CFA Portfolio Management

• A portfolio is essential to investors in achieving their financial goals.
• Portfolio Management has a topic weight under 10% on the CFA Level I exam and increases to 35-40% on the CFA Level III exam.
• Portfolio Management is the most popular career that CFA candidates are currently interested in pursuing.
• CFA candidates will learn to describe the portfolio approach to investing, the steps in the portfolio management process, aspects of the asset management industry, and more.

As you begin to explore Portfolio Management for the CFA Level I exam, it’s important to focus on the key concepts to help build a foundation that will serve you well during each level of the CFA exam. The topic weight increases at each level and so does the difficulty, so start early with UWorld’s study materials to ensure you’re prepared for every challenge this essential topic will throw at you.

Portfolio Management isn’t a main focus on the Level I exam, but what you’ll learn will become embedded into your understanding of the subject matter at each step of your journey towards earning your CFA charter.

When you consider how to approach Portfolio Management on the CFA Level I exam, one successful approach is, to begin with a series of steps that need to be followed in the Portfolio Management process. Additionally, the readings in this section focus on how building a portfolio is an investment strategy, how to measure your progress, how to be aware of the scale and risks involved, and how to adapt portfolio investment strategies to different investor profiles.

Step 1: Planning

The planning step takes into account a client’s investment objectives, constraints, and portfolio benchmark and documents them in an Investment Policy Statement. The investments are managed moving forward using the IPS document.

Step 2: Execution

The execution step involves three components. The first is Asset Allocation, where a portfolio manager develops a view of the risk and return expectations of asset claims. Executing this step is determined by the optimal allocation of the portfolio assets among available asset classes. Next is Security Analysis, where specific securities are selected for purchase that line up with the asset classes from the previous step. Finally, Portfolio Construction takes the information from the previous steps and creates an investment portfolio where securities are purchased and trades are executed.

Step 3: Feedback

The feedback step involves monitoring and rebalancing so that exposures are in line with the IPS. Performance is also tracked and reported to clients.

Portfolio Management: An Overview Practice Question

An investor is most likely to purchase which of the following investments at net asset value?

1. Exchange-traded fund.
2. Open-end mutual fund.
3. Close-ended mutual fund.

Answer: B. An open-end mutual fund sells shares to investors at net asset value, while a closed-end mutual fund and an exchange-traded fund may trade at a premium or discount to net asset value based on the demand for the fund’s shares.

Investors want an optimal portfolio, and this section helps candidates understand the process of examining the risk and return characteristics of individual assets. It also explores all possible portfolios and chooses the most efficient option given client goals and constraints, which should lead to choosing the optimal portfolio for an investor.

Risk Aversion Explained

Put simply, risk aversion is the level of an investor’s unwillingness to take a risk. There are also risk-neutral investors who are indifferent about the risk or outcome and have a primary focus on returns. Risk-seeking investors prefer a more speculative approach, where the indifference curve is downward sloping as reported return decreases at higher risk levels. And of course, risk-averse investors not only are not willing to take risks but expect an additional return for taking potential risks. This describes the majority of investors who are wary of steep indifference curves.

Minimum Variance Portfolio Explained

Minimum variance portfolios include several components and help filter all investable options. Risk-averse investors prefer a combination of assets in order to minimize risk for a given level of return. Included in this reading is a line combining all portfolios with a minimum level of risk given a rate of return called a Minimum Variance Frontier. Additionally, the Global Minimum Variance Frontier is a portfolio with the lowest variance amongst all risky assets, and the Efficient Frontier describes the part of the minimum variance frontier that is above the global minimum variance portfolio.

Capital Allocation Line (CAL) Explained

The Capital Allocation Line (CAL) reduces the shortfall of the Efficient Frontier by showing a line that represents the possible combinations of risk-free assets and optimal risky asset portfolios.

Portfolio Risk and Return: Part I Practice Question

The risk that can be diversified away is:

1. Beta.
2. Firm-specific risk.
3. Systematic risk.

Answer: B. Firm-specific risk is also known as unsystematic risk. It’s the risk factor that can be diversified away by forming portfolios.

