Level I Review, Portfolio Management

Download Mock Exams for 2019 Exam Levels I, II and III by clicking here.

Level I CFA Program curriculum includes readings on portfolio management and sets the basis for further material in the other two exams.

While the topic area is only worth about 7% of your Level I CFA Program test score, it makes up about 10% of the second exam and is the core focus on the third exam.

The material here is pretty basic and easy to understand if you give it a little time and do the readings.

Portfolio Management: An Overview

The different types of clients, individual and institutional, are important here. Understand the basic return objectives and risk tolerance for individuals and the seven institutional clients (banks, pensions, insurance, endowments, foundations, investment companies, and sovereign wealth funds) as well as their time horizon, liquidity/spending needs and special circumstances for each.

Individual clients objectives and special constraints vary by individual.
Pension plans usually have long time horizons, high risk tolerance, varying income and liquidity needs.
Endowments and foundations usually have very long time horizons, high risk tolerance, with income needs based on that of college or foundation programs.
Banks have shorter time horizons, low risk tolerance, high income needs to pay interest and operational expenses.
Insurance companies have short horizons for P&C and long time horizons for Life companies, while the risk tolerance and income needs vary.
* Memorizing the needs is not nearly as important as knowing why they differ. You will need to understand this and be able to explain in on the Level 3 essay section, GUARANTEED.

The actual steps in the portfolio management process are of less importance than understanding individual sections in the process. Just remember that understanding the client’s needs through an IPS always comes first, followed by putting the portfolio together and then monitoring and rebalancing.

Target asset allocation is an important concept and you absolutely need to get the basics here to go into detail in Level 2. Weights are determined based on capital market expectations and the risk/return analysis of asset classes according to the needs of the specific client.
Understand the basics behind mutual funds, ETFs, hedge funds, and venture capital funds. Pay special attention to the differences between mutual funds and ETFs.

Portfolio Risk and Return (part 1 and 2)

These readings are more quantitatively focused and will set the stage for your quant material in the next exam. All the calculations can be done fairly easily on your calculator.

Understand the difference between arithmetic and geometric return. Geometric return measures the compound return and is appropriate when there are multiple periods. Arithmetic return is the average and is easier to compute and more commonly used.

Understand the IRR and how to work the cash flow functions on your calculator.
Remember, the asset class weights must sum to 1 for a portfolio return. Beyond that, it’s pretty easy. Just take the return of each asset times its weight and add them all up.

The calculations behind gross, net and real return are probably of lesser importance than how they differ. Understand what comes out of gross return (trading expenses, managerial and administrative expenses) to get net.

Variance and covariance, and correlations can seem overly lengthy and complex but you must know how to calculate them (despite the fact that your calculator can do it for you). Put them in some practice problems on flash cards and drill until its natural to run through the formulas.
Remember the three percentages to a normal distribution. +- 1 deviation holds 68% of observations, 95% within two deviations and 99% within three deviations.

The utility function is one of the few formulas in the curriculum that is pretty inconsequential in practical terms but seems to show up on exams because it’s easily testable. Just put it on a flash card and learn it.

Be able to calculate the capital allocation line and understand the idea behind indifference curves and the optimal portfolio. Understand the capital market line and how it relates to the CAL.
The capital asset pricing model will come into the curriculum several times and is the basis for many assumptions and valuation. At this point, just remember the basic formula and the assumptions underlying the model as well as limitations.

Basics of Portfolio Planning and Construction

Used to be, you didn’t start into the IPS until Level 2 and then really got into detail in Level 3. The Institute has moved it up to level 1 so that should give you an idea of its importance. We covered the basics of the IPS (Return Objective, Risk Tolerance, and 5 Constraints) in a previous post on Level 2 so click here for the summary.

Understand the criteria to specifying asset classes and how strategic asset allocation fits into portfolio construction. Understand the difference between SAA and tactical asset allocation. In TAA, the manager deviates from policy weights according to temporary changes in short-term capital market expectations but the long-term policy weights are constant.

Understand the difference and advantages/limitations between top-down and core-satellite.
Study session 13 in the Level I CFA Program curriculum begins the material on equity investments with three readings in equity market structure and efficiency.

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

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