2 18 CFA® EXAM REVIEW W IL E Y Wiley Study Guide for 2018 Level III CFA Exam Review Complete Set Thousands of candidates from more than 100 countries have relied on these Study Guides to pass the CFA® Exam Covering every Learning Outcome Statement (LOS) on the exam, these review materials are an invaluable tool for anyone who wants a deep-dive review of all the concepts, formulas, and topics required to pass Wiley study materials are produced by expert CFA charterholders, CFA Institute members, and investment professionals from around the globe For more information, contact us at info @efficientleaming.com Wiley Study Guide for 2018 Level III CFA Exam Review Wi l ey Copyright © 2018 by John Wiley & Sons, Inc All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, 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materials should be used in conjunction with the original readings as set forth by CFA Institute in the 2017 CFA Level III Curriculum The information contained in this book covers topics contained in the readings referenced by CFA Institute and is believed to be accurate However, their accuracy cannot be guaranteed ISBN 978-1-119-43611-9 (ePub) ISBN 978-1-119-43610-2 (ePDF) Contents About the Authors xi Wiley Study Guide for 2018 Level III CFA Exam Volume 1: Ethical and Professional Standards & Behavioral Finance Study Session 1: Code of Ethics and Standards of Professional Conduct Reading 1: Code of Ethics and Standards of Professional Conduct Lesson 1: Code of Ethics and Standards of Professional Conduct Reading 2: Guidance for Standards l-VII Lesson 1: Standard I: Professionalism Lesson 2: Standard II: Integrity of Capital Markets Lesson 3: Standard III: Duties to Clients Lesson 4: Standard IV: Duties to Employers Lesson 5: Standard V: Investment Analysis, Recommendations, and Actions Lesson 6: Standard VI: Conflicts of Interest Lesson 7: Standard VII: Responsibilities as a CFA Institute Member or CFA Candidate 3 9 36 46 70 84 97 107 Study Session 2: Ethical and Professional Standards in Practice Reading 3: Application of the Code and Standards Lesson 1: Ethical and Professional Standards in Practice, Part 1: The Consultant Lesson 2: Ethical and Professional Standards in Practice, Part 2: Pearl Investment Management Reading 4: Asset Manager Code of Professional Conduct Lesson 1: Asset Manager Code of Professional Conduct 119 119 120 121 121 Study Session 3: Behavioral Finance Reading 5: The Behavioral Finance Perspective Lesson 1: Behavioral versus Traditional Perspectives Lesson 2: Decision Making Lesson 3: Perspectives on Market Behavior and Portfolio Construction 131 131 136 140 Reading 6: The Behavioral Biases of Individuals Lesson 1: Cognitive Biases Lesson 2: Emotional Biases Lesson 3: Investment Policy and Asset Allocation 147 148 154 159 © W iley © CONTENTS Reading 7: Behavioral Finance and Investment Processes Lesson 1:The Uses and Limitations of Classifying Investors into Types Lesson 2: How Behavioral Factors Affect Advisor-Client Relations Lesson 3: How Behavioral Factors Affect Portfolio Construction Lesson 4: Behavioral Finance and Analyst Forecasts Lesson 5: How Behavioral Factors Affect Committee Decision Making Lesson 6: How Behavioral Finance Influences Market Behavior 165 165 168 169 172 178 179 Wiley Study Guide for 2018 Level III CFA Exam Volume 2: Private Wealth Management & Institutional Investors Study Session 4: Private Wealth Management (1) Reading 8: Managing Individual Investor Portfolios Lesson 1: Investor Characteristics: Situational and Psychological Profiling Lesson 2: Individual IPS: Return Objective Calculation Lesson 3: Individual IPS: Risk Objective Lesson 4: Individual IPS: The Five Constraints Lesson 5: A Complete Individual IPS Lesson 6: Asset Allocation Concepts: The Process of Elimination Lesson 7: Monte Carlo Simulation and Personal Retirement Planning Reading 9: Taxes and Private Wealth Management in a Global Context Lesson 1: Overview of Global Income Tax Structures Lesson 2: After-Tax Accumulations and Returns forTaxable Accounts Lesson 3: Types of Investment Accounts and Taxes and Investment Risk Lesson 4: Implications for Wealth Management Reading 10: Domestic Estate Planning: Some Basic Concepts Lesson 1: Basic Estate Planning Concepts Lesson 2: Core Capital and Excess Capital Lesson 3: Transferring Excess Capital Lesson 4: Estate Planning Tools Lesson 5: Cross-Border Estate Planning 3 10 18 20 21 21 23 31 34 39 39 