Part II dives into identifying the optimal risky portfolio for investors by using the capital asset pricing model (CAPM). Candidates will be tasked with computing the risk and return of a portfolio and the role that parallel plays in diversifying portfolio risk which helps us get to the Efficient Frontier. You’ll also learn about the Capital Market Line (CML), a special case of the capital allocation line used for passive investor portfolios.

Capital Market Line (CML) Explained

A representation of portfolios that optimally combine risk and return, the CML is a theoretical concept that represents all the portfolios that optimally combine the risk-free rate of return and the market portfolio of risky assets.

Systematic vs Non-Systematic Risk Explained

Systematic risk refers to the threat associated with the market or market segment. Non-systematic risk is the risk associated with a particular security, company, or industry. The most common systematic risks are inflation, price movements, fluctuation in interest rates, and rises in unemployment. Non-systematic risk, also known as Specific Risk or Residual Risk, can occur at any point and cause widespread disruption quickly.

Beta Explained

Beta is a measure of systematic risk and depends on the degree of correlation between a security and the market. To calculate beta, variances and correlations are determined using the historic returns for the asset and the market.

Capital Asset Pricing Model (CAPM) Explained

The Capital Asset Pricing Model (CAPM) explains the relationship between systematic risk and expected return for assets. This model is generally used to price risky securities and generate expected returns for assets with the risk of those assets and cost of capital in mind.

Security Market Line (SML) Explained

The security market line (SML) is added to a chart that provides a graphical representation of the capital asset pricing model. The SML is also known as the “characteristic line” and is a visualization of the CAPM where the x-axis of the chart represents risk, and the y-axis represents expected return.

Other Portfolio Performance Evaluation Measures Explained

Additional portfolio performance evaluation measures include attribution, appraisal, and broad categories of performance measurement. Differentiating between these and explaining their interrelationships is key.

Portfolio Risk and Return: Part II Practice Question

According to capital market line, which risk is priced?

1. Total risk.
2. Systematic risk.
3. Nonsystematic risk.

Answer: A. According to the capital market line, total risk is priced for efficient, completely diversified portfolios.

Portfolio Management has an added focus on the CFA Level II exam. The foundation you’ve built at Level I will come in handy, but be prepared for an increased amount of material and a format change at Level II. UWorld’s support and study materials are your best bet again, with everything you need to walk into the Level II exam with confidence.

CFA Level II’s format is comprised of item sets comprised of vignettes with 88 accompanying multiple-choice questions. With this in mind, this step toward becoming a chartered financial analyst should include plenty of time working through practice questions during study sessions related to Portfolio Management. There is also an increase in topic weight as you step up from Level I to Level II, where 10-15% of the exam is focused on Portfolio Management.

Gaining an understanding of how Exchange-Traded Funds are created and redeemed is a vital part of understanding how they can add value to portfolios. As you approach practice questions in this area, you’ll learn the importance of index tracking or tracking error, as well as an understanding of how to assess an ETF’s trading costs, including differences between an ETF’s market price and the fair value of its portfolio holdings.

Exchange-Traded Funds: Mechanics and Applications Practice Question

Identify which of the following is not a drag on ETF performance relative to its index.

1. Fees.
2. Securities lending.
3. Fund accounting practices.

Answer: B. Securities lending provides income for the ETF to offset costs to benefit shareholders.

Multifactor models are the return on an asset in terms of the risk of the asset with respect to a set of factors. These models demonstrate their value in helping asset managers and asset owners address practical tasks in measuring and controlling risk. During study sessions, you can expect to learn about systematic factors which explain the average returns of a large number of risky assets.Multifactor models describe the return on an asset in terms of the risk of the asset with respect to a set of factors. Such models generally include systematic factors, which explain the average returns of a large number of risky assets.

Using Multifactor Models Practice Question

An investor wishing diversification among risk factors would most likely choose:

1. A factor portfolio.
2. The CAPM model.
3. A multi-factor portfolio.

Answer: C. A factor portfolio is a portfolio with unit sensitivity to a factor and zero sensitivity to other factors. The CAPM is that type of portfolio, according to theory. A multi-factor model allows an investor to diversify holdings in a portfolio based on their contribution to factor diversity, thus possibly contributing to a more diverse portfolio.

