest rate parity (UIP), and
portfolio balances and compositions.
In terms of capital mobility, when there is an improvement in investment opportunities
in a country, the currency initially tends to see signi icant appreciation but overshoot.
Following an extended level of stronger exchange rates in the intermediate term,
investors will start to expect a reversal. Then the exchange rate in the long run will tend
to start reverting once the investment opportunities have been realized.
UIP states that exchange rates should equal differences in nominal interest rates only and
implies that the premium differentials in the above equation do not matter. In contrast to
UIP, carry trades involve borrowing in a low-rate currency and lending in a high-rate
currency (the rate differences arising from improved investment opportunities in that
country, for example). Carry trades have been shown to be successful in the past because
they include a risk premium and that is a contradiction to UIP.
Strong economic growth in a country tends to correspond to an increasing share of that
country’s currency in the global market portfolio. Investors need to be induced (by
higher interest rates, for example) to increase their allocations to that country and
currency. As described above with capital mobility, that tends to weaken the currency
and increase the risk premiums in the long-run. However, there are mitigating factors
such as investors tending to have a strong home country bias, which leads them to absorb
a larger share of the new assets. If growth is due to productivity gains, investors may
fund it with inancial lows and foreign direct investment.
Large current account de icits also weaken exchange rates, but if the de icits are due to
large investment spending the de icits are easier to inance if the investments are
expected to be pro itable.
Volatility Forecasting
Variance-Covariance (VCV) Matrix
Estimating a constant VCV matrix can most easily be done from deriving variances and
covariances from sample statistics. However, choosing the appropriate sample size for
large portfolios will be critical.
The main advantage of using multifactor models for VCV matrices is that it signi icantly
reduces the number of required observations. Correlations can be estimated from a few
common factors, while variances require factors related to speci ic assets. The factor
model also helps simplify the number of calculations used in the VCV matrix. However,
factor-based VCV matrices are biased in that the inputs need to be estimated and will be
misspeci ied, and they are inconsistent because as the sample size increases, the model
does not converge to the true matrix.
Shrinkage Estimates
Combining information in the sample VCV matrix with a target matrix (e.g., factor-based
VCV matrix) will result in more precise data and reduced estimation error.
The shrinkage estimate is a weighted average estimate of the sample and target matrix,
with the same weights used for all elements of the matrix, including the variance and
covariance factors. The resulting igures will be more ef icient because they will have
smaller error terms.
Smoothed Returns to Estimate Volatility
It is important that analysts adjust the data for the impact of smoothing
(e.g., underestimating risk and overstating returns), by taking a weighted average of the
current true returns and previously observed returns.
ARCH Models
Asset returns generally show periods of high and low volatilities, leading to volatility
clustering. Those volatilities are addressed through autoregressive conditional
heteroskedasticity (ARCH) models.
1. Richard Grinold and Kenneth Kroner, “The Equity Risk Premium,” Investment Insights (Barclay’s Global
Investors, July 2002).
ASSET ALLOCATION AND RELATED
DECISIONS IN PORTFOLIO
MANAGEMENT (1, 2)
Study Session 3
This study session is built around the concept of mean variance optimization (MVO), so
you will recognize the basics from Levels I and II, but these readings emphasize the
practical pitfalls of MVO and its application in the real world so the focus is not on the
math. Pure mathematical perfection can be misleading when you deal with real clients.
Keep a big picture and practical focus here and avoid the temptation to get buried in
every detail.
OVERVIEW OF ASSET ALLOCATION
Cross-Reference to CFA Institute Assigned Reading #5
Effective investment governance models do the following:
Establish long-term and short-term investment objectives.
Allocate rights and responsibilities within the governance structure.
Specify processes for creating an investment policy statement (IPS).
Specify processes for creating a strategic asset allocation.
Apply a reporting framework to monitor the investment program’s stated goals and
objectives.
Periodically perform a governance audit.
Strategic asset allocation (SAA) combines capital market expectations and the
investor’s IPS. It is long term in nature. Studies have shown that SAA largely explains
differences in portfolio returns.
Tactical asset allocation (TAA) involves short-term deviations from the SAA in an
attempt to capitalize on capital market disequilibria (mispricing).
An economic balance sheet contains an individual’s or organization’s inancial assets
and liabilities, as well as any non inancial assets and liabilities (extended portfolio
assets and liabilities) such as human capital and expected future expenditures. While
these extended assets and liabilities are more dif icult to quantify, their inclusion leads to
more comprehensive decision making.
Asset Allocation Approaches
Asset-only approaches manage the risk and return of the assets. Liabilities are
considered only indirectly by setting a return objective suf icient to meet the needs of
the client. Basic MVO is a common form of asset-only management. Risk is typically
de ined as the standard deviation of asset return (or some related concept, such as
downside deviation) or deviation from the assigned benchmark.
Liability-relative approaches focus directly on managing assets in relation to
quanti iable liabilities. The focus is on managing the expected return and risk of the
surplus, where surplus is the present value of assets less the present value of liabilities (S
= PVA − PVL). Risk may be de ined as shortfall risk (the probability of insuf icient assets
to meet the liabilities), a need for additional contributions, or volatility of surplus.
Goals-based approaches view the client assets as made up of sub-portfolios, with each
sub-portfolio managed in relation to meeting speci ic client objectives. Risk is the
probability of not meeting a goal.
Both liability-relative and goals-based approaches consider client liabilities, but the
liability-relative approach is focused on the more objective, quanti iable, and legal
obligations of institutions, while the goals-based approach focuses on the more varied
situations of individuals.
Asset Classes and the SAA Process
An asset class is a group of assets with similar investment characteristics. Each asset
class will carry with it exposure to various risk factors such as equity market risk,
interest rates, in lation, or currency. Thus, controlling asset class weights control the
portfolio’s risk exposures. The criteria for de ining an asset class are as follows:
Assets in an asset class should have similar attributes from both a descriptive and
statistical perspective.
Assets cannot be classi ied into more than one asset class.
Asset classes should not be highly correlated to provide desired diversi ication.
Asset classes should cover all possible investable assets.
Asset classes should contain a suf iciently large percentage of liquid assets.
Granularity refers to the number of asset classes into which the world market is
subdivided. SAA focuses on a smaller number (lower granularity) of distinctly different
classes, such as domestic and international equity and ixed income. TAA may utilize
more subdivided asset classes (increasing granularity), such as dividing the equity by
market cap and categories such as value, growth, and emerging market. However,
excessive granularity runs the risk of creating asset classes that are not distinctly
different from each other.
An alternative to this traditional approach to asset allocation by asset class is allocation
by risk factor. It assumes that the return of each class is driven by its exposure to
underlying risk factors.
Neither the traditional asset class nor risk factor approach has been found to be superior;
the choice comes down to how the client and manager choose to think about markets.
The process of determining the SAA for a given investor involves:
Determining investor objectives, tolerance for risk, time horizon(s), and
constraints.
Selecting the asset allocation approach (from those we’ve discussed).
Specifying the asset classes and capital market expectations.
Developing potential asset allocations.
The global market portfolio can be used as a baseline portfolio for asset allocation. By
de inition, it contains all investable risky assets and, in portfolio theory, eliminates all
diversi iable risk. By using it as a starting point, the biases of an individual client (or
manager) are mitigated. The weights by asset class can then be tilted to meet the
objectives of a given client.
The most passive investors can implement their SAA with broad index funds. More active
investors can add TAA decisions at the asset class level and/or actively manage the
assets within an asset class.
PRINCIPLES OF ASSET ALLOCATION
Cross-Reference to CFA Institute Assigned Reading #6
The inputs for mean variance optimization (MVO) are expected return, standard
deviation, and correlations between the asset classes (or risk factors). The optimizer then
solves for the ef icient frontier (EF) and provides the asset allocation for each point on
the EF. The EF is made up of the portfolios with the highest expected return for each level
of risk.
MVO is constrained such that the asset allocation weights must sum to 100%. As a
practical matter, it is also typically constrained to allow only positive weights. (No short
sale positions, as very few portfolios will allow a strategic short position in any one asset
class.) Practical constraints speci ic to a given client’s situation, such as minimum or
maximum weights, risk, or return, are often added.
Determining which portfolio to select off the EF can be based on several different
approaches.
Utility maximization selects the highest risk-adjusted return (utility), where risk
adjustment depends on the investor’s risk aversion factor (lambda). Clients with higher
risk aversion will tend toward the left side of the EF (lower return and risk), while those
with less risk aversion tend toward the right. Utility is calculated as:
The 0.5 multiplier requires that expected return and standard deviation be input as
decimals (e.g., 10% as 0.10, which will reduce the risk of errors).
Safety irst selects the portfolio with the lowest probability of falling below a clientspeci ied minimum acceptable return (MAR). Selecting the highest Roy’s safety irst
(RSF) ratio (from a group of otherwise acceptable portfolios) is one way to implement
the safety irst approach:
Another approach to implementing safety irst is to select the portfolio with highest
expected return minus some agreed-upon number of standard deviations (often two).
Other approaches are to select the portfolio that meets the required return or does not
exceed an allowable level of risk.
There are two approaches to the risk-free asset in asset allocation.
In portfolio theory, the risk-free asset has a known return with, therefore, zero
standard deviation and correlation to all other assets. Over a single discrete time
period, cash equivalents are likely to meet this de inition. That leads to a capital
allocation line (CAL) between rf and the single tangent portfolio (T). Selecting this T
from the EF produces the CAL with the highest Sharpe ratio. (Note that the Sharpe
ratio is just RSF with rf used as the MAR.) This CAL is superior to all other points
on the EF. Portfolios to the left (right) of T are composed of T and investing in
(borrowing at) rf.
Over multiple time periods, no true risk-free asset exists. Cash equivalents are
simply a low-risk asset (but not zero standard deviation) that can be included in
the MVO process, like any other asset class. Portfolios are then selected from the
resulting EF. Because cash equivalents are handy to meet certain types of liquidity
needs, a speci ic allocation to cash equivalents suf icient to meet client needs may
be speci ied for the asset allocation.
In addition to specifying an allocation to cash equivalents to meet liquidity needs, other
practical considerations to consider in applying MVO include:
Human capital (HC) can be included as an asset class with its weight in the
portfolio set by its actual value. In other words, managers cannot tell clients to
change the value or nature of their HC. Stable, low-risk HC can be modeled as an
in lation-protected bond. Higher-risk HC will have an increasing component of
corporate bonds and equity.
The investor’s personal residence (and other assets that are designated to be held)
can be treated as a ixed allocation in the portfolio with its investment
characteristics based on an index of similar properties (or of the assets).
Less liquid assets are more dif icult to incorporate in the MVO. Reliable investment
data is harder to obtain. A liquidity premium may need to be included in the
expected return. Diversi ication within the asset class may be dif icult. Three
general approaches are possible:
– Exclude the assets from MVO and simply retain them.
– Model the assets using the expected characteristics of the investor’s speci ic
holdings.
– Model the assets based on the best available broader asset class data.
Monte Carlo analysis is often used to complement MVO and analyze how an asset
allocation mix may perform over time. Assumptions are made regarding the normal or
non-normal return distributions of the asset classes. Rules for rebalancing, assumed
turnover and taxes, in lation, and spending can be speci ied. A statistically based process
is then applied to randomly vary what can happen by period to the portfolio. This
process is repeated, perhaps hundreds of times or more. The results can be ranked from
best to worst to quantify probabilities of various outcomes.
Criticisms of MVO and Solutions
It should be apparent that the mathematical elegance of MVO does not mean it is
lawless. It is a model, and the output is only as good as the input. Criticisms and
solutions to the criticisms are as follows.
Criticisms: MVO tends to produce highly concentrated asset allocations, as the math
tends to concentrate the allocation of those asset classes with lower correlation to each
other. In addition, the allocations can shift signi icantly for even modest changes in
estimated return by asset class. There are various solutions to these two problems:
Reverse optimization is less dependent on initial estimates of return. Correlations,
standard deviations, and the weights of asset classes in the world market are used
as the starting inputs. MVO is then used to solve for expected return by asset class.
(Technically, the process solves for risk premiums.) These market consensus
estimates of return are then used to construct the client’s allocation.
Black-Litterman starts with the consensus return estimates from reverse
optimization. The manager then view adjusts those return estimates up or down
and uses their view-adjusted estimates to run MVO and produce the ef icient
frontier and the associated asset allocations. Because both reverse optimization and
Black-Litterman start with market weights, they are less dependent on initial
return estimates and tend to include more asset classes in the inal portfolios.
Resampling deals directly with the uncertainty of estimating returns. It starts with
MVO and the manager’s best estimates of return and other inputs. Then the return
data is varied up and down. Each variation produces a new EF and set of asset
allocations. An average asset allocation for any point on the EF is then computed.
By considering multiple possible allocations, the average allocation will be less
affected by one more variation in return data and will likely include more asset
classes.
Another approach to broader asset class diversi ication is to directly constrain the
MVO to minimum and maximum allocations by asset class.
Criticism: MVO assumes a normal distribution of returns. The solution is to use more
sophisticated software that can incorporate other return distribution patterns.
Criticism: Diversi ication by asset class may not provide diversi ication by risk source.
The solution is to use factor-based allocation. Sensitivities to risk factors can be
determined by multifactor regression of historical asset class returns. Typical risk
factors include the market risk premium (from the CAPM), market cap, value versus
growth, market momentum versus mean reversion, duration, credit risk, and volatility.
Some argue that correlations between risk factors are lower than between asset classes
and that allocation by risk factor (rather than by asset class) provides better
diversi ication.
Factor-based long/short portfolios can be used to indirectly invest in the underlying risk
factors. For example, long U.S. Treasury bonds and short in lation-indexed bonds would
bene it if in lation declines and suffer if in lation increases. The risk premium, standard
deviation, and correlations of the risk factors can then be used in MVO to generate an
ef icient frontier and portfolio allocations by risk factor.
Criticism: MVO is a single-period model that ignores issues such as taxes, transaction
costs, and in lation that cumulatively impact the portfolio over time. A related criticism
is that standard MVO is assets only and does not consider liabilities. The solutions are to
directly model the liabilities as part of the MVO and to use MCS to model how the
portfolio may perform over time.
Incorporating the liabilities in the MVO is variously referred to as asset liability
management and liability-driven or liability-relative asset allocation. The nature of
the liabilities and the extent to which they can be quanti ied affect how appropriate this
approach will be. In general, the more essential it is to meet the liabilities, the lower the
discount used to determine their present value and the higher their PV. Approaches to
liability-relative management include:
Surplus optimization: The characteristics of the liabilities are de ined and
included in the MVO to generate a surplus ef icient frontier. Like any MVO approach,
this is a single-period perspective and is suitable for low- to high-risk portfolios.
A “two-portfolio” approach: Suf icient funds are used to fully fund a portfolio of
assets that best mimic the characteristics of the liabilities. This mimicking
portfolio will closely track the liabilities and maximize the chance of meeting the
future payout. Any remaining assets are allocated to a return-seeking portfolio
and managed to maximize value added. A more aggressive variation on this
approach may underfund the mimicking portfolio and allocate more funds to return
seeking but monitor the total surplus and shift more funds to mimicking if the
surplus deteriorates.
Like any MVO approach, this is a single-period perspective. It is more suited to
lower-risk portfolios.
Integrated asset-liability approach: This is a more complex approach that
assumes the client (typically an institution, such as a bank or insurance company)
can simultaneously alter the characteristics of the assets and liabilities. It uses
more complex modeling that can incorporate a multi-period perspective as well as
linear and nonlinear relationships. It is suitable for low- to high-risk portfolios.
Liability-relative approaches are more suited to institutions with de inable, quanti iable
liabilities. A goals-based approach considers the liabilities but is more suited to
individuals who tend to have multiple goals. Goals are irst analyzed to determine a time
horizon when the goal must be met and the required probability of success (meeting the
goal).
Managers who use a goals-based approach may also use standard investment modules
(sub-portfolios) that meet the typical goals of their clients. The manager can allocate
funds to the appropriate module for each goal, and the total portfolio allocation is simply
a result of the allocations within the modules. The appropriate module is the one that has
the highest return at the acceptable probability of success over the required time
horizon of the goal.
Miscellaneous approaches to asset allocation include:
Allocating 120 minus the client’s age to equity (for individuals).
Allocating 60/40 equity/ ixed income for the average (individual) investor.
For the endowment (Yale) model, increasing allocation to alternative and other
less-ef icient assets to capture manager value added.
For risk parity, allocating so that the contribution to total portfolio risk is the same
for each asset class.
Allocating the same percentage to all asset classes (the 1 / n rule).
Risk Budgeting and Rebalancing
Risk budgeting is a process to allocate where, how much, and what kinds of risk to take.
The goal is, of course, to maximize return per unit of risk. A portfolio will maximize
return to risk when the excess return to marginal contribution to total risk (MCTR) ratio
for all allocations in the portfolio are equal, at which point MCTR will also equal the
portfolio’s Sharpe ratio.
MCTR is also used to calculate absolute contribution to total risk (ACTR), and the sum of
the portfolio’s ACTRs is its standard deviation.
Excess return = return of an asset class − rf
MCTR = beta* of the asset class × the portfolio standard deviation
ACTR = weight in the portfolio of the asset class × MCTR
*The beta used in calculating MCTR is not CAPM beta but a regression of each asset
class’s returns versus the portfolio’s returns.
Rebalancing is a process of restoring portfolio weights to the desired SAA. A disciplined
rebalancing process should increase return to risk ratios because:
Riskier assets tend to increase in value and portfolio weight, leading to excessive
risk in the portfolio.
Rebalancing earns a diversi ication bene it in that you sell the assets that have
appreciated and buy the assets that have depreciated on a relative basis. Essentially,
you are betting against momentum and in favor of mean reversion (e.g., the asset
that had gone down—and that you therefore bought to restore its portfolio weight
—will now increase in value on a relative basis). It is also considered shorting
volatility and akin to selling calls and puts (e.g., you lose any further upside on the
appreciated asset you sold, just as you would lose its upside if you sold a call on
that asset).
Rebalancing restores the desired levels of risk exposures.
The expected bene its of rebalancing must be weighed against the transaction costs.
Managers generally set a range around the desired weight for an asset class and rebalance
when the range is violated. Wider ranges are appropriate for:
Higher transaction costs.
Taxable portfolios.
Investors with higher risk tolerance.
Asset classes that have higher (positive) correlation with the portfolio.
Momentum markets.
Other considerations include the following:
Narrower ranges are appropriate if the rest of the portfolio is highly volatile and for
mean-reverting markets.
Higher volatility increases both the risk of not rebalancing and the cost of
rebalancing.
Illiquidity makes rebalancing more dif icult.
Derivatives may provide an alternate way to rebalance.
An alternative to setting target ranges is to rebalance based on some calendar
frequency.
ASSET ALLOCATION WITH REAL-WORLD
CONSTRAINTS
Cross-Reference to CFA Institute Assigned Reading #7
Other than the discussion of tactical asset allocation (TAA), this reading is redundant
coverage of issues discussed in more detail elsewhere. These include:
The size of the portfolio affects allocation strategies. Small portfolios may lack
resources or quali ications to implement complex strategies; as an alternative to
direct investment, they may use commingled funds. Large portfolios may be too big
to invest in smaller markets.
Liquidity must be suf icient to meet the investor’s needs. Decision risk should be
considered to determine if the investor is likely to panic and try to exit an
investment during the worst conditions.
The investor’s time horizon must be at least as long as that of the investment.
The investor’s regulatory and tax constraints must be considered.
Investor biases must be considered.
SAA is not ixed but must be reviewed and updated as client and longer-term
market expectations change.
TAA seeks to add return or reduce risk by deviating from the SAA to exploit shorter-term
opportunities. The expected bene its must be weighed against the costs of the
transactions. Methods of evaluating the success of the TAA include:
Evaluating the ex-post Sharpe ratio (or information ratio or t-statistic of excess
return) of the TAA versus that of the SAA.
Plotting the return to risk achieved versus the ef icient frontier of SAAs.
Using performance attribution to determine if positive value was added.
Approaches to TAA include:
Discretionary analysis of economic and fundamental data, as well as market
sentiment indicators, to determine which asset classes to over- or underweight.
Systematic analysis of data to determine whether to favor value versus growth or
momentum versus mean reversion.
DERIVATIVES AND
CURRENCY MANAGEMENT
Study Session 4
There is a signi icant amount of overlap between the derivatives and the ixed income
material, which provides an opportunity to maximize studying ef iciency. The foreign
currency material builds on the material you learned at Levels I and II. On the exam, item
set questions for this topic area are most likely to appear given the technical and
numerical nature of the material but constructed response questions have also been
included on past exams. Concepts, calculations, and terminology are all important and
despite the apparent complexity and obscurity of some of the material, you should also
expect some relatively straightforward questions on the exam that test core concepts.
OPTION STRATEGIES
Cross-Reference to CFA Institute Assigned Reading #8
Analyzing Combined Option Positions
Synthetic Positions
Put-call parity: S0 + p0 = c0 + PV(X).
Put-call forward parity: PV(F0(T)) + p0 = c0 + PV(X).
Covered Call
Own the underlying security at S0 (which hedges the short position) and sell a call
option (which generates call premium income, or extra yield).
Best if the underlying security is relatively stable in price and the investor thinks
there is limited upside.
Maximum pro it at expiry = X − S0 + c0
Breakeven stock price at expiry = maximum loss at expiry = S0 − c0
Could write covered calls when an investor holds a position in a stock and intends
to reduce that holding in the near future. As long as the share price at expiry is no
lower than the strike price, the options will get exercised, the shares delivered, and
total proceeds will be enhanced by the premium already received.
Could also write covered calls when investor believes the stock should be worth a
bit more than its current price. The calls are written with a strike price just above
the current market price. However, if stock price rises substantially, there would be
a loss in having to sell at the low strike price instead of the higher market price.
Protective Put
Own the underlying security at S0 and buy a put option (pay a premium).
Limits downside risk and retains upside.
Maximum loss at expiry = S0 − X + p0.
Breakeven stock price at expiry = S0 + p0.
Maximum pro it = unlimited.
Hedging a Short Position
Since a short position loses if the price rises, buying a call (with strike price above
the current stock price) would provide a hedge against the price rise.
Selling a put (with strike price below the current stock price) sells off the bene it of
the stock price falling.
Collar
A collar is the combination of owning the underlying at S0, buying a put XL (low
strike price), and sell a call XH (high strike price).
If the premiums of the two are equal, it is called a zero-cost collar.
Maximum pro it = XH − S0.
Maximum loss = S0 − XL.
Breakeven stock price = S0.
Long Straddle
A long straddle is a volatility play.
Involves the purchase of an equal number of calls and puts on a given underlying.
The options all have the same expiry date and strike price.
There is no position in the underlying.
Maximum loss = p0 + c0.
Maximum gain = unlimited.
Breakeven stock price = (S0 + p0 + c0) or (S0 − p0 − c0).
Short Straddle
The exact reverse of a long straddle, therefore, a neutrality play.
Maximum gain = p0 + c0
Maximum loss = unlimited
Breakeven stock price = (S0 + p00 + c0) or (S0 − p0 − c0)
Bull Call and Bull Put Spreads
Gains if the underlying increases but with limited upside potential and downside
risk.
Can be constructed as:
– Buy a call XL and sell a call XH (debit spread = net out low of premium).
– Sell a put XH and buy a put XL (credit spread = net in low of premium).
For a bull call spread:
– Maximum loss = net premium paid.
– Breakeven = XL + net premium paid.
– Maximum pro it = (H − L) − net premium paid.
For a bull put spread:
– Maximum pro it = net premium received.
– Breakeven = XH − net premium received.
– Maximum loss = (H − L) − net premium received.
Bear Put and Bear Call Spreads
Gains if the underlying decreases but with limited upside potential and downside
risk.
Can be constructed as:
– Buy a put XH and sell a put XL (debit spread = net out low of premium)
– Sell a call XL and buy a call XH (credit spread = net in low of premium)
For a bear put spread:
– Maximum loss = net premium paid
– Breakeven = XH − net premium paid
– Maximum pro it = (H − L) − net premium paid
For a bear call spread:
– Maximum pro it = net premium received
– Breakeven = XL + net premium received
– Maximum loss = (H − L) − net premium received
The Greeks
Delta
Delta = change in option price per +1 change in stock price.
Delta is positive for (long) calls and negative for (long) puts.
The more ITM (OTM) the option, the higher (lower) its absolute delta. On an absolute
value basis, deltas range from 0 to 1.
The following diagram summarizes the ranges of values of delta for long and short calls
and puts:
Gamma
Gamma = change in option delta per +1 change in stock price.
Gamma is positive for (long) calls and for (long) puts.
The option price line is not a straight line (other than at expiration); the curvature is
measured by gamma, so delta itself varies with the underlying.
Gamma tends to be higher the closer to ATM an option and is greatest for ATM options
that are close to expiration.
Position Deltas
The overall (or portfolio) delta for a combination of options and positions in the
underlying is computed by adding up the individual deltas (being careful with the signs).
Protective Put Pre-Expiry
This graph illustrates a protective put on XYZ stock at initiation. Based on the graph, the
net effect is that for large rises in the stock price, the option moves substantially OTM,
and the position delta tends towards +1 (so we have almost the same exposure as from
the unhedged stock).
For large falls in the stock price, the option moves substantially ITM, and the position
delta tends towards 0 (protecting against the stock’s downside).
Covered Call Pre-Expiry
This graph illustrates a covered call at initiation. The position delta varies from close to
+1 (when the call is deeply OTM) to close to 0 (when the call is deeply ITM, and virtually
all of the stock’s upside is hedged away).
Collar Pre-Expiry
This graph illustrates a collar [XYZ stock, long Jun 50 put (premium = $4.88), short June
55.87 call (premium = $4.88)]. At initiation, the impact of the collar is to considerably
dampen down the variability of the position.
Bull Call Spread Pre-Expiry
This graph illustrates the value and delta for the XYZ bull call spread (long 50 call and
short 55 call) at initiation. The exposure is highly muted compared to the position at
expiration (look at the extreme values for delta).
Theta
Theta is the daily change in option price (effect of time passing); how quickly an option
loses value; as there is less time to expiration there is less time value.
Theta is negative for (long) calls and (long) puts.
Theta changes as the time passes. Options that are close to ATM have the highest thetas
(in absolute terms) and lose value at an increasing rate as they mature.
Calendar Spreads
The basic motivation with calendar spreads is to exploit the difference in theta between
close-to-expiry and more-distant-from-expiry options.
A long calendar spread entails buying longer-dated options and selling shorter-dated
options with the same strike and underlying. The belief is that the premium on the
shorter-dated should fall faster (gain more) than the premium on the longer-dated (lose
less). Both options are either calls (if bullish) or puts (if bearish).
A short calendar spread entails selling longer-dated options and buying shorter-dated
options with the same strike and underlying. Assuming the options are suf iciently ITM
or OTM, the thetas are relatively higher for longer-dated options so the belief is that the
longer-dated options will lose time value more rapidly, therefore resulting in a gain for
the investor.
A long calendar spread will bene it from a stable market or an increase in implied
volatility. A short calendar spread will bene it from a big move in the underlying market
or a decrease in implied volatility.
Vega
Vega is the change in option price per +1% change in volatility.
Vega is positive for (long) calls and for (long) puts. Vegas are always positive because a
more volatile underlying makes all the options on it more valuable (because there is
more uncertainty about how things will turn out at expiration, thus more time value).
In general, vega is higher the more time there is to expiry, but it diminishes the further
ITM or OTM the option is.
Straddle Pre-Expiry
This graph shows that at a given point in the option’s life, the level of volatility can have a
dramatic effect on the value of the position. In other words, for a long straddle, an
increase in volatility will likely result in a gain on the position even if nothing happens to
the price of the underlying.
Volatility Smile and Skew
A volatility smile is where the further-from-ATM options have higher implied
volatilities, resulting in a U-shaped (smiling) curve if implied volatility were plotted
against strike.
A volatility skew is where implied volatility increases for more OTM puts, and decreases
for more OTM calls. This is explained by OTM puts being desirable as insurance against
market declines (so their values are bid up by higher demand, and higher values imply
higher volatility), while the demand for OTM calls is low.
A long (short) risk reversal combines long (short) OTM calls and short (long) OTM puts
on the same underlying. A long risk reversal assumes the OTM calls are relatively
underpriced (their implied volatility is relatively too low, compared to OTM puts).
The term structure of volatility has implied volatilities differing across option
maturities (contango is quite common, with longer-dated options having higher implied
volatilities).
An implied volatility surface uses a three-dimensional graph, with implied volatility on
the z-axis, to examine the joint in luence of maturity (x-axis) and strike price (y-axis).
SWAPS, FORWARDS, AND FUTURES STRATEGIES
Cross-Reference to CFA Institute Assigned Reading #9
Interest Rate Swaps
Altering Portfolio Duration
The notional principal of the interest rate swap to increase (or decrease) current
portfolio duration to the target duration can be calculated as follows:
where:
NPS = notional swap principal
MDT = target modi ied duration
MDP = current portfolio modi ied duration
MDS = modi ied duration of swap
MVP = market value of portfolio
Interest Rate Forwards and Futures
Forward Rate Agreements (FRAs)
FRA Diagram
This diagram illustrates a FRA based on the future 120-day borrowing rate that settles 60
days from initiation. Note that the payment is made at the future borrowing or lending
rate and is equal to the present value of the difference in interest between a market-rate
loan and a loan at the forward rate (rate speci ied in the FRA).
Short-Term Interest Rate (STIR) Futures
Eurodollar futures ($-based STIR futures) are based on deposits of $1 million and priced
using the IMM Index convention (i.e., 100 − annualized forward rate). The pricing
convention means that futures prices will rise when forward rates fall. The forward rate
is calculated from current spot LIBOR rates in the same way the forward price of a FRA
is established.
Both Eurodollar futures and FRA agreements allow lenders and borrowers to lock in
rates for future borrowing and lending. They must be priced correctly in order to prevent
arbitrage between futures and an equivalent FRA.
Fixed-Income Futures
In practice, the majority of bond futures are closed out prior to settlement by entering an
offsetting trade. For futures held until settlement, bond futures include delivery options
for the short party. Using an example of Treasury bond futures, its price is based on a
notional government bond with a 6% coupon rate. Each eligible bond that can be
delivered by the short party is assigned a conversion factor (CF).
Bonds with a 6% coupon have a CF of one. Bonds with coupons higher (lower) than 6%
will have CFs greater (less) than one.
The short party will receive the principal invoice price on delivery:
principal invoice price = (futures settlement price / 100) × $100,000 × CF
To account for accrued interest if the bond is between coupon dates:
total invoice amount = principal invoice amount + accrued interest
Due to the bias in the computation of CFs, one of the eligible bonds will generate the
greatest gain (or smallest loss) to the short party at delivery and that is the cheapest-todeliver (CTD) bond.
pro it/(loss) on delivery = [(settlement price × CF) + AIT] − (CTD clean price + AIT)
Hedging Using Treasury Futures
To fully hedge (immunize) a portfolio’s value against interest rate changes, the change in
portfolio value must be offset by the change in the futures value:
∆P = HR × ∆ futures price
where:
ΔP = change in portfolio’s value
HR = hedge ratio = Number of futures contracts
In practice, the CTD bond and the bonds in an investor’s portfolio are unlikely to be
perfect substitutes; the mismatch gives rise to basis risk. If the portfolio does not consist
solely of the CTD bond, a duration-based hedge ratio (BPVHR) is used:
To achieve a target duration, the formula can be amended to:
Managing Currency Exposure
Currency Swap
In a currency swap, one party agrees to make periodic interest rate payments on a
notional amount in one currency, while the other party agrees to make periodic interest
payments on a notional amount in another currency. The notional amounts are
equivalent based on the exchange rate at the inception of the swap.
The parties in a currency swap may exchange only interest payments. In the case of a
cross-currency basis swap, they also exchange the notional amounts of each currency
at the beginning and the end of the swap. The periodic payments may be loating or ixed.
A cross-currency basis swap would be utilized by a foreign borrower who is borrowing
USD if the cost of borrowing directly in USD is too high compared to the total cost of
borrowing in the local currency (pay foreign interest) and then entering a currency swap
to exchange the local currency for USD (receive foreign interest, pay USD interest), with
the net being pay USD interest.
To illustrate, assume a European company wants to borrow directly in USD and that cost
is LIBOR + 100bp. An alternative would be to borrow in the local currency at Euribor +
60bp and then enter into a currency swap to exchange euros for USD. Assume the
Eurodollar swap is quoted at −20bp. In computing the net cash lows on the transaction,
there are three amounts to consider:
Pay Euribor + 60bp on loan
Receive Euribor − 20bp on swap
Pay LIBOR on swap
In the end, the pay Euribor and receive Euribor cancel each other out. What remains is
pay LIBOR, pay 60bp, and receive −20bp. That can be restated as pay LIBOR + 80bp,
which represents a 20bp improvement over borrowing directly.
Currency Forwards and Futures
The hedge ratio (number of contracts) for futures can be calculated as:
If receiving foreign currency in the future, sell contracts to hedge, this short position
delivers foreign currency and receives domestic currency at the pre-speci ied exchange
rate.
If paying foreign currency in the future, buy contracts to hedge, this long position
receives foreign currency and pays for it using domestic currency at the pre-speci ied
exchange rate.
Managing Equity Risk
Equity Swaps
Equity swaps can be used to enable investors to achieve the economic bene its of share
ownership without the cost and expense of ownership. The swap structure would be pay
ixed or loating and receive equity return.
Additionally, equity swaps can be used for changing asset allocation: swap the return on
one index for another index. The return could be price return or total return.
EXAMPLE
A client has $100M allocated 50/50 between LC U.S. stocks and bonds. The manager swaps the return
on $10M S&P 500 Index plus $10M of a bond index for the return on $20M LC stocks.
Equity Futures and Forwards
Short equity futures positions can be used to decrease the beta of a portfolio, and long
positions can be used to increase the beta of a portfolio. The number of contracts
required to change the beta of an existing portfolio can be calculated with the following
formula:
number of futures required =
where:
βT = target portfolio beta
βP = current portfolio beta
βF = futures beta (beta of stock index)
MVP = market value of portfolio
F = futures contract value = futures price × multiplier
EXAMPLE: Achieving a target portfolio beta using index futures
A fund manager has a $60 million portfolio of aggressive stocks with a portfolio beta of 1.2 relative to
the S&P 500. The fund manager believes the market will decline over the next six months and wishes
to reduce the beta of the portfolio to 0.8 using S&P 500 futures. S&P 500 futures currently have a
contract price of 2,984 and a multiplier of $250. At the end of the six-month period, the S&P 500 Index
has decreased by 1.5%. By de inition, beta of the S&P 500 Index equals 1.
