5 Things I Wish I Knew about the CFA Level III Exam



We’ve already covered the top five things you should know about the CFA Level I and Level II Exams, along with the exams in general. After the Level II exam, I enjoyed the final exam of the series though it presents its own challenges. If you approach it wisely, following these five points, the Level III exam can be just as enjoyable when you take it.

  • It’s all about the Essays

The essay portion of the exam terrifies many candidates and for good reason. Not only are you asked to come up with your own answers, much more difficult that picking it out of three options, but the essays present a physical challenge as well. When is the last time you spent almost three hours straight writing by hand? The post-exam party is filled with more than a few horror stories about muscle cramps and aching hands. You must physically prepare yourself by doing consecutive essay problems and writing for hours or you will not make it through the morning section.

Most of the topic areas are fair game for essay questions. The first two questions will always be on individual and institutional wealth management so being ready for those two topics can give you a huge confidence boost for the rest of the test. Corporate Finance, Financial Reporting, Quantitative Methods and Alternative Investments are the least likely to show up as essay questions but will be in the afternoon section. I covered the essay section in more detail in a prior post linked here.

  • The only exam with prior year’s available

Ok, this one is about the essays as well but I thought it merited its own bullet. The Institute releases the essay section, along with guideline answers, for the last three years. This is huge and I don’t think most candidates take advantage of it. Working through these essay questions not only helps you study the material and practice writing for an extended period, it also helps you write more efficiently and get a feel for the types of information for which the Institute is scoring.

We worked through several essay questions last year from prior years, click here and scroll through last year’s study plan. While only the last three years’ exams are available, you should be able to get prior years’ essays from members of your local society. Ask around to see if anyone has the pdf copies. It is well worth the effort to have a couple more sets of practice essays, especially in the all-important wealth management topic area. Make sure you check for LOS changes between the test year and the current year for material that has been dropped or changed.

  • Don’t get overconfident

You’ve made it through two of the hardest exams of your academic life and notice that the pass rate for the CFA Level III exam is above that of the other two. Sounds like it is time to sit back and ease through to your charter, right?

You have put in too much work to get lazy now. While the pass rate on the Level III exam, 49% in 2013, is higher than that of the other exams it is still incredibly difficult. Think about it, every CFA Level III candidate has had the perseverance and has put in the effort to pass the other two exams but less than half will make it through the exam this year.

Put in just as much time and work for this final exam as you did for the other two levels. Not only will you be rewarded with a passing score, but mastering the essay section will give you the ability to talk through these topics in your job.

  • Harder to ‘game’ the topic areas

You could clearly see in the other two exams which topic areas were most important and where you should focus your studying. The topic weights don’t help much on the CFA Level III exam. Ethics and the asset classes are weighted but the investment tool topic areas are wrapped up in portfolio management. This uncertainty throws some candidates for a loop and leads to inefficient use of study time.

Fortunately, by studying the prior essay sections, you can get a good idea of topic area importance. Look through the prior three years’ morning sections and you will see that the two portfolio management topics are always considered (with each historically above 10% of total exam points).

Again, studying these previous morning sections can give you nearly everything you need.

  • Do not wait until you pass the exam to start thinking about the charter

You will not immediately be granted the charter after passing the Level III exam. You first need to fill out an application for membership and acquire two sponsors that will answer questions on your experience. One of these will need to be your current supervisor, the other needs to be a charterholder from the local society. Now is the time to start talking to society members and establishing a sponsor. In my own experience, it is frustrating when a candidate comes out of nowhere and asks for a sponsor when you have never talked or really know what they do.

You will also need to complete the requirement for 48 months of professional experience. This is the sticking point for a lot of candidates and many have to wait years until they can use the designation. There is not much you can do if you are taking the exam this year and do not have the necessary experience. Review the work experience guidelines established by the Institute, linked here. If your current responsibilities do not qualify, you need to start looking at your options. Consider talking to your supervisor to add some responsibilities to your role that might help qualify.

As a level III candidate, you are almost there and the anticipation building up to the exam can be unbearable. Take a step back and realize that you still have one hurdle to jump. Study just as hard for the final exam as you did for the other two, maybe harder, and go into that first Saturday of June with the confidence to pass.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Level 3 Emergency Preparation



What if you were dramatically unprepared for the CFA Level 3 exam and needed to focus on the most important information for the upcoming test. What would you study over the next nine days?

Whatever the reason, many candidates find themselves unprepared at this point whether it be real for a lack of studying or imagined from simple anxiety. While I wouldn’t think it’s possible to do all your studying in just the next week and a half, there are some sections you can focus on to get the most points and have a chance at passing the exam.

The topic weights for the CFA Level 3 exam doesn’t really help like it may for the other two exams. We see that each of the asset classes are worth between 5% and 15%, with the exception of fixed income which is weighted a little more heavily. Beyond these four topics, we’re only told that the rest of the exam, between 45% and 55%, is wrapped up into portfolio management.

We do know that the exam is divided into an essay section in the morning and a item-set section in the afternoon. Since the afternoon item-set section isn’t really any different than that seen in the CFA Level 2 exam, the best use of your time might be to focus on the morning essay section.

There are a couple of reasons for this. First, there is a lot that goes into the morning section that just knowing the material. You need to be able to write for upward of three hours without getting tired and knowing the format of the exam helps a lot. Some questions can be answered directly under the problem while others are answered in a special template box.

Another reason to focus on the morning section for your last minute studying is that your performance on the essays can really help set the tone for your mood in the afternoon. Don’t underestimate the confidence boost from getting max points on the essays, in particular the first couple of portfolio management essay questions.

Fortunately, practicing the morning section is made easier by the Institute. You’ll find the last three years’ worth of essay questions along with guideline answers on the CFA Institute website. Using these helps to get a sense of what you might see on this year’s exam as well as how to approach it. Studying the last few years can also give you a sense of the topics that most frequently show up on the morning section, discussed in a previous post here.

If I had just one week to study for the Level 3 exam, I would focus first on the individual and institutional management questions in the last three years’ exams. These will be the first questions you get in the morning.