42 46 51 53 Study Session 5: Private Wealth Management (2) © Reading 11: Concentrated Single-Asset Positions Lesson 1: Concentrated Single-Asset Positions: Overview and Investment Risks Lesson 2: General Principles of Managing Concentrated Single-Asset Positions Lesson 3: Managing the Risk of Concentrated Single-Stock Positions Lesson 4: Managing the Risk of Private Business Equity Lesson 5: Managing the Risk of Investment in Real Estate 59 59 60 66 71 74 Reading 12: Risk Management for Individuals Lesson 1: Human Capital and Financial Capital Lesson 2: Seven Financial Stages of Life Lesson 3: A Framework for Individual Risk Management Lesson 4: Life Insurance Lesson 5: Other Types of Insurance Lesson 6: Annuities Lesson 7: Implementation of Risk Management for Individuals 77 77 78 80 83 88 91 95 © W iley CONTENTS Study Session 6: Portfilio Management for Institutional Investors Reading 13: Managing Institutional Investor Portfolios Lesson 1: Institutional IPS: Defined Benefit (DB) Pension Plans Lesson 2: Institutional IPS: Foundations Lesson 3: Institutional IPS: Endowments Lesson 4: Institutional IPS: Life Insurance and Non-Life Insurance Companies (Property and Casualty) Lesson 5: Institutional IPS: Banks 103 103 111 115 117 120 Wiley Study Guide for 2018 Level III CFA Exam Volume 3: Economic Analysis, Asset Allocation, Equity & Fixed Income Portfolio Management Study Session 7: Applications of Economic Analysis to Portfolio Management Reading 14: Capital Market Expectations Lesson 1: Organizing the Task: Framework and Challenges Lesson 2: Tools for Formulating Capital Market Expectations,Part 1: Formal Tools Lesson 3: Tools for Formulating Capital Market Expectations,Part 2: Survey and Panel Methods and Judgment 13 Lesson 4: Economic Analysis, Part 1: Introduction and Business Cycle Analysis 19 Lesson 5: Economic Analysis, Part 2: Economic Growth Trends, Exogenous Shocks, and International Interactions 27 Lesson 6: Economic Analysis, Part 3: Economic Forecasting 30 Lesson 7: Economic Analysis, Part 4: Asset Class Returns andForeign Exchange Forecasting 33 Reading 15: Equity Market Valuation 39 Lesson 1: Estimating a Justified P/E Ratio and Top-Down and Bottom-Up Forecasting 39 Lesson 2: Relative Value Models 46 Study Session 8: Asset Allocation and Related Decisions in Portfolio Management (1) Reading 16: Introduction to Asset Allocation Lesson 1: Asset Allocation in the Portfolio Construction Process Lesson 2: The Economic Balance Sheet and Asset Allocation Lesson 3: Approaches to Asset Allocation Lesson 4: Strategic Asset Allocation Lesson 5: Implementation Choices Lesson 6: Strategic Considerations for Rebalancing Reading 17: Principles of Asset Allocation Lesson 1: The Traditional Mean-Variance Optimization (MVO) Approach Lesson 2: Monte Carlo Simulation and Risk Budgeting Lesson 3: Factor-Based Asset Allocation Lesson 4: Liability-Relative Asset Allocation Lesson 5: Goal-Based Asset Allocation, Heuristics, Other Approaches to Asset Allocation, and Portfolio Rebalancing 53 53 54 55 57 64 65 67 67 70 71 72 75 Study Session 9: Asset Allocation and Related Decisions in Portfolio Management (2) Reading 18: Asset Allocation with Real-World Constraints Lesson 1: Constraints in Asset Allocation Lesson 2: Asset Allocation for the Taxable Investor © W iley 81 81 84 CONTENTS Lesson 3: Altering or Deviating from the Policy Portfolio Lesson 4: Behavioral Biases in Asset Allocation Reading 19: Currency Management: An Introduction Lesson 1: Review of Foreign Exchange Concepts Lesson 2: Currency Risk and Portfolio Return and Risk Lesson 3: Currency Management: Strategic Decisions Lesson 4: Currency Management: Tactical Decisions Lesson 5: Tools of Currency Management Lesson 6: Currency Management for Emerging Market Currencies Reading 20: Market Indexes and Benchmarks Lesson 1: Distinguishing between a Benchmark and a Market Index and Benchmark Uses and Types Lesson 2: Market Index Uses and Types Lesson 3: Index Weighting Schemes: Advantages and Disadvantages 85 87 89 89 95 98 101 104 112 113 113 117 119 Study Session 10: Fixed-Income Portfolio Management (1) Reading 21: Introduction to Fixed-Income Portfolio Management Lesson 1: Roles of Fixed Income Securities in Portfolios Lesson 2: Fixed Income Mandates Lesson 3: Bond Market Liquidity Lesson 4: Components of Fixed Income Return Lesson 5: Leverage Lesson 6: Fixed Income Portfolio Taxation Reading 22: Liability-Driven and Index-Based