Juggling Family and a Social Live with the CFA Exams

I was always impressed by fellow CFA candidates managing to study for the exams while also making time for their families. I worked throughout the three years, but was only married just after the level II exam. I didn’t have to face disappointed children each weekend when I would retreat to my office to study.

Then again, I was also a little jealous of the candidates still in college that seemingly had all the time in the world to study. The fact is, we all have social lives that are going to be vying for attention during the process. Some people have a greater demand from others (wife & kids), but we all need to find that happy medium.

Two issues are important though, one is being around someone who is going to be supportive of your goals and willing to sacrifice a little for what you need. Finding your ‘soulmate’ and keeping friendships is important, but those true friends or partners are going to be there through the tough times as well. If they expect you to put aside your goals for the sake of a little extra time now, expect to do that for the rest of your life and never achieve what you need.

The other, more important issue, is spending time with those that will support you and will sacrifice a little time for your needs. This doesn’t mean completely neglect them for the next three years while you are studying. Here, you are going to need to make sacrifices as well. Whereas before I was married, I could study for the exam any time of day, during the level III exam I rearranged my study hours to late night or early mornings on the weekend. Waking up at 7am on Saturday is no fun, but it can get you a couple of extra hours. You may also try starting the curriculum earlier in the year. Starting a couple of months earlier lets you spread your time out to maybe 5-10 hours per week instead of cramming everything into the last few months.

As I’ve recommended in a prior post, encouraging the family to get involved in their own extracurricular activities can grab another few hours of study time per week as well. You may also need to study somewhere other than home. A wife or friends can understand if you need a little quiet time to study, kids won’t. Little Johnny will understand that mommy is at work, but may not understand if she is at home but cannot play right now.

The old cliché of ‘quality’ time is important here. Just as spending time interacting with your friends and family in a meaningful way justifies fewer total hours with them, you need to be focusing your study time in a meaningful way. I know the ‘purist’ route is to rely on the official curriculum but, in my experience, it is just too long. I could work through study guides at least twice in the amount of time it usually took to get through the curriculum books. That, combined with the fact that the curriculum is extremely dry (academic) at points, and I never made it entirely through the curriculum books for any of the three levels.

Studying for the CFA exams does not mean the end of your social world. Even the most committed candidate probably doesn’t need more than about 15 hours a week studying. Juggling a social life and the CFA might be a little harder for some, but it just means keeping a strict schedule and using the best resources possible.

Wednesday, we’ll cover the capital market/portfolio management section of the level II and look at the economics essay question in last year’s level III exam. ‘til then, happy studyin’.
Joseph Hogue, CFA

Forget Time Management. You Need Behavior Management!

There are five weeks left and let’s face it, many are wondering if there is enough time left to prepare for the exam. Scene jump to candidates frantically surfing the internet for time management tips and tricks.

Problem is, for all but the most overworked of us, time management really isn’t the answer. Even the best time management techniques are not going to give you 25 hours in the day. What you need is behavior management, and to use your time differently.

Before we go further, understand that it takes between 8-12 weeks to break a bad habit and form a good one. If you get home from work and are habitually inclined to plop down in front of the tv for a few hours, you are not going to break this behavior before the exam. It is going to take commitment to get in the time you need, along with a strict schedule.

So, if you are not going to be able to change your behavior in time, you need a strict plan that will keep you on schedule. Stick with your habit-changing routine and you might be able to rely on behavior for next year’s exam.

Poor Time Habits

The culprit in most of our lack of time is those little time-wasters that only take a few minutes but break our concentration and add up to hours of study time. Most likely you realize what these are but are ‘powerless’ to stop them. What you need is a counter-behavior that will not allow you to waste time. A few ideas:

  • Turn off the cell phone during study time. Tough, I know, but is it really that big of a leap to think you will be unreachable for a couple of hours.
  • Disable your Wi-Fi connection.
  • Unplug the TV, or better yet, give the plug-in wires to someone and tell them when to return them.
  • Reserve a study room at the library or another secluded spot. Being away from everything else forces you to concentrate on the one thing available.

Are you fine once you get started, but always seem to lose track of time? Set a reminder on your cellphone or through email to go off daily just before your study time. Don’t use it as your personal snooze alarm though. When the alarm goes off, you MUST start studying.

Ever hear, you have to spend money to make money? Sometimes it helps to spend a little time to find more time. Spend five minutes each morning explicitly planning out your day and when you are going to study. Don’t be too restrictive, give yourself a little bit of time to relax. Actually writing out a schedule will help keep you from finding ‘other’ ways to occupy yourself throughout the day.

Set time limits for tasks, even those that are unexpected. Be realistic and give tasks their priority, but don’t be overly generous to the point that it squeezes out study time. If a task looks like it is going to go over on time, try to prioritize what needs to be done today and allot some time to finish tomorrow.

As mentioned in a previous email, find the right resources for the right study breaks. You probably won’t be able to pull out the curriculum to study every time you have five minutes free, but you might be able to carry around a set of flash cards or some topic summary sheets. A lot of the exams are conceptual information that can be learned by repetitive review. Reviewing concepts during short breaks will save more time in your sit-down study sessions for practice problems.

Incorporate some of these ideas into your daily routine. Just because its July doesn’t mean you do not need to be studying something. After the exam in June, sit down and plan out a study program or a few hours per week to research other areas of your job. If you stick to a schedule long enough, you’ll break some of those poor study habits and will make next year’s exam so much easier.

All for today. ‘til next time, happy studyin’
Joseph Hogue, CFA

Level III CFA Exam: essay question #3 2009

Question three on the 2009 Level III exam was worth 24 points, or almost 7% of the total exam points available. Combined with question #4, another on institutional portfolio management worth 11 points, the material on institutional pm was worth close to a tenth of the exam.