Measuring and managing market risk covers movements in stock prices, interest rates, exchange rates, and commodity prices. You’ll learn how market risk is the risk that arises from changes in markets that an organization has exposure to.

The stakes are raised yet again for Portfolio Management as you prepare for the CFA Level III exam. In fact, at this level, the topic weight for Portfolio Management is nearly half the exam at a whopping 35-40%. Combine that with another format change and it’s obvious that you’ll need plenty of help from a trusted study partner like UWorld.

The CFA Level III exam is considered to be the most difficult in the CFA Program. This is in part due to the format change which presents constructed response or essay questions for candidates. The huge focus on Portfolio Management is an added challenge as well and should be approached with a study plan and plenty of resources and tools. UWorld supports CFA candidates with everything they need to make it through this difficult but manageable step.

When you begin to prepare for the Portfolio Management vignette questions, it’s wise to go through all the readings and go through practice questions under timed constraints. Timed practice papers can help as well as you learn time management.

Portfolio Management Constructed Response (Essay) Question Example

Paddington Pool Investments is a boutique fund located in London that offers clients a small range of U.K. equity, bond, and property mutual funds. Walter Huang, CFA, works as a distribution manager for Paddington Pool and is currently working on the sales case for their newest fund, a U.K. bond fund that invests in indexed-gilts and other inflation-linked fixed income securities.

Huang has appointments with the following clients today, and he would like to introduce them to the new investment opportunity:

• Annuity Care House – A provider of annuities to residents of U.K.-based retirement home facilities run by Care House
  
• Best Advice Wealth Management – An investment committee that approves and recommends funds for their advisers to utilize in building portfolios for private clients

Portfolio Management Item Set Question Example

A. Discuss the suitability of the Paddington Pool U.K. Indexed Bond Fund in a portfolio backing the annuities of Annuity Care House.

B. Discuss the suitability of the Paddington Pool U.K. Indexed Bond Fund in the portfolios of Best Advice Wealth Management’s clients.

Answer:

A. Discuss the suitability of the Paddington Pool U.K. Indexed Bond Fund in a portfolio backing the annuities of Annuity Care House.

The portfolio for Annuity Care House will need to be able to fund the annuity income streams of their clients. The bond fund would be appropriate due to its steady stream of income returns generated from gilts and other fixed income securities. Furthermore, to the extent that some or all of the annuities provided are indexed to inflation, the indexation feature of the fund would also make it suitable for Annuity Care House.

B. Discuss the suitability of the Paddington Pool U.K. Indexed Bond Fund in the portfolios of Best Advice Wealth Management’s clients.

The advisers of Best Advice Wealth Management are likely to have clients across the age and situation spectrum. They are also likely, for most clients, to be helping clients construct well-diversified portfolios according to their respective risk tolerances. The bond fund is likely to be suitable for almost any client. More conservative clients will benefit from the stable, inflation-linked income that the fund is expected to provide. Furthermore, aggressive clients can benefit from the defensive qualities of the fund that arise from its likely low/negative correlation with growth assets (e.g., stocks), which can help to reduce the risks of portfolios.

Even though formats and topic weights vary across CFA exam levels, there are a handful of cross-level tips that can help as you prepare for each exam. One of those is having a firm grasp of terms and definitions. You’ll also want to know important concepts like CML, SML, CAL, and CAPM across each exam level. Finally, don’t neglect risk and return calculations, another integral piece in the Portfolio Management topic.

Calculation: Practice Makes Perfect

It’s difficult to not stress the importance of practicing calculating and comparing returns across each CFA exam level. These common Portfolio Management questions center around risk and return calculations.

Understand Core Terms and Definitions

A firm grasp of terms and definitions is another important focus throughout the Portfolio Management topic. Make sure you have all of these memorized before you sit down to take the exam.

Understand CAL, CML, SML, and CAPM

Questions involving CAPM, CAL, CML, and SML are common throughout the CFA curriculum. Be sure to have these memorized as well and know how to explain them when you are faced with the challenge.

Get Support From an Experienced Study Program

At each step and exam level, UWorld offers the most comprehensive study materials and tools to help you succeed. In fact, 9 out of 10 students who complete the UWorld CFA excel course pass the first time.