LEVEL III ScH\VESER's SECRET SAucE® Foreword Echics: SS & Behavioral Finance: SS 35 Private Wealth Management: SS 51 Ponfolio Management for Institutional Investors: SS 78 Capital Ma rker Expectations in Po rrfolio Management: SS 91 Economic Conceprs for Asse LValuaLion in Portfolio Management: SS ? 103 Asset Alloca tion: SS 107 Management of Passive and Accive Fixed Income Porrfolios: SS 11 Porcfolio Management of G lobal Bonds and Fixed lncome Derivatives: SS 10 126 EquiLy Portfolio Management: SS 11 & 12 139 Alternative Investments for Portfolio Management: SS 13 156 Risk Management: SS 14 169 Risk Management i\pplicarion of Derivatives: SS 15 182 Trading, Monitoring, and Rebalancing: SS 16 20 I Performance Evaluation and Amibution: SS 17 212 Global Investment Performance Standards: SS 18 219 Essential Exam Strategies 238 Index 263 ©2013 Kaplan, Inc Pagel SCH\X!ESER'S SECRET SAUCE®: 2014 C.FA LEVEL I1I ©2013 Kaplan, Inc All rights resnved Published in 2013 by Kaplan Schweser Primed in the United Stares of /1J11eri ca ISBN: 978-1-4277-4937-6 I 1-4277-4937-X PP1\: 3200-4038 If chis book docs nor h ave rhe hologram with the Kaplan Schweser logo on the back cover, it was disrribmcd witho ut permission of Kaplan Schweser, a Division of Kaplan, Inc., and is in dirccr violation of global copyrigl: t l;;ws Your ass ist;rnce in p1mu ing porenrid violators of this law is greatly appreciarcd Required CFA Institute disclaimer: "CFAl°' and Cha rrered l~inancial Analyse® are trademarks owned by CFA lns:itute CFA lnsrirnre (fo rmerly rhe Associ21io11 for lnvesm1enr f.fanagemenr and Research) does nor endorse, promote, review, or warrant the accuracy of the products or servi ces offered by f(J pbn Schweser." Certain materia ls comained within this text are the copyrighted property of CFA Institute The following is the copyright disclosure for these materials: "Copyright, 2013, CFA lnstiture Reproduced and republished from 2014 Learning Outcome Sratemenrs, Level I, II, and III questions from CFA® Program Materials, C:FA Insritun: Standards of Professional Conduct, and CFA lnstitute's Global Investment Performance SLanciards wirh permission from CFA Institute All Rights Reserved." These materials may not be copied without written permission from the author The unauthorized duplication of these notes is a violation of global copyright laws and the CfA Institute Code of Ethics Your assistance in pursuing potential violato rs of this law is greatly appreciated Disclaimer: Schweser study tools should be used in conjunction with the original readings as set forth by CFA Instirure in their 2014 CFA Level Ill Study Guide The information comained in these materials covers topics contained in the readings referenced by CFA Insrirute and is believed to be accurate However, their accuracy cannot be guaranteed nor is any warranry conveyed as to your ultimate exam success The authors of the referenced readings have nor endorsed or S?onso red Schweser study tools Page ©2013 Kapbn , Tn c FOREWORD The Secret Sauce should be used as pan of a rigorous study program It is a summary of the high points in the CFA® Level III Curriculum It is best used after reading the 2013 Level III SchweserNoresTM and working both the Schweser practice questions and CFA end-of-reading questions Candidates who study and practice the material have every reason to well on the exam But not fall inro the trap of expecting exam questions to be exactly like practice questions The Level III exam is intended to integrate rhe material across study session far more than at Levels I and II Learn the underlying concepts, apply the concepts in practice questions, and expect surprises on exam day At Level I, you largely memorized facts and then regurgitated them on the exam At Level II, the topical coverage was more difficult, but each topic was tested in a stand-alone item set in much the way it was presented in the curriculum At Level III, yo u \Vill be expected to combine different topics from different parts of the curriculum into a single, multi-part question The other major challenge at Level III is the constructed response section You must not only know the material bur respond directly to what is asked in the question The CFA Institute does not award poinrs for a general display of knowledge Our ClassNotes and Practice Exams illustrate how to answer constructed response questions It is a skill learned through practice Level III provides its own unique challenges 'X'ork hard, practice, and you can make your own good luck I wish you all the best on exam day David Herherington, CFA Vice President and Level III Manager Kaplan Schweser ©2013 Kaplan, Inc Page ETHICS Study Sessions & STUDY SESSION 1- ETHICAL A ~D PROFESSIONAL STANDARDS CFA INSTITUTE ConE OF ETHICS AND STANDARD·s OF PROFESSIONAL CONDUCT Cross-Reference tO CFA Institute Assigned Readings #1 & Ethics is covered in Study Sessions and It will be tested in tVlm selected response item sets for l 0% of the exam points The form of questions will be like Level II Read the case, think of the appropriate principles that are most pertinent, and then select the best answer choice In some cases, an educated guess is the best you can Also, be prepared for questions related to compliance issues, the Asset Manager Code of Conduct, and the disciplinary process The best way to prepare for ethics is to read the CFA material and then work all of our questions plus the CPA end-ofreading questions Code of Ethics Members of CFA Institute, including Chartered Financial Analyst® (CPA®) charterholders, and Candidates for the CPA designation ("Members and Candidat~'~) must: • • • Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients, prospective clients, employers, employees, colleagues in the investment profession, and other