This post will complete the series of six blog posts, reviewing the last three years’ individual and institutional essay questions. Please download the exams and guideline answers from the CFA Institute and go over these questions again before June. The first two questions, always individual and institutional portfolio management, are usually worth around 15% of your total score and you WILL NOT PASS without good points here.

Question #3 in 2009 was a defined benefit pension vignette about Wirth-Moore company and the Foundation-for-the-Future (FF) foundation. As always, I skimmed through the questions before reading the vignette.

  1. The first question asks for a return objective and REQUIRES calculations. Pay attention whether a question says, “show your calculations,” or not. Return objectives for institutionals are usually pretty easy and come from a few items straight from the vignette. The standard form is: (required distributions or return)*(appropriate inflation rate)*(management expenses). Adding the three numbers will get you points but the multiplicative approach is technically accurate.

Don’t forget to throw in a few qualitative statements as well, usually something like preserving real value of the portfolio. Also, be sure to use the appropriate inflation rate or that which is most directly related to spending. The traditional example is healthcare or educational inflation being higher than general consumer inflation.

  1. We’ve covered ability and willingness to tolerate risk quite a bit in other posts. Ability is usually tied to some quantitative measure like how high is spending relative to total portfolio assets? Willingness for risk almost always comes out of qualitative statements made in the vignette or by the participants like desiring a high return or previous experience with loss.

Foundations usually have a greater ability for risk because they are not contractually obligated to make payments as are banks/insurance/pensions, nor does the charitable cause depend on them for spending needs like endowments.

  1. Liquidity needs for an institution are all contributions minus spending needs for the year. Since foundations have a certain percentage they must spend to avoid taxes, this is usually the spending needs plus management fees.

Time horizons for institutionals are almost always single stage, long-term if they are to remain a going concern. Look for clues in the vignette for whether the company will stay in business or may close.

  1. The smoothing rules are fairly important but you really only need to know a few things. Understand how to calculate the geometric and the rolling three-year rules.  Understand the order in which each is when it comes to volatility of spending (single-year most volatile) and that using a smoothing rule increases the institution’s tolerance for risk because of the lowered volatility.
  2. Part E is a little harder here only because you have to get all your info from the vignette rather than using a few rules-of-thumb concepts. Look to the quantitative information for quick clues (i.e. the five-year lockup on funds and the $2.5 million minimum).

After reading through the questions, you are ready to read the case and make notes when something looks relevant or important. For pensions, you always want to look for the proportion of active to retired lives and whether the payments are inflation-adjusted. Fewer active workers will mean lower risk tolerance and adjusting payments for inflation will mean you need some equities or TIPS in the portfolio to hedge price increases. The financial health of the company and cyclical correlation between company/pension assets is usually important as well.

***Watch for contradictory or changing information in the follow-up questions. I got a question last week on one of the individual pm essay questions. The guideline answer did not make sense from data provided initially in the case. What the candidate did not see was the information update just before the question. Notice that on many of the questions, there is a small paragraph of additional information (i.e. just before questions D and E on page 16 of the exam). Use this information for the question, even if some of it contradicts or changes data previously written in the vignette.

For the rest of the level III posts until June, we’ll cover a few of the other essay questions from the last three years’ exams. Let me know if there is any particular question you are having trouble with and I’ll try to cover it.

Thanks and happy studyin’
Joseph Hogue, CFA

How to Use Your Financial Calculator and Which One is Better?

It seems candidates find every little thing to worry about. You are only allowed to use one of two calculators on the exam, the Texas Instruments BA II Plus or the Hewlett Packard 12C, and the forum boards are filled with questions on which one is better and how to best use the calculators.

I never used anything other than the BA II Plus but have heard that the HP is just as good. Both are pretty much the same price and available in most electronic stores. So there really isn’t an answer to the question of which one is better. Probably the best advice is buy your calculator early so you can practice on it during your exam prep.

The calculator cover, keystroke card, a small screwdriver, and loose batteries are the only calculator-related items you will be allowed to bring into the exam. Frankly, if you need to refer to the keystroke card during the exam, you haven’t practiced enough. A lot of people bring in extra batteries and the screwdriver. I bought my calculator before taking the level I exam and used it through the three years of studying. I did bring the screwdriver and spare batteries for the third exam, but didn’t need them. The odds are huge that you will never need to change out the batteries, but you might as well bring them just in case. If you really want to plan ahead, try changing out the battery sometime before the exam so you know what to do.

If you do need to change the battery, do not forget that you will need to reset the decimal places by [2nd] -[format] -(# of decimal places) -[enter]. I usually set mine for four decimal places but I’ve heard others using five as well.

**Remember** Always clear out your prior work before beginning another problem. Don’t think that you will always remember to replace old data with new data, because that one time you do not do it will mean valuable points. Clearing out the memory is easy if you just make it a habit of clearing your work at the beginning of a calculation. [2nd]- [CLR TVM] or [2nd]- [Data] -[2nd] -[Clr work] -[ce/c]

**Remember** In a time value calculation, you need to enter one of the inputs (pv, pmt, fv) as a negative number to represent outflows. The most common is to enter present value [PV] as a negative amount.

Ordinary annuities are received at the end of the period and entered as a normal TVM calculation. Annuity Due calculations must be set up on your calculator to represent cash flow at the beginning of each period. [2nd] -[BGN] -[2nd]-[SET]

It is tempting to neglect the variance and standard deviation formulas because the calculator will compute them for you, but trust me, you need to learn these for the exams (especially some of the more intense stuff at level II). I was never anything like a math whiz but I spent the time to understand what was happening in the formulas and it made everything much clearer and easy to remember.

The user’s guide for the BA II Plus is available here.