Strategies Lesson 1: Liability-driven Investing Lesson 2: Managing Single and Multiple Liabilities Lesson 3: Risks in Managing a Liability Structure Lesson 4: Liability Bond Indexes Lesson 5: Alternative Passive Bond Investing Lesson 6: Liability Benchmarks Lesson 7: Laddered Bond Portfolios 127 127 129 133 135 137 140 143 143 144 147 148 148 149 149 Study Session 11: Fixed-Income Portfolio Management (2) Reading 23: Yield Curve Strategies Lesson 1: Foundational Concepts for Yield Curve Management Lesson 2: Yield Curve Strategies Lesson 3: Formulating a Portfolio Postioning Strategy for a Given Market View Lesson 4: A Framework for Evaluating Yield Curve Trades Reading 24: Fixed-Income Active Management: Credit Strategies Lesson 1: Investment-Grade and High-Yield Corporate Bond Portfolios Lesson 2: Credit Spreads Lesson 3: Credit Strategy Approaches Lesson 4: Liquidity Risk and Tail Risk in Credit Portfolios Lesson 5: International Credit Portfolios Lesson 6: Structured Financial Instruments 153 153 155 161 167 169 169 172 175 185 189 191 © W iley EQUITY PORTFOLIO MANAGEMENT Example 3-4 Zachary Hunt, CFA, is a professor at a state university with a large endowment fund Hunt is asked to evaluate the fund’s investment style using a holdings-based style analysis Hunt collects the following information about the fund and its benchmark Price to Book Ratio Price to Earnings Ratio Dividend Yield Three-Year Estimated EPS Growth Rate Portfolio 2.45 22.6 1.56% 9.79% Benchmark 1.89 18.5 2.43% 7.21% A State whether Hunt is more likely to identify the investment style as one of growth or value B Justify your answer with at least two explanations Solutions: A Growth B The P/B and P/E ratios and earnings estimate are all in excess of the benchmark, which would indicate a clear growth style In addition, the dividend yield is less than that of the benchmark, another indicator of growth tendencies LOS 25j: Compare the methodologies used to construct equity-style indices Vol 4, pg 291 Of course many financial institutions create style indexes that can be used at least for comparison purposes, but also for indications of which stocks fall into value or growth categories Most style indexes will be divided in just those two (value or growth) using HBSA and once an identification is made, the stock typically remains in its style index There are likely some buffering rules in which a stock can be partly assigned to both value and growth, but most style index creators try to make definite identifications For example, a growth stock will stay as a growth stock until the majority of its characteristics change enough to make it a value stock While this could lead to excessive turnover for stocks that are on the cusp of being categorized as value or growth, turnover can be reduced by buffering the categorization Some style indexes, however, use three categories: value, growth, and core, with a core style being one in which stocks cannot be clearly defined as either growth or value 210 ©2018 Wiley EQUITY PORTFOLIO MANAGEMENT Exhibit 3-1: Two Approaches to Style Analysis: Advantages and Disadvantages Advantages Returas-based • Characterizes entire portfolio style analysis • Facilitates comparisons of portfolios • Aggregates the effect of the investment process • Different models usually give broadly similar results and portfolio characterizations • Clear theoretical basis for portfolio categorization • Requires minimal information • Can be executed quickly • Cost effective Holdings-based • Characterizes each position style analysis • Facilitates comparisons of individual positions • In looking at present, may capture changes in style more quickly than retums-based analysis Disadvantages • May be ineffective in characterizing current style • Error in specifying indices in the model may lead to inaccurate conclusions • • • Does not reflect the way many portfolio managers approach security selection Requires specification of classification attributes for style; different specifications may give different results More data intensive than retums-based analysis LOS 25k: Interpret the results of an equity-style box analysis and discuss the consequences of style drift Vol 4, pp 294-295 Style Box The style box is a popular way of examining style, especially for equity mutual funds Many financial institutions, including Morningstar, report a style box for funds, but financial analysts can create one if they know the