participants in the global capital markets Place the integrity of the investment profession and the interests of clients above their own personal interests Use reasonable care and exercise independent professional judgment when conducting investment analysis, making investment recommendations, taking investment actions, and engaging in other professional accivities Copyri~ht 2010, CFA Institute Reproduced and republished from "The Code of Ethics,' from Standards ofPractice Handbook, 10th Ed., 2010, with permission from CFA Institute All rights reserved Page4 ©2013 Kaplan, Inc Study Sessions & Ethics • • Practice and encourage others to practice in a professional and ethical manner that will reflect credit on themselves and the profession Promote the integrity of, and uphold the rules governing, capital markets Maintain and improve their professional competence and strive to maintain and improve the competence of other investment prvfessionals GUIDANCE FOR STANDARDS I I-VII Professionalism I(A) Knowledge of the Law Members must understand and comply with laws, rules, regulations, and Code and Standards of any authority governing their activities In the event of a conflict, follow the more strict law, rule, or regulation Guidance Members must know the laws and regulations relating to their professional activities in all countries in which they conduct business Do nor violate Code or Standards even if the activity is otherwise legal Always adhere to the most strict rules and requirements (law or CFA Institute Standards) that apply Dissociate from any ongoing client or employee activity that is illegal or unethical, even if it involves leaving an employer (an extreme case) While a Member may confront the involved individual first, he must approach his supervisor or compliance depanment Inacri:m with continued association may be construed as knowing participation Recommended Procedures for Compliance Members should keep up with changes in applicable laws, rules, and regulations: • • • Review compliance procedures on an ongoing basis to assure that they address current law, CFAI Standards, and regulations Maintain current reference materials Seek advice of counsel or compliance department when in doubt Document any violations when they disassociate themselves from pro11ibited activity and encourage employers to bring an end to such activities There is no requirement under the Standards to report violations to governmental authorities, but this may be advisable in some circumstances and required by law in others Members should encourage their firms • • to: Develop and/or adopt a code of ethics Make information available that highlights applicable laws and regulations Establish written procedures for reporting suspected violations ©2013 Kaplan, Inc Page Study Sessions & Ethics I(B) Independence and Objectivity Use reasonable care to exercise independence and objccriviry in professional activities Do not ofter, solicit, or accept any gift, benefic, compensation, or considerarion that wo uld comprom ise independence and objcctiviry Guidance Do not let the investment process be influenced by any external sources Modest gifts are permitted i\llocation of shares in oversubscribed TPOs ro personal accounts is KOT perm itted Distinguish between gifts from clients and gifts fro m entities seeking influence to the derrimenc of any client Gifts musr be disclosed to the Member's employer in any case Guidance- Investment-Banking Relationships Do not he pressured by sell-side firms t0 issue favorable research on current or prospeccive investment-banking clients Ic is appropriate w have analysts work with investment bankers in "road shows" only when che confl icts arc adequately and effectively managed and disclosed Be sure there are effective "firewalls" her.ween research/invtstmenr management and investment banki ng activities Guida11co.-Public Companies Analysts should not be pressured to issue favorable research by rhe companies they follow Do not confine research to discussions with company management, but rarher use a variety of sources, including suppliers, customers, and competitors Guidance-Buy-Side Clients Buy-side clients may try to pressure sell-sid e analysts Portfolio managers may have large positions in a particular security, and a rating downgrade may have an effect on the portfolio performance As a portfolio manager, there is a responsibility tO respect and foster intellectual honesty of sell-side research Guidance-Issuer-Paid Research Analysts' compensation for preparing such research should be limited, and th e preference is fo r a flat fee, without regard to conclusions or the report's recommendations Page ©2013 Kaplan , Inc Srudy Sessions l & Ethics Recommended Procedures for Compliance • • • • • • • Protect the integrity of opinions-make sure they are unbiased Create a restricted list and distribute only factual information about companies on che list Restrict special cost arrangemenrs-pay for one's O\Vtl commercial transportation and hoed; limit use of corporate aircraft to cases in which commercial transportation is not available Limir gifrs-roken items only Business-related entertainment is okay if it does not influence a Member's independence or objectivity Restrict employee investments in equity IPOs and private placements H ave effective supervisory and review procedures Finns should have formal wrinen policies Appoint a compliance officer; p rovide clear procedures for employee reporring of unerhical behavior and violations of regulations l (C) Misrepresentation Do not misrepresent facts regarding invcsrmem analysis, recommendations, actions, or other professional activities Guidance Do not make misrepresentations or give false impressions lvlisrepresenrations include guaranteeing investment performance