Honestly, it’s been a while since I used my calculator for some of the formulas so I’m sure there are uses and tricks that I haven’t mentioned here. Please use the comment form below to include any tips you’ve come across so we can get a good list going.

‘til Friday, happy studyin’

Joseph Hogue, CFA

Formulas on the CFA Exam: Which do I REALLY need?

This is something that all candidates come up against, especially while studying for the Level II CFA exam which is extremely formula-intense. Whether there are in fact ‘unnecessary’ formulas or not, the temptation is strong to ‘game’ the exam and only focus on the stuff with higher odds of showing up in questions.

The short answer is DON’T DO IT! The curriculum states in the front of the books that, “every question on the CFA examination is based on a specific page in the required readings and on one or more LOS. Frequently, an examination question is also tied to a specific example highlighted within a reading or to a specific end of reading question and its solution.”

Though, it appears that the exams focus strongly on actual LOS the above paragraph leads me to believe that anything in the readings is possible exam questions. Further, though an LOS may not explicitly require calculating something it might be implicitly necessary to arrive at a decision or to understand the LOS. With around 50% of candidates failing each exam in any given year, you need all the points you can get and can’t afford to miss from guessing wrong at which formulas might show up. The time spent studying to earn your CFA designation is miniscule relative to the big picture. Spend the time necessary to learn this material, no matter how long it takes and be a stronger professional for having done it.

The long answer, of course, is more complicated. The fact is, unless you’re one of those quant geeks that I secretly envy but openly deride, you are not going to be able to memorize all the formulas in the curriculum. There is an element of gaming the exam in that you have to spend the time on the topics and formulas that you will be able to pick up and less time on those where time is less well-spent.

There are really two issues here. One, some formulas within the curriculum don’t seem to be a focus or are not explicitly mentioned in any learning outcome statements (LOS). With so much material, why would you spend time on stuff with a lower probability of being tested? Secondly, some of the formulas are extremely intense and difficult, and the range of material is extensive. It is tempting to skip material that is more difficult.

The problem with the first issue is that, despite what you may hear from other candidates or through rumors, since we can’t talk about questions on the exams you really can’t know what will be on the test or not. I would play it conservative and say that ANYTHING written in the curriculum is testable despite not being explicitly mentioned in an LOS.

The problem with the second issue is that, after dismissing a topic or formula, it becomes extremely tempting to dismiss others. Before you know it, you are only reading half of the topic areas and neglecting a large section of the curriculum. Try looking for help on internet forums or from other candidates that have tackled the formula. Check out some of the study notes or summary sheets that might be able to explain it a different way.

I ran into this myself on the level II exam. After several hours on swaptions pricing and valuation, I still was not confident that I could replicate the procedure on the exam. I could have spent a few more hours on the topic, but chose to spend the time on other areas. I got the general concept down so I might be able to make an educated guess on the test, then moved on to other topics.

Before totally dismissing a formula, at least try to get the concept of what is happening. One, this will most likely make it easier to memorize the formula since its not just rote learning. Second, you may be able to make a better educated guess on the exam.

The best advice I can offer is that which you’ve already heard. Focus on end of chapter questions and blue-box examples. These should give you plenty on which to concentrate. Work your practice exams and make sure you have at least 70% or higher in all topic areas. Will you see every formula on the exam, no. Do you need to be able to answer every formula that even makes it to the tests, no. You need to get 70% or better on the exam and you need to spend your time getting the most information learned as possible. If this involves just getting the general idea on some material to be able to quickly move on to other areas, then so be it.

All for today. ‘til next time, happy studyin’
Joseph Hogue, CFA

Six Weeks Left! Where did the Time Go?

I am in a very happy place right now. There are six weeks left before the 2012 CFA exams and I don’t have to worry about it! I can guarantee you, this will be a very good Memorial Day (May 28th here in the U.S.) for me.

You, on the other hand, need to assess where you are in your test prep and kick it up a bit if needed. You should have taken at least one practice exam, but preferably more to see in which topics you need more work. You need to be above 70% consistently before you go into the exam so averaging less than 60% in a topic at this point is a problem.

Depending on where you are at in your preparation, you may need to step up the hours spent each week and focusing on the resources that are going to get you the most points with less time commitment.


  • Study guides are still going to be your ‘core’ resource. Hopefully, you don’t need to re-read all the material but you should try to get through your problem areas again.
  • Flash cards! I’ve covered these in a previous post. This is one of the most useful resources at this point because you can carry them around easily and focus on specific questions/formulas.
  • Topic area summaries are worth the cost for their portability. Not quite as useful for formulas (practice is best) but you can easily review a summary page a few times a day and get core concepts down.
  • I would be spending the majority of time on practice problems and mock exams. Don’t just grade your answers but study the guideline answer for those you got wrong. I cannot think of a better way of focusing in on the stuff you don’t know yet.

If you are not feeling comfortable with your level of preparation, or aren’t scoring well on mock exams, you need to find some extra time each week to ratchet up the studying. This may be tough for those that waited too late to begin and are already studying 20+ hours per week. Either way, you need to find some extra time unless you want to be in a very unhappy place around August.

Finding more study time:

  • Try writing out a quick outline of how you spent your time over the last few days. How much TV did you watch? Did you meet up with friends or family? What did you do for lunch? The idea is not to account for every minute but to see where you might be able to get in some extra time for studying. Be honest and realize that a six-week deadline means cutting back on everything but the essentials.
  • If you need to, cut back on sleep in 10-30 minute increments per week. I usually get between 7-8 hours but was able to cut back to 6 hours during my last few months of exam prep. I would not recommend less than 6 hours for an extended period of time (your brain won’t be working right anyway so what’s the point). Don’t try to cut back all at once either, just shave off a half hour each week or so.
  • Those flash cards and summary pages are great for carrying around and using during lunch, waiting in line, or any time you have more than 10 minutes free.