composition of the portfolio The box typically takes the 3-by-3 form, in which individual stocks are assigned a size and style grade © W iley EQUITY PORTFOLIO MANAGEMENT Example 3-5 A financial institution publishes a style box for the Almond Fund: Small-cap Mid-cap Large-cap Value 22 13 Blend/MarketOriented/Core 31 A Determine the style of the Almond Fund B Justify your answer with one reason Growth 27 0 Solutions: A Small-cap fund B This is clearly a small-cap fund with 80% of the securities being relatively small in size The fund is almost evenly split among value and growth and marketorientation, so it can be categorized as a broad small-cap fund The fact that there is mid-cap value of 13% does little to affect the identification as small-cap There are few large-cap securities so it is clearly not a large-cap fund One problem with style assignments is style drift in which the manager drifts away from the stated style The only way to determine style drift is to use HBSA over time to see if the manager is investing in stocks with higher or lower valuation ratios, dividend yields, or earnings estimates The consequence of style drift is that a manager showing significant style drift could be moving into areas in which there is a lack of expertise This is particularly true if a growth (value) manager suddenly drifts towards value and has little experience in selecting value (growth) stocks LOS 251: Distinguish between positive and negative screens involving socially responsible investing criteria and discuss their potential effects on a portfolio’s style characteristics Vol 4, pp 296-297 Social Responsibility Some investors have become increasingly sensitive about social and ethical issues as they relate to portfolio composition Investor groups, including those affiliated with religious organizations and others concerned about the social implications of investing, have included a social component to their policy statements Socially responsible investing (SRI) typically involves a screening process in which types of firms are either excluded or included Negative screening reduces the number of issues available to the socially responsible investor by eliminating entire industries (oil and gas, alcohol, gambling or gaming, tobacco, and armaments) or individual firms because of corporate practices (human rights practices, labor issues, animal rights, and pollution) 212 © W iley EQUITY PORTFOLIO MANAGEMENT Positive screening identifies firms with morally and ethically responsible behaviors, such as a firm with efficient and fair corporate governance policies or firms with welldocumented fair labor standards The implications for style management include: eliminating value stocks in certain industries such as energy which might tilt the style towards growth In fact, studies show that SRI mutual funds have more small-cap stocks This means portfolio managers must be aware of the bias possibilities and adjust appropriate benchmarks, both of which can be done using RBSA LOS 25m: Compare long-short and long-only investment strategies, including their risks and potential alphas, and explain why greater pricing inefficiency may exist on the short side of the market Vol 4, pp 297-298*• Long and Short Investment Strategies Most investors pursue long-only strategies in the pursuit of capital gains and dividend income The relevant measure of value added by a portfolio manager is known as the alpha, defined as the portfolio’s return in excess of the benchmark return Risks include asset selection and asset allocation errors Some investors, however, pursue both long and short strategies, which should generate two portfolio alphas measuring value added, one for the short position and one for the long position If the short positions are used to finance the long portfolio positions, a market neutral strategy is created and the portfolio should have a zero beta The main advantage of long-short strategies is the ability to trade on negative information or expectations, which is not possible in long-only strategies Risks include the extra leverage inherent in short positions and the frequently used margin loans to finance long positions (a practice especially used by hedge fund managers) Remember an investor can hold on to a long position until the firm ceases to exist, which could be decades Longterm short positions, however, are less likely as there are rules governing the payment of dividends and the