Level II Review | Portfolio Management

Study session 18 in the Level II CFA Program curriculum concludes the material with three readings (54-56) in Portfolio Management.
Portfolio Concepts
A lot of the quantitative stuff here you’ve already seen in the quant methods section so be ready to calculate the return and variance on a portfolio. Remember, the portfolio return is just the asset weights times the asset returns while the variance calculation involves standard deviation and correlations.
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 the CAL lies on the efficient frontier.
  • The line between the risk-free rate (intercept point) 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.

Understand the assumptions used in the CAPM (i.e. optimal portfolios can be built from just expected returns, variances and covariances; identical expectations about returns and variances; ability to borrow and lend at risk-free rate; no trading costs or taxes) and be able to calculate with a historical or adjusted beta.
The material on APT and multifactor models is mostly conceptual so focus on the basic ideas as well as the differences between the two methods. Multi-factor models are basically just a simple regression so don’t get confused by all the terminology.
The Theory of Active Portfolio Management
The reading is almost entirely Treynor Black model with some quick conceptual stuff as an introduction. The Treynor-Black model is a portfolio optimization model that combines market inefficiency with MPT.
Understand the steps in Treynor-Black
1)      Estimate expected return and standard deviation for the passively managed portfolio
2)      Identify limited set of mispriced securities
3)      Determine weights for the mispriced securities
4)      Group securities with non-zero alpha into an active portfolio
5)      Allocate funds between the passive and active portfolio
Understand the use of R2 in Treynor-Black alpha forecasts and analyst accuracy
The Portfolio Management Process
The easiest reading, and possibly the most important, is on the portfolio management process. This material is really the focus of the level III CFA exam but is shown here 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 fairly explanatory
    • 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.
Wow, we’ve made it through the entire curriculum. Hopefully, you have been able to keep up and have been doing well on practice problems and using other resources. You’re not done just yet. There’s still three weeks left to the exam and they can be the most important three weeks of your preparation. We’ll cover what to expect on test day in Friday’s post and other tips and strategies in subsequent posts all the way up to test day.
‘til next time, happy studyin’
Joseph Hogue, CFA

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