Most of all, you are going to need to understand that sacrifices need to be made. If you need to go out with friends and family less to be able to pass the exam, then do it. It is only for another 6 weeks, then the party begins!

Use the comment box below to let me know where you are at in your preparation. I’m interested in hearing where the average candidate is right now. Thanks.

‘til Monday, happy studyin’
Joseph Hogue, CFA

CFA Level III Essay Practice: 2009 Question #1

Question #1 was, as always, an individual portfolio management question. In 2009 it was worth 26 points, or about 7.2% of your total exam points. Download the exam and guideline answers from the CFA Institute to follow along with the discussion.

We’ve covered the individual and institutional portfolio management essay questions in the 2011 and 2010 Level III exams already. See prior posts for practice and a general strategy.

Skimming over the questions, I know that I need to look for:

Ai. Don’t forget to explicitly write out a return objective! Look for copy/paste stuff from the vignette like estate gifts, funding expenses and preserving capital after inflation, and any special inflows/outflows mentioned. The objective is anything the investor wants or needs to do with their money. When I took the exam, I did this one after the return calculation so I could also put in the relevant figures (i.e. total assets, return % needed, expenses, etc.), it’s not always required in the guideline answer but it can’t hurt.

Aii. A few clues should jump out in the question, ‘pre-tax nominal’ and ‘first year’. Pre-tax means you are going to need to gross up the net income needed for taxes. The tax rate is always given so just divide income needs by (1-tax rate).

‘First year’ signals one of two questions you will definitely be getting on the exam, a one-year return needed for retirement. The other question is the multi-year return needed for retirement in the future and one where you will use your calculator (covered in previous essay posts).

Do Not Forget to Show Your Calculations!! Don’t throw away easy partial credit! Even if you miss the final answer, you will still get some points for having: Cash Inflows, Outflows (expenses), Investable Assets (minus debt payoff), Return Calculation (with inflation). Of the twelve points available for Part A, I would guess about 3 points are for the return objective and nine are for the return calculation (but only 3-5 are for the correct final answer, meaning you may still get 4-6 points even with a wrong return).

Practice setting your calculations up exactly as they are shown in the guideline answer, with headings and format.

Bi. Ability to take risk is usually going to be more quantitative information. What is proportion of expenses to total assets? (Around 5% or less will be higher tolerance).  Will they have any other funds besides investments? How important are planned spending needs? (They don’t necessarily NEED that vacation home in Malibu, so higher tolerance). Is retirement within a couple of years?

Bii. Willingness to take risk is usually explicit statements by the participants in the vignette. Look for past experiences that might make them fearful of losses, conservative or risk-taking behavior, attitude toward loss.

Ci. Liquidity constraints are debt and/or expenses stated in the vignette. The typical needs are paying off home-mortgage and paying for children’s tuition.

Di. Always talk of time horizon in ‘stages’ separated by significant life and spending events. Events that usually delineate stages are: working career (accumulation), paying for tuition, and retirement. Always list out the relevant time in years for each stage as shown in guideline answer (retirement is usually set at 25 or more years, we don’t need to put an explicit time on their death).

We’ve now covered the last three years essay questions for individual portfolio management. I would recommend working through them one more time along with making sure you understand the key concepts for the topic area. This first question on the exam can be EASY POINTS! The range of questions is fairly limited to return objective statements, calculating returns, and describing risk tolerance and constraints. There may be some tax or wealth transfer stuff thrown in for good measure, but you should be able to pick up some good points here. BE READY!

Please let me know if you have any questions. This is important stuff and can be some seriously easy points! ‘til next time, happy studyin’

Joseph Hogue, CFA

CFA Level II Exam Review: Dividend Policy and Safety

Much of the Corporate Finance topic area is conceptual and the points can be picked up through a quick run through your study guide and a few times with summary sheets. We’ll review some of the ideas hear but don’t neglect the section completely. Get the concepts and basic formulas down and then spend the extra time on problem areas.

Types of Dividends and other Forms of Shareholder Returns

Dividends are usually paid out on a regular or special basis. Regular dividends fromU.S.companies are paid on a quarterly basis with the holder-of-record date two business days after the ex-dividend date. The ex-dividend date is the first day the shares trade without the dividend so anyone with the shares on the day before will receive the dividend on the payment date.

Special dividends, more often from cyclical companies experiencing a profit windfall, are rare and set by the board of directors. Liquidating dividends may be paid to shareholders when a company dissolves and is treated as a capital gain or loss for tax purposes.

There is some light material and formulas for stock dividends, where investors receive additional shares instead of a cash dividend. Cost basis per share is decreased (spread over the new number of shares) for tax purposes and debt/equity characteristics of the firm do not change.

Factors affecting Dividend Policy

The Institute does not spend a lot of time on taxes other than to say it depends on specific rates and the difference between imputation, split rate, and double taxation systems. You do not need to know the specific countries using different systems, just understand the basic difference between the three systems:

  • Double taxation: corporate earnings are taxed then taxed again at the shareholder level which may or may not lead investors to favor dividends depending on the difference between capital gains and dividend tax rates.
  • SplitRate: Earnings paid out as retained earnings are taxed differently than dividends which are then taxed at the individual level. This affects shareholder preference for dividends depending on their own individual tax rates.
  • Imputation: Dividends are only taxed at the shareholder level through a credit for corporate taxes paid.

Float costs on equity affect policy but the material only covers it briefly in that as float costs increase firms will use more retained earnings (and issue fewer dividends) for capex rather than issuing more stock.

Dividend restrictions- debt or regulatory requirements may prohibit dividend payments. The capital impairment rule is the most often cited, that the company cannot cause retained earnings to become negative by issuing dividends.