Remember, there are two primary types of return questions you will get for individual portfolio management, a single-period return calculation or a required return (multi-period) calculation. We’ve worked both of these in previous posts here on the blog. You also need to know the five portfolio constraints for the IPS and how they relate to the risk tolerance and return objectives.

We’ve reviewed each study session and several of the previous years’ essay questions in our 21-week study program, so you might want to start there as a quick review. If you do decide to just focus on the prior essay questions, you may want to review some material from the topics that do not typically appear in the morning section like: Financial Reporting & Analysis, Corporate Finance, and Quantitative Methods.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Level 3 Essay #9 2012



The material on derivatives is worth between 5% and 15% of your overall score and last year (2012) was the first time in four years that it appeared in the morning section. This might have thrown some candidates if they were not expecting an essay question, so I thought I would go over one of the questions in this week’s post.

The essay questions, along with the guideline answers, are available on the Institute’s website for your practice.

Together, questions #8 and #9 were worth 25 points or about 7% of the overall exam. Problem #8 covered the use of equity futures in changing a portfolio’s beta, using equity and bond futures to adjust portfolio allocation, and pre-investing with futures. Problem #9 covered options with delta hedging and some conceptual material on how gamma changes closer to expiration. These are formula intensive sections but the calculations really are not that hard once you work through them.

The first thing you should notice when starting #9 is that the three parts (A,B,C) are worth 12 points. Unless you have saved some time elsewhere in the morning, you should try to get through these in no more than 10-15 minutes. Don’t spend 30 minutes on a question that is only worth 12 points! Use your time wisely.

You may want to underline or highlight key figures as you’re reading to make it easier to pick out data when you come to questions. Here things that jump out to me are 2,000 shares of equity, x-price of 1,300 Euros, premium of E19.09, etc.

  1. A put is a right to sell while a call is a right to buy, so being on the other side of the transaction (the writer of the option) would be the obligation to do the reverse (i.e. put is obligation to buy while call is obligation to sell). Knowing your ultimate exposure, you can figure out how to hedge it through an equity position. In this case you need to create an offsetting short position so you take the number of shares times the option delta times the current price.
  2. You need more in-depth knowledge of how options price here with the convex relationship between price and the underlying. You’ve seen this concept with mortgage-backed securities in the fixed income topic area so it shouldn’t be totally new. Remember, delta is the change in option price relative to stock price while gamma is the change in delta relative to the underlying. Long options (calls) have positive gamma (change in price is less for a decrease in underlying than the change for an increase in the underlying) while short options (puts) have negative gamma (change in option price will be greater for a decrease in underlying equity relative to the change from an increase in the underlying).
  3. The toughest part here is continuous compounding and the fact that you need to do six calculations for just five points. Don’t stare at the problem too long if you do not know it. Just get something down and move on to make sure you get the easy points in the exam. You will get partial credit if you hit on some of the points for which the graders are looking, so write something down!
    1. First, start with the trader’s net cash position which is the number of shares long times the price, minus the premium collected for the options sold.
    2. Even if you can’t remember how to do the continuous compounding, do the equation anyway and move on to the next steps. You can still get credit for doing the remaining calculations even if the result is off because of a prior mistake (and here the difference between continuous compounding is only $0.05).
    3. From here it’s just a matter of subtracting the short call position from the long equity position and finding the relative return.

 Of the 12 total points, you could have gotten 6 or 7 easily by just knowing the conceptual material and working through the equations quickly. The remaining points would have been a little harder and may have taken more time than they were worth if you really didn’t know the material. This is a great example of making sure you get the easy points and not spending too much time where it’s not going to pay off.

If you know that you don’t know something or it’s going to take a while to figure it out, move on and come back to it if you have time.

Two more weeks to the exam. Make sure you are ready for the first two questions (individual and institutional portfolio management) and get a few mock exams done.

‘til next time, happy studyin’
Joseph Hogue, CFA

Which topics usually show up on the CFA Level 3 Essay Section?



While I’m generally not one to recommend ‘gaming’ the CFA exams, knowing which topic areas and material has a better chance at showing up on the essay section of the Level 3 exam can help out big time. The afternoon section is worth just as many points and you still need to master all of the curriculum, but the morning section can make or break your day.

First, a disappointing experience in the morning can devastate your confidence and ruin your concentration during the afternoon. You need to go into the exam feeling like you’re going to pass and carry that optimism all the way through. Secondly, there are questions that are more suitable and do show up in the essays. Preparing for these through practicing old exams will put you way ahead anyone on test day.

Your first question on the exam will always be an individual portfolio management question. The individual management question is usually around 12% of the exam (44 points) and will either be a multi-period return or a single-period return. Within the question you’ll often see questions on taxes, investor behavior and estate planning but the core is built around the return objective, risk tolerance and the five constraints. We’ve covered a few of these in the past, linked here and here for review.

An institutional portfolio management question usually follows directly but last year it didn’t come until #6, but you will always see one. It is usually around 36 points (10% of the total exam) but ranges from 24 to 49 points. There’s really no way of knowing which institution type will show up but make sure you know the basic comparisons between them all for the IPS components. We’ve done a couple of past questions, linked here.

Practicing several (at least) old individual and institutional questions from past exams will make your day on that first Saturday of June. Imagine starting the exam being totally confident and easily completing the first two questions and knowing you’ve just aced about 20% of the exam!

Economics has been in the morning section in each of the last four years and has been worth an average of 11% of your morning score. Biases and sources of error in data is a popular topic along with one of the economic measurement tools  (tobin’s q, fed model, cobb douglas, h-model, yardeni ). We ran through the 2011 Economics question here.

Risk management is often in the morning section, though it skipped last year. The question is usually about 10% of your morning score and often has a question about hedging with options, forwards, futures or swaps.