Calculate the number of futures contracts and determine whether they should be bought or sold to
achieve the target portfolio beta. Compute the effectiveness of the strategy at the end of the six-month
period.
Answer:
number of futures required =
futures contract value = 2,984 × $250 = $746,000
Because the calculated value of the number of futures contracts is negative, the futures contracts
should be sold.
Value of portfolio in six months:
$60,000,000 × [1 − (0.015 × 1.2)] = $58,920,000
Note that if the market falls by 1.5%, the portfolio will fall by more than 1.5% because its beta is
greater than 1.
Pro it on futures contract:
Futures contract value in six months: 2,984 × (1 − 0.015) = 2,939.24 = 2,939 (rounded to the nearest
0.5 index point)
Futures pro it: (2,984 − 2,939) × $250 × 32 = $360,000
Net position: $58,920,000 + $360,000 = $59,280,000
Cash equitization refers to purchasing index futures to replicate the returns that would
have been earned by investing the cash in an index with risk and return characteristics
similar to those of the portfolio.
EXAMPLE: Cash equitization
A U.S. fund manager runs a passive fund, which tracks the S&P 500. Cash balances have built up in the
portfolio and the fund manager is concerned that the cash drag will lead to portfolio
underperformance relative to the S&P 500. The fund currently holds $8 million in cash. S&P 500
futures currently have a contract price of 2,780, a multiplier of $250, and a beta of 1.
Calculate the number of stock index futures needed to equitize the portfolio’s excess cash.
Answer:
number of futures required =
where:
βP = current portfolio beta of cash position = 0 (note cash has a beta of 0)
MVP = cash position
number of futures required =
where:
βT = target portfolio beta (In this case, the target will be set to 1, as we want the beta of the
synthetically invested cash to match the beta of the index.)
number of futures required =
= 12 futures contracts
F = 2,780 × $250 = $695,000
Derivatives on Volatility
VIX Index
The VIX Index measures implied volatility in the S&P 500 Index over a forward period of
30 days. It is not a measure of actual volatility but rather the expected volatility that is
priced into options.
Evidence suggests that volatility is mean-reverting over time.
VIX Futures
The VIX futures price is the expected S&P 500 Index volatility in the 30-day period after
the futures contract expiration date.
Because there is negative correlation between the VIX level and equity returns, equity
holdings can be protected from extreme downturns (tail risk) by buying VIX futures.
Selling VIX futures creates a short volatility position and captures the volatility risk
premium embedded in S&P 500 options. Short volatility positions can result in large
losses if expected volatility rises signi icantly.
The term structure of VIX futures can provide insights into the market’s expectations of
volatility over time. For example, if the VIX futures market is in contango, then longerdated futures contracts have higher prices than shorter-dated futures contracts. That
suggests the expectation of 30-day volatility to increase in the future. VIX Index levels
that are low would suggest that the futures market is in contango. The exact opposite
indings would occur if the VIX futures market is in backwardation.
Variance Swaps
Variance swaps payoffs are based on variance rather than standard deviation.
There are two counterparties, one making a ixed payment and the other making a
variable payment. The ixed payment is typically based on implied variance and the
variable payment is referred to as realized variance.
There is a single payment at the expiration of the swap:
settlement amountT = (variance notional)(realized variance − variance strike)
Long (purchaser) describes the counterparty who receives the realized variance (actual)
and pays the swap’s variance strike (implied volatility).
realized volatility > strike, buyer (long) of swap makes a pro it
realized volatility < strike, buyer (long) of swap incurs a loss
pro it/(loss) = NVAR × (σ2 − K2)
where:
σ = realized volatility
K = strike (implied volatility)
Convexity
Convexity makes variance swaps more attractive for hedging tail risk because, as
volatility rises and equity returns fall, the payoffs on variance swaps increase at an
increasing rate.
Mark to Market
The value of a variance swap is zero at initiation, but over time, the swap will either gain
or lose value as realized and implied volatility diverge.
Consider a one-year swap where three months have elapsed since inception:
Step 1: Compute expected variance at maturity (the time-weighted average of realized
variance and implied variance over the remainder of the swap’s life).
expected variance to maturity =
where:
= annualized realized volatility from initiation to valuation date squared
= annualized implied volatility from valuation date to swap maturity squared
Step 2: Compute expected payoff at swap maturity:
payoff = NVAR × (expected variance to maturity − original strike2)
Step 3: Discount expected payoff at maturity back to the valuation date.
CURRENCY MANAGEMENT: AN INTRODUCTION
Cross-Reference to CFA Institute Assigned Reading #10
Foreign Investments: Risk and Return
A domestic investor in a foreign asset is exposed to:
The return on the foreign asset (RFC) that would have been earned by an investor in
that country and its standard deviation [σ(RFC)].
The return on the foreign currency (change in value of the foreign currency, RFX)
and its standard deviation [σ(RFX)].
The return to a domestic investor (RDC) is:
Like any investment, RDC can also be calculated as ending value divided by beginning
value − 1, if the values are already measured in the investor’s DC.
The standard deviation of return to a domestic investor is the square root of the variance,
where:
σ2(RDC) ≈ σ2(RFC) + σ2(RFX) + 2σ(RFC)σ(RFX)ρ(RFC,RFX)
The standard deviation of a risk-free asset is a special case:
σ(RDC) = σ(RFX)(1 + RFC)
Managing the Currency Exposure
Neither academic theory nor empirical evidence provides clear support for the optimal
approach to currency management:
Do nothing:
Avoid the time and cost of currency trading.
A zero-sum game, if one currency appreciates, then another depreciates.
In the long run, currencies are fairly valued.
Do something:
In the short run, currency movements can be extreme.
Misvaluations of currency value caused by central banks and international trade
can be exploited.
Passive: Match the currency exposure of the portfolio’s benchmark to minimize value
added and risk due to currency.
Discretionary: Focus on risk reduction but allow small deviations from the benchmark
to add modest value.
Active: Focus on value added and allow wider deviations.
Overlay: Use a separate manager for currency management. Potentially allow the
manager to treat currency as an asset class and take positions independent of the
securities in the portfolio, a pure value added approach.
Factors that favor the low risk passive approach are shorter-term investment objectives,
higher risk aversion, higher short-term income and liquidity needs, ixed-income assets,
low hedging costs, and a client skeptical of the manager’s ability to add value and/or a
manager with no views.
Active currency management strategies to vary from the benchmark’s currency exposure
can be based on:
1. Economic fundamentals: In the long run, currency value will be based on
economic fundamentals such as purchasing power parity. In the short run,
appreciating currencies are associated with greater undervaluation relative to longterm value, a faster rate of increase in long-term value, lower relative in lation,
higher real (and nominal) interest rates, and a decreasing currency risk premium.
2. Technical rules such as overbought or oversold markets will mean revert, prices
will reverse at support or resistance levels (unless they pierce the level in which
case they will continue in the same direction), and a shorter-term moving average
moving above (below) a longer-term moving average signals prices will rise (fall).
3. The carry trade: Borrow in the lower interest rate (developed market) currency to
convert to and invest in the higher interest rate (emerging market) currency. The
carry trade assumes the forward exchange rate calculated by uncovered interest
rate parity (UIP) is a biased prediction of the spot exchange rate.
FP/B = SP/B[(1 + iP)/(1 + iB)] → ST
The bias is that generally the higher interest rate currency will either appreciate or
depreciate less than predicted by UIP. Thus, the carry trade is trading the forward
rate bias. It is usually pro itable but has generated large losses during market crises
when volatility spikes upward.
PROFESSOR’S NOTE
This reading has extensive discussion of option based strategies. Throughout this
section, L will be used for long, S for short, C for call, P for put, and h, m, or l for higher,
medium, or lower strike price. Thus LCm is a long call with a medium strike price. In
addition, it is assumed the currency being referred to is the base currency (B) in any
P/B quote unless clearly indicated otherwise.
4. Volatility Trading is designed to pro it from changes in volatility. It uses delta
hedging to take a delta-neutral position, the value of the position should be
unaffected by changes in value of the currency.
– Long call and short put positions have +delta (the position increases in value
when the underlying currency rises).
– Short call and long put positions have –delta (the position decreases in value
when the underlying currency rises).
– Thus a LC and LP pair or a SC and SP pair would have offsetting deltas.
– Recall that both calls and puts increase in absolute value with rising
volatility.
Summary of Currency Trading Rules
If volatility is expected to increase:
Use a long straddle: Buy ATM calls and puts on the currency.
Use a long strangle: Buy OTM calls and puts on the currency (reduces initial cost
and upside).
If volatility is expected to decrease:
Use a short straddle: Sell ATM calls and puts on the currency.
Use a short strangle: Sell OTM calls and puts on the currency (lower premium
in low and risk).
If volatility is expected to be low, use the carry trade.
If volatility is expected to spike in a market crisis, discontinue the carry trade.
If a currency is expected to show:
Relative appreciation, reduce the hedge on or increase the long position in the
currency.
Relative depreciation, increase the hedge on or decrease the long position in the
currency.
A call on currency B is a put on the pricing currency P and a put on currency B is a call
on the pricing currency P.
Currency Hedging Techniques
Static hedges are held to expiration and dynamic hedges are adjusted as circumstances
change.
Shorter-term contracts or dynamic hedges improve the hedge results but increase
cost.
Rolling shorter-term contracts creates interim cash lows.
Higher risk aversion suggests more frequent rebalancing.
Lower risk aversion and strong manager views suggests discretionary hedging.
Roll Yield and Hedging Costs
Roll yield or roll return is the change in forward minus change in spot price:
(Ft − F0) − (St − S0)
At contract expiration Ft = St (therefore at contract expiration), roll yield and percent roll
yield are:
S0 − F0 and (S0 − F0) / S0
Roll yield can be considered a cost of hedging. If the hedge is held to contract expiration,
the hedge locks in the differential between S0 and F0.
While the formulas for roll yield just presented are the most common way to express
them, they are not always followed. For example, an author or question may well refer to
roll as F0 − S0. You are expected to grasp the next section discussing the interpretation
and implications of the calculated value. The case will provide suf icient information to
make a correct determination and answer to the question asked.
If FP/B > SP/B, then iB < iP and the forward price curve is upward-sloping.
A short forward position in B earns positive roll yield, decreasing hedging cost and
encouraging hedging.
A long forward position in B earns negative roll yield, increasing hedging cost and
discouraging hedging.
If FP/B < SP/B, then iB > iP and the forward price curve is downward-sloping:
A short forward position in B earns negative roll yield, increasing hedging cost and
discouraging hedging.
A long forward position in B earns positive roll yield, decreasing hedging cost and
encouraging hedging.
Trading Strategies
Hedging with forward contracts has no initial explicit cost. A perfect hedge would lock
in F0 as the ending exchange rate for the position. It symmetrically modi ies risk and
return. It has high opportunity cost by eliminating upside potential.
Discretionary hedging allows the manager to hedge more of the currency if it is
expected to depreciate or hedge less of the currency if it is expected to appreciate.
Option based hedging strategies will have an initial cost but can selectively modify
downside protection or upside potential:
Buy ATM put options, LPm: Removes all downside risk below strike m and retains
all upside potential; highest initial cost.
Buy OTM put options, LPl: Removes downside risk below the lower strike price l
and retains all upside potential; lower initial cost.
Buy a higher strike price and sell a lower strike price put option (a put spread)
LPm and SPl: Provides downside protection only between the two strike prices m
and l while retaining all upside potential; lower initial cost. Downside risk below l
remains.
Buy a put option and sell a call option (a risk reversal or collar) LPl and SCh:
Provides downside protection below the put strike price and retains upside
potential to the call strike price; lower initial cost. Called a zero-cost collar if the
two option premiums are equal. It is equivalent to a forward sale at the strike price
if the two strike prices are equal.
Buy a higher strike price and sell a lower strike price put option, plus sell an
OTM call option (a seagull spread) LPm, SPl, and SCh: Provides downside
protection between the two put strike prices and upside potential to the call strike
price; lower initial cost.
Other modi ications to lower initial cost include: mismatch the size of the option
position (e.g., buy fewer puts and sell more calls and puts), use exotic options such as
knock-in or knock-out options or binary options that pay a ixed amount or nothing.
Other Currency Hedging Issues
A perfect direct hedge of the currency risk in a risky foreign investment is generally
impossible. It requires selling forward the ending value of a risky investment, a value that
cannot be known in advance.
Cross hedges introduce additional risk to the hedge because the hedged item and
hedging vehicle are different. They are highly—but not perfectly—correlated and the
correlation can change.
Macro hedges are a kind of cross hedge designed to hedge portfolio-wide risk as
opposed to a single currency risk. Shorting a basket of currencies that is similar to the
currency exposures in the portfolio is an imperfect macro hedge but may be less
expensive than hedging each exposure directly.
A minimum variance hedge ratio (MVHR) is a regression-based approach to determine
the hedge ratio that will minimize risk. It is a cross hedge and a macro hedge. One form of
MVHR uses the slope coef icient found by regressing the portfolio’s unhedged return
measured in investor’s currency (RDC) versus RFX. It considers the interaction of RFC and
RFX:
Positive correlation between RFC and RFX, increases the volatility of RDC resulting
in a MVHR > 1.
Negative correlation between RFC and RFX, decreases the volatility of RDC, resulting
in a MVHR < 1.
Hedging emerging market currencies poses additional challenges: bid-asked spreads
are larger and can expand during crises, return distributions tend to have negative skew
and fat tails, contagion is a problem as correlations rise during crisis, tail risk is common
as governments arti icially support their currency’s value for long periods followed by
severe currency value correction, and emerging market (EM) governments may restrict
lows of their currency, making cash settlement of swaps and forwards impossible.
Nondeliverable forwards (NDFs) can be used to address this last issue. Instead of
settling with delivery of an EM currency versus a developed market currency, the
NDF settles the net gain or loss on the trade in the developed market currency.
FIXED-INCOME PORTFOLIO
MANAGEMENT (1, 2)
Study Sessions 5 & 6
This is a signi icant section in Level III and you must devote suf icient time and effort to
the material, which can appear to be daunting at times. There is overlap with the
derivatives material, which provides an opportunity to maximize studying ef iciency. The
material at Level III builds on many of the concepts you learned earlier in Levels I and II
(e.g., repos, duration, convexity, and riding the yield curve), so a good understanding of
the earlier material is important in order to be successful at Level III. Similar to other
technical sections in the curriculum, focusing on the key concepts and avoiding the
trivial details will reduce your stress levels and likely enhance your performance in this
important portion of the exam. Expect at least two item sets and one constructed
response question dedicated to Fixed-Income Portfolio Management. For 2022, much of
the material in Reading 13 is signi icantly revised and much of Reading 14 is new
material.
OVERVIEW OF FIXED-INCOME PORTFOLIO
MANAGEMENT
Cross-Reference to CFA Institute Assigned Reading #11
Within the portfolio, ixed income (FI) provides:
Risk reduction with low correlation to other asset classes and generally lower
volatility.
Regular stable cash low.
In lation protection (with in lation-linked and loating-coupon bonds).
Fixed Income Portfolio Measures
Macaulay duration
– Weighted average time to receive cash lows
Modi ied duration
– Macaulay duration divided by 1 plus the bond periodic yield
– Approximate expected percentage change in bond price for a 1% change in
yield
Effective duration
– Approximate expected percentage change in bond price for a 1% change in
benchmark curve
– Used for complex bonds with uncertain cash lows (e.g., embedded options)
Key rate (partial) duration
– Sensitivity of a bond’s price to a change in a benchmark yield curve for a
speci ic maturity, while other rates remain the same
Empirical duration
– Interest rate sensitivity computed by regressing bond returns with
benchmark yield changes
Money (dollar) duration
– Monetary gain or loss expected due to a 1% change in yield (modi ied
duration × market value)
Spread duration
– Portfolio’s percentage sensitivity to a 1% change in credit spreads
Duration times spread (DTS)
– Spread duration times bonds’ credit spread
Price value of a basis point (PVBP) or basis point value (BPV)
– Money duration × 0.0001
Convexity
– Extent to which a bond’s price behavior versus changes in yield is nonlinear
Effective convexity
– Measures the nonlinear relationship of above based on directly modeling
changes in prices due to changes in a benchmark curve
FI markets are less liquid than the equity markets because:
Trading is mostly over-the- counter, which decreases transparency of trade
information.
Of the large number of bond issuers, most of whom have multiple bond issues, and
many issues have a unique combination of features.
As time passes, a given bond issue tends to be acquired by buy-and-hold investors,
becoming less liquid.
As a result, many bond issues do not trade in any given period. The highest liquidity is
found in recent (on-the-run), larger bond issues by higher quality (sovereign
government) issuers.
The return or expected return of a bond can be computed as a sum of component returns:
1. Yield income: annual coupon amount / current bond price.
2. Rolldown return: (projected ending bond price − beginning bond price) / beginning
bond price; based on no change in the yield curve.
3. Price change due to investor yield change predictions: (−MD × ΔY) + (½C × ΔY2)
4. Less credit losses: predicted default adjusted for recover rate.
5. Currency G/L: projected change in value of foreign currencies weighted for
exposure to those currencies.
Rolling yield = yield income + rolldown return
Leveraging the portfolio is an attractive way to increase portfolio return when borrowing
rates are relatively low and markets are expected to be stable. The leveraged portfolio
return can be calculated as:
rp = rI + [(VB / VE) × (rI − rB)]
where:
rp = return on portfolio
rI = return on invested assets
rB = rate paid on borrowings
VB = amount of leverage
VE = amount of equity invested
Alternatively the leveraged portfolio return could be calculated more intuitively as:
[return on invested assets – (amount borrowed × rate paid on borrowings)] / amount
of equity invested
The two primary risks to a leveraged portfolio are:
If rI < rB, there is negative carry, and leveraged portfolio return will be below the
unlevered return on portfolio assets.
If collateral value declines, lenders may demand repayment, leading to forced
liquidations. Such forced liquidations can contribute to a market collapse.
A common way to leverage the portfolio is to use portfolio assets as collateral for a
repurchase agreement. A repo is actually two transactions. The borrower of the money
“sells” assets (receiving funds) and simultaneously agrees to “repurchase” the assets at a
later date. The repo will specify the amount of the loan, how long it lasts (the repurchase
date), and the interest rate. Interest is calculated as principal amount × rate × (days /
360). Normally, the securities delivered as collateral (the assets “sold”) are described
only in general terms, such as U.S. Treasury securities. The amount of collateral generally
exceeds the loan amount (e.g., 102% of the loan amount).
Securities lending is a closely related process, focusing on the collateral assets rather
than the cash side of the repo. Securities lending is often motivated by short sellers who
need to borrow speci ic assets to deliver when initiating a short sale. Unlike a repo, there
is usually no stated expiration to the transaction. Instead, either counterparty to the
transaction can terminate it on demand.
While a repo is a form of explicit borrowing and leverage, comparable economic results
can be achieved by entering a long futures contract or a swap to earn the desired market
return. These derivatives-based techniques are discussed elsewhere.
This reading includes a brief discussion of typical tax principles followed in various
countries, as follows:
Tax is imposed on realized but not unrealized gains.
– Realized capital gains tax rates are usually lower than other rates, with the
lowest rate imposed on sales made after longer holding periods.
– Realized losses can be used to reduce realized gains.
Collective investment funds are usually taxable at the level of the investor and not
to the fund.
– Income earned by the fund is taxable to the investors and taxed regardless of
whether it is passed out or reinvested in the fund.
– Some countries tax realized gains the same way, while other countries tax
realized gains when shares of the fund are sold by a fund investor.
LIABILITY-DRIVEN AND INDEX-BASED STRATEGIES
Cross-Reference to CFA Institute Assigned Reading #12
Liability-driven investing (LDI) is primarily used for institutional investors with explicit
liabilities. Immunization is a form of LDI and refers to various techniques where assets
are set aside and managed, and all cash lows are reinvested until needed to meet speci ic
liabilities. Immunization techniques will minimize the variability of total return earned
over the full period until the liabilities are paid. As such, the immunizing assets mimic
the return of a zero-coupon bond that would come due when the liability is due.
Cash low matching is the most conservative form of immunization. It has the
lowest expected return and risk, and therefore, the highest initial cost. The easiest
form of cash low matching is to buy zero-coupon bonds. If there are multiple
successive liabilities, it may also be possible to ind and structure a coupon-bearing
bond portfolio whose cash lows directly match the liability payouts.
Duration matching is more lexible and requires selecting a portfolio of assets with
a duration that matches the liability duration. In concept, if the durations match,
the change in value of assets and liabilities will match, and the future value of the
assets will be suf icient to fund the liabilities. A cash low match is also a duration
match, but all duration matches will not be cash low matches.
Contingent immunization is an active/passive strategy and a more aggressive
approach. The portfolio is initially overfunded with a positive surplus (S = PVA −
PVL). As long as the S is positive, the portfolio can be actively managed. If active
management is successful, the surplus will grow and the ultimate realized return
will exceed what could have been earned with cash low or duration matching. The
surplus must be continually monitored, and if the S reaches zero, the portfolio is
immunized at the then-available immunization rate in the market. By immunizing
then, the assets should be suf icient to pay the liabilities when they are due, though
the total return will be less than could have been achieved with initial
immunization.
Four types of liabilities exist:
Type I: known future amount(s) and payout date(s)
Type II: known future amount(s) but uncertain payout date(s)
Type III: uncertain future amount(s) but known payout date(s)
Type IV: uncertain future amount(s) and uncertain payout date(s)
Laddered portfolios can be used in cash- low matching multiple liabilities. A laddered
portfolio has roughly equal par amounts purchased across different maturities.
Advantages of laddered portfolios include:
Regular liquidity as some bonds come due each year
Broad diversi ication of cash low across time; less concentration
Diversi ication between price risk on long-dated bonds and reinvestment risk on
short-dated bonds
More convexity than a bullet, a bene it if there are large parallel shifts
In concept, duration matching works when there can be only one immediate, small,
parallel shift in the yield curve. To deal with realistic changes in rates, duration matching
follows these rules:
For a single liability:
– PVA ≥ PVL
– Match Macaulay D; DA = DL
– Minimize asset convexity (the single liability has minimal C)
For multiple liabilities:
– PVA ≥ PVL
– BPVA = BPVL
– CA slightly exceeds CL
Regardless of the type of liabilities, the portfolio must be monitored and rebalanced to
maintain the duration match.
Beyond the obvious risks of credit risk (failing to initially fund the portfolio with
suf icient assets and maintain the duration match), the biggest risk is structural risk.
Structural risk can occur due to nonparallel yield curve shifts. The rules effectively (for
both single and multiple liabilities) require the convexity of assets to exceed that of
liabilities. Thus, large parallel shifts will lead the assets to perform better that the
liabilities and bene it the performance of the portfolio with an increase in surplus.
Nonparallel shifts may (but will not inevitably) cause problems. In general:
A lattening of the yield curve is generally bene icial, as the relative decline in
longer rates applied to higher-duration assets produces a greater relative price gain
than the relative price loss due to the relative increase in shorter rates applied to
lower-duration assets.
A steepening of the yield curve is generally detrimental, as the relative increase in
longer rates applied to higher-duration assets produces a greater relative price loss
than the relative price gain due to the relative decrease in shorter rates applied to
lower-duration assets.
A negative butter ly is generally bene icial. The decrease in relative short and long
rates would increase the relative value of the assets, while the relative increase in
medium rates would decrease the relative value of the liability.
A positive butter ly is generally detrimental. The increase in relative short and long
rates would decrease the relative value of the assets, while the relative decrease in
medium rates would increase the relative value of the liability.
These are generalizations. This discussion is based on the same concepts as presented
later to analyze a more bullet-like portfolio (the liabilities) versus a more barbell-like
portfolio (the assets). As in that later discussion, speci ic performance would depend on
the speci ic exposures along the yield curve and relative size of interest rate changes at
various points of the curve.
Monitoring and correcting any duration gap is critical to the success of immunization.
Duration gap = |BPV A − BPV L|
BPV = MD × V × 0.0001
The adjustment can often be done at lower cost using derivatives. To calculate the
adjustment amount:
Closing the gap using futures:
Nf = desired ∆BPV / BPVfutures
BPVfutures ≈ BPVCTD / CFCTD
Closing the gap using a swap:
NP = desired ∆BPV / BPVswap
BPVswap = +BPVreceived − BPVpaid
Partial adjustment is common when the client lacks a full understanding of derivatives
and the associated accounting, reporting, and cash low requirements.
The duration gap can also be adjusted using swaptions. To increase asset duration, buy a
receiver (receive ixed rate) swaption. To decrease asset duration, buy a payer (pay ixed
rate) swaption. The buyer of the swaption receives asymmetric protection and can later
choose to exercise the swaption and turn on the swap. The buyer of the receiver (payer)
swaption will earn economic bene it if new swap ixed rates (SFR) decline below
(increase above) the SFR of the swaption.
Evaluating the relative merits of a swap versus collar (buy and sell a receiver and payer
swaption) versus swaption is complicated. All three approaches can provide protection
from adverse rate movements. Determining which approach is optimal will depend on
the subsequent movement in interest rates. The following comparison and summary is
consistent with the coverage in the CFA text. More complete background discussion is
found there and in the SchweserNotes.
Swap vs. Collar vs. Swaption
LDI and immunization strategies are subject to numerous additional potential risks:
Calculations depend on estimated duration and duration changes with time and
market conditions.
Duration assumes parallel shifts and ignores convexity effects.
Models are used in estimating the characteristics of the assets and liabilities
(e.g., for callable bonds and pension liabilities).
Weighted average YTM, D, and C may be used instead of portfolio characteristics
based on aggregate portfolio cash lows.
Futures BPV is:
– Based on a CTD, and the CTD can change.
– An approximation.
Spread risks, such as:
– The relationship of liability discount rate to asset IRR can change.
– Rebalancing may require selling an asset where spread has widened and
buying where spread has narrowed.
– Swaps are based on the LIBOR market but liability discount rates are not.
OTC instruments introduce counterparty risk.
Exchange-traded (and collateralized OTC) instruments introduce cash- low risk
(meeting margin requirements).
Index-Based Strategies
Approaches range from fully passive to fully active.
Pure indexing is fully passive. Given the relative illiquidity of most bond issues,
pure replication of the index holdings is generally impractical for bonds, and
instead, the indexer matches the risk exposures of the index.
Unrestricted active management can deviate from the index in any way the
manager believes will add value.
Enhanced indexing falls in between and allows modest deviations in risk exposures
from the index but usually matches the duration.
To control portfolio risk versus the index, match the risk exposures of the index.
Matching duration controls risk due to parallel shifts in the yield curve.
Matching key-rate durations will match duration and also control risk due to
nonparallel shifts. A key-rate duration can also be called a duration contribution.
Both are calculated as the time until a cash low is due times its weight in the
portfolio. The sum of these calculations is the portfolio’s Macaulay duration.
Matching exposure to various bond sectors, quality, and issuers will control risk
due to spread changes.
An alternate approach to risk control is cell matching. The manager selects relevant
risk factors and matches cell weights in the portfolio to those of the index. Cell
matching will then produce a matching of relevant risk exposures.
Other methods of obtaining passive exposure include:
Buying open-ended or ETF mutual funds.
Entering into a total return swap to receive an index return.
Buying futures or call options on an index.
To select an appropriate index for a client, ind the index that best matches the goals and
objectives of the client’s portfolio. This selection is complicated by (1) bonds changing in
maturity and duration as time passes, (2) indices changing character as bonds are added
and deleted, and (3) the bums problem. The bums problem refers to the fact that the
weight of an issuer in an index increases as it issues more bonds, while such issuance may
be positively correlated with higher leverage and declining credit quality.
YIELD CURVE STRATEGIES
Cross-Reference to CFA Institute Assigned Reading #13
Yield curve changes result from three sources:
Level change
– Parallel shift where all yields shift up (or down) by the same amount
Slope change
– Slope = Long-term yield – short-term yield
– Curve becomes steeper (larger slope) or latter (smaller slope)
Curvature change
– Butter ly spread = –(short-term yield) + (2 × medium-term yield) – longterm yield
– If butter ly spread or curvature is increasing (decreasing), then medium-term
yields are rising (falling) relative to short-term and long-term yields
Cash-based static yield curve strategies (the CFA material assumes a normal, upwardsloping, concave yield curve)
Buy and hold
– Extend the duration of the portfolio to be longer than that of the benchmark
in order to earn higher returns, primarily through higher coupon income on
longer-dated bonds
Rolling down the yield curve
– Essentially a more active version of buy and hold
– Buy higher-yield bonds at the end of a steep segment of the curve and sell
them for a gain as they roll down to a lower-yield portion of the curve
Repo carry trade
– Borrow at lower shorter-term rates to invest at higher longer-term rates
Derivatives-based static yield curve strategies
Long futures positions
– Implicit leverage because investors are required only to fund margin
payments to open positions, which are usually a small fraction of the exposure
gained through the futures contract
Receive- ixed swap
– By receiving the ixed leg and paying the loating leg under an interest rate
swap, the duration of the portfolio is synthetically increased
Divergent Rate Level View
Cash bond
– Increase (decrease) duration by buying (selling) bonds
– Increase (decrease) duration by overweighting longer-dated (shorter-dated)
bonds
Swap
– Increase (decrease) duration by receiving (paying) ixed
Futures
– Increase (decrease) duration with long (short) contracts
Divergent Yield Curve Slope View
Bear steepener
– Position overall portfolio duration to be negative such that the portfolio
increases in value as rates rise
– View that long-term rates will rise by more than short-term rates: buy shortterm bonds, sell long-term bonds
Bull steepener
– Position overall portfolio duration to be positive such that the portfolio
increases in value as rates fall
– View that short-term rates will fall by more than long-term rates: buy shortterm bonds, sell long-term bonds
Bear lattener
– Position overall portfolio duration to be negative such that the portfolio
increases in value as rates rise
– View that short-term rates will rise by more than long-term rates: sell shortterm bonds, buy long-term bonds
Bull lattener
– Position overall portfolio duration to be positive such that the portfolio
increases in value as rates fall
– View that long-term rates will fall by more than short-term rates: sell shortterm bonds, buy long-term bonds
Divergent Yield Curve Shape View – Change in Curvature
In a butter ly strategy, the bullet is referred to as the “body” and the barbell is
referred to as the “wings”
Believe that butter ly spread and curvature will increase
– Think that medium-term rates will rise relative to short- and long-term rates
– Sell a medium-term bullet and buy a barbell
Believe that butter ly spread and curvature will decrease
– Think that medium-term rates will fall relative to short- and long-term rates
– Buy a medium-term bullet and sell a barbell
Yield Curve Volatility Strategies
Long call on bond prices/bond futures prices
– Increase duration and increase convexity
Long put on bond prices/bond futures prices
– Decrease duration and decrease convexity (put options place a loor)
Long payer swaption (valuable when rates rise)
– Decrease duration and decrease convexity (like a put option)
Long receiver swaption (valuable when rates fall)
– Increase duration and increase convexity (like a call option)
Key Rate Duration
The sum of key rates durations for a portfolio will equal the effective duration of
the portfolio because the sum represents the aggregate sensitivity of the portfolio
to a move in all maturity yields at the same time (i.e., parallel shift in the yield
curve)
Used to identify which maturities in the portfolio have the most sensitivity to
nonparallel changes in the yield curve (slope/curvature)
Calculated as: change in portfolio value / (portfolio value × change in key rate)
Hedging Strategies Across Currencies
A manager with several different foreign exposures should calculate the domestic
returns (RDC) individually for each foreign market and then weight those returns
according to each foreign market’s weight in the portfolio
A manager may choose to hedge their foreign currency exposure by selling the
foreign currency forward, thereby locking in an exchange rate to convert the foreign
funds back to their domestic currency
Uncovered interest rate parity (UIRP)
– States that high interest rate currencies should actually depreciate over time,
such that all unhedged investors earn the same return regardless of which
currency they hold
– Implies that spot rates should move toward the original forward rates set by
covered interest rate parity (CIRP)
– UIRP tends not to hold in real life
Hedging Foreign Coupon-Paying Bonds
Refer to details in SchweserNotes Book 3 page 86
Unhedged Cross-Currency Trade: Carry Trade
Borrowing in a low interest currency and investing in a high interest rate currency
– Risk that the high interest rate currency weakens
If using swaps
– Receive loating in markets where loating rates are expected to rise, pay
loating in markets where loating rates are expected to fall
– Receive ixed in markets where rates are expected to fall, pay ixed in
markets where rates are expected to rise
– Foreign exchange risk exists and any currency depreciation must not wipe
out the expected interest rate advantage
FIXED-INCOME ACTIVE MANAGEMENT: CREDIT
STRATEGIES
Cross-Reference to CFA Institute Assigned Reading #14
Credit risk
Probability of default (POD).
– Chance that issuer fails to make payments on its obligation when due.
Loss given default (LDG), also known as loss severity.
– Proportion of investment lost if a default occurs.
– Calculated as 1 – recovery rate (RR).
Credit spread is approximated as POD × LGD.
Credit-risky securities are classi ied as.
– Investment grade (IG): high quality rated BBB and above.
– High yield (HY): speculative rated BB or below.
The shape of the credit curve is primarily driven by changes in credit conditions over the
credit cycle, summarized in the following table:
An extreme example of spread change is for very low quality HY bonds. In a weakening
economy, rates often decline with economic weakness (−Δr), but spread increases (+Δs)
as default risk increases in the weak economy. For very low rated bonds, absolute Δs may
exceed absolute Δr, leading the yield of the credit risky bond to increase and the bond’s
price to decline even with a decline in the general level of rates (−Δr). This is referred to
as negative empirical duration.