Clientele effect- Some investors, depending on tax rates and income needs, prefer dividends so are drawn to dividend payers. The curriculum addresses this later in the point that, again depending on taxation, investors could effectively create a dividend by selling shares anyway so the argument for the clientele effect is somewhat weak.

Make sure you understand the idea behind information content of dividends (signaling effect). That increasing dividends could signal a lack of investment opportunities or that management perceives stability/adequacy in future earnings. Conversely, a decrease in dividends could signal lack of sufficient capital or reliability of future earnings. The concept is the impetus behind conservative dividend payout practices to avoid volatility in payments.

The firm can set its dividend policy by: residual, long-term residual, stable dividend, or the target payout approach. Be sure to understand the concept behind the first three but be able to calculate the target payout approach. In the Target Payout, the expected dividend increase will be the expected increase in earnings times the target payout ratio times an adjustment factor. The adjustment factor helps to reduce volatility in the dividend and allows for an incremental move towards a target payout ratio. The adjustment factor also allows dividends to increase even with a decrease in earnings but will also cause the dividend to increase less in strong years.

The dividend ‘theories’ seem a little academic. Again,  just understand the basic idea behind dividend irrelevance, bird-in-the-hand, and tax aversion.

Three Measures of Dividend Safety

Three basic measures of dividend safety are given and candidates should be able to use the formulas.

Dividend Payout Ratio is just the dividend amount divided by net income. A higher ratio (more net income paid out) is obviously more risky because less is retained and available. If the company has increased capital needs, then the dividend will need to be cut.

Dividend coverage Ratio is the inverse of the payout ratio (net income divided by dividends) so really says the same thing but with a lower ratio being more risky.

Free Cash Flow to Equity (FCFE) Coverage Ratio is FCFE divided by the amount of dividends and share repurchases. Remember FCFE is the available cash for equity holders after necessary fixed investment and borrowing to keep the company a going concern. See the previous post on how to calculate FCFE. If the company is returning all available cash as dividends or share repos, then the ratio is one. If the ratio is less than one, the company is paying out more in dividends/share repos than is available and will eventually need to issue more equity.

As with a lot of the sections within the Corporate Finance topic area, the dividend material is fairly conceptual with some basic formulas. It should be easy points that you can get by going over your study guide or just a summary sheet a few times. Get the concepts down and spend the rest of your time on the more intense sections like FRA and Equity.

Friday, we’ll review some of the best resources and ways to find a little extra time as you get close to the exam.

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

Work Experience and Applying for Your Charter

Thought I would take a break from exam prep and cover a decidedly more fun topic that many of you (hopefully) will need to address pretty soon, applying for your CFA charter. The process is fairly straight forward but I still get a lot of questions from candidates and there are a few road blocks that present themselves.

After you’ve passed all three exams you need to:

  • Meet the requirement for 48 months of ‘qualifying’ work experience.
  • Have two sponsors fill out the Institute’s sponsorship application.
  • Pay member dues and sign the Professional Conduct Statement

‘Qualified’ Work Experience
This is the part that trips up most candidates. The Institute gives some detail in what they are looking for with:

  • Evaluating or applying financial, economic, and/or statistical data as part of the investment decision-making process involving securities or similar investments, which includes, but is not limited to, publicly traded and privately placed stocks, bonds, and mortgages and their derivatives; commodity-based derivatives and mutual funds; and other investment assets, such as real estate and commodities, if these other investment assets are held as part of a diversified, securities-oriented investment portfolio; or
  • Supervising, directly or indirectly, persons who practice such activities; or
  • Teaching such activities.

The focus is really on ‘front’ office activities that directly relate to analyzing and selecting investments but there is some leeway. I found it a little frustrating when my years as a financial analyst were denied credit (presumably because it was corporate finance-related rather than investment analysis) but was later approved after I re-worded my application to focus on the parts of my job that were more investment-related.

When filling out your profile, try to focus on activities that relate directly to the Learning Outcome Statements in the exams. I have even heard of candidates listing the LOS beside each work activity though it’s not necessary. Most people working in finance can find at least a few of the qualifying activities within their resume or current job.

If you do get denied based on work experience, take another look at the description you listed. Compare this to some of the work experience descriptions listed on the Institute’s website. Looking through the descriptions, it becomes clear that the Institute is not requiring applicants to be Gordon Gekko incarnate but there are some ‘concepts’ that need to be obvious from your job description. Re-write your description, again focused on material in the curriculum, and resubmit your application.

If you do not perform any approved activities in your job, or do not have at least 48 months, you will be put on Affiliate membership until you meet the requirements. You will still receive all the benefits of a regular membership but will not have voting rights or be able to use the designation.

The Institute will send you an email when you have registered for the Level III exam that will initiate your membership process. Within this email will be a link to email two people that will act as your sponsors for membership. The requirement is that one sponsor is a direct supervisor while the other is a member of the local CFA Society, but I have seen exceptions where two local society members can be used.

I would HIGHLY recommend you send your sponsorship request early. Others do not always have your priorities in mind and it would suck to have your charter held up because you were late getting your sponsorship material in to the Institute. The questionnaire is short and won’t take much time for your sponsors to fill out. The biggest issue I have seen is finding a local society sponsor. Many candidates neglect their local society until they come hat-in-hand for a sponsorship need. As a member of the Board of Directors for the local society, this is a pet peeve of mine. The society is there for your benefit and there are some great local programs available. Get to know your society and some of its members before you come begging for sponsorship.

All for today. We’ll cover another Level 3 exam essay question and some Level 2 material on Wednesday.

‘til then, happy studyin’.
Joseph Hogue, CFA

Equity Valuation using FCF and EV

Today we wrap up the level II material on market-based valuations with Price-to-Cash Flow and Enterprise Value-to-EBITDA ratios. You will need both of these concepts different parts of level II and in the level III exam so make sure you know the concepts as well as the basic formulas.