return of borrowed securities with severe penalties being levied for breaking those rules Shorting stocks has the potential for greater inefficiencies due to the following: • • • • Most investors search for only undervalued securities so the market for overvalued securities is not as complete Poor accounting practices, negligence, or even fraud provide short-term opportunities to exploit falling stock prices, which not really exist in long strategies because corporate leaders typically not understate cash flows or earnings on purpose Analysts on the sell-side typically issue significantly more buy recommendations than sell recommendations, mostly not to upset clients who own shares that might be expected to experience a drop in prices Analysts making sell recommendations might have less access to corporate data and information in the future, so they are less likely to issue sell reports © W iley 213 EQUITY PORTFOLIO MANAGEMENT LOS 25n: Explain how a market-neutral portfolio can be equitized to gain equity market exposure and compare equitized market-neutral and short-extension portfolios Vol 4, pg 299 Market-Neutral Equitizing Strategy Market-neutral portfolio managers search for pairs of securities that are undervalued and overvalued, sometimes resulting in a zero beta portfolio, but usually resulting in a low beta portfolio This active strategy will be successful only if the manager correctly identifies mispriced pairs Sometimes, it is appropriate for a market-neutral portfolio to have exposure to the broad equity market This can easily be achieved by going long equity index futures contracts The portfolio manager typically takes the long position in the futures contract equal to the cash amount of the aggregate short positions This position moves the portfolio beta much closer to 1.0, allowing for an interesting combination of active management and a passive (beta) return on an index (without much investment required) Note the futures contracts must be rolled over when they mature in addition to the marking to market requirements of the futures exchanges Exchange traded funds can also be used to equitize market-neutral positions, which can be more efficient than futures contracts Short extension strategies are those that allow for long-only portfolio managers to take advantage of falling prices They are designed to have market betas close to one but provide opportunities for managers to take complete advantage of an information set, especially negative information about a firm or industry For example, portfolio managers permitted short extensions can short a specific stock, and then use the proceeds to invest in additional shares currently held or to invest in new securities Common short extensions include a 130/30 position, in which 130% of the portfolio is long and 30% is short Note this portfolio is much different than a long-only position (100/0), and has the advantages of not relying on derivatives markets for equitizing the portfolio and enjoying an increase in potential capital gains as a result of the manager’s skill set in finding both undervalued and overvalued stocks Of course, if the manager is unskilled, then capital losses will accrue and portfolio performance will suffer Example 3-6 Emily Marks, CFA, is a portfolio manager for a family tmst and has historically invested in long-only positions Marks achieves the fund’s return requirement for each of the last five years in addition to generating superior performance of 100 basis points against the relevant benchmark Marks approaches the family to request permission to include short positions for the coming year After several meetings, the family agrees that a 120/20 allocation is optimal for their portfolio At the conclusion of the meeting, one family member asks Marks to explain the worst case scenario Explain the worst case scenario for the family trust 214 © W iley EQUITY PORTFOLIO MANAGEMENT Solution: Pursuing short extension strategies have several important risks The worst case scenario is still the collapse of the 120% allocation to the long position, so the extra leverage provided by the short positions will magnify the losses The worst case scenario would include not only a drop in the long positions, but a rise in the short positions, which will bring about liquidity issues as well as margin calls and trading costs So, leverage and liquidity are worse case drags on performance, but the biggest risk