Asset allocation is another that usually shows up but was skipped last year. Some will say that this makes it more likely to show up in an essay this year but there’s no real proof of it (though I would agree from what I’ve seen in the past tests). The question is around 15 points (about 8% of your morning score) and will often be a selection of an appropriate portfolio or calculation of corner portfolios. The basic concepts, differences and advantages/disadvantages of the portfolio techniques is also something that has come up in the past (Black-Litterman, Mean Variance Opt., resampled efficient frontier, Monte Carlo). Linked here is the 2011 Asset Allocation Question.

Performance evaluation and the material on monitoring/rebalancing are also frequent essay questions. Each has had a question in three of the last four years with an average of about 15-17 points. Make sure you can do a micro- and macro-attribution for performance evaluation as well as breaking total return down into its components. The buy/hold, constant mix, and cppi methods of rebalancing often show up as questions so make sure you spend some time there as well.

The material on fixed income and equity investments also frequently find themselves into an essay question though no specific formulas or processes jump out as regulars. Even if you receive a question in the morning section, the topics are a fairly large percent of your total score so you may get a question in the afternoon as well.

The material in corporate finance, financial reporting & analysis, and quantitative methods don’t usually show up in the morning section. The material in alternative investments shows up only rarely, with a question on swaps and futures in 2009 (question #8).

We cover study session 18 next week and will spend the last few weeks reviewing and talking about test day. Let me know if you have any questions,

‘til next week, happy studyin’
Joseph Hogue, CFA

CFA Level 3 Review, Portfolio Evaluation



Study session 17 in the CFA Level 3 curriculum concludes the portfolio management topic area with two readings (41-42) on performance evaluation and attribution.

Evaluating Portfolio Performance
The curriculum gives several ways to calculate the rate of return on an account depending on if and when cash flows occur. Don’t try to memorize each individual method, instead think about it intuitively to work through the problem. If cash flows happen at the beginning of the period, then they should be included in the return metrics because it is money that was/wasn’t in the account for the entire period. If cash flows happen at the end of the period, they should not be included.

Understand the difference between time-weighted and money-weighted returns. The money-weighted return is the IRR and is only appropriate when the manager has discretion over deposits/withdrawals.

The material on benchmarks is fairly testable, make sure you know the types of benchmarks and advantages/limitations.

  • Absolute is the return objective or a minimum return target on the portfolio. It is simple and straightforward but not investable.
  • Manager universe  is usually the median manager or fund from a broad list. It is measureable but not investable, specified in advance, and is ambiguous.
  • Broad market is the comparison to a market index like the S&P500. The benchmark method is easy to understand, widely available and unambiguous, investable and measurable but there may not be an index appropriate for the manager’s investment style.
  • Factor model based uses models to relate systematic sources of returns to the account through  a regression model. It can be modeled to the manager’s specific style but may be difficult to use, ambiguous, and may not be investable.
  • Returns based benchmarks are constructed using the series of account returns and the series of style index returns over a period to make allocation weights. The method is intuitive and simple, unambiguous, investable and specified in advance but may not be matched to the manager’s actual style and require detailed data points.

Understand the basic steps to creating a custom security-based benchmark and its advantages/limitations.

Question #9 in the morning section of the 2010 and 2011 Level 3 exams was an attribution problem. I highly recommend that you download the test and the guideline answers to work through the problems. You need to be able to do both a macro-attribution and a micro-attribution analysis. The past three years of essay questions and guideline answers are available here.

Understand the objectives and basic process for a manager continuation policy.

Global Performance Evaluation
The reading revolves around breaking a total return out into its three components: capital gain (in the local currency), yield, and currency return.

Example: If you invest $100 in the Mexico index on January 1 2013 and by the end of the year the index has increased by 10% with a depreciation of 3% in the peso against the dollar, what is the return of the investment in dollars? (no dividends paid)

The return to currency is (% change in currency)(1+return +yield) = -.03(1+0.10+0)= -0.033
The return in the domestic currency is (cap gain)+(yield)+(currency)= 0.10+0+-0.033 = 6.7%
**Note it isn’t as simple as reducing the overall gain by the 3% depreciation

You will also need to be able to break the total portfolio return down further to its returns from market selection, security selection, yield and currency. The market selection return is that which would have been achieved with a passive investment in the local market index. The security selection component is made by the manager’s individual selections, in the local currency and compared to the market index.

Beyond the two types of global attribution analysis, the material on active and passive currency management is fairly testable. Passive currency management can be fully hedged to the exposure or selectively hedging some currencies but not others. Active currency management is a strategy that differs from the benchmark and creates different exposures. Currency management is usually done by futures or forwards as seen in the prior topic area.

Be sure to catch Friday’s post where we’ll look at what topics typically show up in the Level 3 morning essay section. We’ll cover study session 18 in the CFA Level 3 curriculum next week, which consists of one reading on the Global Investment Performance Standards (GIPS).

‘til next time, happy studyin,
Joseph Hogue, CFA

CFA Level 3 Review, Monitoring and Rebalancing



Study session 16 in the CFA Level 3 curriculum covers execution of portfolio decisions with two readings (39-40) on monitoring and rebalancing. The material is part of the large Portfolio Management topic area which is worth approximately half of your total test score.

Execution of Portfolio Decisions
Know the basic types of orders (market, limit, participate, portfolio, reserve) and what each means for price, timing, and liquidity.

Understand the basics for the type of markets (crossing networks, auction, dealer, and automated auctions). Don’t confuse electronic crossing networks (automated markets for institutionals that match buy and sell orders at specific times during the day) and Electronic communications Networks (ECN, computer-based auctions that operate throughout the day.

Understand the differences and roles of brokers and dealers. The relationship between the trader and dealer is adversarial while the broker represents the trader. Brokers help to find the opposite side of a trade, can supply market information, provide discretion and secrecy, and can provide other supporting investment services.

The material on transaction costs is the most testable portion of the reading and often shows up on the essay portion. Make sure you can work through an implementation shortfall problem and calculate explicit costs, realized profit/loss, delay costs, and the missed trade opportunity costs.

Be able to calculate the volume-weighted average price and describe differences between the two approaches.

Understand the motivations for each of the different types of traders (informational, value, liquidity, and passive) and what it means for timing and liquidity.