Price-to-Cash Flow Ratios
There are several of these ratios listed in the curriculum but the most attention is given to Free Cash Flow-to-Equity (FCFE). You should already be familiar with FCFE and FCFF from the corporate finance material as well as in other parts of the equity curriculum. For the other P/Cash Flow ratios, just remember some of the adjustments that are typically made like non-cash charges and financing. Cash Flow metrics are preferred because it is not as easily manipulated by management as earnings numbers.

Free Cash Flow-to-Equity (FCFE)
The calculation for FCFE is fairly easy but you need to make sure not to get the components confused with FCFF. FCFE is CFO minus investments in fixed capital plus net borrowing, or the cash flow available to common equity holders without placing a burden on operations.

FCFE can be more volatile than other cash flow measures because of the capital expenditures spending, so you might have to use a multi-year average if the test question mentions it. Though you will probably not be asked to do so on the test, some analysts adjust CFA for nonrecurring expenses before calculating FCFE. A big focus in the CFA curriculum is conservative practices, almost always favored when a choice is given. Adjusting items for non-recurring events and taking the average of volatile accounts over a period of time are more conservative and provide a more stable estimate.

Make sure you can go from FCFF to FCFE or can get there from multiple routes. Thinking through the various accounts and why they are included will help get these concepts down. PRACTICE, PRACTICE, PRACTICE.

FCFF = CFO + interest(1-tax rate) – Fixed Capital Investment

FCFF = EBITDA(1-tax rate)+depreciation expense(tax rate) + (increase in deferred tax) – (investments in fixed and working capital)

FCFE = FCFF – interest(1-tax rate) + net borrowing

Enterprice Value-to-EBITDA
EV is the total value of firm in excess of cash and investments. This is the market value of debt plus common and preferred equity, minus cash and investments. We use the market value of debt because it is a more realistic amount that someone would pay for the firm, when combined with equity. Earnings before interest, depreciation and amortization (EBITDA) measures the potential cash flow to all providers of capital, so by taking a ratio of the two we find a market driven valuation of the firm.

The advantages of the metric are that it is more appropriate when valuing capital-intensive companies or those with differing amounts of leverage (because it is a pre-interest and depreciation measure). The metric is also useful when earnings are negative and P/E cannot be used.

The main disadvantage is that it does not account for several adjustments that should be made for good measures of operational cash flows. Different revenue recognition practices will change results as well as trends in working capital.

Generally, higher valuation multiples mean more expensive valuation. It may seem a little simplistic, but the curriculum spends a lot of time on these market-based valuation measures. Understand each one and its advantages & disadvantages. Given the multiples for two or more companies, be able to say which one is most overvalued and which one is most undervalued. Just remember, relative valuation (the fact that one asset is less-expensive than another based on a market multiple) does not necessarily mean that it is a good investment only that it is less expensive when compared to another investment.

All for today. Only seven weeks left, don’t forget to hit those practice problems. Happy studyin’

Joseph Hogue, CFA

CFA Level 3 Essay Review: 2010 Question #3

Question #3 is portfolio management for a defined benefit pension plan, an institutional investor that often makes its way onto the essay section of the level 3 exam. In 2010 it was worth 24 points, or about 6.7% of your total exam points. Download the exam and guideline answers from the CFA Institute to follow along with the discussion.

Reading through the questions quickly, you see that you need info for:

  • Factors that affect ability to take risk, including the directional affect
  • Determining appropriateness of pension portfolios for different companies

These are both IPS-type questions so we’ll review the material for pensions first,

Return- This is usually an actuarial assumption given in the vignette, a return that depends on the funding status and contributions to the plan. It may be affected if the company wants to increase/decrease future contributions. Whether the plan is indexed for inflation or not is important as well. Remember, bonds do not protect investors for inflation so will need equity exposure if the plan is not indexed for inflation.

Risk Tolerance- Key here are things to look for that affect tolerance (below would decrease tolerance)

– older workforce or low ratio of active/retired lives
– pension funding shortfall- this does not mean taking on more risk to make up for the shortfall!
– financial health of company is not good- high debt on balance sheet, low liquidity ratios, poor income trends all mean the company can take less risk in pension accounting
– high correlation of business with pension assets- If pension and business are both under pressure at the same time, then there is little change the company can bail out the plan. Similarly, if the company is in a new industry then business risk is higher and free cash flow presumably lower so lower risk tolerance
– Any early retirement or lump sum offers may speed up payment estimates


Time Horizon- This usually depends on the active/retired ratio and is multi-stage.

Unique Circumstances- As with individual portfolio management, usually determined directly in the vignette.

Tax Considerations- Pension plans are tax-exempt

Legal and Regulatory- regulated by ERISA or depending on country of jurisdiction. Plan assets must be invested for the benefit of the participants and according to entire portfolio, not just based on individual assets

Liquidity- This depends on sponsor contributions (and ability to contribute), any plan features like early retirement or lump sum, and the estimated expense based on active/retired ratio

For part A, the info in the vignette that jumps out at me is: profitable, outlook for profitability is positive, pension surplus, growing ratio of inactive to active (inactive is equivalent to retired).

*Remember- you can markup/underline the exam all you want but make sure your answers are in the designated places, either template or on the answer booklet.

Detail your answers with data from the vignette so the grader knows that you understand the concept, not just “pension has a surplus so higher risk tolerance.” Instead something like, “Pension surplus of $95 million enables plan to face some negative returns without risk of liability coverage.” The guideline answers show five possible choices. On the test, pick the three most obvious/easy answers and then move on. You will not get extra points by trying to explain the most detailed concepts. Answer the question and move on!