remains the skill set of Marks in being able to identify overvalued stocks for the 20% short position LOS 25o: Compare the sell disciplines of active investors Vol 4, pg 302 Sell Decisions Portfolio managers sell securities for a variety of reasons, including liquidity issues, rebalancing needs, asset allocation changes, or simply to eliminate a poorly performing stock Regardless of the motivation, portfolio managers need a sell strategy Substitution strategies are frequently used by investors as they search for appropriate replacements when the time for selling arises Forward-looking portfolio managers will always evaluate potential investments to determine if they have a higher risk-adjusted return than the securities being sold This analysis is essentially an opportunity cost assessment of the financial environment in which some stocks are owned by the manager and the rest could be Style managers pursuing value or growth strategies tend to sell based on a set of trading rules For example, a value stock might be sold if its P/E ratio gets too high Many active managers use a combination of substitution and rules driven strategies to replace securities in their portfolios Average turnover ratios for managed portfolios are between 20% and 80%, but each investor must educate themselves on turnover levels that seem reasonable based on the details of the policy statement LESSON 4: SEMIACTIVE EQUITY INVESTING LOS 25b: Discuss the rationales for passive, active, and semiactive (enhanced index) equity investment approaches and distinguish among those approaches with respect to expected active return and tracking risk Vol 4, pg 303 Semiactive Investing The combination of passive and active investing is attractive to many investors because of the possibility of earning higher than passive returns without taking much additional risk The challenge, of course, is for the active manager to generate active returns that exceed the active trading risks Consequently, the semiactively-managed portfolio, also known as enhanced indexing, is expected to outperform a benchmark return A portion of this outperformance is the management of the additional tracking risk caused by the active part of the management strategy © W iley 215 EQUITY PORTFOLIO MANAGEMENT Synthetic or Derivatives-Based Investing Synthetic strategies use securities other than shares of stock to gain equity exposure Option contracts, futures contracts, and even swap contracts can easily offer returns that at least are greater than the risk free rate One common strategy is to equitize the cash position of the portfolio by taking long or short positions in interest rate futures contracts depending on the expected direction of interest rates This provides an extra return over cash if the manager is correct on his or her position on interest rates Other strategies include using broad equity index futures contracts with different maturity dates to take advantage of volatility changes in the equity market and by using options on stock indexes that differ from the benchmark index The portfolio manager must always be aware to remain within the risk-return boundaries outlined in the policy statement LOS 25p: Contrast derivatives-based and stock-based enhanced indexing strategies and justify enhanced indexing on the basis of risk control and the information ratio Vol 4, pg 303 Stock-Based Investing This is a simple strategy of adding undervalued stocks to the portfolio or by changing the allocation of the portfolio to one that is different than the benchmark They key to success is for the portfolio manager to have high quality asset allocation and asset selection skills There will be an increase in tracking risk, but the incremental return should compensate the investor adequately Under-weighting and over-weighting benchmark allocations are a common focus of enhanced indexers The main difference between active and semiactive managers is that semiactive managers operate within a controlled risk environment, which implies that similar metrics can be used to evaluate their performance The information ratio is therefore appropriate to apply to semiactive managers Remember the information ratio is simply the ratio of residual return (portfolio alpha) to residual risk (portfolio residual risk) This is a key formula Be sure to recognize that the information ratio increases by the square root of independent investment decisions taken The fundamental law