Fixed-Rate Bond Credit Spread Measures
Yield spread (benchmark spread)
– YTM – YTM of closest maturity on-the-run government bond
G-spread
– YTM – interpolated YTM of the adjacent maturity on-the-run government
bonds
I-spread (interpolated spread)
– YTM – maturity interpolated swap ixed rate
Asset swap spread (ASW)
– Fixed coupon – maturity interpolated swap ixed rate
– Spread that the bond is offering over the loating market reference rate
(MRR) over its life
Zero-volatility spread (z-spread)
– Uses a trial-and-error calculation to determine a single spread that, when
added to risk-free spot rates, discounts the bond’s future cash lows back to its
current market value
Option adjusted spread (OAS)
– Only spread measure appropriate for assessing credit/liquidity risk of bonds
with embedded options
– Uses an assumption of interest rate volatility to build an interest rate tree of
possible paths for forward risk-free interest rates
– Trial-and-error calculation to determine a single spread that, when added to
every node of the interest rate tree of risk-free rates, discounts the bond’s
adjusted future cash lows back to its current market value
Floating-Rate Note Credit Spread Measures
A loating-rate note (FRN) pays a periodic coupon equal to a loating MRR plus a
ixed quoted margin (QM)
Required rate of investors above the current MRR is the discount margin (DM). DM
assumes MRR stays constant at its current level over the life of the bond
– When DM = QM, the FRN will trade at or close to par
– When DM > QM (deteriorating credit conditions), the FRN will trade below
par
– When DM < QM (improving credit conditions), the FRN will trade above par
Zero-discount margin (Z-DM)
– Future coupon rates = relevant MRR forward rate + QM
– Discount rates = relevant spot MRR + Z – DM
Duration times spread (DTS)
DTS is approximated as effective spread duration × spread
Expected excess spread
Spread – (EffSpreadDur × Δspread) – (POD × LGD)
Bottom-Up Credit Strategies
Engage in individual security selection to earn excess return (e.g., best issuer or
individual bond investment)
Identify universe of bonds relevant to mandate and then look for relative
misevaluation within each sector to determine individual securities to select
Credit risk models
– Structural models assume POD to be driven by the likelihood of the future
value of the assets of a borrower falling below the threshold that would
trigger default
– Reduced form models (e.g., Altman’s Z-score) look for relationships between
macroeconomic conditions and the individual characteristics of a borrower
to infer default intensity. The default intensity and estimated LDG are then
used to estimate the fair credit spread
Top-Down Credit Strategies
Focuses on macro factors (e.g., strength of economic growth, corporate pro its) that
are likely to affect the credit portfolio
Also used to identify sectors of the market most likely to improve (or deteriorate)
so as to overweight (or underweight) them
May also focus on historical patterns such as the credit cycle and credit spread
changes
Factor-Based Credit Strategies
Factors offering a risk premium:
– Carry: expected return if conditions remain unchanged
– Defensive: lower-risk assets offer higher risk-adjusted returns
– Momentum: recent outperformance (underperformance) continues in future
– Value: high excess return
Environmental, Social, and Governance (ESG) Factors
Negative screening to exclude industries and companies with poor ESG records
Use ESG ratings to target issuers with favorable ESG characteristics
Investing to directly fund ESG-speci ic initiatives (e.g., green bonds)
Liquidity Risk
For illiquid bonds that trade infrequently, matrix (evaluated) pricing is often used,
which estimates fair value through reference to the yields and prices of similar
actively traded and government securities
Effective spread for a buy order = trade size × (trade price – midquote); midquote =
(bid + ask) / 2
Effective spread for a sell order = trade size × (midquote – trade price)
Methods to manage liquidity risk:
– Use more liquid bonds for short-term strategies and less liquid bonds for
long-term strategies
– Use liquid ixed-income alternatives such as credit default swaps (CDSs) or
exchange-traded funds (ETFs)
– Use asset swaps to hedge exposure on illiquid bonds over the time it takes to
transact
Tail Risk
Value at risk (VaR) is a measure of minimum expected loss occurring in a given time
frame with a speci ied probability
– VaR is a percentile in a return distribution
Methods used to derive the return distribution from which VaR is estimated
– Parametric method: assumes normal returns and uses the parameters (mean
and standard deviation) to calculate the loss at a given percentile of the
distribution
– Historical simulation: applies historical movements in key risk factors (e.g.,
rates, spreads) to the existing portfolio to generate a return distribution
– Monte Carlo analysis: generates a return distribution through random
simulations from a user-de ined model
Extensions of VaR
– Conditional VaR (CVaR): expected loss given the portfolio is experiencing a
loss in the tail
– Incremental VaR (IVaR): measures the change in VaR from adding or
removing a position in a portfolio
– Relative VaR: measures the VaR of a portfolio’s returns relative to a
benchmark
Credit Default Swaps (CDS)
A CDS involves two parties: a protection buyer and a protection seller
The ixed coupon paid periodically by the protection buyer is standardized to 1% for
investment-grade (IG) issuers and 5% for high-yield (HY) issuers for operational reasons.
Depending on the relationship between the CDS spread and the ixed coupon, there may
be an upfront premium paid as noted below.
The CDS price is approximated as: 1 + [( ixed coupon – CDS spread) × EffSpreadDurCDS]
Active CDS strategies
CDS long-short strategy
– Buy protection on issuers where credit spreads are expected to widen
relatively
– Sell protection on issuers where credit spreads are expected to narrow
relatively
CDS curve trade
– Buy protection at maturities where CDS spreads are expected to rise
relatively
– Sell protection at maturities where spreads are expected to fall relatively
Static Credit Spread Curve Strategies
A manager who believes that the current credit spread curve will remain
unchanged can earn excess return in the cash market through:
– Lowering the average credit rating of their bond portfolio, or
– Increasing the spread duration of the portfolio by buying and holding longerdated bonds
See extended blue box examples in the SchweserNotes Book 3
Dynamic Credit Spread Curve Strategies
See extended blue box examples in the SchweserNotes Book 3
Global Credit Strategies
Watch for emerging markets that are heavily reliant upon a dominant industry or
commodity export as diversi ication opportunities may be limited
Signi icant sector differences may exist, even between developed markets
A starting point is the willingness and ability of governments to meet their
sovereign debt payments
– Institutional considerations: enforcement of rights and laws, political
stability, geopolitical risk
– Economic pro ile: tax revenues, debt and annual de icit as a % of GDP
– Exchange regime: ixed versus lexible in terms of effectiveness of monetary
policy
Consider liquidity risk and currency risk of emerging market bonds
Structured Credit
Allows investors to purchase securities that are backed by debt-based collateral,
such as a pool of mortgages or commercial loans
Two key reasons to invest:
– Structured instrument issues different tranches of security, each with a
different risk pro ile, allowing the investor to create risk exposures not
available through investing directly in the collateral (e.g., collateralized debt
obligations, collateralized loan obligations)
– Structured investment offers exposure to collateral that the investor cannot
access directly (e.g., mortgage-backed securities, asset-backed securities,
covered bonds)
Fixed Income Analytics
Inputs
– Including portfolio position data, relevant market data, credit and ESG
ratings
User-de ined parameters
– Models for term structure, risk, scenario analysis, and ilters
– Time horizon and overall objective
Outputs
– Including summary of portfolio positions and risk exposures versus the
benchmark index, risk and scenario analysis, trading and cash management
tools
EQUITY PORTFOLIO MANAGEMENT
(1, 2)
Study Sessions 7 & 8
Expect at least two item sets or a combination of constructed response questions and
item set(s) dedicated to Equity Portfolio Management. Notice that some of this material
overlaps with concepts covered earlier in Fixed Income and Asset Allocation, for
example. Even more importantly, many of the concepts (e.g., weighting methods, HHI,
factor models, growth vs. value, and fundamental law) were introduced in Levels I and II,
which should make your studying at Level III more ef icient.
OVERVIEW OF EQUITY PORTFOLIO MANAGEMENT
Cross-Reference to CFA Institute Assigned Reading #15
Within the overall investment portfolio, equity securities play several bene icial roles.
These roles include capital appreciation, dividend income, diversi ication, and the
potential to hedge in lation.
Equity Investment Segmentation
The three main segmentation approaches include size and style, geography, and
economic activity. Using these approaches provides a better understanding of how equity
investments integrate into the overall portfolio and enhance diversi ication bene its.
A style box can be used to rank (or score) companies, portfolios, indices, or benchmarks
among the style and size metric. An example is shown as follows.
Equity Investment Style Box
Portfolio Income
There are several ways to earn (current) income from an equity portfolio.
Dividend income is the most obvious and often the largest. Dividends may be subject to
income and/or withholding tax. Investors with a growth-oriented focus are less likely to
seek portfolio income from dividends.
Securities lending is often part of short selling, which is the sale of a security that is not
owned. To make the short sale, the seller must typically borrow the security in order to
deliver it to the buyer when the short sale is made. The lender of the security is typically
paid a fee and may also receive collateral or cash on which the lender can also earn a
return. The lender also receives back the security lent at a future date.
Additional income strategies include:
Writing options (i.e., selling options) to earn option premiums.
Dividend capture, where an investor buys a stock right before its ex-dividend date,
holds that stock through the ex-dividend date (entitling the investor to receive the
dividend payment), and then sells the stock.
Portfolio Costs
Management fees compensate the manager and pay research and analysis, computer
hardware and software, compliance, and processing trades. These fees are typically based
on a percentage of assets under management (i.e., ad valorem fees) and are due at regular
time intervals (e.g., annually).
Some managers also earn performance fees (i.e., incentive fees) when the portfolio
outperforms a stated return objective. These fees are more common for hedge funds and
alternative managers. Incentive fees are often one sided; the manager shares in
outperformance but is not penalized for underperformance. To protect an investor from
paying for performance twice, there may be a high water mark. For example, assume a
hedge fund earns a performance fee for outperforming its return objective and then the
portfolio declines in value. The manager will only earn an incentive fee on future
appreciation above the previous level that was already compensated for.
Portfolios may be subject to administration fees associated with corporate activities,
such as measuring risk/return and voting on company issues. The manager may include
these services in the basic management fee; however, if these functions are conducted by
external parties, administration fees will likely be separate from management fees.
Some irms also charge separate marketing and distribution fees.
Trading costs (i.e., transaction costs) refer to costs associated with buying and selling
securities.
Investment strategy costs are an implicit cost related to the chosen investment
strategy. Actively managed funds that require more investment analysis and transactions
will have higher fees or costs than passively managed funds.
Shareholder Engagement
Shareholder engagement refers to investors and managers interacting with companies in
ways to potentially favorably impact the stock price. Engagement also bene its the
company with improved corporate governance. Engagement includes participating in
calls with the company and/or voting on corporate issues at general meetings
(i.e., general assemblies). Shareholder engagement is not free because it requires an
investment of time and resources.
Activist investing takes engagement even further. Activist investors may:
Propose shareholder resolutions and launch media campaigns to in luence the vote.
Seek representation on the company’s board of directors.
Launch proxy ights to win to achieve their goals. A proxy ight means seeking to
persuade other shareholders to support their proposals.
Active Management and Passive Management for Equity
Portfolios
Passive investors seek to replicate an equity market index or benchmark. Active
managers seek to outperform the benchmark and add value. While the distinction seems
clear, the reality is strategies may blur this distinction, such as closely track the index
with limited deviations allowed to add some value. Active investing is riskier as the
manager could also underperform the benchmark. Rationales for shifting to active
management include:
Con idence that the manager has the expert knowledge and skill to add value.
Client preferences—growth strategies are often seen as more likely to bene it from
active management, while value styles may be more passive.
Mandates from clients to invest in certain companies (e.g., ESG considerations) may
require a more active approach as the manager may need to use screening and
other techniques to meet the mandates.
The results of active management are less certain, and the costs are higher. Active
management is also subject to other potential risks: reputation risk, key person risk, and
higher portfolio turnover, which can lead to higher tax burdens.
PASSIVE EQUITY INVESTING
Cross-Reference to CFA Institute Assigned Reading #16
Benchmarks
An equity index used as a benchmark for equity investment strategies must be (1) rules
based, (2) transparent, and (3) investable.
Considerations in choosing a benchmark include (1) determining the desired market
exposure and (2) identifying the methods used in constructing and maintaining the index.
The construction of an index starts with the method of identifying stocks to include. This
method can be exhaustive (every stock in a de ined universe), or it can be selective (a
subset of stocks within a universe).
The weighting method of the stocks chosen for inclusion in the index can be (1) marketcap weighting, (2) price weighting, (3) equal weighting, or (4) fundamental weighting:
Market-cap weighting includes each stock in the portfolio as a relative percentage
of its market capitalization to the total capitalization of all the stocks in the index.
Price weighting weights each stock by its price; thus, higher-priced stocks are more
heavily weighted in the index. This mimics an investment strategy of holding one
share of each stock in the portfolio.
Equal weighting weights each stock equally (e.g., a 10-stock index would weight
each stock at 10%). This method reduces concentration risk and is slow to change
sector exposures.
Fundamental weighting weights stocks by fundamental factors, such as sales,
income, or dividends.
Stock concentration is a key concern in the selection of the appropriate index.
Concentration can be captured using the concept of effective number of stocks, which can
be measured using the Her indahl-Hirschman Index (HHI). HHI is the sum of the
squared weights of the individual stocks in the portfolio:
Here, n is the number of stocks in the portfolio and wi is the weight of stock i. HHI ranges
from 1/n (an equally weighted portfolio) to 1 (a single stock portfolio), so as HHI
increases, concentration risk increases.
The effective number of stocks is the reciprocal of the HHI:
effective number of stocks =
It can be interpreted as the effective number of stocks in an equally weighted portfolio
that mimics the concentration of the index.
Market Capitalization–Weighted Strategies vs. FactorBased Strategies
A passive market capitalization–weighted investment strategy involves creating a
portfolio that tracks the benchmark index as closely as possible at a low cost by
investing in all or a subset of the index stocks.
Portfolio returns can also be explained by factor models, so another way to replicate the
risk/return characteristics of an index is to create a portfolio with the same exposures to
a set of risk factors as the index. This strategy is often referred to as a passive factorbased strategy (also known as smart beta). The goal of the strategy is to improve on the
risk/return performance of the market cap–weighted strategy by more than enough to
offset the higher costs.
The most common equity risk factors are as follows:
Growth factor: stocks with high P/E, high P/B, and above-average net income
growth.
Value factor: stocks of mature companies with low P/E, low P/B, stable net income,
and/or high dividend yield.
Size factor: stocks with low loating-adjusted market caps.
Yield factor: high dividend yield stocks.
Momentum factor: stocks with recent above-average returns.
Quality factor: stocks with consistent earnings and dividend growth, high cash lowto-earnings, and low debt-to-equity.
Volatility factor: stocks with low standard deviation of returns.
The three types of passive factor-based strategies are (1) return oriented, (2) risk
oriented, and (3) diversi ication oriented:
Return-oriented strategies include dividend yield, momentum, and fundamentally
weighted strategies.
Risk-oriented strategies include volatility weighting (where the weights are the
inverse of price volatility) and minimum-variance investing where portfolios are
selected that minimize portfolio variance.
Diversi ication-oriented strategies include equally weighted portfolios and
maximum diversi ication strategies (achieved by maximizing the ratio of the
weighted average volatility of the individual stocks to the portfolio volatility).
Approaches to Passive Investing
Three common approaches to passive equity investing involve the use of (1) pooled
investments, (2) derivatives-based strategies, and (3) separately managed index-based
portfolios:
Pooled investments. These include open-end mutual funds and exchange-traded
funds (ETFs).
Derivatives-based strategies. These use derivatives (options, futures, and swap
contracts) to recreate the risk/return performance of an index.
Separately managed equity index-based portfolios. These hold all of the
constituent stocks in the index or a representative sample.
Passively managed index-based equity portfolios can be constructed by (1) full
replication (hold all of the securities in the index), (2) holding a sample of the securities
based on strati ied sampling, or (3) using more complex optimization to maximize
desirable characteristics while minimizing undesirable characteristics. In practice, a
blend of these approaches may be used.
Tracking Error
Tracking error initially declines as sample size increases because the manager irst
purchases the most liquid, lowest transaction cost stocks. Tracking error of an indexed
equity fund increases with:
Management fees charged to manage the fund.
Paying commissions (or bid-asked spread) to execute trades.
The addition of less liquid securities with higher transaction costs to the sample.
The use of intraday trading at prices other than closing prices, while performance
of the benchmark index is based on close-of-day pricing.
Cash drag in the portfolio, while indices are the return of a fully invested portfolio
with no cash drag.
ACTIVE EQUITY INVESTING: STRATEGIES
Cross-Reference to CFA Institute Assigned Reading #17
Fundamental Approaches vs. Quantitative Approaches
Active equity investing seeks to outperform a passive benchmark. At the broadest level,
these approaches can be divided into two categories: fundamental and quantitative.
Fundamental approaches are subjective in nature, relying on analyst discretion and
judgment. An analyst will carry out and collate research on companies, markets, and
economies; then, he will use his skill and experience to estimate the intrinsic value of
securities. The research will typically use the company’s inancial statements as well as
insight into its business model, management team, and industry positioning to establish a
valuation of the company’s shares.
Quantitative approaches are objective in nature, relying on models that generate
systematic rules to select investments. Expertise is required in statistical modeling,
typically using large amounts of data. Historical data is analyzed to identify relationships
between equity returns and variables (called factors) that have predictive power. These
variables could relate to valuation (e.g., P/E ratio), size (e.g., market capitalization),
inancial strength (e.g., debt-to-equity ratio), and industry sector– or price-related
attributes (e.g., price momentum).
Types of Active Management Strategies
Both fundamental and quantitative managers can be further categorized as either
bottom-up or top-down strategies.
Bottom-Up Strategies
Bottom-up strategies use information about individual companies such as pro itability
or price momentum to build portfolios by selecting the best individual investments.
Types of bottom-up strategies include both value-based and growth-based approaches,
the substyles of which are summarized next.
Value-based approaches attempt to identify securities that are trading below their
estimated intrinsic value. Substyles of value investing include relative value; contrarian
investing; high-quality value; income investing; deep-value investing; restructuring and
distressed debt investing; and special situations such as divestures, spin-offs, or mergers.
Growth-based approaches attempt to identify companies with revenues, earnings, or
cash lows that are expected to grow faster than their industry or the overall market,
such as consistent long-term growth; shorter-term earnings momentum; and growth at
a reasonable price (GARP) using the price-to-earnings/growth (PEG) ratio.
Top-Down Strategies
Top-down strategies use information about variables that affect many companies such
as the macroeconomic environment and government policies to build portfolios by
selecting the best markets or sectors. Top-down managers typically use broad market
ETFs and derivatives to overweight the best markets and underweight the least attractive
markets according to country/geography and industry sector. Managers can use a blend
of bottom-up and top-down approaches.
Factor-Based Strategies
A factor is a variable or characteristic with which asset returns are correlated. Typical
examples are the size and value factors introduced by Fama and French (1993) in their
multifactor model. They noticed that smaller companies tend to offer higher returns than
larger companies (the size factor), and stocks with higher book values relative to market
values tended also tended to outperform (the value factor).
Investors who are restricted to long-only positions can tilt the portfolio toward factors
that are expected to outperform the overall benchmark. If the tilts are modest, the
portfolio will still have low tracking error and could be considered an enhanced indexing
strategy.
A common subcategory of factor investing is equity style rotation, where the manager
believes that different factors work well at different times. These strategies allocate to
portfolios that represent factor exposures when that particular style is expected to
outperform.
Activist Strategies
Activist investors specialize in taking stakes in listed companies and pushing for
companies to make changes that are expected to enhance the value of the activist’s stake.
The changes could be non inancial in nature (e.g., related to environmental, social, or
governance issues).
Statistical Arbitrage
Statistical arbitrage, or stat arb strategies, make extensive use of technical stock price
and volume data to exploit pricing inef iciencies. Typically, they aim to pro it from mean
reversion in related share prices or by taking advantage of opportunities created by
market microstructure issues.
Pairs trading is an example of a statistical arbitrage strategy that identi ies two
securities in the same industry, buying the underperforming security while shorting the
outperforming security pro iting from mean.
Market microstructure-based arbitrage strategies take advantage of mispricing
opportunities occurring due to imbalances in supply and demand that are expected to
only last for a few milliseconds. Investors with the tools to analyze the limit order book
of an exchange and the capability for high-frequency trading are in a position to capture
such opportunities.
Event-Driven Strategies
Event-driven strategies exploit market inef iciencies that may occur around corporate
events such as mergers and acquisitions, earnings or restructuring announcements, share
buybacks, special dividends, and spin-offs. The risk arbitrage strategy associated with
merger and acquisition (M&A) activity is an example of an event-driven strategy.
Creating a Fundamental Active Investment Strategy
The fundamental active investment process will likely include the following steps:
1. De ine the investment universe in accordance with the fund mandate.
2. Prescreen the investment universe to obtain a manageable set of securities for
detailed analysis.
3. Analyze the industry, competitive position, and inancial reports of the companies.
4. Forecast performance, most commonly based on cash lows or earnings.
5. Convert forecasts to valuations.
6. Construct a portfolio with the desired risk pro ile.
7. Rebalance the portfolio as needed.
Pitfalls in Fundamental Investing
Behavioral biases can affect the human judgment that fundamental strategies use for
their insights into pro itable investments. These biases include con irmation bias, the
illusion of control, availability bias, loss aversion, overcon idence, and regret aversion
bias.
A value trap is where a stock that appears to be attractive because of a signi icant price
fall may in fact be overvalued and decline further.
A growth trap is where the favorable future growth prospects are already re lected, or
overre lected, in the price.
Creating a Quantitative Active Investment Strategy
The quantitative active investment strategy has a well-de ined process:
1. De ine the market opportunity using publicly available information to predict
future returns of stocks, using factors to build return-forecasting models.
2. Acquire and process data, which is the most time-consuming step involving
building databases, mapping data from different sources, understanding data
availability, cleaning up the data, and reshaping the data into a usable format.
3. Backtest the strategy, which involves applying the strategy to historical data to
assess performance. The correlation between factor exposures and subsequent
portfolio returns for a cross section of securities is used as a measure of factor
performance in backtests. This correlation coef icient is known as the factor’s
information coef icient (IC). The Pearson IC of the raw data is sensitive to even a
few outliers (extreme high or low historical return). The Spearman Rank IC
addressees this issue and is often considered more robust (superior). The
Spearman Rank IC is the correlation of the rank of the factor scores and rank of
subsequent performance.
4. Evaluate the strategy using out-of-sample testing, looking at returns generated and
risk measures such as VaR and maximum drawdown.
5. Construct the portfolio using risk models to estimate the risk of the portfolio, also
taking into consideration explicit and implicit trading costs.
Pitfalls in Quantitative Investing
Quantitative investing involves the following pitfalls:
Survivorship bias. If backtests are only applied to existing companies, then they
will overlook companies that have failed in the past, and this will make the strategy
look better than it actually is.
Look-ahead bias. Results from using information in the model to give trading
signals at a time when the information was not available, e.g., using December
inancial accounting data to generate trading signals for the following January.
Data-mining/over itting. Excessive search analysis of past inancial data to ind
data that shows a strategy working.
Turnover. Constraints on turnover may constrain the manager’s ability to follow a
strategy.
Lack of availability of stock to borrow. For short selling, this may also constrain
a manager’s ability to follow a strategy.
Transaction costs. This can quickly erode the returns of a strategy that looked
good in backtesting.
Equity Investment Style Classification
An investment style classi ication process is designed to split a stock universe into
subgroups of stocks that represent the styles discussed in this reading (e.g., size, value).
These groups should contain stocks that have a high correlation with each other (because
they are part of the same style), but correlation between groups should be lower
indicating that styles are distinct sources of risk and return. This process is useful for
classifying the style of a portfolio and benchmarking managers.
Approaches to Style Classification
The two main approaches in style analysis are the holdings-based approach and the
returns-based approach.
Holdings-Based Style Analysis
The holdings-based approach looks at the attributes of each individual stock in a
portfolio and aggregates these attributes to conclude the overall style of the portfolio. A
common application of this idea is the Morningstar Style Box. In a style box, two factors
—value and size—are each split into three groups. There is no consensus on the
de inition of large, mid, and small cap. The style box approach aims to classify
approximately the same number of stocks in each of the value, blend, and growth groups,
essentially distributing the market value of each row evenly across the grid.
Returns-Based Style Analysis
A returns-based style analysis aims to identify the style of a fund through regression of
the funds returns against a set of passive style indices. By imposing a constraint on the
regression that the sum of the slope coef icients should sum to a value of 1, the slope
coef icients can be interpreted as the manager’s allocation to that style during the period.
For example, a returns-based style analysis might conduct a regression of fund returns
versus four passive indices as follows:
Rp = a + b1SCG + b2LCG + b3SCV + b4LCV + ε
where:
Rp = returns on the manager’s portfolio
a = a constant often interpreted as the value added by the fund manager
bi = the fund exposure to style i
SCG = returns on a small-cap growth index
LCG = returns on a large-cap growth index
SCV = returns on a small-cap value index
LCV = returns on a large-cap value index
ε = residual return not explained by styles used in the regression
giving an output of:
b1 = 0, b2 = 0, b3 = 0.15, and b4 = 0.85
From the values of the regression coef icients, we would conclude that the manager’s
portfolio has no exposure to growth stocks (b1 = 0 and b2 = 0), and that the manager is a
value manager with primary exposure to large-cap value (b4 = 0.85) and a small exposure
to small-cap value (b3 = 0.15).
Manager Self-Identification
The fund’s investment strategy is usually self-described by the manager. Comparing that
self-description with returns-based and holdings-based style analysis will either con irm
a consistent identi ication or indicate a need for further investigation and analysis to
explain the discrepancy. Some styles such as equity long/short, equity market neutral,
and short bias do not it traditional style categories, and the manager’s description and
fund prospectus becomes the key source of information on the style of such funds.
Strengths and Limitations of Style Analysis
A summary of the advantages and disadvantages of returns-based versus holdings-based
style analysis is displayed in the following table:
A holdings-based analysis pinpoints the current exposure of a fund. This is an advantage
if the analyst wishes to know the most up-to-date positioning of a manager. However, if
the analyst wishes to assess the average exposure a manager takes over time, then
historical holdings-based analyses need to be available. A returns-based style analysis
based on historical returns would capture this average exposure automatically through
regressing historical returns.
ACTIVE EQUITY INVESTING: PORTFOLIO
CONSTRUCTION
Cross-Reference to CFA Institute Assigned Reading #18
Building Blocks of Active Equity Portfolio Construction
Active equity portfolios aim to outperform a benchmark after all costs. In the simplest
terms, the excess return above a benchmark (active return) will be positive if the
manager overweights securities that outperform the benchmark, and underweights
securities that underperform the benchmark, because active returns are driven by
differences in weights between the active and benchmark portfolios:
where:
Ri = the return from security i
∆Wi = the active weight, the difference between portfolio and benchmark weight for
security i.
Sources of Active Returns
Active returns come from three sources:
1. The level of strategic long-term exposures to rewarded factors, which are risks
that are widely accepted as offering long-term positive risk premiums [market risk
(beta), size, value, liquidity, etc.].
2. Tactical exposures to mispriced securities, sectors, and rewarded risks that
generate alpha (return that cannot be explained by long-term exposure to rewarded
factors). Alpha is directly related to manager skill.
3. Idiosyncratic risk (from concentrated active positions) that generates returns
related to luck. It is labeled luck in the sense that it is not due to market risk
exposure or value-added alpha.
Different managers will generate different proportions of their active returns from each
source.
The decomposition of realized (ex post) active return can be seen in the next equation:
where:
βpk = the sensitivity of the portfolio to each rewarded factor (k)
βbk = the sensitivity of the benchmark to each rewarded factor
Fk = the return of each rewarded factor
(α + ε) = the return not explained by exposure to rewarded factors—alpha (α) is the
active return attributable to manager skill, and ε is the idiosyncratic return—noise or
luck (good or bad, and in practice, it is very dif icult to distinguish between α and ε)
Building Blocks Used in Portfolio Construction
The three main building blocks of portfolio construction are:
1. Factor weightings. This relates to the manager taking exposures to rewarded risks
that differ from those of the benchmark. This can be thought of as active return due
to differences in beta, where beta refers to sensitivity to a rewarded risk factor such
as the market risk of CAPM, or the market, size, and value factors of the Fama and
French model.
2. Alpha skills. These are excess returns related to the unique skills and strategies of
the manager.
3. Position sizing. This will affect all three sources of active risk, but the most
dramatic impact will be on idiosyncratic risk. The general rule is that smaller
positions in a greater number of securities will diversify away idiosyncratic risk
and lead to lower portfolio volatility.
These three building blocks are integrated into a successful portfolio construction
process through a fourth component: breadth of expertise.
Integrating the Building Blocks: Breadth of Expertise
Success at combining the three building blocks is a function of a manager’s breadth of
experience. A manager with broader expertise is more likely to generate consistent
active returns. This can be seen in the fundamental law of active management:
where:
E(RA) = expected active return of the portfolio
IC = expected information coef icient of the manager, calculated as the correlation
between manager forecasts and realized active returns
BR = breadth, the number of truly independent decisions made by the manager each
year
TC = transfer coef icient, a number between 0 and 1 that measures the level to which
the manager is constrained; TC will take a value of 1 if the manager has no constraints,
and 0 if the manager is fully constrained
σR = the manager’s active risk (the volatility of active returns)
A
This equation shows there is a direct link between breadth and expected
outperformance; a larger number of independent decisions (higher breadth) should lead
to higher active return.
Approaches to Portfolio Construction
The majority of investment approaches can be classi ied as:
Systematic or discretionary, which is the degree to which the manager follows a set
of systematic rules, rather than using discretionary judgment.
Bottom-up or top-down, which is the degree to which the manager uses bottom-up
stock-speci ic information, rather than macroeconomic information.
These approaches, and their use of the building blocks, are summarized as follows.
The Implementation Process: Objectives and Constraints
Portfolio construction can be viewed as an optimization problem with a goal (the
objective function) and a set of constraints. Objectives and constraints may be stated in
absolute terms or relative to a benchmark. Examples are given below.
Objective Functions and Constraints of Portfolio Construction
Active Share and Active Risk
Active share measures the degree to which the number and sizing of the positions in a
manager’s portfolio are different from those of a benchmark, and is given by the
following equation:
where:
n = total number of securities in the benchmark or the portfolio
Wp,i = weight of security i in the portfolio
Wb,i = weight of security i in the benchmark
The vertical line brackets indicate that we take the absolute value of the weighting
difference, irrespective of whether it is positive or negative.
Active share takes a value between 0 and 1. If managers hold a portfolio of stocks that are
not in the benchmark, their active share equals 1, whereas if managers hold the
benchmark weights in their portfolio, their active share will be 0. If a portfolio has an
active share of 0.5, we can conclude that 50% of the portfolio is identical to that of the
benchmark and 50% is not.
If two portfolios with the same benchmark invest only in benchmark securities, the
portfolio with the fewer securities and therefore higher degree of concentration in
positions will have a higher level of active share.
Active share is used by many investors to assess the fees paid per unit of active
management. For example, a fund with an active share of 0.2 would be considered
expensive versus a fund with an active share of 0.5 if both funds were charging the same
fees.
Active risk, also called tracking error, is the standard deviation of active returns
(portfolio returns minus benchmark returns). Here it is as an equation:
where:
RAt = the active return at time t
T = the number of return periods
Decomposition of Active Risk
Given the earlier decomposition of active return into returns to factors, alpha, and
idiosyncratic risk, it is possible to show that active risk is a function of the variance due
to factor exposures and the variance due to idiosyncratic risk:
Research conclusions on the composition of active return include:
High net exposure to a risk factor leads to high level of active risk.
A portfolio with no net factor exposure will have active risk attributed entirely to
active share.
Active risk attributable to active share is inversely proportional to the number of
securities in the portfolio.
Active risk increases as factor and idiosyncratic risk levels increase.
Distinguishing Between Different Portfolio Management
Approaches
Active risk and active share can be used to discriminate between different portfolio
management approaches, with respect to their factor exposures and level of
diversi ication. The types of approaches, in order of increasing Active Share and active
risk, can be broadly summarized as follows.
Causes and Sources of Absolute Risk
Absolute risk measures focus on the size and composition of absolute portfolio variance
(i.e., without reference to any benchmark variance).
The contribution of asset i to portfolio variance (CVi) is given by the equation:
where:
wj = asset j’s weight in the portfolio
Cij = the covariance of returns between asset i and asset j
Cip = the covariance of returns between asset i and the portfolio
The portfolio variance is the sum of each asset’s contribution to portfolio variance.
Portfolio variance can also be separated into variance attributed to factor exposures and
unexplained variance. The contribution to portfolio variance of a factor is analogous to
the contribution to portfolio variance of an asset, with weights replaced by beta
sensitivities and assets replaced by factors. The contribution of factor i to portfolio
variance is given by the following formula:
where:
βi = sensitivity of portfolio to factor i (regression coef icient)
Cij = the covariance of factor i and factor j
Cip = the covariance of factor i and the portfolio
The portfolio variance is the sum of each factor’s contribution to portfolio variance.
Causes and Sources of Relative/Active Risk
Relative risk is an appropriate measure when the manager is concerned with
performance relative to a market index. Active variance, which is the variance of the
differences between portfolio and benchmark returns, can be broken down in an
analogous manner to absolute variance.
The contribution of asset i to portfolio active variance (CAVi) is given by the following
equation:
CAVi = (wpi − wbi)RCip
where:
wpi = weight of asset i in the portfolio
wbi = weight of asset i in the benchmark
RCip = the covariance between the active returns of asset i and the active returns of
the portfolio, which re lects the covariances between the active returns for asset i and
the active returns for each of the n assets in the portfolio:
Adding up the CAVs for all the assets in the portfolio will give the variance of the
portfolio’s active return (AVp).
Similar to the absolute risk attribution of the previous section, relative risk attribution
can be conducted on a country, sector, or factor level.
Active portfolio variance can also be segmented into variance explained by active factor
exposures, and unexplained active variance associated with idiosyncratic risks.
Determining the Appropriate Level of Risk
Practical considerations when considering the appropriate level of portfolio risk include:
Implementation constraints. Constraints on short positions or on leverage may limit
the manager’s ability to under/overweight. Liquidity issues may increase costs as a
manager increases active risk, which leads to a degradation of the information ratio
as the extra costs weigh on active returns.
Limited diversi ication opportunities. Increasing risk leads to decreasing marginal
increases in expected returns (this gives rise to the concave ef icient frontier of
Markowitz).