Monitoring and Rebalancing
The material on monitoring is basically understanding the constraints on the IPS and being able to see when an investor’s situation changes materially enough to take action. The curriculum is fairly basic and you should be able to work through it if you’ve spent the time on the individual/institutional management portions.

The rebalancing portion of the reading is the more testable. Understand the costs of rebalancing (transaction costs and taxes) and the two methods for rebalancing, calendar and percentage of portfolio.

Calendar rebalancing is simple and less costly because there is no need for monitoring but it is unrelated to market behavior so costs may outweigh benefits if the portfolio weights have not moved much. The percent-of-portfolio method requires frequent monitoring but has a relatively tighter control on allocations especially in a volatile market.

Understand the effect of transaction costs, risk tolerance, asset correlations, and volatility on the optimal corridor width.

The buy-and-hold, constant mix, and constant proportion portfolio insurance methods are also highly testable and you absolutely must understand the differences and how to calculate affect on the portfolio given different types of markets.

Study session 16 in the CFA Level 3 curriculum concludes the portfolio management topic area with two readings on performance evaluation and attribution.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Level 3 Review, Risk Management



Study session 14 in the CFA Level 3 curriculum begins the readings on Risk Management with two readings (34-35). The Level 3 exam puts a lot of emphasis on the topic area and it is extremely testable. There is typically a question in the morning essay section, in fact last year was the first time since 2007 that there was no risk management essay. REVIEW THOSE PAST ESSAY QUESTIONS.

Risk Management
The reading starts of with some basic concepts and is important but secondary to the later material. Understand the advantages and disadvantages of both a centralized risk management system versus a decentralized system. A centralized system is led by a senior management employee within its own department and benefits from economies of scale and can provide an integrated picture of the company’s risks. In a decentralized system, each department handles their own risks and allows people closer to the actual risk to directly manage it.

Understand the different categories of risk: financial, non-financial, and sovereign  and the risks within each category:

Financial risks: market, credit, and liquidity
Non-financial risks: operational, model, regulatory and settlement

The measures of market risk are the more important material. You must understand standard deviation and value at risk, and the three methods of calculating value at risk.

Analytical- VAR = E® – z value (StDev)
Remember, you may need to adjust the standard deviation and expected return depending on the data provided and the question.  Daily StDev =Annual StDev/(square root of 250)
Historical Method- uses actual historical returns ranking in decending order and picks out corresponding return for the % probability. For example, if there are 100 observations and we want a 5% probability, then we would select the fifth worst return (or the average of the two closest).
Monte Carlo Simulation – generates random outcomes according to assumed probability distribution and a set of parameters to estimate the VAR.

Understand the extensions/supplements to VAR like stress testing and scenario analysis, as well as the performance measures like the Sharpe and Sortino ratios.

Currency Risk Management
The reading can get pretty detailed and quantitatively intense but you need to be able to work through all the hedging exercises. Pay attention to whether the question asks for the return in the local or domestic currency and whether the expected future value is hedged or only the principal.

Understand the differences between hedging with futures and using options. Futures are less expensive and appropriate when the investor risks volatility in rates but has a clear view of the direction of change. Options may be more expensive but provide more precision and are appropriate when exposures are uncertain with respect to timing and magnitude of exchange rate changes.

Understand the concepts behind strategic and tactical currency risk management. The three types of approaches are strategic management with a balanced mandate, currency overlay (tactical management), and treating the currency as a separate asset class.

Study session 15 in the CFA Level 3 curriculum concludes the readings on risk management with three readings on applications of derivatives.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Level 3 2011 Essay Question #3



You will always have an institutional portfolio management question in the essay portion. The question from 2011 was worth 26 points (14.4% of morning session and 7.2% of total exam points) while last year’s question was worth 34 points (almost 10% of your total exam score!).

Please download the essay and guideline answers from the CFA Institute’s website here.

We covered the reading on institutional investors back in February, linked here. Each type of institution (pensions, foundations, endowments, insurance, and banks) have their own special idiosyncracies but there are some commonalities as well. As with the individual investor material, you need to understand their risk and return needs and how the five IPS constraints fit into them.

The question from 2011 had five parts, each with a couple of sub-questions. I read the questions quickly to find out the specific data for which I am looking but a lot of candidates start by reading the vignette.  You absolutely must be practicing these old essay exams to figure out what information the Institute is looking for and how you will approach the questions.

Skimming the questions, we see that we need:

  • Return objective- *** Remember, this is an explicit statement of what the investor needs or wants. Just writing out a numerical return percentage won’t cut it. These are easy points, most of the objective will be a cut and paste from within the vignette. Things like, the investor needs to grow assets at a rate sufficient enough to cover X% of the institution’s spending needs and maintain the real value of the portfolio.
  • Calculate a required return- the instructions say SHOW YOUR CALCULATIONS for a reason. Show all steps to make sure you at least get some partial credit.
  • Factors in Risk Tolerance, remember risk tolerance is compose of both willingness and ability. You need to know what factors influence each. When in doubt, go with the more risk averse objective.
  • Liquidity and Time Horizon constraints for the IPS
  • Spending rule affect on goals and funding
  • More risk tolerance factors

endowments & foundations are often tested together because they are similar but with important differences.

  • Know the spending rules: volatility/riskiness in funding and why would you choose each
    • A simple spending rule is just a percentage rate times the portfolio’s market value. This rule can lead to volatile spending and would necessitate a lower risk tolerance to avoid volatility in the portfolio value.
    • A rolling three-year average rule is the percentage rate times the portfolio’s average value over the last three years. The rule helps to decrease volatility and can increase risk tolerance.
    • A geometric smoothing rule is the weighted average of the prior year’s spending (adjusted for inflation) and the product of the percentage rate times the portfolio’s market value. This rule also increases risk tolerance but places more emphasis on the recent market value of the portfolio.
  • Difference between endowments/foundations. A foundation may be the sole source of funding whereas endowments are usually a smaller part of overall funding. Foundations may have a limited time horizon whereas endowments are usually indefinite. Endowments do not have legally required spending levels.