For part B, the info in the vignette (in addition to what you read in A) that should jump out is:
CarbX- unprofitable, pension deficit, plan frozen, high ratio of active/inactive, not inflation indexed
DataComp- growing and profitable, global sales, plan surplus, no inactive, inflation indexed

For Apex, we see that there is no inflation protection through equities so buy equities and sell nominal bonds (real rate bonds protect for inflation so we would not want to sell these)

For CarbX, since there is no need for inflation protection and the plan is closed we only need to satisfy accrued liabilities and can do so through (relatively safer) nominal bonds

For DataComp- There are no current inactive members and the plan has a surplus so we are looking at a higher risk tolerance and focus on growth, buy equity and sell nominal bonds

Don’t forget to be working on the other essay questions provided by the Institute. There is no reason you shouldn’t be able to rock out the morning section and be that much closer to your charter. Work the past essay exams and pay attention to the guideline answers. This is exactly what the graders are going to be looking for in June.

We’ll start on the 2009 essay questions next week. Let me know if there are any topics you want to see covered. Happy studyin’

Joseph Hogue, CFA

***New CFA Exam ID Policy*** IMPORTANT!!

Linked below is the new CFA Exam ID policy. You must have a valid international passport and it must match the data on file with the Institute. This is IMPORTANT! You will not be able to get a passport overnight! Plan ahead and start the process This Week.


If you already have a passport, get it out RIGHT NOW and make sure all information matches the name, address, etc that is on file with the CFA Institute and that the passport is valid through the exam date.

I know many will ‘do it later’ and I can guarantee you that there will be people turned away on exam day because of ID issues. How frustrating would it be to bust your butt for 3+ months studying and then not be able to take the exam because of your ID????

Joseph Hogue, CFA

2010 CFA Level 3 Exam Essay Question #1

The individual and institutional questions for the level 3 CFA exam in 2010 were worth almost a quarter of the entire test! The first question, individual portfolio management, was worth about 19.4% of the essay portion while the institutional question was worth 27.2% (along with behavioral).

This is not far from the historical averages for these questions. You will get massive points on the exam if you master these two topic areas of the curriculum! We are covering some of the last three years’ essay questions here, but you need to go to the Institute’s website and download the exams to work them on your own.

Question 1 has five parts (A,B,C,D,E) for a total of 35 minutes.

You know the first two questions will be individual and institutional problems and will be fairly intense. In 2010, they totaled 84 points/minutes (that is more than an hour of intense CFA exam fun, so be ready!).

Again, I skim through the questions quickly to see what I need. For this one, we can see that we need:

  • A- Liquidity and Time constraints
  • B- Return objective and calculate the required annual pretax nominal rate SHOW YOUR CALCULATIONS!
  • C- Two factors that increase ABILITY to take risk for each person
  • D- Determine which has greater willingness to take risk with one reason
  • E- How much of bonds/equities to sell or buy for tax efficiency

We won’t go over the general advice here (like paying attention to where you write your answers) so you need to check the other blog posts for the level 3 exam and the other essay questions.

This gives us a great idea of what we are looking for in the vignette.

  • Liquidity constraints are almost always <1yr spending needs and planned debt/giving
  • Time constraints are going to be the time horizon for any large outlays or life events (college, retirement, etc)
  • MAKE SURE YOU WRITE A RETURN OBJECTIVE! This is an explicit statement of need and usually is cut and paste from vignette. You already know some of it from the next part of the question!! “earn a pretax nominal rate to retire in 25 years”
  • Remember, pretax and nominal! Add inflation to your return needs and watch for tax information.
  • Ability to take risk is usually things like: proportion of spending needs to assets, time horizon, importance of spending needs. You only need two for each person
  • Willingness for risk is almost always explicit statements in the vignette. Things like, “I am comfortable living on less,” or “I would be really stressed if we lost any principal.” You only need one.

Now, as you are reading through the vignette you can highlight/underline any relevant information as you come to it.

A- We see that Lima wants to pay education costs in one year (large cash outlay so liquidity needs). For time constraints, always explicitly state whether it is single- or multi-stage and approximate years in each and long- or short-term.  (last stage usually in retirement and just written as >25 years)

B-  Objective is usually something like, “grow investments to (specific objectives like protect purchasing power in retirement and leave amount to charity)” plus any relevant numerical info like how much spending is needed on how large of an asset base.

  1. a.       ** This is one of two types of return problems you will get. You must know both. Show all steps of calculation (as shown in guideline answer). Even if you mess up the final calculation, you will still get some credit for your work along the way. Remember: Current investable assets, cashflows, expenses & debt repayment
  2. b.      These long-term required return calculations can be done on your calculator with the appropriate (PV), (FV), etc written on test as shown. **FOR ALL ESSAY QUESTIONS, circle and/or double underline your final answer. Make it easy for the grader to find your answer!

C- The guideline answers show four possible answers, you only need two. Factors that are going to INCREASE ability to take risk are: longer time horizon, low % of spending needs to assets, flexibility in spending needs, importance of spending needs, amount of debt

D- Factors that INCREASE willingness to take risk are usually explicit statements in vignette showing confidence or fear of investor.

E-  Past essay exams have included questions like these that often hinge on taxes paid now or later and possible tax law changes. The tax section is fairly quantitatively intense but it seems like the exam tests the concepts in tax management rather than the more intense calculations. Make sure you understand the basic ideas behind deferment, taxable/non-taxable accounts, and the different types of taxes.

Other than part E, the question was fairly easy if you understand the IPS and can do basic return calculations.  You need to work through the last three years’ individual and institutional essay questions at least twice before the actual exam. Doing this will not only help you to learn the material but will boost your confidence through the first (and most important) points on the exam.

