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 Wiley’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. Wiley’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.