Part A-

i. Most endowments and foundations, unless explicitly stated in vignette, are going to want to maintain REAL VALUE OF ASSETS. This means they must earn a return high enough to satisfy spending needs and inflation. The first two points in the vignette give you everything you need for the objective (maintain real value, long-term, fund 25% of annual op expenses)

ii. The institute will give you points for a geometric or arithmetic return (but you should know how to do the geometric return because it is technically correct).

Required return is going to be= spending rate * inflation rate * management expenses.

                * remember- the correct inflation rate is that applicable to spending (this case higher education) not necessarily general inflation = (1+ spending rate)*(1+inflation rate)*(1+mgmt. expense rate)
   * Know how to calculate your spending rate from the three spending rules

Part B-

Worth six points: one point for circling the correct answers in middle box, two points for ONE REASON stated in third column. ** Remember- graders are only going to look at your first response. Don’t waste your time putting down more than one response.

The guideline answer shows two possible responses, only one was asked for.

- For endowments, generally as funding increasesà risk tolerance increases because spending needs are lower proportion of total assets.

- As inflation increases, risk increases as well because it becomes harder to protect REAL VALUE of assets in portfolio and also satisfy spending needs

Part C-

Remember TUTLL, IPS constraints are just as important for institutionals as for individuals

Time- will generally be infinite for most institutional types or the vignette will say otherwise
Unique- usually explicit in case as well (endowments and foundations often have prohibitions against investing in ‘vice’ stocksà Socially-Responsible Investing)
Taxes- Endowments/Foundations are tax exempt, Banks and Insurance are Taxable
Liquidity- Annual spending needs for Endowment/Foundations, Very important for Banks/Insurance to fund claims and withdrawals.
Legal- UMIFA for Endowments/Foundations, Highly-regulated Banks/Insurance on the state level

Part D-

i. primary goal for endowment is usually spending with protection of real value- reducing portfolio risk will also reduce expected return and make it harder to cover spending and inflation

ii. LEARN THE SPENDING RULES! Three-year average rule will smooth needs thus lowering volatility

Part E-

Again, ONLY WRITE WHAT IS ASKED FOR. The questions asks for 3 factors (don’t write six and hope the grader will look for the best 3, they don’t do this)

For differences in risk tolerance, think about the IPS constraints that affect tolerance.

  • Time – Longer or infinite horizons will have longer to make up portfolio shortfalls
  • Liquidity – The need to fund a larger percentage of total institutional spending is an important one and makes for lower ability to tolerate risk. Spending rules that lower volatility (smoothing or the 3-yr average rule) will increase ability to tolerate risk.
  • Legal – remember foundations must spend a certain percentage to maintain tax status while endowments do not have this requirement
  • Additionally, other sources of funding and the yearly increase (inflationary or otherwise) in operating expenses are always important to needs

Guideline answer provided by Institute shows 7 possible answers, you only need 3

We’ll cover study session 14 in the CFA Level 3 curriculum next week. The readings start Risk Management, an extremely important topic in the Level 3 exam and definitely worth a couple of questions on the test.

‘til next time, happy studyin’
Joseph Hogue, CFA

2011 Essay Question #2 Individual Portfolio Management



We covered question #1 in the 2011 CFA Level 3 essay section last week. This week we look at question #2, probably one of the two most important questions you will study in your test prep. That’s because it is one of the two types of questions you will get on the exam and is usually worth more than 10% of your morning section score. The question in 2011 was worth 23 points (12.8% of total essay points) and combined with #1 made individual portfolio mgmt more than 10% of the total level 3 exam.

Please download the 2011 Morning Section and Guidelines answers from the CFA Institute’s website and follow along with question #2.

The individual portfolio management question will always be one of two types of calculations:

  • Single-period return like 2011: Look for clues like, “first year of retirement,” or, “cash flow required one-year from now.”  As with both types, SHOW ALL STEPS OF YOUR CALCULATIONS!
    - Make sure you include all cash inflows: pension, salary
     - Minus all cash outflows: living expenses, mortgage & debt repay, gifts
    - Investable assets: (do NOT include primary residence unless otherwise instructed)
     - When the time period is in one year and nominal:  Add the rate of inflation to the real return as in guideline answer (should be geometrically but graders usually give credit for added as well). Remember “real” return is without inflation.
  • Inflation is one of the points that gets many candidates, remember to multiply current living expenses by the rate of inflation. As shown in the guideline answer, (current expenses * 1+ inflation). For the required rate of return, the Institute will almost always take either a geometrically-calculated (after-tax r times 1 plus inflation) or just adding the inflation to the required return.

        – Rates of return on these questions are usually within the realm of reason (around 4-6% real, 6-10% nominal) so if you work the problem and get something like 15% or more, go over your calculations because you might have something wrong

  • The Institute usually keeps these questions and calculations fairly easy and in the same format. If yours is varying wildly, you may want to go back over the information and make sure you are not complicating it unnecessarily. Practicing several years’ worth of essay questions will give you a feel for what the Institute is asking and what they expect in an answer. Do not neglect these past essay exams!
  • We’ll cover the multi-period return question (2010 exam) in another post.

These questions will also include questions on the IPS statement.

** Though 2011 does not ask for it, many years will ask you to, “State the return objective portion of the IPS.” A lot of candidates miss easy points because they either forget this or think that the return calculation will do to satisfy it. NO! YOU MUST STATE A RETURN OBJECTIVE! Easy points, most of the objective is just copying from the vignette. Example: The Beckers’ objective is to retire at the end of one year and live off of investments after paying debts.

  - Include in return objective: the investor’s age and stage of life, inflation concerns, needed % required, other relevant facts of the case
- Do the return calculation before the return objective, as this will help with numerical requirements of return objective

Part B: Remember risk tolerance has two components (ability and willingness)

Factors affecting ability: long-term versus short-term (long-term means higher ability to TOLERATE RISK), Importance of goals (high importance means lower ability), size of income needs to portfolio size (very high % means lower ability)

Factors affecting willingness: These are usually statements in vignette (past losses and fear of future loss, desire a conservative approach)

** Remember: When the ability and willingness to tolerate risk are in conflict go with less overall risk tolerance. Example: high willingness but low abilityà investors have low overall portfolio risk tolerance.