‘til next time, let me know if you have any questions.  Happy studyin’
Joseph Hogue, CFA

CFA Level 2 – Balance Sheet and Cash Flow Statement Accruals

While most of the level 2 Financial Reporting Analysis is quantitatively intense, there are a couple of sections that are more conceptual and include only basic formulas. Even the formulas within the material can be remembered through a basic understanding of the cash flow statement or balance sheet.

The Learning Outcome Statements and curriculum for evaluating financial reporting quality are fairly easy points if you get down the general concepts and remember a few relationships. In the 2012 curriculum, these are LOS 25a-26f and are available here.

The readings revolve around manipulation of earnings, where to look for it and how to measure quality of earnings. The income statement lends itself to management manipulation in quite a few areas so most of the reading focuses on the statement.

** You need a solid base of understanding in the Financial Statements** If you cannot reconstruct the basic framework for the balance sheet, income statement and cash flows and understand what everything is and where it comes from, time would be VERY well spent by reviewing this material. You are going to need it throughout the level 2 and into the level 3 exam as well (besides most likely in your job).

Discretion in Accrual Basis Accounting

Remember that the accrual basis of accounting more accurately reflects the company’s financial performance because revenues and expenses are more closely matched. The disadvantage, relative to cash basis accounting, is that accrual basis lends itself to management discretion in matching and possibly manipulation of earnings.

For the income statement, understand management discretion in the line items: EBITDA, Operating Income, EBIT, Income from continuing, Income before extraordinary, and Net Income

While the curriculum reminds candidates to check Management’s MD&A and footnotes for a number of issues, you are never really shown how to do this. For the exam, your really only need to know that a lot of information can be buried here and that you should look it over skeptically.

Some areas where discretion in reporting may lead to manipulation:

  • Revenue recognition: sales can be booked too early, too late, or smoothed over a period to change the company’s revenue picture
  • Expenses: accounting for costs in the current period or over time by capitalizing expenses
  • Depreciation: management selects the method of calculating depreciation as well as the useful life of the assets
  • Inventory: the determination of cost flow assumption (LIFO, FIFO, or weighted average) is a big part of the curriculum here and elsewhere
  • Classifying events as continuing operations, non-recurring, or extraordinary
  • Calculation and impairment of goodwill and other intangibles
  • Assumptions in post-retirement benefit accounting

Management Incentives to Cheat

This section covers basic reasons management might want to manipulate earnings and what companies do to avoid the problem. Again, just high-level conceptual stuff and fairly intuitive.

There is pressure on management to meet or beat expectations set by the market. Management will try to speed up revenue recognition or delay expenses if it looks like results will come in below expectations. Conversely, management may actually slow down revenue recognition or pay for future expenses in order to smooth earnings into upcoming quarters.

The curriculum talks about contract-based incentives in a few different places. While tying management compensation to performance is a good way to promote shareholder interests, it can also lead to earnings manipulation as management looks to make their bonus or an options payout. Covenants in debt instruments can also incentivize earnings manipulation to avoid default or rate adjustments.

Mechanisms to avoid earnings manipulation revolve mostly around outside supervision like corporate governance, external audits, and regulation. General market oversight by analysts is also mentioned as a balance to keep management from manipulating statements.

Balance-sheet and Cash-flow based Aggregate Accruals

The only quantitatively-based material in the section is the calculation of aggregate accruals and the net operating assets. The calculation and concept has a few steps and lends itself well to an item-set question. Aggregate accruals are used to measure the ‘discretionary’ component of earnings apart from cash earnings. Aggregate accruals are basically the current period’s change in non-cash balance sheet items. It excludes cash and debt because these accounts are subject to less manipulation.

The curriculum shows two ways to calculate aggregate accruals and net operating assets, through the balance-sheet and through the statement of cash flows.

Balance-Sheet Method

Aggregate Accruals = NOAt – NOA t-1
Where Net Operating Assets (NOA) =
(Total Assets – Cash) – (Total Liabilities – Total Debt)

The absolute measure of aggregate accruals, compared to previous periods, is used to measure the company’s earnings quality and to forecast possible reversion of earnings. If management is increasing the amount of overall earnings, not by actual cash earnings, but by accrual accounting manipulation then the possibility of a reduction in earnings or earnings growth is high. Conversely, a company with low or declining aggregate accruals should have more persistent earnings and higher quality.

The accrual ratio is used to compare companies of different sizes. This is just the aggregate accruals divided by the average net operating assets between the balance sheet periods. **Remember, since the balance sheet is a snapshot in time you need to take the average between current and last period for many of your ratios.

Accruals Ratio = (NOAt – NOA t-1)/ ((NOAt + NOA t-1)/2)

This ratio can then be compared across companies for a relative analysis of earnings quality.

Statement of Cash Flows Method

A preferred measure of aggregate accruals is found using the Statement of Cash Flows. The measure is found by reducing Net Income, which is highly susceptible to manipulation, by cash flows from operations and investing.

Aggregate Accruals = Nit – (CFOt + CFIt)

Again, the measurement can be standardized by taking the average net operating assets for the period to compare across companies.

Accruals Ratio = Nit – (CFOt + CFIt)/ (NOAt + NOA t-1)/2

The two measures of aggregate accruals will generally not give you the same result but will usually yield the same directional theme on earnings. The difference comes from noncash transactions and classification differences in accounts.

I have applied this measure of earnings quality in a recent post on the website Seeking Alpha. Click here to see the example of the calculation performed on the financial statements of Johnson & Johnson and several consumer staples companies.

Next week, we’ll look at the advantages and disadvantages of valuation multiples and some of the key takeaways you need for the level 2 CFA exam.

Happy Studyin’
Joseph Hogue, CFA

Last updated: October 18, 2017 at 5:45 am