Leverage and its implications for risk. While leverage could be used to solve issue
number two in a single period (allowing the portfolio to move up the linear capital
allocation line, rather than following the curved ef icient frontier), too much
leverage will eventually bring a reduction of expected compounded return in a
multiperiod setting. This comes from the fact that the geometric compounded
returns (Rg) of a portfolio are approximately related to arithmetic noncompounded
returns (Ra) and portfolio volatility σ as follows:
Leverage increases both Ra and σ, but the squaring of σ in the expression means there
will be a point where increasing leverage will lower expected geometric compounded
returns over time.
Additional Risk Measures
Risk constraints can be classi ied as heuristic or formal:
Heuristic risk constraints are based on experience or general ideas of good
practice. Examples include limits on exposure to individual positions, sectors or
regions, or limits on leverage.
Formal risk constraints are often statistical in nature. A key distinction between
formal and heuristic risk measures is that formal risk measures require forecasts of
return distributions, which introduces estimation error. Examples include limits on
volatility, active risk, skewness, drawdowns, and VaR-based measures including the
following.
– Conditional VaR (CVaR)—the expected loss given VaR has been exceeded
(also called expected tail loss or expected shortfall).
– Incremental VaR (IVaR)—the change in VaR from adding a new position to a
portfolio.
– Marginal VaR (MVaR)—the impact of a very small change in position size on
VaR.
Implicit Cost-Related Considerations in Portfolio
Construction
The market impact cost of an investment strategy is an implicit cost related to the price
movement caused by managers executing trades in the market. A manager buying
securities may force security prices up, similarly a manager selling securities may force
security prices down, thereby eroding the manager’s alpha.
Factors that affect market impact costs include:
Assets under management (AUM) versus market capitalization of securities. The
lower absolute level of trading volume for smaller-cap securities can be a liquidity
barrier to managers with higher AUM.
Higher portfolio turnover and shorter investment horizons, which generally
lead to higher market impact costs.
Managers whose trades include “information” (where the trades act as a signal to
the market that investment conditions have changed and encourage other market
participants to carry out similar trades). This will likely have higher market impact
costs.
The market impact cost of a single trade is often measured by slippage. Slippage is
de ined as the difference between the execution price and the midpoint of the quoted
market bid/ask spread at the time the trade was irst entered. Estimates of
slippage based on recent empirical data lead to four notable conclusions:
1. Slippage costs are usually higher than explicit costs.
2. Slippage costs are greater for smaller-cap securities than for large-cap securities.
3. Slippage costs are not necessarily greater in emerging markets.
4. Slippage costs are substantially higher in times of high market volatility.
Long/Short, Long Extension, and Market-Neutral Portfolio
Construction
Short-selling securities is the process of borrowing securities and selling them in the
market, with the intention of buying the securities back later at a lower price and
returning them to the lender. Short-sellers therefore make pro its from security prices
falling.
Introducing the ability to short-sell securities allows investment managers to take
advantage of negative insights gained through their investment research. Long/short is a
general term used to describe any portfolio that can short-sell securities.
The Merits of Long-Only Investing
An investor’s choice between following long-only or long/short strategies is in luenced
by several factors:
Long-term risk premiums, such as the market risk premium, are earned by
investors going net long securities. Investors that short-sell securities over the long
term will therefore suffer negative returns.
The capacity and scalability of a long-only strategy is set by the liquidity of the
underlying securities. Capacity of short-selling strategies is set by the availability
of securities to borrow to facilitate short-selling. This means the capacity of
long/short strategies is likely to be lower than for long-only strategies, particularly
those large-cap funds that face few long-only capacity issues.
Due to limited legal liability laws, the maximum a long investor can lose is the
amount the investor paid for the security (if the security falls to zero). The
potential loss to a short-seller is unlimited since the seller loses as stock prices rise
with stock prices having no price ceiling. This makes “naked” short-selling with no
hedging riskier than a long-only strategy.
Regulations allow some countries to ban short-selling in the interests of inancial
market stability.
Transactional complexity is higher for a long/short fund.
Costs are likely to be higher for long/short funds than long-only funds, both in
terms of management fees and operational expenses.
The personal ideology of an investor might cause him to object to short-selling
(e.g., pro iting from the failure of others); the leverage involved in some long/short
strategies is unacceptable.
Long/Short Portfolio Construction
There are many different styles of long/short strategies, de ined by their gross and net
exposure. Gross exposure is the sum of the value of the long positions plus the absolute
value of the short position, expressed as a percentage of investor’s capital. Net exposure
is the difference between the value of the long positions and the value of the short
positions, again expressed as a percentage of investor’s capital.
Speci ic types of long/short funds include long extension and market-neutral funds.
Long extension portfolios are long/short strategies typically constrained to have a net
exposure of 100%. For example, a long extension portfolio might have a long position of
130% and a short position of 30% (referred to as a 130/30 fund).
Market-neutral portfolios aim to remove market exposure through their long and short
exposures. A simple example would be a fund that is long $200 million of assets with a
market beta of 0.9 and short $150 million of assets with a market beta of 1.2, giving a net
market beta of zero. These funds should have lower volatility than long-only strategies,
and low correlation with other strategies. The objective will be to neutralize risks where
the manager believes they have no comparative advantage in forecasting, allowing them
to concentrate on their speci ic skills. Often, market-neutral strategies are used for
diversi ication purposes, rather than for the purpose of seeking high returns. Note that it
is dif icult in practice to maintain a zero beta, given that correlations between exposures
change continually.
Market-neutral portfolios can be constructed through pairs trading, where the securities
of similar companies are bought and sold to exploit perceived mispricings. Quantitative
approaches to pairs trading are referred to as statistical arbitrage.
The Benefits and Drawbacks of Long/Short Strategies
Long/short strategies offer the following bene its:
Greater ability to express negative ideas than a long-only strategy.
Ability to use the leverage generated by short positions to gear into high-conviction
long ideas.
Ability to remove market risk and act as a diversifying investment against other
strategies.
Greater ability to control exposure to risk factors. Because most rewarded factors
(size, value and momentum) are obtained through a long/short portfolio, being able
to short-sell allows managers to better control their exposure to these factors.
Long/short strategies contain the following drawbacks:
Unlike a long position, a short position will cause the manager to suffer losses if the
price of the security increases. This means potential losses are unlimited, because
security prices are not bounded above. It also means the manager is reducing longterm exposure to the market risk premium.
Some long/short strategies require signi icant leverage, which magni ies losses as
well as gains.
The cost of borrowing securities can become too high, particularly for securities
that are dif icult to borrow.
Losses on the short position will increase collateral demands from stock lenders,
particularly if leverage has been used. This may force the manager to liquidate positions
at unfavorable prices.
ALTERNATIVE INVESTMENTS FOR
PORTFOLIO MANAGEMENT
Study Session 9
The basic ideas and concepts are not dif icult, and have been introduced at Levels I and II,
especially with the hedge funds material from Level I. The most likely exam scenario is
one item set, or one item set and one constructed response question, although the
bene its of alternative investments in diversifying risk appears and is pertinent in
multiple topic areas. There is a signi icant amount of detail so focus on the main
conceptual points and conclusions of the material. Compared to other topics, this is an
ideal topic to pick up relatively easy points on the exam without excessive effort.
HEDGE FUND STRATEGIES
Cross-Reference to CFA Institute Assigned Reading #19
Distinguishing Features Between Hedge Funds and
Traditional Investments
1. Lower regulatory and legal constraints.
2. Flexibility to use short selling and derivatives.
3. A larger investment universe.
4. Aggressive investment exposures.
5. Comparatively free use of leverage.
6. Liquidity constraints for investors.
7. Lack of transparency.
8. Higher cost structures.
Classifications of Hedge Fund Strategies
1. Equity related.
2. Event driven.
3. Relative value.
4. Opportunistic.
5. Specialist.
6. Multi-manager.
Equity-Related
Long/Short (L/S) Equity
The strategy is to buy (long) stocks that are believed to rise in value (currently
underpriced) and sell (short) stocks that are believed to fall in value (currently
overpriced).
The objective is not to eliminate market exposure entirely. Most managers take a sectorspeci ic focus in a particular industry with which they are familiar.
Higher fees than long-only equity position, so must weigh tradeoff between incremental
returns and incremental fees.
Dedicated Short Selling and Short-Biased
Dedicated short selling managers (e.g., typically 60% to 120% short) carefully seek out
overpriced securities for pure short exposure. Short-biased managers do the same but
offset with some long exposure (e.g., typically 30% to 60% net short). A bottom-up
approach is used to identify investment opportunities.
The objective is to produce returns that are uncorrelated (or negatively correlated) with
conventional securities.
Equity Market Neutral (EMN)
EMN strategies seek to attain a near-zero overall exposure to the stock market. Lack of
beta exposure results in lower returns but can be increased by leverage. There is also
signi icant diversi ication and low volatility; EMN works well when markets are volatile.
The objective of the portfolio is to create a portfolio generating alpha and immune to
overall market movements. Alpha is generated when mean reversion in stock prices
eventually occurs.
Popular subtypes of EMN funds include pairs trading, stub trading, and multiclass
trading.
Event-Driven
Merger Arbitrage
Merger arbitrage strategies attempt to earn a return from the uncertainty that exists in
the market in the time between an acquisition being announced and when the acquisition
is completed.
Most commonly, managers take positions in securities in expectation of a successful deal
(e.g., long target company and short acquiring company), or the opposite positions in
expectation of an unsuccessful deal.
Signi icant left-tail risk (i.e., event risk) occurs in the form of losses when a deal fails (or
succeeds) unexpectedly.
Distressed Securities
A distressed securities strategy takes positions in irms that are in inancial distress;
securities prices often trade at greatly depressed prices, which may be due partly to
pricing inef iciencies resulting from investment restrictions.
Returns are subject to longer lockup periods but are generally greater compared with
other event-driven strategies, with a larger variability of outcomes.
Most investments are in the form of long investments (e.g., passive investment, majority
interest) with low use of leverage.
Relative Value
Fixed-Income Arbitrage
Fixed-income arbitrage strategies will go long on comparatively undervalued securities
and go short on comparatively overvalued securities. Signi icant leverage is often utilized
to augment the relatively low returns due to generally ef icient pricing.
Yield curve trades involve making long and short investments to pro it from the
anticipated yield curve steepening or lattening. Carry trades involve shorting a lowyield security (overpriced?) and going long a high-yield security (underpriced?). There
are two sources of return: yield differential, and price changes as mean reversion occurs.
Depending on the type of securities used (e.g., U.S. Treasuries or mortgage-backed
securities), the liquidity may vary considerably.
Convertible Bond Arbitrage
Convertible bonds can be thought of as a regular bond plus a long call option on the
corresponding stock. The primary goal of a convertible arbitrage strategy is to pro it
from buying the implied volatility (of the optionality) of convertible bonds, which is
often underpriced. Such bonds often have low implied volatilities when compared to the
historical volatilities of the equities that underlie the option.
The challenges with the strategy involve hedging away other sources of risk embedded in
the convertible security as well as the signi icant amounts of leverage required to
implement.
The strategy works best in normal market conditions and not so well in periods of
illiquidity or weak credit.
Opportunistic
Global Macro
Global macro strategies attempt to pro it from making correct forecasts of global
economic variables (e.g., in lation, exchange rates, yield curves, and policies). Positions
taken can be based on themes, regions, or styles. In contrast to other strategies, lowvolatility-mean-reverting markets are not generally favorable. Returns tend to be uneven
and volatile.
Strategies tend to be based on top-down analysis to identify potential opportunities. The
goal is to pro it by anticipating changes before other market participants (i.e., contrarian
tendency). They also tend to apply signi icant leverage, often 600–700% of fund assets.
If successful, a global macro strategy will bring both alpha (e.g., right-tail skewed
returns) and diversi ication to an existing portfolio.
Managed Futures
Managed futures strategies involve long and short positions in derivatives contracts to
gain desired exposure. Because only a small amount of upfront capital is typically
required, signi icant leverage can be used. Managed futures are very liquid due to the
highly liquid nature of the futures contracts themselves.
The most common method of investing is time-series momentum (TSM) and another
similar method is cross-section momentum (CSM), the latter of which does the same as
TSM but in a particular asset class. The goal of managed futures strategies is to develop
rules and signals that work well; therefore, the implementation typically occurs using
systematic approaches.
The main bene it of managed futures strategies is their low correlation with traditional
assets and therefore, high diversi ication potential. Such strategies work well during
periods of market stress where they will typically provide positive right-tail skewed
returns.
Specialist
Volatility Trading
The overall strategy is to exploit perceived differences in volatility pricing—buy
underpriced volatility, sell overpriced volatility.
Four methods of implementation include: exchange-traded options for strategies such as
straddles and spreads, OTC options, futures on the VIX index, and volatility swaps or
variance swaps.
Liquidity of the strategy depends on the instruments used (e.g., futures being extremely
liquid while OTC options are less liquid). Using futures also makes it easy to apply
leverage. A long volatility strategy serves as a strong diversi ier, since stock market
volatility is highly negatively correlated with market returns.
Reinsurance/Life Settlements
For reinsurance, such strategies involve hedge funds purchasing catastrophe reinsurance
policies from reinsurance companies—the hedge fund will receive the premiums but is
responsible for payouts should an insured catastrophic event occur. Success partly
depends on suf icient geographical diversity given the limited geographic scope of most
catastrophic events.
For life settlements, such strategies involve hedge funds purchasing insurance policies
from insured persons—the hedge fund will continue to pay the premiums and will
eventually receive the death bene it. Success largely depends on choosing policies
whereby the present value of the future insurance payout exceeds the payments to be
made by the fund.
Such strategies are illiquid, because insurance policies are somewhat dif icult to sell after
initiation.
The risk inherent in such strategies is almost entirely uncorrelated with market risks and
business cycles; therefore, there is the potential to add return diversi ication in addition
to alpha.
Multi-Manager
Fund-of-Funds (FoF)
The FoF strategy involves taking capital from smaller investors (e.g., small investors or
moderately wealthy individuals) and investing in a variety of different hedge funds with
different strategies. The primary bene its to the investor are diversi ication and manager
expertise in the individual funds.
Liquidity is a challenge for FoF investors with a typical one-year initial lockup period in
addition to the liquidity constraints imposed by the underlying funds.
FoFs have both a strategic allocation and tactical allocation, the latter consisting of
overweighting or underweighting various hedge fund strategies based on expected
outperformance or underperformance, respectively.
Assuming the underlying funds are relatively uncorrelated, FoFs allow for greater
diversi ication, steadier returns, and less downside risk compared to any individual fund.
Multi-Strategy
Multi-strategy funds are similar to FoFs in many aspects; however, the key difference is
that the underlying funds in multi-strategy funds are run by the same organization,
rather than being managed by different hedge fund irms. That increases operational risks
but reduces administrative costs for multi-strategy funds.
Tactical allocations for multi-strategy funds can be done with much greater speed and
ease compared to FoFs. With all the funds being managed under one organization, multistrategy managers should have a much better view of correlations and common risks
between the underlying funds.
Historically, multi-strategy funds have generally performed better (but with greater
variance) than FoFs due to superior fee structure and greater ability to execute on
tactical asset allocation. However, the more leveraged nature of multi-strategy funds may
lead to signi icant left-tail losses during time of stress.
Conditional Factor Risk Model
Such models are used to quantify the risk exposures of hedge fund strategies.
(Return on HFi)t = αi + βi,1(Factor 1)t + βi,2(Factor 2)t + … + βi,K(Factor K)t +
Dtβi,1(Factor 1)t + Dtβi,2(Factor 2)t + … + Dtβi,K(Factor K)t + (error)i,t
where:
αi = intercept for hedge fund i
βi,K(Factor K)t = exposure during normal periods to risk factor K
Dt = dummy variable that equals zero during normal periods, and one during a
inancial crisis
Dtβi,K(Factor K)t = incremental exposure to risk factor K during inancial crisis periods
(error)i,t = random error with zero mean
Six risk factors that could be used in the model include equity risk, interest rate risk,
currency risk, commodity risk, credit risk, and volatility risk.
Using a stepwise regression process, interest rate risk and commodity risk could be
eliminated due to multicollinearity issues.
Reallocation to Hedge Funds
When adding a 20% allocation to most hedge fund strategies to a traditional portfolio,
the general result is the following:
Total portfolio standard deviation decreases.
Sharpe ratio increases.
Sortino ratio increases.
Maximum drawdown decreases in approximately a third of portfolios.
Sharpe ratio is lowered due to both downside and upside standard deviation.
Sortino ratio considers only downside risk below a prede ined level of return; given the
left-tail risk of hedge funds, Sortino is the superior measure.
Lowering overall portfolio standard deviation to reduce risk can be achieved with some
lower risk hedge fund strategies (e.g., dedicated short-biased, bear market neutral).
Drawdown is the peak-to-trough decline (% drop between a peak and the subsequent
trough). The high-water mark is the maximum value the portfolio has ever reached.
Hedge funds with the smallest maximum drawdowns include the two opportunistic
strategies (global macro and systematic futures) and equity market neutral.
ASSET ALLOCATION TO ALTERNATIVE INVESTMENTS
Cross-Reference to CFA Institute Assigned Reading #20
Role of Alternative Investments
Types of Alternative Investments
Alternative investments include hedge funds, private equity, private credit, commercial
real estate, and real assets.
Hedge funds were discussed earlier and are mainly expected to increase returns through
their managers’ security selection skill.
Private equity has the main function of increasing expected returns.
Private credit includes direct lending and distressed debt. Direct lending is primarily
income-producing and distressed debt has a risk-return pro ile more like equity
securities.
Commercial real estate provides rental income and may hedge in lation risk.
Real assets such as agricultural commodities, metals, and infrastructure, do not usually
provide income, but often provide protection against in lation risk.
Investment Horizon
With a short investment horizon, the primary risk is returns volatility. Reported
volatility of alternative investment returns appears lower than the volatility of equity
returns and correlation with equity returns appears low. Both statistics are likely
downward biased because:
Appraisal-based valuations of privately held investments result in smoothing of
reported returns.
Databases of alternative investment returns are subject to sampling biases, such as
survivorship bias and back ill bias, which result in downside risk being
understated in the reported data.
With a long investment horizon, the primary risk is failing to achieve a minimum
required return over time. In that regard, alternative investments may be useful in that
their expected returns are higher than bonds and equity. The less than perfect correlation
with equities (even after adjusting for statistical biases) offers potential diversi ication
bene it to an equity portfolio.
Investment Opportunity Set
Two traditional approaches to de ining the investment opportunity set include
classifying asset groups by liquidity or by how they perform over economic cycles.
Liquidity-Based Investment Opportunity Set
Economic Environment-Based Investment Opportunity Set
Alternatively, a risk factor based approach to de ining asset classes involves
statistically estimating their sensitivities to risk factors identi ied by the manager.
Examples include economic growth and in lation, interest rates, credit spreads, currency
values, liquidity, and capitalization.
Two advantages include being able to identify sources of risk that are common
across asset classes as well as the ability to analyze multiple dimensions of
portfolio risk in order to develop an integrated risk management framework.
Two disadvantages include risk factor estimates being sensitive to the period used
for analysis and the results being more dif icult to communicate to decision makers
and to implement compared to traditional approaches.
Allocating to Alternative Investments
Investment Vehicles
A typical structure is a limited partnership whereby the investment manager is the
general partner and the fund investors are limited partners.
A fund of funds (FoF) provides access to alternative investments to investors who
otherwise would not have access. The drawback is that they charge an additional layer of
fees above those charged by the underlying limited partnerships.
Some investors are large enough to demand favorable investment terms and can establish
separately managed accounts (SMAs) or a fund of one to access alternative
investments.
Some open-ended mutual funds and “undertakings for collective investment in
transferable securities” (UCITS) allow smaller investors access to alternative
investments.
Liquidity Concerns
Some structures provide only speci ic times for accepting capital, impose lockup periods
(often a minimum of six months to a year), or provide restrictions on redemption (such
as speci ic times, required notice periods, and maximum redemption amounts), all of
which increase liquidity risk.
A general partner is not required to call (invest) the full amount of committed capital
during the calldown period. Therefore, a fund may achieve an impressive rate of return,
but a limited partner is only earning that return on the portion of committed capital that
has been called.
General partners might designate some of a fund’s less liquid holdings as not subject to
the fund’s ordinary redemption terms, known as a side pocket. A fund’s redemption
terms may be misleading if a large portion of its holdings are side pocketed.
Funds that hold signi icant portions of illiquid investments may restrict redemptions
under certain market conditions to avoid having to liquidate those assets during crisis
periods.
Expenses, Fees, and Taxes
Many alternative investments involve signi icant fees and expenses, such as the “2 and
20" fee structure of many hedge funds (annual management fee 2% of assets under
management, incentive fee 20% of gains).
Funds with calldown structures charge management fees on the amount of committed
capital, regardless of how much of it has been called down.
Some fund strategies may result in short-term taxable income to investors, or may be
subject to tax withholding.
Intermediaries or In-House Programs
As an alternative to using intermediaries (such as FoF), large investors may consider
developing an in-house program with highly customized solutions and allows them to
have close control over its investment program. The build or buy decision depends on
whether the investor can produce similar results to those of an intermediary at lower
cost or generate returns high enough to offset any costs in excess of the costs charged by
an intermediary.
Suitability Considerations
Key suitability considerations include:
Investor needs a high level of expertise to understand the risks being undertaken
and the market factors that drive the success of various fund strategies.
Investor does not strongly believe in the price-ef iciency of markets.
Investor must consider the appropriate alternative investment that is consistent
with the time (investment) horizon.
Investor must have a strong governance program.
Investor must be comfortable with a lower level of transparency due to fewer
reporting requirements.
Asset Allocation Approaches
Three approaches include:
Monte Carlo simulation.
Mean-variance optimization.
Risk factor based optimization.
Monte Carlo simulation has been described elsewhere in the CFA curriculum. Its use
with respect to optimizing an asset allocation can be summarized as follows:
1. Decide between asset class returns or risk factors as the variables to be simulated.
2. De ine how the model should behave statistically, for example by accounting for
properties like mean reversion, fat-tailed distributions, or unstable correlations.
3. If the model is based on risk factors, translate them to asset class returns.
4. Use the resulting asset class return scenarios to develop meaningful outputs, such
as the probability of a shortfall to a portfolio’s required or target rate of return.
Mean-variance optimization (MVO) has also been described elsewhere in the CFA
curriculum. When using MVO with alternative investments, the results may produce an
excessive allocation to this asset class, particularly illiquid investments. An optimization
model may be designed to constrain the allocation or to limit the overall volatility or
downside risk. The asset allocations suggested by the optimization model should be
taken as a guidelines rather than a prescription, and consider the allocation in context of
their objectives and constraints.
Risk-factor-based optimization is similar to MVO, but models risk factors and factor
return expectations instead of return and risk characteristics. Exposures to risk factors
are optimized with respect to an overall risk budget. Constraints in the form of limits on
speci ic risk factor exposures can be included. There is the additional step of translating
the optimized risk exposures to an asset allocation. Two limitations of this approach
include asset classes’ return sensitivity to some risk factor exposures might not be stable
over time, and correlations among risk factors may increase during periods of inancial
stress.
Liquidity Planning
An alternative investments portfolio must be managed in a way that meets its capital
commitments while still providing required liquidity. Forecasting models can be
developed to help manage liquidity. A simple cash low model might assign a percentage
of remaining capital to each year of the calldown period. In this model, the capital
contribution in period t would be the following:
percentage to be called in period t × (committed capital − capital previously called)
Distributions from a fund can be modeled as percentages of its net asset value (NAV). The
NAV increases with capital calls and investment returns, and decreases with
distributions. Distributions in period t would be the following:
percentage to be distributed in period t × [NAV in period t − 1 × (1 + growth rate)]
NAV in period t would be the following:
NAV in period t − 1 × (1 + growth rate) + contributions in period t – distributions in
period t
Capital calls, distributions, growth rates, and even fund lifetimes may turn out
signi icantly different than expected. An investor should stress-test liquidity planning
models against unexpected events such as delayed fund distributions when expected
distributions have been earmarked to meet capital calls.
Monitoring
Monitoring is done to ensure the investment is achieving its stated goals in terms of
return, risk, income, and safety. Performance should be evaluated in the context of those
goals.
Due to heavy active management of many alternative investment strategies, selecting a
representative benchmark or peer group is dif icult, since any benchmark chosen is
unlikely to be directly comparable to a portfolio’s actual investments.
Given that using internal rate of return is in luenced by the timing of capital calls and
distributions (and therefore, may be subject to manipulation), investors may prefer to
monitor a private fund’s multiple on invested capital (MOIC). MOIC is calculated by
dividing the value of the fund’s underlying investments, plus distributions, by total
invested capital.
PRIVATE WEALTH MANAGEMENT (1, 2)
Study Sessions 10 & 11
Study Sessions 10, 11, and 12 are central to the portfolio management process and, therefore,
to the Level III material. Study Session 10 lays out the basics of constructing and using an
IPS for individuals. Study Session 12 builds on this for institutional portfolios. This material
is commonly tested as part of longer, multi-part constructed response questions, and may be
integrated with other topics; all of which is a decent re lection of reality. Case Study in Risk
Management: Private Wealth, which is covered in Study Session 14, is an example of such
integration. Study Sessions 10 and 11 also include substantive readings on the investment
implications of taxation approaches, estate planning, low-cost basis concentrated positions,
and individual risk management.
Candidates regularly report frustration with the individual IPS material and questions.
Inappropriate study habits are a hindrance in this section. A shortcut that has served many
candidates well at Levels I and II is to learn the material through practice questions. From
behavioral inance, you know that mental shortcuts are sometimes an appropriate way to
deal with overload. You also know they fail in more complex situations. IPS material often
falls in the latter category due to the variety of individual situations and subtle details as
well as the fuzzy, non-mathematical nature of some critical data.
Candidates regularly underestimate the importance of preparing effective constructed
response answers under exam conditions. It turns out there is a big difference between
looking at and knowing the answer, and being able to prepare a response. Answers must be
based on the speci ic question asked, all of the relevant case facts given, the most relevant
taught material, and the number of minutes associated with that question. Mechanically
repeating what you saw as the answer to a different question will demonstrate to the grader
that you do not know how to answer the question. Use our Practice and Mock Exams and old
CFA exams to gain experience with constructed response questions.
In reality, the exam questions are, in aggregate, not very dif icult if you approach them as
expected. Tens of thousands of exams must be consistently graded. The questions are
solvable if you apply appropriate technique. Do not ight the material and do not persist in
bad habits. Base your approach on the prominently taught material, not the occasional
outliers or personal opinion.
OVERVIEW OF PRIVATE WEALTH MANAGEMENT
Cross-Reference to CFA Institute Assigned Reading #21
The investment policy statement (IPS) is a center point for organizing and then processing
relevant portfolio information. The investment objectives and constraints are the focus of
the IPS for the portfolio manager.
The beginning point in answering an exam question is assessing the client situation in
context of the investment objectives, constraints, and other considerations; later comes
investor sophistication and uniqueness.
Investment Concerns of Private Clients and Institutions
Investment Objectives
Private clients have a wide range of investment objectives (e.g., maintaining the real value of
the investment portfolio, being inancially secure in retirement, or providing inancial
support to family members). They may be dif icult to quantify and reconcile, and may
change over time. In contrast, institutional clients are more likely to have clearly de ined
and quanti iable objectives (e.g., funding pension or life insurance liabilities) that are stable
over time.
Constraints
Private clients differ from institutional clients as follows:
Private clients tend to have shorter time horizons (which limits liquidity and risktaking ability) or different time horizons for different investment objectives.
Institutional clients tend to have a single time horizon for a clearly de ined objective.
Private clients tend to have smaller portfolios that institutional clients, which may
cause certain asset classes to be unsuitable (e.g., real estate and hedge funds) as they
may lead to concentration risk
Private clients are very concerned with taxes as they can impact asset allocation and
manager selection whereas some institutional clients (e.g., endowments and
foundations) are frequently tax-exempt.
Other Considerations
Institutional clients are likely to have a more formal investment governance structure,
and have greater investment sophistication compared to private clients.
Behavioral issues are likely more important for private clients than institutional
clients.
Information Needed In Advising Clients
Personal Information:
Family circumstances.
Employment information.
Retirement plans.
Sources of wealth.
Return/investment objectives and risk tolerance.
Investment preferences (e.g., liquidity, unique concerns).
Financial Information:
Assets (e.g., cash, investment accounts, retirement accounts, real estate).
Liabilities (e.g., consumer debt, mortgages).
Income (e.g., salary, pension, business, investment).
Expenses.
Other Information:
Wills and trust documents.
Insurance policies.
Liquidity and reporting requirements.
Tax Considerations
Three general classi ications of tax:
Income tax.
Wealth-based taxes. Paid based on assets owned or assets transferred.
Consumption tax.
Three tax strategies to reduce adverse impact of taxes:
Tax avoidance. Legal methods (e.g., exemptions) to avoid paying taxes.
Tax reduction. Legal methods to earn more tax ef icient income.
Tax deferral. Payment of taxes later (e.g., long-term capital gains, retirement plans);
takes advantage of time value of money.
Client Goals
Planned goals can be reasonably estimated within a speci ied time horizon and would
include items such as retirement goals, speci ic purchases, funding the education of
dependents, and charitable giving.
Unplanned goals are unexpected inancial expenditures with uncertainty as to the amount
and timing, and would include uninsured property repair or medical costs.
Private wealth managers can help clients with quantifying, prioritizing, and changing goals.
Risk Tolerance
Risk tolerance is a somewhat subjective measure that re lects both a client’s ability and
willingness to take risk.
Risk capacity is a more objective measure that addresses ability to take risk based on
wealth, income, time horizon, liquidity requirements, and size and importance of goals, for
example.
Risk perception is a subjective measure on investment risk on the part of the client.
Capital Sufficiency
Capital suf iciency analysis can be done using deterministic forecasting and Monte Carlo
simulation.
A traditional, deterministic, linear return analysis assumes the portfolio will achieve a single
compound annual growth rate across the investment horizon. It can be done using time
value of money assumptions and calculations. Although easy to understand, the main
disadvantage is that the use of a single return assumption is not representative of actual
market volatility.
Monte Carlo simulation is a useful tool to simulate how an asset mix is likely to perform in
a given client situation over time. It turns out to be particularly useful in retirement
planning for individuals. Multiple simulations of one asset mix can be ranked to assess the
probability of meeting objectives. An example of interpreting the results of a Monte Carlo
simulation (which is the most likely type of exam question) is provided here.
EXAMPLE: Interpreting Monte Carlo simulation results
A private wealth manager has performed a Monte Carlo simulation for a client who wants to gift
$1,000,000 to a local art museum in 20 years. The results of the simulation for speci ic time intervals and
percentiles are shown in the following table.
Monte Carlo Simulation Results for Client’s Portfolio (In lation Adjusted)
Retirement Planning
The inancial stages of life are education, early career, career development, peak
accumulation, preretirement, early retirement, and late retirement.
Retirement goals can be analyzed using mortality tables, annuities, and Monte Carlo
simulation. Mortality tables raise the issue of longevity risk, annuities attempt to reduce
longevity risk, and Monte Carlo simulation addresses the probability of success but not the
amount of any potential shortfall.
Behavioral biases associated with retirees include increased loss aversion, consumption
gaps, avoidance of purchasing annuities, mental accounting, and lack of self-control.
The Investment Policy Statement (IPS)
An IPS for a private client usually covers the following areas.
Client Background and Investment Objectives
Use relevant personal, inancial, and tax background information in quantifying investment
objectives (if possible) and reconciling any competing objectives.
If there are multiple objectives, the client may need to prioritize between primary and
secondary ones.
Capital suf iciency analysis can be used to determine the likelihood of meeting the
investment objectives as well as revising them to make them more realistic.
Key Investment Parameters
Risk tolerance is usually:
Low(er) for more important goals and near-term goals
High(er) for less important goals and longer-term goals
Time horizon is usually expressed as a range:
Less than 10 years = short horizon
More than 15 years = long horizon
With multiple objectives, there could be different time horizons for each
Asset class preferences may be listed (or unsuitable ones), together with the risk-return
characteristics for each.
Liquidity preferences not already speci ied should be included here (e.g., cash reserves,
income preferences that may restrict investment in certain asset classes).
Other investment preferences are unique items based on the case facts provided
(e.g., concentrated positions).
Constraints are speci ic items based on the case facts that restrict the choice of investments
or strategies for the portfolio (e.g., invest in ethical companies only).
Portfolio Asset Allocation
Strategic asset allocation (SAA) indicates a long-term target allocation for each asset class.
Tactical asset allocation (TAA) speci ies an acceptable range for each asset class.
Portfolio Management and Implementation
Discretionary authority: taking investment actions without irst seeking the client’s
approval; full discretion versus limited discretion versus no discretion
Rebalancing: approach could be time-based or threshold-based
Tactical changes: if TAA is allowed, then should state:
Acceptable range of weights for each asset class
Extent to which the manager is allowed to go beyond the upper or lower bounds when
making tactical changes
Implementation: state the acceptable investment vehicles and the due diligence process for
making investment decisions
Duties and Responsibilities of the Private Wealth Manager
General responsibilities include:
Formulating and reviewing the IPS
Recommending or selecting investment options
Constructing the investment portfolio’s asset allocation
Monitoring and rebalancing the portfolio
Reporting portfolio performance and taxes
Appendix
Includes details of items that typically change more frequently, such as:
Modeled portfolio performance
Capital market expectations: expected return, standard deviation, correlations of
acceptable asset classes
Evaluating and Recommending Improvements to an IPS
The nature of constructed response questions gives you some latitude in developing an
acceptable answer and, in some cases, there may be more than one acceptable answer. You
will be graded on whether you answer the questions in a way that is consistent with what is
taught in the curriculum.
Numerous examples of how you could be tested on an IPS for a private client are provided in
the SchweserNotes.
Portfolio Construction
Traditional Approach
Risk is viewed in an overall single portfolio context and consists of ive steps:
Identify appropriate asset classes
Develop capital market expectations
Determine asset class weights
Assess investment constraints
Implement the portfolio (e.g., active vs passive management, manager selection,
investment vehicles, tax considerations)
Goals-Based Investing
Similar to the traditional approach except there are separate portfolios for each goal. MVO is
carried out for each goal portfolio rather than the entire portfolio.
Easier for client to specify risk tolerance as it applies to each goal portfolio rather than
the entire portfolio.
However, entire portfolio may not be mean-variance ef icient; unlikely to be as well
diversi ied as the optimal portfolio obtained using the traditional approach.