Part C: I always remembered TUTLL as my acronym for the five IPS constraints. However you choose to remember them will work. Most of the questions in the past have centered around how the constraints affect risk tolerance (ability and/or willingness) so be sure to be able to tie them back to risk and return.

Don’t forget, you need to know these for institutional investors as well. Each institutional investor has a “common” constraint profile that you should remember. We’ll cover these in another post. 

Time- length of life stages is important as well as children’s ages, explicitly write how many stages and whether long-term or short-term (usually long-term)

Unique- large stock holdings or insider positions, client behavioral characteristics (socially responsible investing), any contradictions in the case

Taxes- tax-free investments, types of taxes (wealth, capital gains, income, estate)

Legal- Trusts, prudent investor rules

Liquidity- short-term living expenses, emergency cash, plans to pay off debt

Part D: Choosing a portfolio

- Choose from the portfolios that will satisfy minimum return requirements first (in this case, portfolio B has a chance of falling to 0 so is inappropriate)

- Part ii of Part D, question #2 is a good example of time management. Part D was worth 7 points (7 minutes) and was probably 3 points for #i and 2 points for each of the answers in #ii.

Do not spend half an hour on parts of a question that are worth marginal points! If you look at ii and have no idea (like I did when I took this exam in 2011), then move on and use the time on other questions. If you have extra time after answering the other questions, then revisit the harder questions. Many candidates run out of time in the morning because they spend an inordinate amount of time on the first two questions. The first two portfolio management questions are important, but not worth failing the entire exam because you got stuck.

We’ll cover more on individual portfolio management in other posts, but be sure to study the old exams on the Institute’s website, linked in a prior post outlining the FinQuiz strategy for the essay questions.

Let me know if you have any questions,
Joe Hogue, CFA

CFA Level 3 Review Equity Portfolio Management



Study session 11 begins the level 3 material on equity portfolio management which is worth 5-15% of your total exam score.  There is only one reading (27) and much of the material is more conceptual than quantitative.

Equity Portfolio Management
As with the fixed income portion of the Level 3 exam, a big part here is remembering the differences between active and passive management. The advantages/disadvantages lie on a continuum for tax efficiency, fees and expected return.

Know the advantages/differences between ETFs and mutual funds. ETFs trade throughout the day, do not require shareholder recordkeeping, are more tax efficient because of in-kind redemptions, and do not have high exit costs. The one advantage of mutual funds is lower licensing fees.

Know the three main categories of investment style: value, growth and market oriented. Be able to determine the style from performance or fundamental data on the portfolio like price multiples, volatility, dividend yield, etc. Value styles will usually have lower price multiples, higher dividend yields, lower volatility.

The holding-based and returns-based style analysis is extremely testable and often shows up in the morning section. Understand the advantages and disadvantages of each.  Make sure you can use the output from the analysis to identify the management style as small-cap, large-cap, mid-cap and be able to determine style fit and drift.

The information ratio is easily testable and worth the small amount of time to memorize. It is fairly intuitive once you think about it. An investor’s (value) is a function of his depth of knowledge (IC) and breadth of knowledge (IB).

Be able to calculate the components of active return including misfit active risk, true active risk and total active risk.

I have the 2009 morning section of the Level 3 exam along with the guideline answers, originally released by the Institute but no longer available on the website. The exam includes a good practice question on equity portfolio management. Leave your email in the comments below or email me at info@efficientalpha.com and I will send you a copy.

Study session 12 concludes the material on equity investments with three readings on governance and international investments.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Level 3 Review, Asset Allocation



Study session eight in the CFA Level 3 curriculum includes two readings (21-22) in asset allocation. The material is often tested along with the individual and institutional questions in the essay section so make sure you understand the concepts well enough to synthesize the material.

Asset Allocation
A key focus of the CFA curriculum is based on strategic asset allocation, building a long-term mix of assets given the investor’s IPS and market expectations. Understand that tactical asset allocation is based on short-term expectations for relative performance among asset classes and does not change the long-term strategic mix.

The difference between asset-only and asset/liability management is an important one. ALM involves the explicit modeling of liabilities and adapting the asset allocation to meet these liabilities whereas asset-only is focused on meeting a total return target. ALM is usually more appropriate for some institutions (i.e. banks, insurance, and sometimes pensions) but may also be applied to individuals with extremely low risk tolerance and a stated desire to meet liabilities.

The five criteria for asset classes might be good for a random question and is fairly easy to memorize. The way I did it was to understand the concept for each and associate it with one word, then remember the first letter of each word (H-M-D-P-L) for easier recall.

  • Homogenous – similar attributes within a class
  • Mutually exclusive – overlapping assets will blur the effectiveness of the process
  • Diversifying – important for risk management and correlations
  • Preponderance of world investable wealth – important in developing the risk/return tradeoff
  • Liquidity- to avoid high transaction costs and the ability to rebalance when needed

Understand what makes alternative investments different (i.e. liquidity, information asymmetry, higher cost of investment)

Understand the concepts as well as strength/limitation behind the different approaches: mean-variance, resampled efficient frontier, Black Litterman, Monte Carlo simulation, ALM, and experience-based.

The material tying individual and the specific institutional investors to asset allocation is often tested in the morning section. Make sure you know the differences (needs) across each and look through the old exams to see how it is tested.

The Case for International Diversification
This is largely a conceptual reading so just focus on getting the idea. Calculating the currency return and the investment return, as well as the currency contribution to risk is easily testable.

Understand the reasons economies may move independently: government regulation, technological specialization, fiscal and monetary policy, cultural or sociological differences.

Understand the reasons against international diversification: increasing correlations over time, increasing correlations in times of higher volatility, free trade, integrated capital markets, mobility of capital, multi-national corporations.

