Despite the intense focus on formulas on the level II CFA exam, study session 18 was probably one of the most difficult parts of the exam for me. The formulas in the section are fairly basic and the majority of the points can be earned through conceptual understanding but the material is (my opinion) extremely boring and academic. I just couldn’t get my head around the differences between the capital allocation line and the capital market line or why I should really care.
Regardless, there are 40 learning outcome statements for the topic and it can represent up to 15% of your level II score so you will need to give its due in your study. Additionally, you’ll see most of these concepts in the level III exam so understanding the basics will save you time next year. I’ve put together some notes below on the individual topics but please use the comment section below to add your own tips to understanding the topic. Judging from forum posts, this is one of the most difficult sections for candidates so any advice you can give each other will help everyone.
The easiest sections, and possibly the most important, are the readings on the portfolio management process. This material is really the focus of the level III CFA exam but is shown on the Level II in a summary version. Learning this material at level II will make next year all that much easier for you.
- The ‘steps’ in the process (planning, execution, and feedback) are secondary to the other material and fairly obvious anyway. Understanding the pieces within each step will make it intuitive as to where in the process they occur and the overall flow.
- Understand that the IPS benefits both the client (through a formalized and portable plan) and the advisor (showing fulfillment of duty to client).
- At the second level, you are really only asked to remember the basic structure of the IPS and what each objective or constraint means. The acronym that always helped me was R-R-TUTLL. Risk, Return, Taxes, Unique Circumstances, Time Horizon, Legal, Liquidity.
- Risk tolerance is made up of willingness and ability to tolerate risk. Ability is usually a quantitative concept where a lower proportion of spending to total assets equals higher risk tolerance. Willingness is much more qualitative and comes from the client’s fears and hopes.
- Return requirement and objective (simplified) is what the client wants to do with their money and what kind of return they need to get there.
- Taxes is the basic tax burden of the investor and any unique tax information from the profile.
- Liquidity is the spending needs the client needs, within the next year or during retirement
- Time horizon- the material approaches this in terms of ‘stages’ around life events. Usually something like pre-retirement or pre-college spending and post-retirement.
- Legal usually doesn’t factor into individual IPS expect with trusts and other legal documents
- Unique Circumstances is a catch-all not addressed elsewhere, usually something like client prohibitions against investing in vice assets (smoking, alcohol, gambling, etc) or Socially-responsible investing
- The tax material is fairly lengthy, but again time spent here will save you next year. Start with the basic formulas and concepts behind the different tax regimes. Pay attention to the concepts under tax loss harvesting or deferral within taxed accounts and the compare/contrast material with retirement accounts.
The material on International Asset Pricing revolves around getting the foreign currency quotes down and understanding the exchange rate theories. The rest of the material is conceptual and not too difficult. Understand the difference between theory and an arbitrage relationship. A theory, like the law of one price should hold in the real world but does not necessarily. An arbitrage relationship is one where the assets are freely traded and will correct any mispricing.
- Probably the hardest part for beginners is to get the local currency and domestic currency straight in exchange quotes. The curriculum doesn’t help by switching quote conventions but it looks like they have settled on a Foreign : Domestic (direct quote) convention (whereas the old convention was Domestic/Foreign which quotes the domestic per unit of foreign currency)
- FC:DC=5 is a direct quote for the domestic currency and means you need 5 units of the domestic currency to equal one foreign currency.
- When pricing out forward exchange rates (as well as other forex formulas) remember the interest rates for each currency will be in the same order as the problem is quoted. For example, if the spot is given as a direct quote (FC:DC) and foreign rates are 6% while domestic rates are 8% you will set up the equation as spot*(1.06/1.08)
The first three readings are on Portfolio concepts and include some pretty esoteric stuff. You absolutely must understand the basics like calculating expected returns and standard deviation on a portfolio, the CAPM and the Sharpe ratio. These will be tested and used pretty extensively. Understand the theory behind the efficient frontier and how the CAL and CML incorporate into the idea.
- The capital allocation line (CAL) is a straight line from the risk-free rate to any portfolio in the risk/return area. The optimal portfolio is where theCALlies on the efficient frontier.
- The line between the risk-free rate and the optimal portfolio (the tangency of the efficient frontier) is the capital market line (CML). All points on this line are portfolios consisting of different proportions risk-free asset and risky assets. Where the portfolio falls on this line depends on the risk tolerance of the client.
This should get you the basics of some of the confusing material. When studying for the exams, I had to go back to the basic idea a few times to understand some of the follow-on details. This stuff confuses a lot of candidates, so don’t get frustrated if you do not get it right away. Keep reviewing it until you have a good base of understanding, because (though a lot of it seems academic) you will build on it at the level III exam.
Looking forward to your questions/suggestions. ‘til then, happy studyin’
Joseph Hogue, CFA