Portfolio Reporting, Review, and Evaluation
Reporting
Typical items include:
Performance summary and market commentary for the current period as a means of
comparison.
Portfolio asset allocation at the end of the current period.
Detailed performance of asset classes and individual securities.
Benchmark report comparing asset class and overall performance.
Historical performance of portfolio since inception.
Transaction details, purchases, and sales for the current period.
Review
Typical items include:
Appropriateness of existing goals and changes needed to IPS.
Rebalancing to target allocation or ranges.
Changes to manager’s discretion or duties.
Goal Achievement
Criteria for success should be:
Ful ills goals within speci ic risk parameter.
Still likely to meet longer-term goals without a signi icant change in the original
strategy.
Process Consistency
Some evaluation criteria:
Is the wealth manager’s strategy consistent with the client’s goals and investment
preferences (as stated in the IPS)?
How have recommended third-party fund managers performed relative to their own
benchmarks?
What is the impact of recommended fund manager switches on portfolio performance?
What tax reduction and minimization strategies have been employed?
What has been done to reduce portfolio costs?
If used, has TAA improved portfolio performance?
Portfolio Performance
Can be measured as:
Portfolio performance versus absolute performance benchmark.
Portfolio performance relative to a passive benchmark.
Risk-adjusted returns of portfolio versus benchmark.
Downside risk of portfolio versus client’s risk tolerance.
Other Issues
Ethics
Key considerations:
Fiduciary duty and suitability.
Know your customer (KYC) rule (e.g., obtain personal and inancial information).
Preservation of con identiality.
Disclose con licts of interest (e.g., commission-based compensation structure).
Compliance Considerations
Regulatory requirements vary by jurisdictions.
Client Categories
Mass Af luent Segment
Wide range of wealth management services.
Large number of clients per manager, greater use of technology.
Do not tend to tailor portfolio management approach for each client.
High-Net-Worth (HNW) Segment
Smaller number of clients per manager.
Tailored investment solutions, tax and estate planning.
Portfolios more likely to contain sophisticated strategies and alternative investments.
Ultra-High-Net-Worth (UHNW) Segment
Multigenerational investment horizons, complex tax and estate planning, and more
comprehensive range of services.
Low client-to-manager ratio due to highly customized client service and likely
complemented with a client relationship team; alternatively, a family of ice may be
used.
Robo-Advisors
Automated advisors, lower fees, therefore, suitable for smaller portfolios.
Investment vehicles are usually ETFs or mutual funds.
Increasingly being used for more sophisticated purposes.
TOPICS IN PRIVATE WEALTH MANAGEMENT
Cross-Reference to CFA Institute Assigned Reading #22
Approaches to Taxation
Main categories of taxes: (1) income tax, (2) capital gains tax, (3) wealth/property tax, (4)
stamp duties, (5) wealth transfer tax.
Net sales price – tax (cost) basis = capital gain/loss. It is important to distinguish between
realized gains (actual disposition) versus unrealized gains (appreciation on unsold items).
Types of tax systems:
A tax haven has very low tax rates or no tax for both residents and foreign investors
A territorial tax system only taxes income that is earned locally
A worldwide tax system will impose taxes on all sources of income, which leads to
double taxation on the same income by more than one jurisdiction. Relief may be
provided through tax credits by the home jurisdiction for tax already paid in the
source jurisdiction or through bilateral tax treaties.
A tax-ef icient strategy results in relatively high after-tax returns compared to pretax
returns. Four common metrics used in examining tax ef iciency include:
After-tax holding period return:
After-tax post-liquidation return:
. Liquidation tax = ( inal value – tax basis) × tax rate on capital gains
After-tax excess return:
(after-tax return of portfolio minus after-tax return
of benchmark)
Tax-ef iciency ratio:
(after-tax return divided by pretax return)
Tax Location
Types of investment accounts:
A taxable account is taxed at the relevant rates for each type of investment account
–
A tax-deferred account (TDA) allows for pretax contributions and tax-free
accumulation but all amounts are taxed at withdrawal as regular income
–
A tax-exempt account (TEA) allows for after-tax contributions to accumulate on a taxfree basis and with no taxes upon withdrawal
–
Asset location
Tax-ef icient assets should generally be placed in taxable accounts
Tax-inef icient assets should generally be placed in tax-exempt or tax-deferred
accounts
Taxable accounts have the advantage of allowing losses incurred to be offset against
gains earned
There is a choice between more tax ef iciency and lower return (e.g., passive equity
strategy) and less tax ef iciency and higher return (e.g., active equity strategy)
Key tax management strategies
Structure investments to minimize taxes (e.g., lower tax rates for long-term capital
gains)
Defer income recognition (e.g., maximize tax-free compounding)
Tax loss harvesting involves the sale of securities with embedded losses to offset gains,
which will lower the tax liability for the current year.
Sales prior to year-end could occur for losses to place them in the current tax year and
offset any gains
Sales after year-end could occur for gains to defer them to the following year
Tax lot accounting is allowed in many tax jurisdictions
– Highest in, irst out (HIFO): generally optimal as it minimizes the gain and
capital gains tax due now
– First in, irst out (FIFO): assuming increasing cost base over time, optimal if tax
rates will increase in the future since more gains are taxed now versus later
– Last in, irst out (LIFO): assuming increasing cost base over time, optimal if tax
rates will decrease in the future since less gains are taxed now versus later;
equity markets tend to appreciate over time so LIFO is generally the most taxef icient strategy
Quantitative tax management
General idea is to minimize tracking error and trading costs as well as to minimize
realized gains and maximize realized losses
Tax-optimized loss harvesting looks for opportunities during the year instead of just
once near the end of the year
Gain-loss matching optimization can be used to achieve the goals of minimizing capital
gains and ensuring risk exposures are in line with portfolio objectives
Concentrated Positions
Concentrated single-asset positions have company-speci ic risk that can be diversi ied away.
Such positions could be subject to illiquidity and high transaction costs which is why they
should be managed carefully. Consider level of concentration, tax basis, tax rate, liquidity,
time horizon, investor restrictions, and non inancial matters in choosing a strategy.
Strategies to manage concentrated positions include:
Selling the entire position: incur tax liability immediately but can diversify faster
Selling the entire position gradually over time: incur tax liability over time but more
time needed to diversify
Tax-free exchange funds: may involve numerous investors combining their
concentrated positions to diversify but avoid triggering immediate taxes
Charitable gifts: meet philanthropic goals and avoid taxes upon transfer
Tax minimization strategies: could involve waiting until death to achieve tax-free stepup basis (in some jurisdictions)
Managing concentrated positions in public equities
Completion portfolio: additional assets are structured for greatest diversi ication
bene it to complete the concentrated position
Equity monetization
– Step 1: Hedge a large part of the risk in the position
– Step 2: Borrow using the hedged position as collateral
Zero-cost collars (buy put, sell call): different strike prices for equal premiums and
some upside given up
Covered call writing as a form of staged diversi ication if the share price appreciates
suf iciently
Tax-free exchanges: investors, likely with low cost basis shares, who pool holdings,
with each investor owning a pro rata share of new fund
Charitable remainder trust (CRT)
– Individual makes irrevocable donation to CRT and receives tax deduction
– CRT pays no tax and can reinvest proceeds into a more diversi ied portfolio
– CRT pays out funds to designated bene iciaries and ultimately the remainder of
the capital goes to a designated charity
Managing concentrated positions in privately owned businesses
Personal line of credit secured by company shares: owner can borrow from the
company or from a third-party lender and pledge company stock as collateral
Leveraged recapitalization: could be part of a phased exit strategy whereby owner
essentially sells equity in the company to a private equity irm (PEF) and owner
receives cash that was raised by having the company borrow funds; remaining equity is
sold later
Employee stock ownership plan (ESOP): owner sells stock to the ESOP, which then
sells the shares to company employees
Managing concentrated positions in real estate
Mortgage inancing
– An attractive strategy to raise funds and avoid payment of capital gains taxes,
loss of control, and loss of future property appreciation
– Loan proceeds can be used to invest in liquid and diversi ied investments
Donor-advised fund (DAF)
– Similar to a CRT
– Investor gets a tax deduction for the contribution and tax-exempt entity can sell
or retain property with no tax due
– Investor may also in luence the use of the donation
Gift and Estate Planning
Estate planning is the planning process associated with transferring your estate to others
during your lifetime or at death so that the assets go to the individuals or entities you intend
and in the most ef icient way.
The most common tool used to transfer assets is a will (also known as a testament). The
person transferring assets through a will is known as the testator.
Probate is a legal process that takes place at death, during which a court determines the
validity of the decedent’s will, inventories the decedent’s property, resolves any claims
against the decedent, and distributes remaining property according to the will.
Lifetime Gifts and Testamentary Bequests
The two primary means of transferring assets are through gifts and bequests. Gifts are
referred to as lifetime gratuitous transfers or inter vivos transfers and may be subject to
gift taxes. Whether the gift is taxed and who pays the tax is determined by the taxing
authorities involved. Assets transferred through bequests are referred to as testamentary
gratuitous transfers and can be subject to estate taxes, paid by the grantor
(i.e., transferor), or inheritance taxes, paid by the recipient. Many jurisdictions that impose
gift taxes also provide exclusions. A civil law system is based on old Roman law. In this
system laws are handed down (i.e., a top-down system) by a legislative body.
Common law systems, based primarily on old English law, are more bottom-up. Judges play
very important roles in common law systems by re ining any existing laws to meet
particular situations. Once made by a judge, the decisions become precedent to be applied in
future cases.
Estate or inheritance taxes are set on a lat-rate basis or progressive tax rate schedule, with
increasing rates for greater wealth transferred. There may also be an allowance or threshold
amount for which no transfer tax applies.
Asset Protection
If the system has forced heirship rules, children could have a right to a portion of a parent’s
estate, regardless of the location of the child vis-à -vis the parent, the relationship that exists
between the parent and child, or even the relationship between the parents.
Knowing the situation could arise, wealthy individuals might try to avoid forced heirship
rules by gifting assets or moving them “off-shore” into a trust where they fall under a
different taxing authority with no forced heirship rule. Recognizing this, many regimes apply
claw-back provisions that add the values back to the decedent’s estate before calculating
the child’s share. If the estate isn’t suf icient to meet the child’s entitlement, the child may in
some cases legally seek the difference from those who received the gifts.
Relative After-Tax Value of Gifts
If it is determined an individual has excess capital, tax law may favor either making a gift
now or waiting and making a bequest (which is a gift at death). Because this is excess capital,
the decision criterion becomes maximizing after-tax value to the recipient at a future date,
the assumed date of death for the giver. A relative value (RV) ratio compares the FV of a
dollar to the recipient of gifting now versus a bequest at death. RV above 1 indicates gift now
and below 1 indicates bequest at death. There are two tax scenarios:
No gift or estate tax is owed:
Gift tax owed and paid by receiver, in which case $1 given is $(1 – Tg) received:
In these formulas:
rg and tg are pre-tax return and applicable tax rate on return of gift receiver.
re and te are pre-tax return and applicable tax rate on return of gift giver.
Te is the estate tax rate paid from the giver’s estate.
Tg is the gift tax rate.
Estate Planning and Family Governance
Trusts are a means by which a grantor (or settlor) can transfer assets to bene iciaries
outside of the probate process.
Types of trusts
Revocable
– Settlor can rescind (revoke) the trust and resume ownership of the assets
– Settlor is considered the legal owner of the assets for tax and reporting
purposes, and claims may be made against the trust assets
Irrevocable
– Settlor gives up ownership and control of the assets
– Trustee is considered the owner of the assets for tax purposes and is responsible
for reporting and paying taxes on income generated by the trust
– Generally protects the trust assets from claims against the settlor
Fixed
– Pattern of distributions to the bene iciaries is predetermined by the settlor and
incorporated into the trust documents
Discretionary
– Trustee determines how the assets are to be distributed
– Assets should be distributed to produce the greatest bene it to the bene iciary;
settlor may convey general wishes through the trust documentation
Life insurance
As the only assets transferred by the grantor (policy owner) are the premiums paid, life
insurance policies represent a very ef icient means for transferring assets or even
helping bene iciaries pay inheritance taxes
In most jurisdictions, life insurance proceeds pass to bene iciaries without tax
consequences, and, depending on jurisdiction, the policy might provide tax-free
accumulation of wealth and loans to the policyholder or bene icial terms
A robust system of family governance is needed to reduce the potential reduction in wealth
over generations
Governing bodies include: board of directors (BOD), family council, family assembly,
family of ice, and family foundation
Objectivity and realism is maintained by having external experts on the BOD in
addition to family members active in the business
Business succession
Passing business to the next generation
– Could be done via direct transfer or through a trust; before or after death
– Founder may wish to retain temporary control for some time and only transfer
nonvoting shares
– During transition period, both BOD and family council should be involved to
maximize transparency and fairness
– Diverse viewpoints are needed to avoid social proof bias
Sell the business
– Assuming no appropriate person(s) in the family to take over the business
– Endowment bias may be an issue
– Key issues include: taxation, liquidity, and philanthropy
Reducing taxes on future appreciation
– Estate freeze, limited partnership with gifting, and transferring to trust
– Discount for lack of liquidity/marketability and minority interest discount
After disposition
– Sale proceeds could be used to inance next business venture or be donated to
charitable causes
Planning for the unexpected
Division of inancial assets in the event of a marriage breakdown should be addressed
in advance through a prenuptial agreement. Postnuptial agreements occur after the
marriage is over and deal with inancial matters after the marriage
Incapacity
– Living will: Addresses an individual’s medical care if the individual becomes
incapacitated and is usually a legal, binding document
– Durable power of attorney: Allows a guardian to act on behalf of the grantor
even after the grantor becomes incapacitated; often covers inancial and medical
matters
RISK MANAGEMENT FOR INDIVIDUALS
Cross-Reference to CFA Institute Assigned Reading #23
Human Capital and Financial Capital
The holistic balance sheet is superior to the traditional balance sheet in planning lifetime
consumption and bequests for individuals. For assets, the holistic balance sheet adds human
capital (HC) to the inancial capital (FC) used on the traditional balance sheet. It adds the PV
of planned future expenditures and bequests to the explicit liabilities (debts) shown on the
traditional balance sheet.
HC is the PV of expected future labor income. It is the sum of each year’s projected
year-end salary weighted by the probability of life, discounted at the risk-free rate plus
a risk premium related to the riskiness of the labor income. (Treating salary as yearend is the convention used in the reading).
Future labor income can be projected in real values (and discounted starting with real
rf), or projected in nominal values (and discounted starting with nominal rf).
FC is all assets other than the individual’s HC, including the PV of de ined-bene it (DB)
plan bene its.
The drawback of the holistic balance sheet is that the additional assets and liabilities
that are included are more dif icult to estimate.
Financial Stages of Life
Generally HC is highest in the early career stage and then declines until retirement as total
remaining future labor income to be earned declines. FC is likely to be increasing as the
individual saves for retirement. Any such progression can be disrupted by life events. The
general stages of life are:
Education as the skills to earn HC are acquired.
Early career when low-cost term life insurance plus disability and property insurance
may be needed.
Career development with increases in savings and FC accumulation.
Peak accumulation as savings and FC accumulation accelerate. Portfolio risk reduction
may begin.
Preretirement when portfolio risk reduction may continue along with planning for
retirement.
Early and then late retirement when practical issues must be considered, such as
expenditures initial increase to enjoy retirement, unexpected health issues, and
declining cognitive functions.
The Role of Insurance
Insurance can be used to manage risks that are not addressed by traditional portfolio tools,
such as portfolio diversi ication. Insurance is risk sharing among the users, not a wealth
building tool for the individual. It should be used for risks that are infrequent and severe.
The insurance is priced by the insurance company to re lect morality estimates of when
death and payouts will occur, a ROI of what the company will earn on the insurance
premiums (price charged for the insurance), and a load that covers costs and expected pro it
for the company.
While there are many types of insurance, the focus here is on life insurance and annuities:
Life insurance hedges mortality risk (dying sooner than expected) and should be
suf icient to meet needs of the insured that would have been met in the absence of the
insured’s premature death. The bene iciaries receive the policy payout at death of the
insured.
Annuities hedge longevity risk (outliving FC) and are the economic opposite of life
insurance.
Other types of risk and insurance include:
– Premature job loss—use disability insurance.
– Property risk—use property insurance, such as auto and home insurance.
– Liability risk—use liability insurance.
– Risks to health—use health and medical insurance.
Multiple permutations of life insurance and annuities exist. As features are added, it
increases the cost of the product and makes policy comparisons more dif icult.
For life insurance, the greater the probability of death of the insured, the sooner the payout
occurs. Therefore, the higher the premium cost the company must charge (or the lower the
amount of insurance payout provided). In generally increasing order of complexity, life
insurance can be classi ied as:
Temporary (term) with a premium paid for one year of insurance. The policy may
include guaranteed annual renewal and/or guaranteed level premium for a speci ied
number of periods.
Whole life for the insured’s lifetime with premiums paid every year and including a
build-up of cash value that can be withdrawn or borrowed against.
Universal life that provides a choice among investment options and premium
lexibility.
For annuities (and in contrast to life insurance), the lower the probability of death, the more
payouts the company will make, lowering the periodic payout amount or increasing the
premium cost. For the standard annuity, one premium payment is made at purchase and then
payouts are made to the annuitant. Variations include payouts for:
a inite period (which does not insure against mortality risk),
the life or joint life of two individuals, and
starting at a deferred future date.
Mortality credits: Insurance companies price the product based on expected aggregate
payouts. Some individuals will live longer and others will have shorter lives, resulting in
both individual winners and losers. The winner is collecting a mortality credit from the
loser.
The bene iciaries of a life insurance policy earn a mortality credit if the insured dies
earlier than expected. They collect the face amount sooner (making its PV higher).
Annuitants collect mortality credits if they live longer than expected. They collect
more total payments.
Life insurance policy costs can be compared using various methods, two of which are
presented in the reading. Both are based on:
1. FV of premiums paid (calculated as an annuity due).
2. FV of any dividends received (calculated as an ordinary annuity).
3. Terminal cash value (if any).
The Net Payment Cost Index assumes death and policy payout at the end of an analysis period.
Calculate the FV of all net cost as #1 − #2.
The Net Surrender Cost Index assumes termination of policy and cash value payoff at the end of
an analysis period. Calculate the FV of all net cost as #1 − #2 − #3.
In both cases, this net FV cost can be annuitized as an annuity due PMT amount. That PMT
can be divided by the number of thousands (,000) of insurance for the periodic cost per
thousand of insurance. If all other features of two policies are the same, a lower PMT amount
is a lower cost of insurance.
Fixed vs. Variable Annuities
In general, a ixed annuity will provide a higher initial payout with the payout amount
largely determined by the initial level of interest rates. The higher initial payout makes ixed
annuities better suited to more risk-averse investors, though these policies are less likely to
allow additional early cash withdrawals.
Variable annuities shift more risk to the annuitant as payouts are linked to future returns
earned. The initial payout will be lower but the potential lifetime payout can be higher.
Generally, the annuitant can choose among speci ied investment alternatives and early
withdrawal features are more likely (though there may be fees to exercise the early
withdrawal rights). Such policies are more complex and harder to analyze with less
competitive (higher) pricing.
Total Risk Management
Systematic risk can be managed with traditional portfolio management tools and
diversi ication. Portfolio diversi ication can be extended to TW asset allocation by
considering the correlation of the individual’s HC to FC. Within the desired overall asset
allocation target, higher risk or more equity like HC tilts the FC toward bonds. Lower risk or
more ixed income like HC tilts the FC toward equity. The point is the nature of the
individuals HC is largely set while the FC allocation can be shifted.
Insurance can then be used to manage infrequent and severe unsystematic risks in ways
beyond traditional diversi ication.
For risk of premature job loss, use disability insurance.
For premature death risk, use life insurance.
For longevity risk, use annuities.
For property risk, use property insurance.
For liability risk, use liability insurance.
For health risk, use health and medical insurance.
Not all risks should be insured. Severe, regularly occurring risks should be avoided. Not
severe, but regularly occurring risks should be reduced. Not severe and infrequent risks can
be retained and accepted, sometimes called self-insurance. Severe, in this case, is something
that would jeopardize standard of living and lifestyle.
PORTFOLIO MANAGEMENT FOR
INSTITUTIONAL INVESTORS
Study Session 12
Study Session 12 draws on many individual portfolio management concepts covered in
Study Sessions 10 and 11. Additionally, “Case Study in Portfolio Management:
Institutional” in Study Session 14 is an application of the material in Study Session 12.
The basic IPS construction process continues, with speci ic nuances by institutional
type. In general:
– Institutions are assumed to be more knowledgeable and objective clients for
whom willingness to bear risk is not a factor, unless indicated otherwise in
the case.
– Legal and regulatory issues are material for some institutional types.
The earlier discussions regarding use of annuities, life, and other insurance products
are useful background to understanding the insurance company portfolio
management issues covered here.
PORTFOLIO MANAGEMENT FOR INSTITUTIONAL
INVESTORS
Cross-Reference to CFA Institute Assigned Reading #24
The primary portfolio types covered are pension funds, sovereign wealth funds,
university endowments, private foundations, banks and insurers. Like the individual IPS,
the questions are case speci ic. You must understand the underlying material in depth to
be able to apply it successfully.
Overview of Institutional Investors
Common characteristics:
Institutions are generally larger than individual investors. Large institutions may be
too large to invest in low capacity investments such as small-cap equity and
venture capital. Small institutions may have dif iculty with diversi ication if there
are high minimum investment sizes.
Institutions generally have a longer-term investment horizon compared to
individuals.
Legal, regulatory, accounting, and tax rules are different than those for individual
investors. Differences between institutions are based on national jurisdiction.
Governance structure for institutions is generally more formal than for individuals
(e.g., board of directors, investment committee).
Principal-agency issues for institutions occur internally with the investment
committee and investment staff and occur externally with outsourced investment
managers (e.g., high ixed management fee paid to third-party investment managers
even if performance is poor).
IPS key inclusions:
Mission and investment objectives (i.e., return and risk tolerance).
Investment horizon and liabilities.
External constraints (e.g., legal, regulatory, tax, and accounting).
Asset allocation policy—portfolio weights with ranges and asset class benchmarks.
Rebalancing policy.
Reporting requirements.
Four general approaches to asset allocation:
Norway’s sovereign wealth fund: passive allocation to public equities (60%) and
bonds (40%) with little or no exposure to alternative assets.
Yale University endowment: high allocation to alternatives with signi icant active
management; externally managed assets.
Canada Pension Plan: high allocation to alternatives with signi icant active
management; internally managed assets.
Liability driven: maximize expected surplus return and manage surplus volatility.
Pension Funds
Main Features
Defined Benefit (DB) Pension Plan
Stakeholders
Plan sponsors (employers): extra contributions needed for underfunded plan.
Plan bene iciaries (employees and retirees): employer may default on
contributions.
Investment staff, investment committee, and board.
Governments: tax incentives to employees.
Shareholders: lower income and higher inancial risk when plan is underfunded.
Liabilities and Investment Horizon
Liability factors: service/tenure, salary, longevity, employee turnover,
additional/matching contributions, expected investment return, and discount rate.
Investment horizon depends on active lives, retired lives, and frozen plan.
Risk Considerations
Plan funded status.
Sponsor inancial status, size of plan compared to sponsor, correlation of sponsor
operating results and returns of pension assets.
Provision for early retirement/lump-sum distributions.
Workforce characteristics (e.g., age, proportion of active lives).
Liquidity Needs
Impacted by:
Proportion of retired lives.
Age of workforce.
Level of funded status.
Plan participants’ ability to switch or withdraw from the plan.
External Constraints
Regulations vary by country but there are similar themes such as extensive reporting on
fees and costs, personal liability for pension trustees, minimum funding ratios for DB
plans.
Tax rules vary by country but pension funds are often treated favorably by governments
to encourage individuals to save for retirement.
Accounting rules differ by country; may require funded status to be reported as an asset
or liability on the balance sheet. Valuations of asset and liabilities may need to be at
market value or a similar metric.
Investment Objectives
Primary objective: to achieve a target return over a speci ied long-term horizon, while
assuming a level of risk that is consistent with meeting its contractual liabilities.
Secondary objective: to minimize the present value of the cash contributions the sponsor
will be required to provide.
Target return considerations: discount rate for liabilities and plan-funded status.
Defined Contribution (DC) Pension Plan
Stakeholders
Plan sponsors (employers): contribute to plan, invest plan assets, and offer suitable
investment options to plan participants.
Plan bene iciaries (employees and retirees): face risk of pension not meeting
retirement needs as well as longevity risk.
Board: communicate with plan participants.
Governments: tax incentives to employees.
Liabilities and Investment Horizon
The liabilities pertain to the DC plan sponsor and are the required contributions to plan
assets (but no liabilities associated with future bene its).
The investment horizon for individuals in a DC plan is linked to age. A default life cycle
(target date) investment option is often available where the asset mix is managed
according to a desired retirement date.
Liquidity Needs
Impacted by:
Age of workforce.
Plan participants’ ability to switch or withdraw from the plan.
External Constraints
Regulations vary by country but there are often requirements that plan sponsors must
educate participants on saving for retirement, particularly with regard to default options
(for disengaged participants).
Tax rules vary by country but in many countries, the participants’ contributions are tax
deferred in that they make pretax contributions and investment earnings are not taxable.
All amounts would be taxed as ordinary income upon withdrawal.
Investment Objectives
The main objective is to prudently grow assets to meet spending needs in retirement.
There is an onus on the plan sponsor to provide cost-ef icient default options for
disengaged participants.
Asset Allocation (for both DB and DC plans)
Over the past decade:
Decrease in equities, increase in ixed income and alternative assets to try to lower
the volatility of funded ratios.
Within equities, tendency towards home bias to domestic equities.
Sovereign Wealth Funds (SWF)
Main Features/Mission
Budget stabilization funds: to insulate government budgets from commodity price
volatility or economic cycles.
Development funds: prioritizes national socioeconomic projects (e.g., infrastructure,
research, and development).
Savings funds: invest revenues from nonrenewable assets for future generations.
Reserve funds: earn returns on excess foreign reserves held by central banks and reduce
the negative cost of carry of holding foreign reserves.
Pension reserve funds: to fund future pension liabilities of governments.
Stakeholders
Key stakeholders:
Current and future citizens: may bene it from direct payments or indirectly from
lower taxation.
Investment of ices.
Board.
Governments – SWF returns may be used to balance budget de icits.
Liabilities and Investment Horizon
Liquidity Needs
Budget stabilization funds: potentially sensitive to short-term de icits, therefore, must
invest in high liquidity assets with low risk of signi icant losses in the short-term.
Development funds: low liquidity needs given that the corresponding investments are
long-term.
Savings funds: very low liquidity needs given the main objective is to accumulate
wealth for future generations.
Reserve funds: medium liquidity needs (less than stabilization funds but more than
savings funds).
Pension reserve funds: liquidity needs vary with time; lower during accumulation
stage and higher during decumulation stage.
External Constraints
SWFs are typically established by national legislation that gives them their mission and
structure.
A best practices framework established by the International Forum of SWFs (IFSWF)
called the Santiago principles addresses concerns such as avoiding political in luence,
high quality governance, independence, transparency, accountability, ethics, risk
management, and regular monitoring for compliance with the principles.
SWFs are generally tax-exempt.
Objectives
Asset Allocation
Budget stabilization funds: majority in ixed income and cash.
Development funds: depends on the socioeconomic mission of the fund.
Savings funds: high allocation to equities and alternative investments.
Reserve funds: similar to savings funds but lower allocation to alternative
investments due to potentially higher liquidity needs.
Pension reserve funds: similar to savings funds.
University Endowments
Main Features/Mission
Funds are invested to earn returns to provide ongoing support to the operating budget.
Main objective is to balance the needs of the university today against its future needs
(i.e., intergenerational equity).
Stakeholders
Current and future students, alumni, university employees, and board or investment
committee.
Liabilities and Investment Horizon
The need to maintain intergenerational equity and the unlimited life of the university
means that endowments have a perpetual investment horizon.
The liabilities are the future payouts promised and can be formulated in a spending
policy as follows:
where w = weight of the prior year’s spending amount.
Under the constant growth rule (w = 1), the endowment provides a ixed (real) annual
payout to the university once adjusted for in lation by the Higher Education Price Index
(HEPI). Under the market value rule (w = 0), annual payouts are a pre-speci ied
percentage of the three- to ive-year moving average of asset values. Under the hybrid
rule(0 < w < 1), spending is a weighted average of the previous two rules.
Other liability-related factors include:
Gifts and donations (reduce the net spending rate).
Reliance of the university on the spending from the endowment.
Capability of the endowment or university to issue debt.
Liquidity Needs
Annual spending tends to be low due to gifts and donations.
Low liquidity needs and perpetual time horizon = high risk tolerance.
External Constraints
Legal and regulatory issues will vary by jurisdiction but there are two typical
requirements:
Investment on a total return basis (income + capital) and diversi ication according
to modern portfolio theory.
Investment committees or boards and staff who have a iduciary duty of care in
overseeing investments.
In terms of tax, endowments are typically tax-exempt when earning investment income.
Investment Objectives
To preserve the purchasing power of the assets in perpetuity (i.e., grow in line with
in lation) while achieving returns adequate to maintain the level of spending.
Asset Allocation
Given the need to beat in lation, there tends to be a signi icant allocation to real assets
with expected returns that meet or beat in lation.
Larger endowments tend to allocate more than 50% to alternative investments.
Smaller endowments tend to allocate less to alternative investments and more to
domestic equities and ixed income.
Private Foundations
Main Features/Mission
Funds are invested to earn returns to make grants to support speci ied charitable causes.
Main objective is to maintain purchasing power in perpetuity and earn returns suf icient
to support the grant-making activities of the foundation.
Stakeholders
Founding family, donors, recipients of grants, wider community (that the foundation’s
activities may bene it), government (by providing favorable tax treatment), and board or
investment committee.
Liabilities and Investment Horizon
Typically perpetual investment horizon, although limited-life foundations are becoming
more common.
Some jurisdictions (e.g., U.S.) have tax laws that mandate a minimum annual payout
(e.g., 5% of assets plus investment expenses).
Compared to university endowments, foundations are relied upon almost exclusively to
meet budgets. Along with the higher liquidity requirements of foundations, it means the
risk tolerance of foundations is lower.
Liquidity Needs
The minimum annual payout requirement imposes a liquidity need greater than that of
university endowments.
External Constraints
Similar legal and regulatory issues as for university endowments.
Investment Objectives
To generate a real return over consumer price in lation of the spending rate plus
investment expenses, with expected annual volatility in a reasonable range over a threeto ive-year period.
Asset Allocation
Overall risk tolerance remains high and similar need to beat in lation as for university
endowments.
Larger foundations tend to allocate about 50% to alternative investments.
Smaller foundations tend to allocate less to alternative investments and more to
domestic equities and ixed income.
Banks
Main Features/Mission
Independent of a bank’s investment portfolio, the core business of a bank is to earn
pro its by taking deposits from savers and making loans to borrowers.
Stakeholders
Shareholders, customers (depositors and borrowers), creditors, credit rating agencies,
regulators, communities where the bank operates, bank employees and management, and
board.
Liabilities and Investment Horizon
Deposits (demand and time/term) are the majority of the liabilities − short-term.
Longer-term illiquid mortgages and commercial loans are the majority of the assets.
The investment horizon for the bank portfolio is impacted by the difference between the
long-term illiquid assets and the short-term liquid liabilities. As a result, short-term
liquid assets (as a way to “match” the short-term liabilities) are the most likely
instruments to be held in the investment portfolio.
Liquidity Needs
Liquidity management is key given that deposits are short-duration liabilities and the
potential need to raise liquidity in adverse market conditions. Regulations also require
banks to have much more liquid assets.
External Constraints
Regulations are extensive and focus on capital adequacy, liquidity, and leverage levels.
Main goal of regulators is to make sure that banks have adequate capitalization to absorb
losses.
Accounting for banks could be standard inancial reporting (e.g., IFRS), statutory
accounting (required by regulators), or true economic accounting (uses market values for
all assets and liabilities)
Banks are typically fully taxable entities, so must look at after-tax investment returns.
Investment Objectives
To manage liquidity and reduce risk mismatches between the bank’s noninvestment
assets and liabilities.
Insurers
Main Features/Mission
Life insurers write insurance relating primarily to whole life or term insurance with ixed
payments, variable life insurance, annuity products, and universal life insurance.
Property and casualty (P&C) insurers write insurance relating primarily to commercial
property and liability and home ownership.
Stakeholders
Shareholders, policyholders, derivatives counterparties, creditors, regulators, rating
agencies, insurer’s employees/management, and board.
Liabilities and Investment Horizon
Life insurers generally face a long duration liability stream through their contract
payouts (horizons are typically 20 to 40 years)
P&C insurers generally face a shorter duration liability stream with higher uncertainty
due to the nature of claims
Liquidity Needs
Life insurers: interest rates impact the surrender rates of policies and when rates are high
cash out lows may increase.
P&C insurers: signi icant cash low uncertainty due to the nature of their liabilities,
therefore, ample liquidity is required in the form of cash and short-term ixed income
securities.
Reserve portfolio is needed to meet policy liabilities and contains more liquid and
conservative investments. Surplus portfolio is used to generate higher returns and
contains less liquid alternative investments.
External Constraints
Similar general regulations, accounting, and taxes as banks.
Investment Objectives
Similar investment objectives as banks.
Balance Sheet Management for Banks and Insurers
The primary objective is to maximize the market value of the equity capital.
An expression that captures how changes in the market value of assets, liabilities, and
leverage levels affect the change in the market value of equity capital is:
The sensitivity of the institution’s equity capital to a unit change in the reference yield, y,
of the assets (i.e., modi ied duration) is:
The expected volatility (i.e., standard deviation) of the percentage change in the market
value of equity capital is:
The following is a summary of strategies to use to change the factors driving the
volatility of shareholders’ equity.
TRADING, PERFORMANCE
EVALUATION, AND
MANAGER SELECTION
Study Session 13
One or two item sets or one item set and one constructed response question is most
likely for this section. Similar to other sections, know the calculations, concepts, and
terminology. Be careful not to fall into the trap of getting bogged down into the very
small details, as testing is likely to focus on big picture application and core concepts.
This is another topic in which you can pick up relatively easy points on the exam without
excessive effort.