Understand the hurdles to investing internationally: transaction costs, regulations, taxes, currency risk, political risk, lack of familiarity, and information asymmetry.

Study session nine covers two readings in fixed income. The topic counts towards 10%-20% of your exam so be prepared to spend some time.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Level 3 Review, Institutional Portfolio Management



Study session five in the CFA Level 3 curriculum covers Portfolio Management for Institutional Investors (reading 15-17). You are guaranteed to see an essay question on the material so make sure you devote some time to studying and work through the questions on the previous exams.

The fact that you need to learn the material from the perspective of five different institution types makes it slightly harder than the individual portfolio management section but it’s still easily within reach.

Managing Institutional Investor Portfolios
As with individual portfolios, the focus here is on the IPS components (risk, return and the five constraints) and how they differ for each institutional type.

Return

  • Pensions have an income need with current retirees or an older workforce and a capital gains need for sustainability and a younger workforce. Liquidity and the need/desire to decrease future contributions will also factor
  • Foundations may have a payout requirement and but generally no contractually obligated requirement. Endowments need to meet spending plans for their university or beneficiary. Both should have a total return approach.
  • Insurance companies may differ slightly whether it is life or non-life but generally seek returns for spread management or reduce premiums
  • Banks return requirement is usually determined be the cost of funds and the rate spread

Risk Tolerance

  • Pensions tolerance depends on the age of workforce and time horizon, surplus on pension, and the company’s balance sheet strength
  • Foundations and endowments generally have a relatively high risk tolerance due to infinite life and spending needs relative to total budget
  • Insurance companies have low tolerances and are often Asset-Liability Managed
  • Banks have low tolerances due to high liquidity needs and are often Asset-Liability Managed

Time Horizon

  • Institutionals normally have very long time horizons (increasing risk tolerance) due to corporate nature. Insurance companies have shorter horizons depending on actuarial needs of claims. Banks tend to have shorter horizons due to shorter-term liabilities.

Unique Circumstances

  • These are more rare and will be stipulated in the vignette. Look for moral/ethical considerations in endowments and foundations.

Taxes

  • Banks and Insurance companies are taxable entities while pension plans and endowments are not. Foundations may be taxed under a certain structure but it is generally not the case.

Liquidity

  • Pension plan liquidity depends on age of workforce, proportion of retired/active lives and any special payout stipulations.
  • Spending rules are very important and very testable for the foundation/endowments. Make sure you know the methods (simple, rolling and geometric) and how it affects risk tolerance. Liquidity for foundations/endowments is generally low.
  • Liquidity for Insurance companies and banks is paramount and relative to liabilities. This is why the ALM section is important for the two types of institutions.

Legal Considerations

  • Generally not an issue for institutionals. Understand that pensions fall under ERISA and the prudent investor rule governs pensions, foundations and endowments.
  • Insurance and banks are regulated at the state level and must meet regulatory requirements for liquidity

Linking Pension Liabilities to Assets
Understand the difference between an asset only approach and liability-matching. Asset Liability matching involves constructing a portfolio directly relating to the maturity needs of the liabilities.

Be able to match a sample portfolio with different weights in different asset classes to the needs of a plan (i.e. if a plan is indexed for inflation it will need to have some nominal bonds, if growth is needed it will need a higher weight to equities). Question #3B in 2010 is good practice for this section.

Allocating Shareholder Capital to Pension Plans
The concepts are more important here than the formulas. Make sure you understand how the relative allocation to equities or fixed income affects risk and the total asset beta. With a larger allocation to equities, asset risk increases and the beta increases. The company will need to decrease debt financing in the capital structure to keep the company’s equity beta the same.

Understand the effect of including pension assets and liabilities to determine firm WACC and how it affects the operating WACC and allows the firm to take on lower value projects.

Study session six in the CFA Level 3 curriculum covers capital market expectations and is a fairly conceptual reading. Let me know if you have any questions or comments.

‘til then, happy studyin’
Joseph Hogue, CFA

CFA Level 3 Review, Private Wealth Management



Private wealth management, along with the next study session on institutional management, is probably the single most important portion of the CFA Level III exam. The first questions in the morning are ALWAYS Individual followed by Institutional portfolio management. Learn these sections, be ready for them on the exam and finish your first two questions with confidence!

Practice is really the key with the essay questions. Working through old exams, you get a sense of how the Institute frames scenarios and questions. The old exams released by the Institute also have the guideline answer (max points) so you get an idea of what the graders want.  Being able to practice how you are going to BRIEFLY get your answer across is a huge help. I worked through seven years of old exams and had no trouble with the morning section.

** Practicing old exams will also help you get in the habit of writing again. If you haven’t hand-written anything in a while, you do not want to wait for the 3-hour exam to see how much your hand starts hurting!!

We posted the link to the Institute’s site last week to access the last three years’ essay questions and guideline answers. Make sure you click through to download the exams. We will cover as many of the questions as we can before June. ** Click on “Level III” in the Finquiz Blog menu above and scroll down for the essay questions we covered last year.

Managing Individual Investor Portfolios

The first question on the essay section will always be individual portfolio management and it will be one of two types of calculations, a single period return or a multi-period return. We’ll cover the keywords to watch out for and how to work through each calculation in subsequent posts.

Some of exams specifically ask you to state a return objective:
- Include in return objective: the investor’s age and stage of life, inflation concerns, needed % required, other relevant facts of the case
- Do the return calculation before the return objective, as this will help with numerical requirements of return objective

Remember the constraints!
TUTLL!
TUTLL!
TUTLL!

Time- length of life stages is important as well as children’s ages, explicitly write how many stages and whether long-term or short-term (usually long-term)

Unique- large stock holdings or insider positions, client behavioral characteristics (socially responsible investing), any contradictions in the case

Taxes- tax-free investments, types of taxes (wealth, capital gains, income, estate)

Legal- Trusts, prudent investor rules

Liquidity- short-term living expenses, emergency cash, plans to pay off debt

Taxes
The reading can get pretty detailed but I would concentrate on the conceptual material and the basic equations. Understand the different tax regimes and the treatment of different gains (interest, dividend and cap gains).