of active management shows the information ratio can be approximated by: IRP ~ I C x j B R where 1C is the manager’s information coefficient and BR is the breadth of the manager’s strategy The information coefficient is a direct measure of the forecasting skill set of the semiactive manager It is really just a correlation coefficient between actual returns and forecasted returns An IC of indicates a complete lack of forecasting ability while an 1C close to 1.0 indicates perfectly talented managers The breadth is a measure of the number of independent annual forecasts made by semiactive managers Breadth for the semiactive manager is typically much less than for the active manager Successful enhanced indexing implies a superior combination of breadth and portfolio manager perception of financial securities 216 © W iley EQUITY PORTFOLIO MANAGEMENT Example 4-1 The Beats Foundation has historically used passive investing to achieve its financial goals, but recently it has decided to hire a semiactive manager to enhance its benchmark returns The foundation’s board is considering two managers: • • Joe Tuck, CFA, who follows 400 stocks and has an information coefficient of 0.04 John Kohl, CFA, who follows 300 stocks and has an information coefficient of 0.05 Select the best performing semiactive manager using only the above information Justify your answer with one reason Solution: To determine which manager is superior, it is appropriate to compute the information ratio for each and then choose the manager with the higher ratio: IRP ~ I C x V B R I R ruck * 0-04 x V400 = 0.080 IRKohl « 0.05 x 7300 = 0.087 Choose Kohl Example 4-2 The Beats Foundation decides to hire John Kohl, a semiactive manager, to enhance its benchmark returns Kohl has been successful in using both stock-based and derivativesbased strategies Kohl collects the following data on his past performance: Alpha Tracking risk Stock-Based Strategy 0.011 0.022 Derivatives-Based Strategy 0.018 0.034 Determine the more appropriate semiactive strategy Kohl should pursue for the Beats Foundation Justify your answer with one reason Solutions: The information ratio for each strategy will provide a good indication of which method is superior The traditional measure of the IR is the ratio of portfolio alpha to residual risk: IRstock = 0.011^0.022 = 0.5 ^D erivatives = 0.018 + 0.034 = 0.53 Choose the derivatives-based strategy © W iley 217 EQUITY PORTFOLIO MANAGEMENT LESSON 5: MANAGING A PORTFOLIO OF MANAGERS LOS 25r: Explain the core-satellite approach to portfolio construction and discuss the advantages and disadvantages of adding a completeness fund to control overall risk exposures Vol 4, pp 309-312 Combinations of Passive, Semiactive, and Active Investing For many intuitional investors, it is efficient to hire multiple managers who have specific styles or specific indexing skills When hiring a portfolio of active managers, important decisions include determining the appropriate number of managers necessary to achieve risk and return objectives as well as determining the maximum active risk tolerated These decisions are frequently performed using an optimization method similar to the efficient frontier developed by Harry Markowitz Instead of computing optimal weights for each financial security held in a portfolio, this optimization strategy identifies the optimal weights allocated to each manager Recall that the Markowitz model is based on an objective function of minimizing standard deviation (total risk) This model is based an objective function of minimizing active risk (tracking risk), so the efficient frontier drawn as a result of the model will be quite similar to the Markowitz frontier, with the exception of the axes, which become expected alpha and expected tracking risk The optimization technique will then compute the efficient allocation to each manager, which depends entirely on the risk-return trade-off For example, if the investor decides on a maximum tracking risk of 2%, then those weights producing 2% tracking risk will be selected Finally, portfolio active return and active tracking risk can be calculated using the weighted average formulas learned previously LOS 25q: Recommend and justify, in a risk-return framework, the optimal portfolio allocations to a group of investment managers Vol 4, pp 255-257 Core Satellite Portfolio Many investors prefer having a core portfolio consisting of a passive or semi-active