TRADE STRATEGY AND EXECUTION
Cross-Reference to CFA Institute Assigned Reading #25
Trade Motivations
Profit Seeking
Active managers seek to outperform their benchmark (earn alpha) by trading securities
they believe to be mispriced. The rate of alpha decay will impact trade urgency.
To minimize information leakage, managers may execute their trade in multiple venues,
including less transparent ones such as dark pools (a.k.a., alternative trading systems)
with low pretrade transparency.
Risk Management and Hedging Needs
Trading is required to maintain targeted risk exposures—examples include rebalancing
after a change in market conditions or hedging to remove a risk factor.
Trading in derivatives as opposed to the underlying securities is often easier assuming
appropriate liquid derivative contracts exist.
Cash Flow Needs
Such trades are primarily caused by investor subscriptions into and redemptions out of
the fund. The urgency of the trades depends on the nature of the cash low, the liquidity of
fund investments, and the liquidity terms promised to fund investors.
Corporate Actions, Margin Calls, and Index Reconstitution
Merger and acquisition activity may require trading. Dividends or coupon income may
need to be reinvested.
Margin calls may require urgent sales.
Benchmark index reconstitution may need to execute trades to re lect the change,
especially for index-tracking funds.
Appropriate Trading Strategy
Order Characteristics
Side refers to the direction of the order (buy, sell, short buyback, short sell). For example,
depending on market conditions, it may be better to buy or to sell. Or market risk is
increased when there are only buy or only sell orders instead of both buy and sell orders
with offsetting risks.
Absolute size: larger (smaller) orders will have higher (lower) market impact costs.
Generally, larger orders are traded with less urgency to minimize market impact costs.
Relative size: order size is a percentage of average daily volume (ADV).
Security Characteristics
Different security types trade in different markets with different costs, regulations, and
liquidity.
Higher urgency trades occur when there is a high rate of alpha decay and in adverse
market conditions.
High price volatility implies high execution risk (i.e., adverse price movement).
Liquidity is indicated by bid-ask spread and volume available for trading; greater (lower)
liquidity decreases (increases) execution risk and market impact cost.
Market Conditions
Liquidity: lower (higher) liquidity suggests longer (shorter) trading horizons.
Volatility: lower (higher) volatility might cause investors to lengthen (speed up) trades.
Individual Risk Aversion
Lower risk aversion
Trade with less urgency.
More concerned with market impact costs if trade too quickly.
Higher risk aversion
Trade with more urgency.
More concerned with execution risk if trade too slowly.
Reference Price Benchmarks
Pretrade Benchmarks
They are known before trading starts. They include decision price, previous close,
opening price, and arrival price.
Arrival price is the price of the security when the order is sent to the market for
execution.
Intraday Benchmarks
They are based on prices during the trading day; used for passive trading over a day or
for funds that are rebalancing or minimizing risk.
Volume-weighted average price (VWAP) is used when managers want to participate
with volume patterns over a day.
Time-weighted average price (TWAP) ignores volume. Appropriate when managers
wish to remove the impact of outliers and in market environments with highly
luctuating volume throughout the day.
Posttrade Benchmarks
They are determined after trading has been completed. Closing price is most commonly
used to reduce tracking error of the fund.
Because closing price is not known until after trading is completed, a manager cannot
assess trading performance during the trading horizon.
Price Target Benchmarks
They are prices used by pro it-seeking managers aiming to earn short-term alpha, related
to the manager’s view of the fair value of the security.
Reference Price Benchmarks
Trade Implementation Choices
High-Touch Approaches
Principal trades involve brokers (a.k.a. dealers or market makers) assuming all or some
of the risk to executing the order, which is priced into their spread.
Agency trades involve brokers inding the other side of the trade, and the risk for order
execution remains with the portfolio manager or trader.
Electronic Trading
Involves trading via computer and is used in more liquid markets. Trading is typically
order driven in that buyers and sellers can advertise their limit orders in a central limit
order book.
Electronic trading can involve direct market access (DMA) and/or algorithmic trading.
Algorithmic Trading
Uses programmed rules to electronically trade orders for pro it seeking and trade
execution purposes.
Execution algorithms include:
Scheduled algorithms are appropriate for relatively small orders in liquid markets;
less urgency required and concerned about minimizing market impact.
– Percent-of-volume (a.k.a., participation) algorithms (e.g., “participate as 5%
of traded volume”).
– VWAP algorithms: attempt to match the VWAP price for the period by
carving up the trade and sending orders based on historical intraday volumes.
– TWAP algorithms: similar to VWAP but ensure an equal number of shares is
traded in each time period.
Liquidity-seeking (a.k.a., opportunistic) algorithms are appropriate for larger orders
in less liquid markets with higher urgency while trying to mitigate market impact.
Arrival price algorithms seek to trade close to market prices prevailing at the time
the order is entered. They are appropriate for relatively small orders in liquid
markets with high urgency given the belief that prices are likely to move
unfavorably during the trade horizon.
Dark strategies and liquidity aggregators are appropriate for large orders in illiquid
markets where the full order does not need to be executed immediately.
Smart order routers (SORs) are algorithms that determine the best destination to
route an electronic order to get the best result (e.g., best price, highest probability
of execution). They are appropriate for small market orders with low impact or
small limit orders with low information leakage.
Clustering is a machine learning technique whereby a computer learns to identify which
algorithm is optimal for different types of trades based on the key features of the trades.
The term clustering refers to the technique of grouping trades together with similar
attributes.
High-frequency market forecasting attempts to model short-term market direction.
Combined with the use of the least absolute shrinkage and selection operator (LASSO),
there is the ability to reduce the number of explanatory variables to a manageable
number of signi icant ones.
Characteristics of Key Markets
Equity markets mostly trade electronically with common use of algorithms.
Fixed income securities trade mainly in dealer-based, quote-driven markets due to
typical low liquidity and large order sizes. Some electronic trading occurs but
algorithmic trading is largely limited to the most liquid bonds and futures contracts.
Exchange-traded derivatives commonly trade electronically. There is some use of
algorithmic trading but more for futures than options.
OTC derivatives trading takes place in a dealer quote-driven market, usually
implemented through high-touch approaches.
Spot foreign exchange trading takes place in OTC markets that use both electronic trading
and high-touch broker approaches. There are three tiers: interbank, interdealer, and bankto-client, with decreasing trade sizes and increasing spreads, respectively.
Trade Cost Measurement
Implementation Shortfall (IS)
IS (bps) = paper return (original decision price, zero cost) – actual return net of all costs
= total cost of executing trade
Divide dollar amount by the original cost of the paper portfolio to get bps.
Breakdown of IS:
Execution cost
– Delay cost is the price movement in the time between the manager
submitting the order to the trader and the time the trader releases it to the
market.
– Trading (market impact) cost is the difference between the execution price
and the arrival price.
Opportunity cost is the paper pro it on shares not purchased based on difference
between closing price and original decision price.
Fixed fees such as explicit commissions.
Improving Execution Performance
Delay costs can be minimized with ef icient trading practices that give traders the
pretrade and posttrade analysis they need to make a swift decision on an optimal trading
strategy.
Opportunity costs (such as cash drag) should be analyzed to deploy unused cash into the
next-most attractive investment.
Market impact costs should be analyzed to establish proper price benchmarks and
appropriate trade urgency.
Evaluating Trade Execution
Trade Cost Analysis
Trade costs are calculated such that a positive value represents underperformance
against the benchmark as follows:
where:
side = +1 for a buy order, −1 for a sell order
To express the costs in basis points of the original benchmark price, use:
The market-adjusted cost ensures a trader is not penalized or rewarded for general
market movements over the trade horizon by subtracting the index cost as follows:
The market-adjusted cost of the trade is calculated as follows:
where:
arrival cost = the arrival cost of the trade based on an arrival price benchmark
β = beta of the security versus the index used to calculate index cost
Added Value
Added value (bps) = arrival cost (bps) − estimated pretrade cost (bps)
Trade Governance
Best execution depends on execution price, trading costs, speed and likelihood of
execution and settlement, order size and liquidity, and nature of the trade (e.g., urgency).
It refers to the best possible result and does not simply mean seeking the best price or
trading at the lowest cost.
Optimal execution approach depends on urgency and size of order, liquidity (ADV) and
nature (e.g., standardized vs. customized) of security, characteristics of available
execution venues, investment strategy objectives, and reason for the trade.
General principles for approval to the list of approved brokers and execution venues
include high quality of service (e.g., competitive execution price, speed of service/trade
size capacity), inancial stability to mitigate counterparty risk, good reputation, ethical
behavior, adequate settlement facilities, competitive explicit costs, and willingness to
commit capital to principal trades when required for less liquid securities.
The approved broker list should be constantly monitored for reputational issues, trading
error frequency, criminal actions, and inancial stability. Execution quality should also be
monitored on an ongoing basis.
PORTFOLIO PERFORMANCE EVALUATION
Cross-Reference to CFA Institute Assigned Reading #26
The three interrelated components of performance evaluation are: performance
measurement (what was the period return?), performance attribution (how was it
achieved?), and performance appraisal (was it due to skill or luck?).
Performance Attribution
The attribution process must re lect 100% of the portfolio’s return or risk exposure and
adequately represent the manager’s current investment process.
Return attribution evaluates the impact of the active portfolio management
decisions on the fund’s investment returns.
Risk attribution is the parallel of return attribution but analyzes the impact of the
manager’s active investment decisions on portfolio risk (e.g., compared to a
benchmark or calculated in absolute terms, independent of a benchmark).
Micro attribution (manager level) seeks to understand the drivers of the portfolio’s
return while macro attribution (fund sponsor level) quanti ies the fund sponsor’s
decisions to deviate from their SAA.
Returns-based attribution
Regressions of broad market indexes are run against portfolio returns to
decompose investment performance.
Best for alternative investments where actual holdings are dif icult to obtain.
Easiest method to implement, least reliable, slowest to detect style drift, easiest to
manipulate.
Holdings-based
Accuracy of analysis improves as the time interval becomes smaller; does not
adjust for portfolio changes after initial period.
Best for funds that are passive and/or have little turnover.
More reliable than returns-based, can detect style drift much faster.
Transactions-based
Updates for portfolio changes after initial period.
Most reliable of the methods but more complicated and time-consuming to
implement.
Approaches to Return Attribution
Arithmetic and Geometric Attribution
Arithmetic attribution simply looks at the portfolio return (R) over its appropriate
benchmark (B) and is calculated as: A = R − B.
Geometric attribution is computed as follows:
Brinson-Hood-Beebower (BHB) Model
Quanti ies the portfolio returns as: the allocation effect, the security selection effect, and
the interaction effect.
The allocation effect refers to the manager’s decision to overweight or underweight
speci ic sector weightings in the portfolio versus the portfolio benchmark. For a given
sector, the contribution to allocation (Ai) is calculated as the difference between the
portfolio (wi) and benchmark (Wi) weights multiplied by the sector return for the
benchmark (Bi) as follows:
Ai = (wi − Wi)Bi
The total allocation effect is calculated by adding up all of the contributions to
allocation.
The selection effect refers to the value the manager either added or detracted from the
portfolio by selecting individual securities within the sector and weighting the portfolio
differently compared to the benchmark weightings. For a given sector, the contribution to
selection (Si) is calculated as the benchmark weight (Wi) multiplied by the difference
between the portfolio (Ri) and benchmark (Bi) sector returns as follows:
Si = Wi(Ri − Bi)
The total selection effect is calculated by adding up all of the contributions to selection.
The interaction effect can be thought of as a residual amount that ensures the arithmetic
return minus the relative benchmark is fully accounted for in the attribution analysis. For
a given sector, the contribution to interaction (Ii) is calculated as the difference between
the portfolio (wi) and benchmark (Wi) weights multiplied by the difference between the
portfolio (Ri) and benchmark sector (Bi) returns as follows:
Ii = (wi − Wi)(Ri − Bi)
The total interaction effect is calculated by adding up all of the contributions to
interaction.
The Brinson-Fachler (BF) Method
The BF method addresses a minor drawback in the way the BHB method calculates the
allocation effect for individual segments of the portfolio. The allocation effect for the
segments under the BHB method are potentially problematic because the sign of the
resulting allocation effect does not automatically indicate whether the decision to
overweight/underweight a particular segment of the portfolio was correct.
The BF model tweaks the way the allocation effect is calculated to address this drawback
of the BHB model. Under the BF model, the allocation effect looks at the active weight in
the segment multiplied by the passive benchmark return of the segment relative to the
overall benchmark. This can be formulated as:
Ai = (wi - Wi) ´ (Bi − B)
Equity Return Attribution—Carhart Model
The Carhart Model is a fundamental factor model where a portfolio’s sensitivity to
additional factors can be tested to get a better understanding of an investment strategy.
where:
Rp = portfolio return
Rf = risk-free rate
ap = alpha or return above the expected return for the portfolio’s level of systematic
risk
bp = various portfolio factor sensitivities
RMRF = return on a value-weighted equity index above that of the one-month T-bill
rate
SMB = small minus big, a size (market-capitalization) factor; equal to the difference
between the average return on three small-cap portfolios and the average return on
three large-cap portfolios
HML = high minus low, a value factor; equal to the difference between the average
return on two high-book-to-market portfolios and the average return on two lowbook-to-market portfolios
WML = winners minus losers, a momentum factor; equal to the difference between the
return on a portfolio of the past year’s winners and the return on a portfolio of the past
year’s losers
Ep = error term to capture the part of the portfolio return unexplained by the model
Fixed-Income Return Attribution
Exposure decomposition—duration
Segments risk by using duration to quantify interest rate risk impact on the
portfolio.
Segments portfolios by their market value weight and assigns securities to duration
buckets based on the security’s maturity.
Yield curve decomposition—duration
Uses both duration and YTM in computing price return.
Looks at what factors drive returns when YTM changes; when used on both the
portfolio and benchmark, a comparison of return drivers allows one to determine
the impact of active management.
Yield curve decomposition—full repricing
Similar to price return based on duration and YTM but securities can be repriced
based on spot rates, which provides the most accurate measure of price return.
Note for exam purposes that the focus is not on the calculations but rather the
interpretation of the results from any of the above methods.
Risk Attribution
Macro and Micro Attribution
Fund sponsors irst determine the SAA for the portfolio by assigning speci ic weights to
the asset classes. Assuming the fund sponsor decides to hire external managers for TAA
purposes, then macro attribution allows for the determination of the effect of such
decisions by the fund sponsor.
After completing macro attribution analysis, it is necessary to move down one level to
examine the portfolio manager’s active management decisions. If desired and subject to
data availability, it may be possible to move down further levels to individual securities,
for example.
Note that the BF model is used in both macro and micro attribution; as discussed earlier,
the BF model is slightly different than the BHB model.
Benchmarking
Liability-Based Benchmarking
Focuses on the cash lows necessary to satisfy the liability and frequently limits the
investment choices to conservative ones. A de ined bene it plan is a good example of a
liability. The assets to be chosen to meet those cash lows would consider plan features
(as discussed earlier with de ined bene it plan risk considerations).
Asset-Based Benchmarks
There are seven primary types of asset-based benchmarks in use:
1. Absolute. The return objective aims to exceed a minimum target return.
2. Broad market indexes. Although generally a good benchmark, they may no longer
be relevant if the manager demonstrates style drift.
3. Style indexes. Although generally a good benchmark, there are differing de initions
of investment style that can make them inappropriate benchmarks.
4. Factor-model-based. May be single factor (e.g., CAPM) or multi factor models.
Relevant factors include market index, industry, size, and inancial strength.
5. Returns-based. Benchmark is a weighted average of the asset class indexes
(e.g., small-cap value and large-cap growth) that best explain the subject portfolio’s
return.
6. Manager universes. Median manager is used as a benchmark.
7. Custom security-based. Designed to re lect the manager’s investment process in
terms of security selections and weightings.
Properties of a Valid Benchmark
1. Speci ied in advance.
2. Appropriate.
3. Measurable.
4. Unambiguous.
5. Re lective of current investment opinions.
6. Accountable.
7. Investable.
Benchmark Quality Evaluation
A portfolio return can be broken up into three components: market, style, and active
management.
P=M+S+A
The manager’s active management decisions (A) are assumed to generate the difference
between the portfolio and benchmark returns (P − B):
P=B+A
Introducing the market index (M):
P = M + (B − M) + A
The manager’s investment style is assumed to generate the difference between the
benchmark return and the market index (B − M):
P=M+S+A
Benchmarking Alternative Investments
Hedge fund benchmarks could be broad market indexes, risk-free rate, or hedge fund peer
universes.
Broad market indexes are not appropriate given the wide range of hedge fund
investment strategies.
The risk-free rate is not appropriate given that most hedge funds carry some
systematic risk and use leverage.
Hedge fund peer universes are not appropriate because a speci ic peer group’s risk
and return objectives are not likely to match those of a speci ic hedge fund.
Real estate benchmarks are common but have shortcomings such as sampling, bias
towards most expensive properties, smoothing due to use of appraisal data, and
inconsistency with regard to the use of leverage.
Private equity benchmarks usually use IRR but different methods of valuation make
comparisons between peers more dif icult.
Commodity benchmarks are usually based on futures (not actual assets), which reduces
comparability.
Managed derivatives benchmarks may be too speci ic or not speci ic enough for a given
investment strategy.
Given the illiquidity and severe lack of marketability of distressed securities, it is almost
impossible to determine an appropriate benchmark.
Performance Appraisal
Appraisal Measures
Sharpe ratio
Treynor ratio
Information ratio
Appraisal ratio
Sortino ratio
Capture ratio = upside capture / downside capture
1 = symmetrical return pro ile
>1 = greater upside capture (positive asymmetrical return)
<1 = greater downside capture (negative asymmetrical return)
Drawdown
Drawdown duration is the total time required to fully recover a drawdown.
Maximum drawdown is the point at which the cumulative drawdown is at its
highest (in absolute terms).
INVESTMENT MANAGER SELECTION
Cross-Reference to CFA Institute Assigned Reading #27
Manager Selection Process
The manager universe consists only of those managers who are suitable for the portfolio
in terms of the objectives and constraints of the IPS, invest in the relevant style desired
by the client, and will manage the portfolio with proper balance between active and
passive approaches. It is a process of elimination that is subjective in terms of best or
complement to existing holdings.
Quantitative analysis involves evaluating the potential manager through performance
attribution and appraisal, capture ratios, and signi icant drawdowns.
Qualitative analysis looks at two key issues:
What is the likelihood that the same level of returns will continue in the future
(philosophy, process, people, and portfolio)?
Does the manager’s investment process account for all the relevant risks ( irm,
process and procedures, investment vehicle, terms, monitoring)?
Type I Errors and Type II Errors
H0: The manager adds no value.
HA: The manager adds positive value.
Type I error: Rejecting the null hypothesis when it is true (keeping managers who are
not adding value; error of commission).
Type II error: Failing to reject the null when it is false ( iring good managers who are
adding value; error of omission).
Assuming two separate groups of managers (e.g., strong and weak):
The greater (smaller) the differences in sample size and mean, the greater (smaller)
the costs of Type I and II errors.
The wider (narrower) the dispersion of returns between strong and weak managers,
the easier (harder) it is to distinguish between their relative skills and the lower
(higher) the costs of Type I and II errors.
Style Analysis
Style analysis examines the manager’s risk exposures in relation to an appropriate
benchmark and the changes in those benchmarks.
Returns-based style analysis (RBSA)
Estimates the portfolio’s sensitivities to security market indexes for a set of key
risk factors.
Computational approach is relatively easy, uses objective data, and can be
performed on a timely basis.
Holdings-based style analysis (HBSA)
Looks at the actual securities included in the portfolio at one time.
Similar advantages as for RBSA, however, there are increased computational
complexities.
The point in time analysis format may not be useful in projecting into the future or
if the portfolio has high turnover.
Capture Ratios and Drawdowns
Capture ratios (positive or negative asymmetry) determine how suitable a manager is
with respect to the investor’s risk tolerance and time horizon.
In examining positive asymmetry, the question is whether the convex shape occurs
naturally (e.g., hedging with many small losses (low DC ratio) and far fewer large gains
(high UC ratio) or due to manager skill (e.g., active management to minimize losses and
maximize gains).
Drawdowns are useful for identifying poor or poorly executed investment strategies,
weak internal controls, and operational problems. Signi icant or extended drawdowns
could cause a manager to utilize self-preservationist tactics that could harm the
investors.
Investors with shorter (longer) time horizons and lower (higher) risk tolerances with
less (more) time to recover from losses should invest with managers with smaller
(larger) and less (more) extended drawdowns.
Investment Philosophy
Investment philosophies can be generally classi ied as passive or active.
Passive strategies attempt to earn risk premiums (e.g., equity risk, credit risk, volatility
risk).
Active strategies focus on exploiting inef iciencies.
Behavioral inef iciencies are very short-term and need to be quickly exploited prior
to market correction.
Structural inef iciencies occur because of laws and regulations, which can make
them long-term in nature.
Assuming a valid inef iciency to exploit, the question is whether there is capacity to
exploit it. For example, do the excess returns justify the extra transaction costs and the
borrowing costs? Is the inef iciency repeatable or one-time only? What minimum asset
level is required to earn a suf icient return from the inef iciency?
Investment Decision-Making Process
The process consists of four steps:
1. Idea generation.
2. Idea implementation.
3. Portfolio construction.
4. Portfolio monitoring.
Idea generation focuses on having unique information to exploit an ef iciency and idea
implementation transforms the idea into an investment position.
Portfolio construction (e.g., allocations) must be consistent with the investment
philosophy. Assets under management (AUM) will likely increase over time, which
requires adjusting underlying positions to allow for greater AUM. Care must be taken to
ensure that the portfolio can react appropriately to changing market conditions or
investor liquidity requirements.
Portfolio monitoring checks for signi icant deviations from the investment process and
ensures that investment decisions are congruent with the most up-to-date client
objectives.
Separately Managed Accounts and Pooled Investment
Vehicles
Separately managed accounts (SMAs) and pooled investment vehicles are used to execute
investment strategies.
Pooled vehicles bring together the funds from all investors into one portfolio and
there is no customization for any speci ic investor.
SMAs hold the funds of one investor in a separate account; the cost-bene it trade-off
of holding investments in a SMA must be evaluated.
Compared to pooled investments:
SMAs have higher transaction costs but provide control, customization, tax
ef iciency, separate reporting, and greater transparency.
Customized SMAs require an extra layer of due diligence to evaluate security
selection, portfolio construction, and operational issues.
Manager Contracts
Liquidity of common investment vehicles in descending order from highest to lowest:
1. Closed-end funds and ETFs.
2. Open-end funds.
3. Limited partnerships (e.g., hedge funds).
4. Private equity and venture capital.
With SMAs, the liquidity is determined by the liquidity of the underlying assets, as the
securities can be sold at any time.
Management fees can be structured as a ixed dollar amount or on the basis of a
percentage of assets (e.g., AUM). The fee structure is important to ensure that managers
work to the advantage of the investors. For example, paying fees based on AUM rewards
managers based on skill and ability to grow the asset base. Unfortunately, luck may play a
signi icant role in the short-term growth of assets.
Performance-Based Fees
Three basic forms of performance-based fees:
Symmetrical structure with full upside and downside exposures.
– Fee = base + performance sharing.
– The greatest alignment between investor and manager incentives but
increased risk to manager due to the full downside exposure.
Bonus with full upside and limited downside exposures.
– Fee = Greater of: (1) base, (2) base + sharing of positive performance.
Bonus with limited upside and downside exposures.
– Fee = Greater of: (1) base, (2) base + sharing of positive performance (within
limit).
Base fees are paid (i.e., loor amount) even when the manager underperforms. Also, some
performance fees include high-water or clawback provisions that will offset prior period
negative returns from current period positive returns.
CASES IN PORTFOLIO
MANAGEMENT AND
RISK MANAGEMENT
Study Session 14
The material in the cases integrates material from key sections of the Level III
curriculum and provides some context of how constructed response questions may
appear on the exam. The cases are essentially an application of earlier readings in private
wealth management and portfolio management for institutional investors.
CASE STUDY IN PORTFOLIO MANAGEMENT:
INSTITUTIONAL
Cross-Reference to CFA Institute Assigned Reading #28
Managing Liquidity Risk
Four key methods to manage liquidity risks include liquidity pro iling and time-to-cash
tables, rebalancing and commitments, stress testing, and derivatives.
Liquidity Profiling and Time-to-Cash Tables
Once potential cash in lows and out lows are determined, a liquidity classi ication
schedule (time-to-cash table) is constructed. An example is provided below and it may
include a full range of periods beyond those illustrated.
Rebalancing and Commitments
Systematic rebalancing policies are designed to maintain the long-term (strategic) asset
allocation. Examples include calendar and percent-range rebalancing with predetermined
acceptable ranges for various asset classes.
Automatic adjustment mechanisms assist in keeping the portfolio risk pro ile relatively
constant if there is a change from the target. For example, automatic adjustments to
control market risk may occur in some portfolios if the public market can be a
reasonable proxy for the private market.
By investing in multiple funds, the timing and frequency of when committed capital is
drawn and the return of capital distributions becomes more stable. A multiyear funding
strategy tries to determine the right level of annual commitments (investments) from the
portfolio to arrive at a long-term optimal exposure to the asset class.
Stress Testing
Stress testing explicitly considers how the liquidity needs of a portfolio will change
during a period of market stress. The idea is to conduct analysis to assume worst case or
very extreme market conditions and the impact on both assets and liabilities at the same
time.
Derivatives
Derivatives require far less cash than investing in underlying assets, which makes
derivatives an ideal method for rebalancing. In addition, a futures overlay allows for
rebalancing of many asset classes without altering any of the asset allocation determined
by the external active managers.
Illiquidity Premium
The illiquidity premium refers to the additional return (over the market return) for
taking on the risk of holding up capital for an unknown amount of time. Studies have
shown that the illiquidity premium increases with the amount of time.
Illiquidity premium (%) = expected return on illiquid asset (%) − expected return on
marketable asset (%)
Addressing Liquidity Needs
Endowment Information
An example of a spending rule that incorporates geometric smoothing could be as
follows:
(66% × spending for the previous iscal year) + 34% × (5% × endowment value at the
end of the previous iscal year)
An endowment’s annual nominal return requirement must consider the annual spending
rate, applicable annual in lation, and annual donations (out lows).
Endowment Investment Strategy
Endowment assets are invested in ixed income, public equity, private equity, real assets,
and diversifying strategies.
As endowments grow, long-term strategies tend to increase the allocation to alternative
investments and decrease the allocation to developed market equities in hopes of
providing greater diversi ication and higher risk-adjusted returns.
Strategic Asset Allocation (SAA)
These are some issues to consider in making inal SAA determinations:
Unsmoothing methods for illiquid assets due to smoother reported results resulting
from the lack of frequency of pricing data; the end result is likely an upwards
adjustment to the reported volatility of the illiquid assets.
Higher investment management and performance fees for illiquid assets versus
liquid assets so returns should be compared on a net-of-fees basis.
Liquidity Management
The following are reasons why liquidity may deteriorate signi icantly during stressed
market conditions:
Private equity capital calls exceed capital distributions, resulting in a greater
concentration of a more illiquid investment.
Some investments may restrict investors from withdrawing funds during stressed
market conditions.
Private equity investments have lagged valuations (compared to public equity),
therefore during stressed market conditions, the public equity values fall “faster”
due to more frequent valuation. The end result is a relative increase in illiquid
assets as a percentage of the portfolio, thereby decreasing liquidity.
Modifying Asset Allocation
Asset Manager Selection
The process of asset manager selection requires adherence to the Code of Ethics and
Standards to Professional Conduct.
Potential violations include:
Standard I(B): Independence and Objectivity.
Standard I(C): Misrepresentation.
Standard III(D): Performance Presentation.
Standard III(E): Preservation of Con identiality.
Standard IV(A): Loyalty.
Standard V(A): Diligence and Reasonable Basis.
Standard VI(A): Disclosure of Con licts.
Use of Derivatives
Because changes in the market will often result in asset allocation drifts, the endowment
portfolio will need to be periodically rebalanced. Derivatives are both cash ef icient and
quite liquid, so their role is threefold: rebalancing, changes in TAA, and meeting shortterm liquidity requirements.
Rebalancing with derivatives is most likely to be implemented more quickly, and with no
impact on the active managers. That is on the assumption of reasonably high levels of
liquidity in the equity futures market, for example.
If the rebalancing transaction is larger, then the transaction is likely to be more long term
or permanent. That makes rebalancing with cash more desirable despite the associated
cash drag.
Derivatives overlays would allow the endowment to periodically rebalance exposures to
asset classes without impacting the existing allocations to external active managers. That
makes overlays more desirable for making smaller, short-term adjustments that could
later be easily reversed.
Rebalancing
For cost control reasons, rebalancing a portfolio might only be done quarterly even
though portfolio drift from the SAA may be checked monthly.
At the end of each quarter, if a relatively liquid asset class moves outside the
rebalancing corridor, then it is systematically rebalanced back to either the target
allocation or to the edge of the corridor.
For more illiquid asset classes, high transaction costs mean that rebalancing is done
more implicitly by altering the commitments and reinvestments when allocations
drift to either end of the corridor.
CASE STUDY IN RISK MANAGEMENT: PRIVATE
WEALTH
Cross-Reference to CFA Institute Assigned Reading #29
Early Career Stage
Risk Exposures and Management
Few inancial assets; substantial human capital.
Earnings risk due to earnings loss from unemployment and/or disability.
Accumulate a savings reserve of three to six months of expenses and/or take out
disability insurance
Premature death risk due to untimely death of a spouse and subsequent loss of
income. Purchase life insurance to protect surviving spouse and/or children;
amount can be determined using the human life and/or needs analysis methods.
Career Development Stage
Risk Exposures and Management
More inancial assets. Still substantial human capital.
Earnings risk is similar to early career stage, plus risk increases with rising income
and increase in number of dependents. Update disability insurance to re lect
increased salary.
Premature death risk is similar to early career stage, plus risk increases due to
decrease in income if surviving spouse becomes the primary caregiver for children.
Update life insurance to re lect increase salary and/or needs
Investment portfolio has likely been built up, but there is the risk that is it not
properly diversi ied or may be too correlated to human capital. Review for suitable
asset allocation and diversify against human capital.
Retirement goals (e.g., income objectives) may not have been considered yet.
Formulate retirement goals and lifestyle and begin an appropriate retirement
savings plan.
Peak Accumulation Stage
Risk Exposures and Management
Substantial inancial assets; declining human capital.
Earnings risk is similar to career development stage. Consider decreasing insurance
coverage at this stage to re lect shortened remaining time horizon.
Premature death risk is similar to career development stage. Consider decreasing
insurance coverage at this stage to re lect shortened remaining time horizon.
Investment portfolio asset allocation may no longer be suitable for current lifestyle
or retirement goals. Consider need to reallocate and rebalance to re lect shortened
remaining time to retirement (e.g., reallocate more funds to a balanced fund).
Retirement savings may not be suf icient to meet retirement goals. Continue saving
for retirement and increase amounts, if needed, to match (revised) retirement goals.
Early Retirement Stage
Risk Exposures and Management
Substantial inancial assets; no human capital remaining.
Retirement income may be insuf icient to meet retirement expenses and/or there is
risk of outliving assets. Purchase annuities and/or taking lump sum distributions
from pension plans (if applicable) to maximize potential income and tax bene it.
Investment portfolio may not match family goals at this stage. Reallocate to match
goals and time horizons of those goals.
– Invest more conservatively if becoming more risk averse.
– Invest somewhat more aggressively if time horizon is long (e.g., long life
expectancy) and/or retirement expenses exceed current retirement income.
A Note About Calculating Disability and Life Insurance
Consider a situation with disability or life insurance that involves calculating the future
earnings replacement required, which is a growing annuity due. While the TVM keys of
the calculator are usually used to calculate the present value of a constant annuity due,
they can also be used for a growing annuity due if we make an adjustment to the discount
rate to re lect the growth in payments. This can be done by using a growth adjusted
discount rate, de ined as follows:
[(1 + r) / (1 + g)] - 1
where:
r = annual discount rate
g = annual growth rate
Note that this formula only works when r > g. It cannot be used when r < g.
We can now use the growth-adjusted discount rate to calculate the present value of an
annuity due in the usual manner as follows:
Set the calculator to annuity due mode (BGN) using the keystrokes 2ND PMT 2ND
ENTER.
Assume r = 3%, g = 2%. Therefore I/Y = (1.03 / 1.02) - 1 = 0.0098 = 0.98%.
Also assume 37 years to retirement (N = 37) and $15,670 annual earnings shortfall
(PMT = 15,670)
CPT PV = -$489,087
Depending on whether it is a disability or life insurance calculation, the individual
will require about $489,000 of future earnings replacement in present value dollars.
INTEGRATED CASES IN RISK MANAGEMENT:
INSTITUTIONAL
Cross-Reference to CFA Institute Assigned Reading #30
Risks Faced by Institutional Investors
Risk management covers inancial risks (e.g., market losses, liquidity) as well as
non inancial risks (e.g., reputational, operational, and environmental, social, and
governance [ESG]). Institutional investors are increasingly concerned with ESG issues as
they may lead to reputational damage.
Institutional investors have varying risk objectives. In general, the risk objectives are:
Pension funds: To meet contractual pension payouts to bene iciaries when due.
Endowments and foundations: To provide suf icient inancial support to the budget
of the institution.
Sovereign wealth funds: To provide government funding in either the short,
medium, or long term.
Banks and insurance companies: Asset-liability management.
Liquidity risk is subdivided into two types: (1) market liquidity (how quickly an asset can
be sold at a fair price), (2) funding liquidity (ability to meet inancial obligations when
due). The two are connected, especially in a crisis; sources of funding often dry up or
become expensive. At the same time, market liquidity can fall, leaving investors with
illiquid assets and funding shortages.
Although illiquid assets often provide higher expected returns, they come with some key
disadvantages: (1) high rebalancing costs, (2) return smoothing. Return smoothing
creates a false picture of volatility by applying a downward bias. The end result is that
reported return volatility is too low and reported return correlations are too low, and
that may result in over allocations to illiquid assets in an attempt to increase portfolio
diversi ication.
Direct investments in illiquid assets provide the investor with more control over the
assets as well as better information and the avoidance of fund management fees.
However, they come with potential concentration risk as well as potentially unlimited
liabilities and reputational risk.