Be able to do the basic calculations like accrual taxes, deferred cap gains, accrual equivalent rate and returns.

The differences and advantages between the different tax-advantaged accounts is important so be able to tell where an asset should be placed and calculate basic returns.

Estate Planning

A few terms are important to remember like testament, probate, forced heirship, claw-back, safety reserve, and the different types of trust (revocable, irrevocable, fixed, discretionary, spendthrift).

Be able to calculate the relative after-tax value between a tax-free and a taxable gift as well as the value from generation skipping. As with many of the equations here, the mathematical representation is more intimidating than the concept. Try to talk through what is happening (i.e. capital is growing for n years then taxes are coming off the total) and many of the problems will become clearer.

Understand the difference between the credit, exemption and deduction methods under the residence/source conflicts. The credit method allows for a complete reduction of taxes paid while the deduction method only allows the taxes paid to come off of income.

Be able to work with the information from a mortality table to calculate core and excess capital. Remember, the probability of joint survival equals Prob(husband survival) plus Prob(wife survival) minus the product of each survival.

Low-basis Stock

The reading on psychological considerations and risk, investor stages and attitudes is strictly conceptual. Make a brief outline of the concepts with definitions and be able to reproduce a one or two sentence reasoning on the exam. *Again, looking over past exams will help tremendously in seeing the depth of understanding that the Institute is expecting.

 The rest of the reading basically a comparison of the advantages/disadvantages between the different diversification/sale techniques. A table listing these for sale, public exchange funds, private exchange funds, completion portfolio, and hedging should give you the basic idea.

  • Sale: max flexibility but possibly highest taxes
  • Exchange funds: diversifies portfolio without recognizing gains but include mgmt. fees, lockup period and may not be able to adjust holdings
  • Completion portfolios: diversifies holdings, provides cash without recognizing gains to the extent of loss harvesting but the investor may need considerable other assets and take a lot of time to reach goal
  • Hedging: fast and can monetize the position but the upside may be limited and their may be regulatory risk on a constructive sale

Human Capital, Asset Allocation and Insurance

Don’t get bogged down with the few equations in the reading. Instead understand the meaning behind the equations and the models.

Understand the difference between human capital as a risk-free asset and a risky asset and its impact on the investment decision (i.e. stability of future income and whether the financial assets should be in risky investments or stable investments)

 Understand longevity risk (risk of ruin) is the risk of outliving your assets and the differences between fixed-payout and variable-payout annuities. The fixed-payout risks losing purchasing power from inflation over time and locks in the rate.

Study session five in the CFA Level III curriculum covers institutional portfolio management and will be the second essay question on the morning section of the exam. We will cover the key concepts and formulas in next week’s post and then hit some past essays in subsequent posts on the blog.

‘til next time, happy studyin’
Joseph Hogue, CFA

CFA Level III Review, Behavioral Finance



The material in behavioral finance is historically tested in the morning essay portion. Within the vignette, often within one of the first two portfolio management cases, there will be some information on the advisor or investor that displays a concept or bias. You will then have to identify the bias from a list and justify it with a reason.

Question #4 in last year’s morning section was worth 17 points for 4.7% of your total exam score (click here for the complete morning section and guideline answers).

Question #4A
Most of the points on behavioral questions in past exams have revolved around identifying a bias/error given a client interview. Reading through the curriculum and doing enough practice problems, you will begin to pick up on keywords associated with the terms. These will be the words that tip you the answer on the exam.

Regret aversion, loss aversion and status quo bias are often and easily confused. For status quo, the idea revolves around the lack of action so look for words or ideas like “inactivity” or “no change.” Regret aversion is often signaled with a bad trade or loss in the past leading to fear of more loss, so look for this historical precedent. Loss aversion is focused more on preferences and the utility behind gains and losses.

Question #4B

Mental accounting is one that comes up often in the essays. Look for words like “separate accounts” or “layered-pyramids” and “buckets” to convey the idea that the investor has the bias. Remember, the portfolio should be viewed on a holistic basis or all-together. Keeping your net worth in “separate” accounts does not really change anything.

Anytime you hear someone talk about the ability to control, or influence the performance of their investments directly, it is a tipoff for illusion of control. Consequences are excessive trading and inadequately diversified portfolios.

Question #4C
The answer here is basically two reasons from the list of differences between cognitive errors and emotional biases. Lists of procedures, strengths/weaknesses, differences between methods and applicable situations are the prime material for concept questions across the CFA exams.

Behavioral Finance
This always seemed to me like the lead-in reading to the biases and not that important other than the general idea. Understand the difference between traditional finance and behavioral finance (in traditional finance, individuals are assumed to be rational, risk-averse) as well as the difference between the expected utility and prospect theories. I wouldn’t worry too much about detail here, just get the concepts and move on.

Behavioral Biases
This is almost entirely a list reading which lends itself well to an outline format of notes or flashcards. If you look through old essay exams released by the Institute, you will see that this is the reading that gets questioned the most (many times, it is the only reading questioned).  Focus on the definition of each bias, consequences for a portfolio and how an investor/advisor might overcome it.

Behavioral Finance and Investment Process
Know the limitations of classifying investors into types and the main idea behind how to advise each type. A big part of the behavioral material revolves around how the investor’s type affects their risk tolerance so pay attention to that.

The material on passive and active investors has been around a while. Remember that passive investors are usually the more risk-averse while active investors usually want more control/interaction in the decision-making process.

Understand how naïve diversification and home bias affect portfolio construction. Naïve diversification, often in DC plans is simply allocating an equal sum to each option.

The biases on analyst forecasts and behavioral finance is also important so make sure you study them along with the investor biases.

**We will try to go over as many of the essay questions from previous years as possible during our 21-week plan. You absolutely must work through these essays and study the guideline answers! Practicing with the actual exams from years past is the best way to get ready for the CFA level 3 exam. Posted here are more details on the CFA Level III format and how to study for the essay portion.

‘til next time, happy studyin’
Joseph Hogue, CFA