Indirect investments in illiquid assets provide the investor with greater diversi ication
opportunities and limited liability. However, they come with less control and information
on the assets, the need to pay fund management fees, and liquidity risks because of the
uncertain timing of capital calls.
Enterprise Risk Management (ERM)
A top-down perspective is set by the board of directors and the chief investment of icer.
It de ines the overall risk tolerance, return objectives, and overall investment guidelines
for the institution. In contrast, a bottom-up perspective is taken by the investment team
tasked with implementing the investment strategy. It involves measuring, monitoring,
and reporting risk exposures of individual portfolios and asset classes.
ERM includes: (1) credit risk, (2) market risk, (3) operational risk, (4) liquidity risk, (5)
reputational risk, (6) ESG risks. Consistent with the top-down approach, ERM starts with
strong governance from the board of directors and creates a coordinated risk
management framework with clear accountabilities throughout the organization.
Risk Tolerances
Within the investment policy statement (IPS), risk tolerances can be set for: (1) volatility,
(2) maximum drawdown, (3) value at risk, (4) leverage, derivatives, and short positions,
(5) limits on illiquid holdings, and (6) maximum tracking error budgets. The objective is
not to minimize or eliminate risk but instead to optimize the compensation for taking
the risk.
Value at Risk
Value at risk (VaR) is an estimate of an unexpected loss of an asset or portfolio at a given
con idence level (e.g., 95%, 99%) for a given holding period (e.g., daily, annually). When
selecting a VaR holding period, it is important to consider the liquidity of the asset or
portfolio. As well, consideration must be given to catastrophic losses that lie in the tail of
the distribution beyond the VaR estimate, which gets into conditional VaR (i.e., average
loss beyond a VaR estimate).
Factor Analysis
Portfolio factor analysis indicates common drivers and correlations within portfolio
asset. It is essential to look through portfolio assets to understand common factor
exposures. Strategically selecting factor exposures and required levels of diversi ication
across factors are important risk and return considerations. Tools to explore factor
exposures include: (1) returns-based analysis (analyzing a manager or fund’s past
returns), (2) holdings-based analysis, (3) scenario analysis (historic and forward looking),
and (4) stress testing (of critical risk factors).
ESG Risks Faced by Institutional Investors
Institutional investors are increasingly incorporating environmental and social factors
into investment decisions. A common strategy is to align portfolio exposures to sectors,
industries, and irms that are likely to prosper in transitioning to a more sustainable
society. Conversely, it is important to avoid investing in irms with poor management
practices in the treatment of their workforce, health, and safety or with environmental
issues.
Environmental issues include: air and water pollution, carbon emissions and climate
change, energy ef iciency, water scarcity and waste management, and deforestation and
biodiversity. Social issues include: human rights and labor standards, gender and
diversity, occupational health and safety, customer satisfaction and product
responsibility, data security and privacy, and community relations and charities.
Climate Risks and Opportunities
In looking at a transition toward a low-carbon future, a popular ESG strategy is to align
portfolio assets and exposures to those sectors, technologies, and irms likely to bene it
from the transition. At the same time, there should be a push toward avoiding those with
earnings linked to fossil fuels and outdated unworkable business plans in a future zerocarbon economy. Stranded assets are resources that are no longer viable and dif icult to
monetize due to new regulatory restrictions, outdated technology, or shifts in consumer
demand. Firms that fail to adapt may ind outdated assets stranded.
Adapting to climate change will bring winners and losers. Firms that invest in new low
carbon technology and that can adapt to new business models will become the early
winners. Firms relying on fossil fuels and outdated practices may ind higher taxes and
limits on activities, and changes to customer preferences could ind existing business
models are no longer viable.
Climate Risks: Transition and Physical
Climate transition risk is the risk of being too slow to transition to the new zero-carbon
world, effectively left behind with an outdated business model.
Physical climate risk is comprised of: (1) acute physical risks (i.e., one-off weather
events) and (2) chronic physical risks (i.e., gradual impacts of climate change such as
rising sea levels and global warming). Therefore, physical climate risks illustrate the
importance of the location of portfolio assets and the resulting risks of looding due to
sea level rises and one-off weather events. Portfolio assets may also be impacted by
increases in local temperatures in certain locations.
Climate Risk Responses: Mitigation and Adaptation
Mitigation strategies reduce the reliance on fossil fuels and carbon intensive resources.
Adaptation strategies look to prosper in the zero-carbon world, investing in markets,
companies, and technologies that are likely to bene it from the transition.
Social Issues
International outsourcing aims to reduce costs and increase ef iciency to increase pro it
margins. The means that work is usually done in low-cost labor countries. As a result,
social issues for institutional investors include: exploitation of workers, poor working
conditions, health and safety practices, and equality and human rights. Headline risk is
the potentially costly reputational damage from being associated with the exploitation of
local workers and is important to consider.
To mitigate headline risk, there should be respect for and protection of the rights of
employees (the “just” transition) and measures in place to prevent the exploitation of the
vulnerable.
The term “sustainable development” means meeting the needs of the current generation
while protecting resources for future generations. Transitioning to a sustainable economy
aims to protect the world’s natural capital (e.g., air and water, soil geology, all living
things), limiting negative impacts on the environment, and confronting social inequities.
Creating a “just transition” in the change that lies ahead will help people, regions, and
countries adapt to a zero-carbon future.
ETHICAL AND PROFESSIONAL
STANDARDS
Study Sessions 15 & 16
ETHICAL AND PROFESSIONAL STANDARDS
Ethics is covered in Study Sessions 15 and 16. Ethics (including GIPS) could be tested in
two or three item sets (more likely) or a combination of one constructed response
question and one or two item sets. Read the case, think of the appropriate principles that
are most pertinent, and then select the best answer choice. In some cases, the elimination
of one implausible answer or an educated guess is the best you can do. Also, be prepared
for questions related to compliance issues, the Asset Manager Code of Conduct, and the
disciplinary process. The best way to prepare for ethics is to read the SchweserNotes or
ideally the original CFA material (especially the Application of the Standards, which
contain over 200 examples) and then work all of our questions plus the CFA end-ofreading questions. In addition to knowing each standard, it’s also important to know the
recommendations for each standard.
CODE OF ETHICS AND STANDARDS OF
PROFESSIONAL CONDUCT, GUIDANCE FOR
STANDARDS I-VII
Cross-Reference to CFA Institute Assigned Readings #31 & #32
Code of Ethics
Members of CFA Institute, including Chartered Financial Analyst® (CFA®)
charterholders, and Candidates for the CFA designation (“Members and Candidates”)
must:1
Act with integrity, competence, diligence, respect, and in an ethical manner with
the public, clients, prospective clients, employers, employees, colleagues in the
investment profession, and other participants in the global capital markets.
Place the integrity of the investment profession and the interests of clients above
their own personal interests.
Use reasonable care and exercise independent professional judgment when
conducting investment analysis, making investment recommendations, taking
investment actions, and engaging in other professional activities.
Practice and encourage others to practice in a professional and ethical manner that
will re lect credit on themselves and the profession.
Promote the integrity and viability of the global capital markets for the ultimate
bene it of society.
Maintain and improve their professional competence and strive to maintain and
improve the competence of other investment professionals.
GUIDANCE FOR STANDARDS I–VII
I. Professionalism
I(A). Knowledge of the Law. Members must understand and comply with laws, rules,
regulations, and Code and Standards of any authority governing their activities. In the
event of a con lict, follow the more strict law, rule, or regulation.
Guidance
Members must know the laws and regulations relating to their professional activities in
all countries in which they conduct business. Do not violate Code or Standards even if the
activity is otherwise legal. Always adhere to the most strict rules and requirements (law
or CFA Institute Standards) that apply.
Dissociate from any ongoing client or employee activity that is illegal or unethical, even
if it involves leaving an employer (an extreme case). While a Member may confront the
involved individual irst, he must approach his supervisor or compliance department.
Inaction with continued association may be construed as knowing participation.
Recommendations for Members
Establish, or encourage employer to establish, procedures to keep employees
informed of changes in relevant laws, rules, and regulations.
Review, or encourage employer to review, the irm’s written compliance
procedures on a regular basis.
Maintain, or encourage employer to maintain, copies of current laws, rules, and
regulations.
When in doubt about legality, consult supervisor, compliance personnel, or a
lawyer.
When dissociating from violations, keep records documenting the violations,
encourage employer to bring an end to the violations.
There is no requirement in the Standards to report wrongdoers, but local law may
require it; members are “strongly encouraged” to report violations to CFA Institute
Professional Conduct Program.
Recommendations for Firms
Have a code of ethics.
Provide employees with information on laws, rules, and regulations governing
professional activities.
Have procedures for reporting suspected violations.
I(B). Independence and Objectivity. Use reasonable care to exercise independence and
objectivity in professional activities. Do not offer, solicit, or accept any gift, bene it,
compensation, or consideration that would compromise independence and objectivity.
Guidance
Do not let the investment process be in luenced by any external sources. Modest gifts are
permitted. Allocation of shares in oversubscribed IPOs to personal accounts is NOT
permitted. Distinguish between gifts from clients and gifts from entities seeking in luence
to the detriment of any client. Gifts must be disclosed to the Member’s employer in any
case.
Guidance—Investment-Banking Relationships
Do not be pressured by sell-side irms to issue favorable research on current or
prospective investment-banking clients. It is appropriate to have analysts work with
investment bankers in “road shows” only when the con licts are adequately and
effectively managed and disclosed. Be sure there are effective “ irewalls” between
research/investment management and investment banking activities.
Guidance—Public Companies
Analysts should not be pressured to issue favorable research by the companies they
follow. Do not con ine research to discussions with company management, but rather use
a variety of sources, including suppliers, customers, and competitors.
Guidance—Buy-Side Clients
Buy-side clients may try to pressure sell-side analysts. Portfolio managers may have
large positions in a particular security, and a rating downgrade may have an effect on the
portfolio performance. As a portfolio manager, there is a responsibility to respect and
foster intellectual honesty of sell-side research.
Guidance—Issuer-Paid Research
Analysts’ compensation for preparing such research should be limited, and the preference
is for a lat fee, without regard to conclusions or the report’s recommendations.
Recommendations for Members
Members or their irms should pay for their own travel to company events or tours when
practicable and limit use of corporate aircraft to trips for which commercial travel is not
an alternative.
Recommendations for Firms
Establish policies requiring every research report to re lect the unbiased opinion of
the analyst and align compensation plans to support this principal.
Establish and review written policies and procedures to assure research is
independent and objective.
Establish restricted lists of securities for which the irm is not willing to issue
adverse opinions. Factual information may still be provided.
Limit gifts from non-clients to token amounts.
Limit and require prior approval of employee participation in equity IPOs.
Establish procedures for supervisory review of employee actions.
Appoint a senior of icer to oversee irm compliance and ethics.
I(C). Misrepresentation. Do not misrepresent facts regarding investment analysis,
recommendations, actions, or other professional activities.
Guidance
Do not make misrepresentations or give false impressions. Misrepresentations include
guaranteeing investment performance and plagiarism. Plagiarism encompasses using
someone else’s work without giving credit.
Recommendations for Members
Understand the scope and limits of the irm’s capabilities to avoid inadvertent
misrepresentations.
Summarize your own quali ications and experience.
Make reasonable efforts to verify information from third parties that is provided to
clients.
Regularly maintain webpages for accuracy.
Avoid plagiarism by keeping copies of all research reports and supporting
documents and attributing direct quotes, paraphrases, and summaries to their
source.
I(D). Misconduct. Do not engage in any professional conduct that involves dishonesty,
fraud, or deceit. Do not do anything that re lects poorly on your integrity, good
reputation, trustworthiness, or professional competence.
Guidance
CFA Institute discourages unethical behavior in all aspects of Members’ and Candidates’
lives. Do not abuse CFA Institute’s Professional Conduct Program by seeking enforcement
of this Standard to settle personal, political, or other disputes that are not related to
professional ethics.
Recommendations for Firms
Develop and adopt a code of ethics and make clear that unethical behavior will not
be tolerated.
Give employees a list of potential violations and sanctions, including dismissal.
Check references of potential employees.
II. Integrity of Capital Markets
II(A). Material Nonpublic Information. Members and Candidates in possession of
material nonpublic information must not act or induce someone else to act on the
information.
Guidance
Information is “material” if its disclosure would impact the price of a security or if
reasonable investors would want the information before making an investment decision.
Information is “nonpublic” until it has been made available to the marketplace. This
Standard does not apply to using material nonpublic information for its intended
purpose, such as an investment banker using information from a irm (the client) in order
to advise or act for that client in ways that are otherwise ethical.
Guidance—Mosaic Theory
There is no violation when a perceptive analyst reaches an investment conclusion about
a corporate action or event through an analysis of public information together with items
of non-material nonpublic information.
Recommendations for Members
Make reasonable efforts to achieve public dissemination by the irm of information
they possess.
Encourage their irms to adopt procedures to prevent the misuse of material
nonpublic information.
Recommendations for Firms
Issue press releases prior to analyst meetings to assure public dissemination of any
new information.
Adopt procedures for equitable distribution of information to the market place
(e.g., new research opinions and reports to clients).
Establish irewalls within the organization for who may and may not have access to
material nonpublic information. Generally, this includes having the legal or
compliance department clear interdepartmental communications, reviewing
employee trades, documenting procedures to limit information low, and carefully
reviewing or restricting proprietary trading whenever the irm possesses material
nonpublic information on the securities involved.
Ensure that procedures for proprietary trading are appropriate to the strategies
used. A blanket prohibition is not required.
Develop procedures to enforce irewalls with complexity consistent with the
complexity of the irm.
Physically separate departments.
Have a compliance (or other) of icer review and authorize information lows before
sharing.
Maintain records of information shared.
Limit personal trading, require that it be reported, and establish a restricted list of
securities in which personal trading is not allowed.
Regularly communicate with and train employees to follow procedures.
II(B). Market Manipulation. Do not engage in any practices intended to mislead market
participants through distorted prices or arti icially in lated trading volume.
Guidance
This Standard applies to transactions that deceive the market by distorting the pricesetting mechanism of inancial instruments or by securing a controlling position to
manipulate the price of a related derivative and/or the asset itself. Spreading false
rumors is also prohibited. Actions that affect price and volume but are not done with
misleading intent to deceive are not a violation.
III. Duties to Clients and Prospective Clients
III(A). Loyalty, Prudence, and Care. Members must always act for the bene it of clients
and place clients’ interests before their employer’s or their own interests. Members must
be loyal to clients, use reasonable care, and exercise prudent judgment.
Guidance
Client interests always come irst.
Exercise prudence, care, skill, and diligence.
Manage pools of client assets in accordance with the terms of the governing
documents. The client can be a speci ic individual, group, or even the general
investing public.
Make investment decisions in the context of the total portfolio.
Advise clients of any limitations on the advice, such as only recommending
products of the advisor.
Vote proxies in an informed and responsible manner. Due to cost bene it
considerations, it may not be necessary to vote all proxies.
Client brokerage, or “soft dollars” or “soft commissions,” must be used to bene it the
client.
Recommendations for Members
Submit to clients, at least quarterly, itemized statements showing all securities in
custody and all debits, credits, and transactions. Disclose where client assets are held and
if they are moved. Keep client assets separate from others’ assets.
If in doubt as to the appropriate action, what would you do if you were the client? If still
in doubt, disclose and seek written client approval.
Encourage irms to address these topics when drafting policies and procedures regarding
iduciary duty:
Follow applicable rules and laws.
Establish investment objectives of client.
Consider suitability of a portfolio relative to the client’s needs and circumstances,
the investment’s basic characteristics, or the basic characteristics of the total
portfolio.
Diversify unless account guidelines dictate otherwise.
Deal fairly with all clients in regard to investment actions.
Disclose con licts of interest.
Disclose manager compensation arrangements.
Regularly review actions for consistency with documents.
Vote proxies in the best interest of clients and ultimate bene iciaries.
Maintain con identiality.
Seek best execution.
Put client interests irst.
III(B). Fair Dealing. Members must deal fairly and objectively with all clients and
prospects.
Guidance
Fairly does not mean equally. In the normal course of business, there will be differences
in the time emails, faxes, et cetera, are received by different clients. Different service
levels are okay, but they must not negatively affect or disadvantage any clients. Disclose
the different service levels to all clients and prospects, and make premium levels of
service available to all who wish to pay for them.
Give all clients a fair opportunity to act upon every recommendation. Clients who are
unaware of a change in a recommendation should be advised before the order is accepted.
Treat all clients fairly in light of their investment objectives and circumstances. Members
and Candidates should not take advantage of their position in the industry to
disadvantage clients.
Recommendations for Members
Encourage irms to establish compliance procedures requiring proper
dissemination of investment recommendations and fair treatment of all customers
and clients.
Maintain a list of clients and holdings—use to ensure that all holders are treated
fairly.
Recommendations for Firms
Limit the number of people who are aware that a change in recommendation will
be made.
Shorten the time frame between decision and dissemination.
Publish personnel guidelines for pre-dissemination—have in place guidelines
prohibiting personnel who have prior knowledge of a recommendation from
discussing it or taking action on the pending recommendation.
Disseminate new or changed recommendations simultaneously to all clients who
have expressed an interest or for whom an investment is suitable.
Establish systematic account review—ensure that no client is given preferred
treatment and that investment actions are consistent with the account’s objectives.
Disclose available levels of service and the associated fees.
Disclose trade allocation procedures.
Develop written trade allocation procedures to:
– Document and time stamp all orders.
– Bundle orders and then execute on a irst come, irst ill basis.
– Allocate partially illed orders.
– Provide the same net (after costs) execution price to all clients in a block
trade.
III(C). Suitability
1. When in an advisory relationship with client or prospect:
a. Make reasonable inquiry into clients’ investment experience, risk and return
objectives, and constraints prior to making any recommendations or taking
investment action. Reassess information and update regularly.
b. Be sure recommendations and investments are suitable to a client’s inancial
situation and consistent with client objectives.
c. Make sure investments are suitable in the context of a client’s total portfolio.
2. When managing a portfolio, investment recommendations and actions must be
consistent with stated portfolio objectives and constraints.
Guidance
In advisory relationships, gather and maintain relevant client information. If responsible
for managing a fund to an index or other stated mandate, be sure investments are
consistent with the stated mandate.
If a manager receives an unsolicited trade request from a client and determines the trade
is not suitable, discuss the situation with the client. If the request does not have a
material effect on the client, the trade may be executed after the discussion. If the trade
has a material effect, work with the client to change the investment policy statement
(IPS) or make the trade in a client-directed account.
Recommendations for Members
Establish a written IPS, considering type of client and account bene iciaries, the
objectives, constraints, and the portion of the client’s assets managed.
Review the IPS annually and update for material changes in client and market
circumstances.
Develop policies and procedures to assess suitability of portfolio changes. Consider
the impact on diversi ication, risk, and meeting the client’s investment strategy.
III(D). Performance Presentation. Presentations of investment performance
information must be fair, accurate, and complete.
Guidance
Avoid misstating performance or misleading clients/prospects about investment
performance. Do not misrepresent past performance or reasonably expected
performance. Do not state or imply the ability to achieve a rate of return similar to that
achieved in the past. Abbreviated presentations must include an offer that full details are
available.
Recommendations for Members
Encourage irms to adhere to Global Investment Performance Standards.
Consider the sophistication of the audience to whom a performance presentation is
addressed.
Present the performance of a weighted composite of similar portfolios rather than
the performance of a single account.
Include terminated accounts as part of historical performance and clearly state
when they were terminated.
Include all appropriate disclosures to fully explain results (e.g., model results
included, gross or net of fees, etc.).
Maintain data and records used to calculate the performance being presented.
III(E). Preservation of Con identiality. All information about current and former
clients and prospects must be kept con idential unless it pertains to illegal activities and
disclosure is required by law, or the client or prospect gives permission for the
information to be disclosed.
Guidance
If illegal activities by a client are suspected, Members may have an obligation to report
the activities to authorities. The requirements of this Standard are not intended to
prevent Members and Candidates from cooperating with a CFA Institute Professional
Conduct Program (PCP) investigation.
Recommendations for Members
Members should avoid disclosing information received from a client except to
authorized coworkers who are also working for the client. Consider whether the
disclosure is necessary and will bene it the client.
Members should follow irm procedures for storage of electronic data and
recommend adoption of such procedures if they are not in place.
Assure client information is not accidentally disclosed.
IV. Duties to Employers
IV(A). Loyalty. Members and Candidates must place their employer’s interest before
their own and must not deprive their employer of their skills and abilities, divulge
con idential information, or otherwise harm their employer.
Guidance
Members who are employees must not engage in activities that would injure their irm,
deprive it of pro it, or deprive it of the advantage of employees’ skills and abilities.
Always place client interests above employer interests. Members who are independent
contractors do not owe this presumption of exclusivity to those who hire them for
services. Those members must adhere to the terms of their contract(s).
Members must also comply with their employer’s policies regarding social media.
Guidance—Independent Practice
Independent practice for compensation is allowed if a noti ication is provided to the
employer fully describing all aspects of the services, including compensation, duration,
and the nature of the activities and if the employer consents to all terms of the proposed
independent practice before it begins.
Guidance—Leaving an Employer
Members must continue to act in their employer’s best interests until resignation is
effective. Activities that may constitute a violation include:
Misappropriation of trade secrets.
Misuse of con idential information.
Soliciting employer’s clients prior to leaving.
Self-dealing.
Misappropriation of client lists.
Once an employee has left a irm, simple knowledge of names and existence of former
clients is generally not con idential. Also, there is no prohibition on the use of experience
or knowledge gained while with a former employer.
Guidance—Whistleblowing
There may be isolated cases where a duty to one’s employer may be violated in order to
protect clients or the integrity of the market and not for personal gain.
Recommendations for Members
Keep personal and professional social media accounts separate. Business-related
accounts approved by the irm constitute employer assets.
Understand and follow the employer’s policies regarding competitive activities,
termination of employment, whistleblowing, and whether you are considered a fullor part-time employee, or a contractor.
Recommendations for Firms
Employers should not have incentive and compensation systems that encourage
unethical behavior.
Establish codes of conduct and related procedures.
IV(B). Additional Compensation Arrangements. Accept no gifts, bene its,
compensation, or consideration that may create a con lict of interest with the employer’s
interest unless written consent is received from all parties. An offer from a client that is
contingent on future performance is a form of compensation and requires the disclosure
and approval conditions of this Standard, IV(B). In contrast, an offer from a client that is
based on past performance is a gift (not compensation) and must meet the provisions of
Standard I(B), maintaining Independence and Objectivity.
Guidance
Compensation includes direct and indirect compensation from a client and other bene its
received from third parties. Written consent from a Member’s employer includes e-mail
communication.
Recommendations for Members
Make an immediate written report to the employer detailing any proposed compensation
and services, if additional to that provided by the employer. It should disclose the nature,
approximate amount, and duration of compensation.
Members and candidates who are hired to work part time should discuss any
arrangements that may compete with their employer’s interest at the time they are hired
and abide by any limitations their employer identi ies.
IV(C). Responsibilities of Supervisors. Members and Candidates must make
reasonable efforts to ensure that anyone subject to their supervision or authority
complies with applicable laws, rules, regulations, and the Code and Standards.
Guidance
Members must make reasonable efforts to prevent employees from violating laws, rules,
regulations, or the Code and Standards, as well as make reasonable efforts to detect
violations.
Guidance—Compliance Procedures
An adequate compliance system must meet industry standards, regulatory requirements,
and the requirements of the Code and Standards. Members with supervisory
responsibilities have an obligation to bring an inadequate compliance system to the
attention of irm’s management and recommend corrective action.
When a violation is discovered, the supervisor should:
Respond promptly and investigate thoroughly.
Supervise the accused closely until the issue is resolved.
Consider changes to minimize future violations.
Conduct regular ethics and compliance training.
Design incentive compensation plans to support ethical behavior (e.g., don’t incent
inappropriate risk taking or other actions detrimental to the clients).
Recommendations for Members
A member should recommend that his employer adopt a code of ethics. Members should
encourage employers to provide their codes of ethics to clients.
Once the compliance program is instituted, the supervisor should:
Distribute it to the proper personnel.
Update it as needed.
Continually educate staff regarding procedures.
Issue reminders as necessary.
Require professional conduct evaluations.
Review employee actions to monitor compliance and identify violations.
Respond promptly to violations, investigate thoroughly, increase supervision while
investigating the suspected employee, and consider changes to prevent future
violations.
Recommendations for Firms
Do not confuse the code with compliance. The code is general principles in plain
language. Compliance is detailed procedures to meet the code.
Compliance procedures should:
Be clearly written.
Be easy to understand.
Designate a compliance of icer with authority clearly de ined.
Have a system of checks and balances.
Establish a hierarchy of supervisors.
Outline the scope of procedures.
Outline what conduct is permitted.
Contain procedures for reporting violations and sanctions.
Ethics education will not deter fraud, but it will establish an ethical culture and alert
employees to potential ethical and legal pitfalls. Reinforce the culture with incentive
compensation plans that align employee incentives with client best interests.
V. Investment Analysis, Recommendations, and Action
V(A). Diligence and Reasonable Basis
1. When analyzing investments, making recommendations, and taking investment
actions, use diligence, independence, and thoroughness.
2. Analysis, recommendations, and actions should have a reasonable and adequate
basis, supported by research and investigation.
Guidance
The application of this Standard depends on the investment philosophy adhered to,
Members’ and Candidates’ roles in the investment decision-making process, and the
resources and support provided by employers. These factors dictate the degree of
diligence, thoroughness of research, and the proper level of investigation required.
Guidance—Using Secondary or Third-Party Research
See that the research is sound. Examples of criteria to use to evaluate:
Review assumptions used.
How rigorous was the analysis?
How timely is the research?
Evaluate objectivity and independence of the recommendations.
Guidance—Group Research and Decision Making
Even if a Member does not agree with the independent and objective view of the group,
he does not necessarily have to decline to be identi ied with the report, as long as there is
a reasonable and adequate basis.
Recommendations for Members
Members should encourage their irms to consider these policies and procedures
supporting this Standard:
Have a policy requiring that research reports and recommendations have a basis
that can be substantiated as reasonable and adequate.
Have detailed, written guidance for proper research, supervision, and due diligence.
Have measurable criteria for judging the quality of research, and base analyst
compensation on such criteria.
Have written procedures that provide a minimum acceptable level of scenario
testing for computer-based models and include standards for the range of scenarios,
model accuracy over time, and a measure of the sensitivity of cash lows to model
assumptions and inputs.
Have a policy for evaluating outside providers of information that addresses the
reasonableness and accuracy of the information provided and establishes how often
the evaluations should be repeated.
Adopt a set of standards that provides criteria for evaluating external advisers and
states how often a review of external advisers will be performed.
V(B). Communication With Clients and Prospective Clients
1. Disclose to clients and prospective clients the basic format and general principles
of the investment processes they use to analyze investments, select securities, and
construct portfolios and must promptly disclose any changes that might materially
affect those processes.
2. Disclose to clients and prospective clients signi icant limitations and risks
associated with the investment process.
3. Use reasonable judgment in identifying which factors are important to their
investment analyses, recommendations, or actions and include those factors in
communications with clients and prospective clients.
4. Distinguish between fact and opinion in the presentation of investment analysis and
recommendations.
Guidance
Proper communication with clients is critical to provide quality inancial services.
Distinguish between opinions and facts and always include the basic characteristics of
the security being analyzed in a research report.
Members should communicate risk factors speci ic to non-traditional investments,
including potential gains and losses on all investments in terms of total returns. Members
are required to communicate signi icant changes in the risk characteristics of an
investment or strategy and to update clients regularly about changes in the investment
process.
Members should explain the limitations inherent to an investment and the limitations of
the projections from quantitative models and analysis.
Members must illustrate to clients and prospects the investment decision-making
process utilized. The suitability of each investment is important in the context of the
entire portfolio.
Recommendations for Members
Selection of relevant factors in a report can be a judgment call so members should
maintain records indicating the nature of the research, and be able to supply additional
information if it is requested by the client or other users of the report.
Encourage the irm to establish a rigorous method of reviewing research work and
results.
V(C). Record Retention. Maintain all records supporting analysis, recommendations,
actions, and all other investment-related communications with clients and prospects.
Guidance
Members must maintain research records that support the reasons for the analyst’s
conclusions and any investment actions taken. Such records are the property of the irm.
If no other regulatory standards are in place, CFA Institute recommends at least a 7-year
holding period.
Recommendations for Members
Maintain notes and documents to support all investment communications.
Recommendations for Firms
If no regulatory standards or irm policies are in place, the Standard recommends a
seven-year minimum holding period.
VI. Conflicts of Interest
VI(A). Disclosure of Con licts. Members and Candidates must make full and fair
disclosure of all matters that may impair their independence or objectivity or interfere
with their duties to employer, clients, and prospects. Disclosures must be prominent, in
plain language, and effectively communicate the information.
Guidance—Disclosure to Clients
The requirement allows clients and prospects to judge motives and potential biases for
themselves. Disclosure of broker/dealer market-making activities would be included
here. Board service is another area of potential con lict. The most common con lict that
requires disclosure is actual ownership of stock in companies the Member recommends
or clients hold. Incentive compensation plans that may put member and client interests
in con lict must be disclosed to clients by their advisors.
Guidance—Disclosure of Conflicts to Employers
Members must promptly report potential con licts and give the employer enough
information to judge the impact of the con lict. Take reasonable steps to avoid con licts.
Recommendations for Members
Any special compensation arrangements, bonus programs, commissions, performancebased fees, options on the irm’s stock, and other incentives should be disclosed to
clients. If the irm refuses to allow this disclosure, document the refusal and consider
disassociating from the irm.
VI(B). Priority of Transactions. Investment transactions for clients and employers
must have priority over those in which a Member or Candidate is a bene icial owner.
Guidance
Client transactions take priority over personal transactions and over transactions made
on behalf of the Member’s irm. Personal transactions include situations where the
Member is a “bene icial owner.” Personal transactions may be undertaken only after
clients and the Member’s employer have had an adequate opportunity to act on a
recommendation. Note that family-member accounts that are client accounts should be
treated just like any client account; they should not be disadvantaged.
Recommendations for Members
Members should encourage their irms to adopt the procedures listed in the following
recommendations for irms and disclose these to clients.
Recommendations for Firms
All irms should have basic procedures in place that address con licts created by personal
investing. The following areas should be included:
Establish limitations on employee participation in equity IPOs and systematically
review such participation.
Establish restrictions on participation in private placements. Strict limits should be
placed on employee acquisition of these securities and proper supervisory
procedures should be in place. Participation in these investments raises con lict of
interest issues similar to those of IPOs.
Establish blackout/restricted periods. Employees involved in investment decision
making should have blackout periods prior to trading for clients—no front running
(i.e., purchase or sale of securities in advance of anticipated client or employer
purchases and sales). The size of the irm and the type of security should help
dictate how severe the blackout requirement should be.
Establish reporting procedures, including duplicate trade con irmations, disclosure
of personal holdings and bene icial ownership positions, and preclearance
procedures.
Disclose, upon request, the irm’s policies regarding personal trading.
VI(C). Referral Fees. Members and Candidates must disclose to their employers, clients,
and prospects any compensation consideration or bene it received by, or paid to, others
for recommendations of products and services.
Guidance
Members must inform employers, clients, and prospects of any bene it received for
referrals of customers and clients, allowing them to evaluate the full cost of the service
as well as any potential partiality.
Recommendations for Members
Members should encourage their irms to adopt clear procedures regarding
compensation for referrals.
Recommendations for Firms
Have an investment professional advise the clients at least quarterly on the nature and
amount of any such compensation.
VII. Responsibilities as a CFA Institute Member or CFA
Candidate
VII(A). Conduct as Members and Candidates in the CFA Program. Members and
Candidates must not engage in any conduct that compromises the reputation or integrity
of CFA Institute or the CFA designation or the integrity, validity, or security of the CFA
Institute Programs.
This Standard applies to conduct that includes:
Revealing anything about either broad or speci ic topics tested, content of exam
questions, or formulas required or not required on the exam.
Cheating on the CFA Exam or any exam.
Not following rules and policies of the CFA program.
Giving con idential information on the CFA program to anyone.
Improperly using the designation for personal gain.
Misrepresenting information on the Professional Conduct Statement (PCS) or the
CFA Institute Professional Development Program.
Members and Candidates are not precluded from expressing their opinions regarding the
exam program or CFA Institute.
VII(B). Reference to CFA Institute, the CFA designation, and the CFA Program.
Members and Candidates must not misrepresent or exaggerate the meaning or
implications of membership in CFA Institute, holding the CFA designation, or candidacy
in the program.
Guidance
Members must not make promotional promises or guarantees tied to the CFA
designation. Do not:
Over-promise individual competence.
Over-promise investment results in the future.
Guidance—CFA Institute Membership
Members must sign PCS annually and pay CFA Institute membership dues annually. If
they fail to do this, they are no longer active Members.
Guidance—Using the CFA Designation
Do not misrepresent or exaggerate the meaning of the designation.
Guidance—Referencing Candidacy in the CFA Program
There is no partial designation. It is acceptable to state that a Candidate successfully
completed the program in three years, if in fact the Candidate did, but claiming superior
ability because of this is not permitted.
Guidance—Proper Usage of the CFA Marks
The Chartered Financial Analyst and CFA marks must always be used after a
charterholder’s name.
Recommendations for Members
Members should be sure that their irms are aware of the proper references to a
member’s CFA designation or candidacy, as errors in these references are common.
APPLICATION OF THE CODE AND STANDARDS: LEVEL
III
Cross-Reference to CFA Institute Assigned Reading #33
Ethics Cases: The cases are direct applications of the standards covered in Readings 31
and 32. Details regarding these speci ic cases are not tested, but for practice, you should
read the original cases in the CFA Institute reading and answer the questions.
ASSET MANAGER CODE OF PROFESSIONAL CONDUCT
Cross-Reference to CFA Institute Assigned Reading #34
There are six components to the (voluntary) Asset Manager Code of Professional Conduct
(the “Code”): (1) Loyalty to Clients, (2) Investment Process and Actions, (3) Trading,
(4) Risk Management, Compliance, and Support, (5) Performance and Valuation, and
(6) Disclosures.2 Related to these six components are ethical responsibilities:
Always act ethically and professionally.
Act in the best interest of the client.
Act in an objective and independent manner.
Perform actions using skill, competence, and diligence.
Communicate accurately with clients on a regular basis.
Comply with all legal and regulatory requirements.
Details
1. Loyalty to Clients
– Place the client’s interests irst. Recommendation: Align manager
compensation plans with the client’s interests.
– Maintain client con identiality. Recommendation: Create a privacy policy
and include an anti-money laundering section if needed.
– Refuse business and gifts that would compromise independence and
objectivity. Recommendation: Establish policies and procedures (P&P) setting
appropriate limits.
2. Investment Process and Actions
– Act as a professional using reasonable care and judgment for clients.
– Do not manipulate market price and volume with intent to deceive.
– Deal fairly with clients. Different levels of service are allowed if disclosed
and available to all clients willing to pay.
– Have a reasonable and adequate basis for recommendations and use of thirdparty research. Managers must be knowledgeable, particularly if using
complex strategies, and the strategies must be explained in ways
understandable to the clients.
– Portfolios managed to speci ic styles or strategy must be adequately
explained to the client but do not require determining suitability for the
client. Recommendation: Disclose any permitted deviations from the strategy
and allow client withdrawal without undue penalty if the strategy changes.
– Portfolios managed for a speci ic client must be suitable for that client.
Recommendation: Establish a written IPS. Establish performance
benchmarks.
3. Trading
– Do not act or cause others to act on material nonpublic information. Set up
suitable P&P. Recommendation: Set up irewalls between those with reasons
to have the information and all others.
– Give clients priority over the irm. Establish P&P to limit personal trading by
employees and have a compliance of icer review the trades. Establish a watch
list.
– Use client commissions only for investment uses related to that client.
Recommendation: Consider eliminating soft dollars or, if not, follow the CFA
Institute Soft Dollar Standards.
– Seek best trade execution. Recommendation: Advise clients who direct trades
that this may compromise best execution.
– Establish P&P for fair trade allocation. Recommendations: Group suitable
accounts for block trade execution and use prorated allocation for partial
trade executions. Address how to handle IPOs and private placements.
4. Risk Management, Compliance, and Support
– Develop detailed P&P to meet the AMC plus all legal and regulatory issues.
– Appoint a suitable compliance of icer. Recommendations: The compliance
of icer is independent of investments and operations. The of icer reviews all
irm and employee transactions. Require all employees to understand and
comply with the AMC.
– Have an independent third party verify that the information provided by the
irm to clients is accurate and complete. Veri ication cannot depend only on
internal irm records.
– Maintain records to document investment actions. Recommendations: Retain
compliance records. Document violations and corrective actions. Retain
records for at least seven years or as required by law and regulations.
– Employ suf icient, quali ied staff to meet the AMC and provide the services
promised.
– Establish a business continuity plan.
– Establish a irmwide risk management plan. Recommendations: Outsource if
necessary. Be able to explain the process to clients.
5. Performance and Valuation
– Do not misrepresent. Be fair, accurate, relevant, timely, and complete.
Recommendation: Adopt GIPS.
– Use fair market price for valuation if available or fair value otherwise.
Recommendation: Use independent third parties for valuation.
6. Disclosures
Maintain timely client communication using plain language that is true, accurate,
and complete. Include all material facts, including information about the irm.
Disclose:
– All con licts of interest, regulatory and disciplinary actions.
– Investment process, strategy, and risk information.
– All management fee and client cost information.
– All soft dollar and bundled fee information, including what is received in
return and the bene it to the client.
– Client account performance with quarterly (within 30 days) reporting
recommended.
– Investment valuation methods used.
– P&P for shareholder voting, with particular attention to how controversial
votes are handled.
– Trade allocation policies.
– Review and audit results for client funds and accounts.
– Signi icant irm personnel and organizational changes.
– The irm’s risk management process, changes to the process, and what
regular communication the client will receive. Regular disclosure of clientspeci ic risk information is recommended.
OVERVIEW OF THE GLOBAL INVESTMENT
PERFORMANCE STANDARDS
Cross-Reference to CFA Institute Assigned Reading #35
Within the 10%–15% topic weight for Ethics, one item set for 4%–5% of the total exam
is a very possible scenario for GIPS, if tested. Typical questions require you know the
basic issues of GIPS and recognize compliance or non-compliance in a current GIPS
report. The 2020 edition of GIPS is delineated into three sections: standards for
investment management irms, for asset owners, and for veri iers.
Asset owners who manage assets for an organization, participants, or bene iciaries and
compete for business would use GIPS for irms. Asset owners who do not compete for
business would use GIPS for asset owners. GIPS is voluntary, not mandatory, though it is
strongly encouraged. If adopted, it is up to each irm to determine how to apply GIPS to
its situation. GIPS is consistent with the requirements found in the Code and Standards
(C&S), but if adopted, GIPS will require some policies and procedures beyond the basic
C&S.
Compliance Fundamentals
Compliance must be investment irmwide. However, the irm has wide latitude to
de ine itself. The irm must be a distinct business entity.
The fair value of total irm assets includes discretionary and nondiscretionary
assets as well as fee-paying and non–fee-paying assets. It is also net of leverage
used.
– When calculating composite assets (not total irm assets), nondiscretionary
assets are not included because when calculating composite performance,
performance not controlled by the manager should not be attributed to the
manager.
Other noteworthy compliance fundamentals include:
To initially claim compliance with GIPS, the irm must attain compliance for a
minimum of ive years or for the period since irm inception if the irm has been in
existence for less than ive years.
If GIPS con licts with local laws and regulations, the irm must comply with the
latter and disclose the con lict.
The irm must provide an annual GIPS-compliant report to all existing clients for
the composites in which that client’s performance is included.
Return Calculations
GIPS requires comparable calculation methods by all irms to facilitate comparison
of results. For non-private market investment portfolios, returns must be calculated
monthly and on a total return basis using beginning and ending fair value.
– The above formula assumes no interim external cash lows (ECFs). Note that
ECFs can distort return calculations so to eliminate potential distortions, the
investment would be valued each time an interim ECF occurs. The sub period
returns must then be geometrically linked to create a time-weighted rate of
return (TWRR).
The Modi ied Dietz return method is an approximation that adjusts the above
formula as follows:
– In the numerator, the ECF in low/(out low) is deducted/(added back). For
example, a manager should not get credit for a client’s contribution. In the
denominator, the adjusted ECF uses partial monthly weightings to recognize
that the manager had use of a cash in low for part of the period.
The modi ied internal rate of return (MIRR) is another approximation that is the
IRR adjusted for the timing of the ECFs. It is often solved by trial and error and
therefore, is not covered by an LOS or covered in the CFA reading.
For non-private market investment portfolios, TWRR is used if the irm calculates
daily valuations and returns. If the irm does not calculate daily returns and the
ECFs are not large, then either of the two approximations may be used.
– If the ECFs are large then portfolio must be valued at the time of the ECFs to
calculate a subperiod return.
– Generally, a large cash low is that which is large enough to (materially)
affect the return calculation.
Private market investment portfolio values and returns must be calculated
quarterly. Pooled funds not in a composite must be valued and returns calculated at
least annually.
If the manager/ irm controls the timing of the ECFs, then a money-weighted return
(MWR), which is an IRR calculation, must be used.
The returns must include the impact of manager decisions to hold cash equivalents,
even if a third party manages the cash.
Returns can be reported gross or net of investment management fees. Gross means
after direct trading expenses but before any other fees. Net means after direct
trading and investment management fees.
– A bundled fee combines these two and any other fees. If it is not possible to
separate the direct trading and investment management fee from each other
and from any other fees to meet the intent of this requirement, remove the
entire bundled fee and fully disclose what was done and what is in the
bundled fee.
Composites
Composites are groupings of one or more portfolios with similar investment
mandates, objectives, or strategy. Composite returns must be calculated in one of
three ways:
– Asset-weighting portfolio returns by beginning-of-period values: each
portfolio return is multiplied by its beginning-of-period weight
– Asset-weighting portfolio returns by both beginning-of-period values and
ECFs: same as irst method plus adjustments for the ECFs (weighting)
– The aggregate method: composite is treated as a single portfolio of its
constituents and the return is calculated using the Modi ied Dietz formula
All actual, fee-paying, discretionary segregated accounts must be included in at
least one composite. Same goes for pooled funds that are offered as segregated
accounts.
– Given its importance, a irm must maintain and apply a clear, written
de inition of discretion
– A client’s IPS will specify risk preferences and constraints but none of them
automatically makes a portfolio nondiscretionary
– Guidance is based on whether the manager’s ability to use professional
judgment is materially constrained
– In some cases, the portfolio’s ECFs might indicate that it is nondiscretionary
Nondiscretionary accounts, simulated portfolios, and pooled funds that are not
offered as segregated accounts must not be included in a composite. The
performance of simulated portfolios may be provided in supplemental information
but not in composite results.
Non–fee-paying, discretionary segregated accounts may be included with
disclosure of the percentage of composite assets represented by non–fee-paying
portfolios.
Composite de inition is very important
– If too narrow, then there will be too few portfolios in each and may
jeopardize client con identiality
– If too broad, there will be disparate performance among composite portfolios
Portfolio inclusion and exclusion
– New portfolios should be included in a composite at the beginning of the next
full measurement period
– Terminated portfolios should be included in a composite through the last full
measurement period in which the irm had discretion
Switching portfolios
– A portfolio may be switched to a new composite if the client changes the
portfolio’s mandate, objective, or strategy or if the irm rede ines the
composite
– With a switch to a new composite, the portfolio’s performance must remain
in the old composite’s historical performance
Signi icant cash lows
– Large enough that they impede the irm from implementing the strategy on a
timely basis
– May temporarily exclude the portfolio from the composite or create and
report on a temporary new account (outside of the composite)
Minimum asset levels
– Must be speci ied in advance and a portfolio may be excluded from a
portfolio if its size is so small that it cannot be invested appropriately
– Portfolios that are removed cannot have their prior performance removed
from the composite’s historical record
Presentation and Reporting
GIPS reporting is by annual return periods and composite. Time-weighted returns
of a relevant benchmark for the same periods must be included. The initial GIPS
report for a composite must include at least ive years unless that composite’s
strategy has existed for less than ive years. Thereafter, add at least one year to the
composite presentation record until at least a rolling ten-year history is included.
For each year, disclose
– the number of accounts in the composite (if there are six or more), and
– the amount of assets in the composites and in the irm (or percentage of irm
assets made up by this composite).
The report must include annual measures of internal composite dispersion,
benchmark dispersion, and composite dispersion. Internal dispersion measures the
variability of portfolio returns within the composite, whereas the latter two
measures allow the client to compare the composite’s historical risk against a
benchmark. Acceptable measures of calculating internal dispersion include:
– High and low returns
– Range
– Equal-weighted standard deviation
– Asset-weighted standard deviation
– Or another measure chosen by the irm that fairly represents the composite’s
internal dispersion.
Reporting is for the irm and the historical results cannot be changed (except to
correct a reporting mistake). However, if one irm acquires another irm, that is
now the acquirer’s record and will be included in the historical record of the
acquirer if
– substantially all the decision makers continue to be employed,
– the decision process remains independent and comparable, and
– the past record can be documented.
– there is no break in the performance record between the new and previous
irm.
If only the irst three conditions are met, then the previous irm’s historical performance
can be used to represent that of the new irm but the records may not be linked.
Valuation Hierarchy
Fair value is the amount an asset would be sold for in an arm’s-length transaction
between willing and knowledgeable parties. The GIPS recommended fair value hierarchy
is in descending order of usage as follows:
1. The quoted price for an identical asset in a liquid market on the same day.
2. The quoted price for a similar asset in a liquid market on the same day.
3. The quoted price for identical or similar assets in markets that are not active.
4. A value based on market inputs.
5. A subjective value that is unobservable.
GIPS Verification
While not required, irms are encouraged to have their GIPS process reviewed by a
quali ied independent third party.
The veri ier will issue an opinion regarding whether the irm complies on a irmwide basis (not halfway or just for a single portfolio) and has proper policies and
procedures in place.
– Veri ication is a review of process and not a guarantee of accuracy because a
sampling process is used; larger samples or additional veri ication procedures
are used if warranted.
Veri ication may also include a more detailed review of speci ied composites, which
is known as a performance examination.
Veri ication covers a minimum of one year but covering the period of the full GIPS
report is recommended.
There are extensive lists of what the veri ier will review.
1. Copyright 2014, CFA Institute. Reproduced and republished from “The Code of Ethics,” from Standards of
Practice Handbook, 11th Ed., 2014, with permission from CFA Institute. All rights reserved.
2. Schacht, Stokes, and Doggett, Asset Manager Code of Professional Conduct (CFA Institute, 2010).
ESSENTIAL EXAM STRATEGIES
INTRODUCTION
Your success on the exam depends primarily on effective preparation and practice.
(Success also depends on your previous education and work background, but we cannot
do much about those.) Effective preparation and practice depend both on spending an
adequate amount of time with the material and using effective study techniques.
I hope you have worked through each study session by reading the material and working
through practice questions (e.g., in the SchweserNotes and/or from the CFA text). As you
approach the exam you should include in your study plan an emphasis on
practicing with exam-like questions. We have six mock exams available that simulate
as close as possible the real exam experience. Additionally, on your online Learning
Management System (LMS) within the Resource Library, we have past CFA morning
exams from 2010 to 2018. It’s critical to look at these past exams to see how questions
are constructed and for practice.
We recommend you work in increasing blocks of time to build your endurance and get
accustomed to the two sections of the actual exam, each consisting of 132 minutes
separated by an optional break. This is particularly true for the constructed response
portion of the exam. The idea is to develop time management skills and, at the same time,
attempt only enough questions to ensure that you are able to perform a high quality
review of them. Before the exam, you should do many full 132-minute constructed
response exams and approximate 132-minute item set exams to test your endurance and
concentration. CFA Institute has indicated to us the average Level III candidate
completes seven full-length mock exams before the real exam. Work through the
questions without distractions or interruptions and then review your answers and see
how you did. When you are unable to answer a full question or multiple parts of a
question, do not panic. No one can know everything in the curriculum in full detail. But if
you start to see a recurring pattern of what you are missing, review that material to
improve your knowledge base.
The Level III exam differs from I and II in that the irst half is constructed response. The
second half of the exam uses the item set format you saw at Level II. Although everyone
is different, dif iculty with the constructed response portion of the exam is generally the
number one stumbling block for Level III candidates. CFA Institute has reported over the
years that the scores in the constructed response portion of the exam are signi icantly
lower than those for the item set portion. For item set questions, it is suf icient to choose
the right letter (A, B, or C). Constructed response requires different skills. You must
type an acceptable answer into a blank ield on a computer screen. The grader will
evaluate how closely you match what is expected, based on the CFA curriculum
and taught material. You will not receive any credit for personal opinions or how
you like to think about the material, unless it happens to match the CFA answer
key.
Once you have done the initial preparation by study session, the best way to improve is
to practice with exam-like questions. Use a mix of item set and constructed response
questions to identify areas of weakness where you need to review the material in greater
detail.
ADDITIONAL ISSUES
“Grading” your own constructed response answers is not that dif icult, though it
may be painful. You compare your answer to the sample answer and the discussion we
provide of what is expected in an acceptable answer. Be objective: how close did you
really come? It is tempting to think, “My answer is just as good.” Occasionally you may be
correct, but if you continually diverge from what we are showing you, you take the risk
of performing worse on the exam. It is highly recommended that you grade constructed
response answers with a fellow candidate or two. You can learn a lot by receiving (and
providing) written feedback on a question you have just written. For example, showing or
explaining why you did not award a mark, or stating what additional words the candidate
needed to write to earn the mark can be very useful from a learning perspective. It is
often an eye-opening experience to see how an objective third party perceives your
response and how different it may be from your own perception.
If you are struggling with constructed response, write some questions from old
CFA exams, review our video coverage for those questions, identify where you
went off track, and correct your weaknesses. Be sure to distinguish whether your
weaknesses were due to lack of technical knowledge, careless reading, or poor
time management, to ensure that your follow-up actions are appropriate. We
provide question-by-question coaching using actual morning exam questions from
the 2010 to 2018 CFA exams found on your LMS within the Resource Library.
Please note that we also provide a document that outlines only the relevant
questions to attempt from the 2010 to 2018 exams as some of the questions are
no longer relevant due to numerous changes to the curriculum over the years.
Time management under exam conditions is more dif icult with constructed
response questions. Each question has an assigned number of minutes, and the minutes
are the maximum score you can earn on that question. You should start each question by
carefully noting the minutes assigned and stick to that limit while taking into
consideration the multiple parts of the question (if applicable) and allocating suf icient
time to each part. An effective approach for formulating your answer is to think in 1- or
2-point increments. Command words like “state” or “identify” are likely worth 1 point as
they don’t require any further explanation. Command words like “discuss,” “justify,” or
“describe” are likely worth 2 or 3 points since they require more detail and explanation.
For example, a question that requires you to justify with two reasons may be worth 4
points in that each reason is worth 2 points. In that case, each of the reasons must
contain more depth of discussion and/or use of case facts. Another effective strategy is to
spend about 30%–50% of the allotted minutes reading the question itself (which has
bold command words), reading the case facts that will support your answer, and brie ly
thinking about how you will construct the answer before you start to type. Then use the
remaining time to type your answer in concise short sentences, statements, or bullet
points.
CFA Institute would prefer you answer using clear relevant bullet points that directly
answer the question. They will give you no credit for a general display of knowledge. If
you type long rambling answers, there is a high risk you will score poorly. It is
disrespectful to the grader and only proves you don’t know the material. Partial credit on
a single or multi-part question is normal, so there is no need to obsess about perfection.
The point of constructed response is that you rarely know what a perfect answer looks
like so answer the question as precisely and concisely as possible.
The following are common reasons that graders give for poor candidate performance on
the constructed response portion of the Level III exam:
Not responsive to command word list (e.g., list, de ine, etc.).
Answered a question they wish they had been asked instead of the question that
was asked. (A generic or purely technical response to a question is often ineffective. In
Level III, many questions will require you to apply facts from the case directly in your
response to demonstrate your understanding of the concept(s).)
Hedged on questions that asked for a recommendation and justi ication
(e.g., recommended A, but justi ied B). (Hedging is likely to earn you zero points due
to lack of intellectual integrity—consistency between the recommendation and
justi ication is the only way.)
Neglected to answer part of the question (especially if a several-part question).
Note that you can still answer part E, even if you do not know the answer to part D.
(In other words, don’t give up so easily. The different parts of the question are meant
to be independent of each other.)
Content area experts spent too much time on their area of expertise, leaving too
little time for weak areas. (At the same time, do not spend too little time on your
area of expertise as the way the material is covered in the CFA text may be
signi icantly different from the way it is covered at your workplace. Remember that
the only correct answer on the exam is the CFA answer.)
Providing more items or responses than requested. If a question asks for three
factors, only the irst three that you list will be graded. (They will simply ignore the
remaining responses you provide, whether they are correct or not. For example, they
will not take the best three or the worst three.)
In general, unsuccessful candidates obsess about trivial details and miss the big
picture. The important issues are the ones that receive extensive coverage in our
material and in the CFA readings. The important issues make up the vast majority of the
exam. The exam process is fair. It is not trying to trick you with trivia, so stop
outsmarting yourself. Yes, there will always be a few outlier questions, but they will not
be suf icient to cause you to fail and, therefore, should not be your focus. Recall
quantitative methods: outliers are just distractors from the main trend.
Calculations and formulas are unavoidable but not the full story. Candidates who
are successful regularly say that most formulas are based on a logical understanding of
the concepts. Knowing the logic makes things easier and is more valuable. A few formulas
are not intuitive, however, so memorize those.
For calculations in constructed response questions, candidates are not required to show
their work. A correct numerical value will receive full credit. If the exam question allows
you to do so, you may be able to show your work and it will be evaluated as part of your
response. It could possibly result in partial credit when the numerical answer provided is
not otherwise correct. Additionally, it may be possible to use the equation editor that is
part of the exam software to include a formula as part of a response but be warned that it
may be unnecessarily time-consuming. Alternatively, a candidate may include a simple,
written description of the steps used in a calculation.
CFA Institute grades your answer based on the curriculum. In multiple choice
questions, all that matters is making the right selection. But in constructed response,
showing the work is part of earning full credit. If you have made up your own way to
solve a question or calculate an answer that is inconsistent with the curriculum, you are
increasing the risk that your answer will not be accepted.
Expect 8 to 12 constructed response (essay) questions. Each essay question will be
constructed as in past exams, with a vignette followed by several questions with the
number of minutes (points) given at the beginning of the vignette but no breakdown is
given for each question part. Therefore, it is up to you to use proper judgment as to how
much time to allocate to each part. As stated earlier, generally allocate 1 minute for
state/identify and 2–3 minutes for discuss/describe/justify. With more practice, you will
start to become more comfortable with how much time is appropriate to allocate to each
part. Note that after the vignette there could be a multiple choice question followed by
an essay question related to the multiple choice question similar to past years’ templates
where you had to circle an answer and justify your response.
Once the exam starts, and based on the number of minutes assigned, it is a good idea to
write out the times you need to arrive at each question as a means of imposing the
discipline needed for effective time management. Note that the timer on the exam
computer works backward from 2 hours and 12 minutes (2:12). For example, if question
1 is 12 minutes, then you should make sure you inish question 1 and start question 2
with 2 hours (2:00) remaining. Practicing this way enough times before the exam greatly
increases the chances of success with this strategy on exam day.
Time management for item sets is generally less of a problem than for constructed
response, because there is no writing involved. You have done item sets before in Level II.
Item sets are scored as 12 or 18 minutes (4 or 6 questions), therefore, each question in
the set is 3 minutes. It does not take long to select answer A, B, or C. So track your time.
The most ef icient approach to attacking (solving) an item set is as follows:
Read or scan all the individual questions, then read the case facts, and then answer
each question.
The information for the irst question is usually early in the case facts and the
information for the last of the questions is usually at the end of the case facts.
However, sometimes CFA Institute mixes it up on you.
No method of time management or solving questions will work unless you have
practiced it before the exam. That is why we stress the need to practice with exam
questions and in exam-like conditions. Get busy doing this and you can get better by
exam day.
Skip a part (or parts) of multi-part questions if needed. If you do not understand
Part A or C, for example, of a multi-part question or it is stressing you out, move to
another part and try to come back later. There have been several occasions when Part A
of Question 1 on the exam was just strange. It was not worth much (e.g., 3 minutes) and it
was not hard but if it did not occur to you how to look at the issue, it seemed impossible.
In the end, the only way to solve the question was with creative thinking, which was
never directly covered in the readings. Unfortunately, many failing candidates reported
that they wasted a lot of time on that part of question and got stressed out, hurting their
performance on the rest of the exam. Additional information about the Computer-Based
Testing can be found at: https://www.cfainstitute.org/en/programs/cfa/exam/level-iii.
Manage your stress level. It is critical you do so in preparation and on the exam. In
preparation, manage your energy level by taking breaks. An hour or two of work followed
by a break is more effective in terms of retaining the material. Cut out the multitasking
and focus on one topic at a time unless a given topic has a natural overlap with another
(e.g., ixed income and derivatives); multitasking adds to stress and is not effective.
Cramming has limited value. It may have worked at Level I and possibly Level II.
However, cramming is particularly counterproductive for more conceptual material and
questions that require judgment, which are what the Level III exam emphasizes. Get your
basic studying done early, at least four weeks before the exam, and use the remaining
time before the exam for Mock Exams and inal review of the material. If possible, aim to
have the entire week off from work and open to commit to full-time studying
immediately before the exam. Use the last day (or two) for lighter review (e.g., memory
and recall items such as alternative investments or GIPS) so that you can go in with a
clear head and deliver your best performance.
Do not make up implausible questions. When you are stressed, it is easy to imagine
nightmare questions that just aren’t realistic. It is more effective to use the practice
questions (Schweser and CFA Institute) to get a more realistic sense of what you might
see on exam day.
Relax and apply what has been taught. This exam is not impossible. Successful
candidates frequently report they found Level III the most enjoyable of the three exams.
That is because they prepared the right way, did the practice, managed their stress, and
were ready to perform on exam day.
Distribute your study time roughly by exam weight and do not skip entire study
sessions. I remember a candidate who said, “I’m sure glad you said to spend some time
on ______, because although I can’t tell you speci ically what was asked, I can tell you what
was asked was easy.” Review the comments on stress. Fixation on the hardest or most
obscure material is not part of effective study.
As you go into the inal 10 days of preparation and practice:
Develop a positive mental attitude in order to perform to the best of your
ability. Following the suggestions we have made will help with developing the
positive attitude.
Go to the Prometric website and review their list of exam requirements
located at https://www.prometric.com/prepare-for-test-day
Some basics to remember:
You must bring your valid international passport and exam ticket.
Follow exam day and proctor instructions.
CFA EXAM POLICIES AND PROCEDURES
Prior to exam day, be sure to visit the CFA Institute website and thoroughly read the
information listed under CFA Exams. You can go to www.cfainstitute.org and click on
Programs and then Exam Overview for the complete list and text.
CFA PROGRAM TESTING POLICIES
To protect the integrity of the CFA Program and ensure the exam process is fair for all
candidates, go to www.cfainstitute.org/en/programs/cfa/policies and review all of the
relevant policies, especially the Candidate Agreement for the particular exam you are
taking. The policies cover important topics such as the calculator policy, the
identi ication policy, the personal belongings policy, and the security policy. Failure to
comply may result in suspension or termination from the CFA Program.
It is your responsibility to read and understand all testing policies set forth by the CFA
Program. Testing personnel will report to CFA Institute any violations of testing rules or
policies that occur during the exam.
INDEX
A
active accumulator, 6
active management decisions, 179
active return, 100
active risk, 104
active share, 104
activist investing, 89
additional compensation arrangements, 211
administration fees, 89
agency trades, 170
alpha skills, 101
alternative investments, 120
portfolio management, 113
anchoring and adjustment, 2, 9
appraisal-based, 120
ARCH models, 28
assessing health of an emerging market, 22
asset allocation approaches, 30
asset-only, 30
goals-based, 30
liability-relative, 30
asset class preferences, 132
asset liability management, 35
Asset Manager Code of Professional Conduct, 220
asset manager selection, 190
asset protection, 142
availability, 9
availability bias, 3
B
back ill bias, 120
Bailard, Biehl, and Kaiser (BB&K) ive-way model, 5
Barnewall two-way behavioral model, 5
behavioral biases, 96
belief perseverance, 1
bequests, 141
binary options, 65
Black-Litterman, 34
bottom-up perspective, 195
bottom-up strategies, 94
breadth of expertise, 101
business cycle, 15
C
capacity and scalability, 109
capital suf iciency, 130
carry trade, 61, 115
cash drag, 93
civil law, 141
claw-back provisions, 142
cognitive errors, 1
commercial real estate, 120
common law, 141
communication with clients and prospective clients, 215
conditional factor risk benchmarks, 119
conduct as members and candidates in the CFA program, 218
con irmation bias, 2, 9, 11
con licts of interest, 216
conservatism bias, 1
constant growth rule, 157
constraints, 133
consumption tax, 130
contraction, 17
control bias, 2
conversion factor, 52
costs, 110
covariance, 106
credit strategies, 79
cross-currency basis swap, 53
cross hedges, 65
cross-section momentum, 117
currency risk management, 60
D
data-mining/over itting, 97
dedicated short selling, 114
derivatives, 39, 188
derivatives-based strategies, 92
diligence and reasonable basis, 214
discounted cash low, 20
discounted cash low models, 22
discretionary authority, 133
disposition effect, 11
distressed securities, 115, 116, 117
distribution fees, 89
dividend capture, 88
dividend income, 88
drawdown, 119
duties to clients and prospective clients, 205
duties to employers, 210
dynamic hedges, 63
E
early upswing, 16
economic balance sheet, 30
emerging market government bonds, 26
emotional biases, 1
endowment bias, 4
endowment information, 189
endowment investment strategy, 189
estate planning, 141
estate taxes, 141
Ethical and Professional Standards, 220
Ethical Responsibilities, 220
Ethics in Practice, 220
exchange-traded funds, 92
extended portfolio assets and liabilities, 30
F
factor-based allocation, 35
factor weightings, 101
fair dealing, 207
inancial equilibrium model, 23
iscal policy, 19
forced heirship, 142
forecasting exchange rates, 26
formal risk constraints, 108
formal tools, 20
forward contracts, 64
framing bias, 3
friendly follower, 6
fundamental, 93
funding liquidity, 194
fund of funds, 122
fund of one, 122
G
gambler’s fallacy, 10
general partner, 122
gifts, 141
gift taxes, 141
global market portfolio, 31
growth at a reasonable price, 94
growth-based, 94
growth-based approaches, 94
growth trap, 96
guidance
buy-side clients, 202
CFA Institute membership, 219
compliance procedures, 212
disclosure of con licts to employers, 217
disclosure to clients, 216
group research and decision making, 214
independent practice, 210
investment-banking relationships, 202
issuer-paid research, 202
leaving an employer, 211
Mosaic Theory, 204
proper usage of the CFA marks, 220
public companies, 202
referencing candidacy in the CFA program, 219
using secondary or third-party research, 214
using the CFA designation, 219
whistleblowing, 211
H
hedge funds, 120
herding, 10
Her indahl-Hirschman Index (HHI), 91
heuristic risk constraints, 108
high water mark, 88, 119
hindsight bias, 2, 11
holdings-based, 98
hybrid rule, 157
I
idiosyncratic risk, 100
implementation, 133
implied volatility surface, 50
incentive fee, 88
income tax, 130
independence and objectivity, 201
independent individualist, 6
index-based strategies, 71
indirect real estate, 114
in lation, 17
in lation indexed bonds, 26, 27
inheritance taxes, 141
initial recovery, 16
integrated asset-liability approach, 36
integrity of capital markets, 204
inter vivos, 141
investment analysis, recommendations, and actions, 214
investment horizons, 109
investment strategy costs, 89
investment style, 179
investment vehicles, 122
J
judgment, 21
K
key risks, 22
knock-in options, 65
knock-out options, 65
knowledge of the law, 200
L
lack of availability of stock to borrow, 97
late expansion, 16
level of risk, 32
liability-driven asset allocation, 35
liability-driven strategies, 71
liability-relative asset allocation, 35
lifetime gifts and testamentary bequests, 141
lifetime gratuitous transfers, 141
limited legal liability, 110
limited partners, 122
limited partnership, 122
liquidity concerns, 122
liquidity preferences, 132
long extension, 110
long/short, 109
long straddle, 42
long-term risk premiums, 109
look-ahead bias, 97
loss aversion bias, 3
loyalty, prudence, and care, 205
M
macroeconomic linkages, 20
macro hedges, 65
management fee, 88
market index, 179
marketing, 89
market liquidity, 194
market manipulation, 205
market microstructure-based, 95
market-neutral, 110
market value rule, 157
material nonpublic information, 204
mean-variance optimization, 124
mental accounting bias, 2
minimum variance hedge ratio, 65
mispriced, 100
misrepresentation, 203
momentum effect, 10
monetary policy, 18
Monte Carlo simulation, 124, 131
multiple on invested capital, 125
multi-strategy funds, 118
myopic loss aversion, 3
N
nondeliverable forwards, 65
O
option spread strategies, 42, 48, 49
other investment preferences, 132
overcon idence, 8, 9, 11
overcon idence bias, 3
overlay, 61
P
pairs trading, 95
passive preserver, 6
performance appraisal, 174
performance attribution, 174
performance fees, 88
performance measurement, 174
performance presentation, 209
personal ideology, 110
Pompian behavioral model, 6
pooled investments, 92
portfolio management, 120
portfolio turnover, 109
position sizing, 101
preservation of con identiality, 209
principal trades, 170
priority of transactions, 217
private credit, 120
private equity, 120
probate, 141
processing errors, 2
professionalism, 200
projecting historical data, 15
psychological biases, 14
put spread, 64
Q
quality control charts, 190
quantitative, 93
R
real assets, 120
real estate, 114
rebalancing, 133, 191
record retention, 216
reference to CFA Institute, the CFA designation, and the CFA program, 219
referral fees, 218
regret, 11
regret aversion, 11
regret-aversion bias, 4
regulations, 110
representative bias, 10
representativeness bias, 2
required return, 32
resampling, 34
responsibilities as a CFA Institute member or CFA candidate, 218
responsibilities of supervisors, 212
returns-based, 98
reverse optimization, 34
rewarded factors, 100
risk arbitrage, 95
risk capacity, 130
risk exposures and management, 191, 192
risk factor based approach, 121
risk-factor-based optimization, 124
risk-free asset, 33
risk perception, 130
risk premium, 20
risk premium approach, 23
risk premium (building block) approach, 21
risk reversal, 50
risk tolerance, 130, 132
roll yield, 63
S
safety irst, 32
seagull spread, 64
securities lending, 88
segmentation, 87
self-attribution bias, 9, 11
self-control bias, 3
separately managed accounts, 122
separately managed equity index-based portfolios, 92
Sharpe ratio, 119
short-biased, 114
shrinkage estimates, 28
side pocket, 122
slippage, 109
slowdown, 17
social proof bias, 10
Sortino ratio, 119
Spearman Rank IC, 97
standard deviation, 119
Standards of Professional Conduct, 200
static hedges, 63
statistical methods, 20
status quo bias, 4
stock concentration, 91
strategic asset allocation (SAA), 29, 189
stress testing, 188
suitability, 208
surplus optimization, 35
survey and judgment, 21
surveys, 21
survivorship bias, 97, 120
T
tactical asset allocation (TAA), 29
tactical changes, 133
tax avoidance, 130
tax deferral, 130
tax reduction, 130
technical rules, 61
term structure of volatility, 50
testamentary gratuitous transfers, 141
time horizon, 132
time series analysis, 15
time-series momentum, 117
top-down perspective, 195
top-down strategies, 94
trading costs, 89
transactional complexity, 110
transaction costs, 97
turnover, 97
two-portfolio approach, 35
Type I error, 181
Type II error, 182
U
uncovered interest rate parity, 61
undertakings for collective investment in transferable securities, 122
utility maximization, 32
V
value at risk, 195
value-based, 94
value-based approaches, 94
value trap, 96
volatility skew, 50
volatility smile, 49
W
wealth-based taxes, 130
weighting method, 90
will, 141
Y
yield curve strategies, 76
yield curve trades, 115
Z
zero-cost collar, 41, 64