strategy at the core with active managers operating as satellites around the core It is possible to use similar optimization models to identify the best active and even semiactive managers for the satellite portion of the portfolio The goal is to meet the risk and return objectives of the investment policy statement The core satellite strategy attempts to achieve this goal by focusing the majority of the portfolio on core indexing (passive or enhanced) and then add value by selecting efficient active managers while keeping tracking risk at minimally acceptable levels One concern that must be addressed is the deviation from core strategies that are significant enough to warrant new benchmark standards 218 © 2018 Wiley EQUITY PORTFOLIO MANAGEMENT Example 5-1 The Western College endowment fund uses a core-satellite strategy with the following managers: Manager Davis Williams Rogers Smith Assets Under Management (AUM) $100 million $100 million $100 million $100 million Expected Alpha 0.01 0.03 0.04 0.00 Expected Tracking Risk 0.019 0.038 0.050 0.000 A Identify the managers who are most likely part of the core and who are part of the satellites B Calculate the expected alpha of the core-satellite strategy C Calculate the expected tracking risk (error) of the core-satellite portfolio Assume that the correlation among managers is equal to zero D Select an appropriate allocation range for the core-satellite strategy Solutions: A Smith is the indexer (with alpha and tracking risk of 0); Davis is the enhanced indexer (with alpha and tracking risk between 1% and 2%) Williams and Rogers are the active satellite managers (with alphas in excess of 2% and tracking risk greater than about 4%) B 0.25 x 0.01 x 0.25 x 0.02 + 0.25 x 0.04 + 0.25 x 0.00 = 0.0175 C [0.252 x 0.0192 + 0.252 x 0.0382 + 0.252 x 0.052 + 0.252 x 0.0002]172 = 0.0164 D The core weights should exceed 50%, so it is likely that Western College would select between 40% and 60% allocated to Smith; another 10% to 20% allocated to Davis The remainder will be equally split between the two active managers, so around 10% to 25%, depending on the risk tolerance of the endowment’s board © W iley 219 EQUITY PORTFOLIO MANAGEMENT LOS 25s: Distinguish among the components of total active return (“true” active return and “misfit” active return) and their associated risk measures and explain their relevance for evaluating a portfolio of managers Vol 4, pp 311-312 Components of Active Return Managers can be evaluated by breaking their total active return into two parts: • Manager’s true active return = Manager’s actual return - Manager’s normal benchmark return (MNBR) Manager’s misfit active Return = Manager’s normal benchmark return - Investor’s benchmark return (IBR) • Where the MNBR is the return on the population of securities from which the manager would make asset selection decisions and the IBR is the benchmark return used by investors to compare performance of the portfolio A positive misfit active return shows that the manager should be expected to outperform the benchmark established by the investor or client The question then becomes whether or not it is worth taking the extra risk to outperform If the manager is skillful in his stated style, then the misfit return is worth pursuing By dividing the active investment strategy into its two components, it is possible to use an optimization technique that will provide a maximum active return at each level of active risk In addition, the total active risk can be divided into true active risk and misfit active risk, where: These two measures can then be used to determine the manager’s information ratio, which is an even more complete measure of performance Example 5-2 Lisa Bowers, CFA, is an active portfolio manager who reports the following year-end information to her client: • • • • • 220 Portfolio return: 13% Client benchmark return: 14% Manager benchmark return: 12% Manager active risk: 6% Manager misfit risk: 4% A Determine the true active return and misfit active return for Bowers B Compute the information ratio for Bowers © W iley EQUITY PORTFOLIO MANAGEMENT Solutions: A True active return = 13% - 12% = 1% Misfit active return = 12% - 14% = -2% B Determine true active risk first with the formula: Total active risk = {(True active risk)2 + (Misfit active risk)2}172 0.06= {(TAR)2 + (0.04)2}1/2 TAR = 0.0447 Information ratio = True active return -r True active risk Information ratio = 0.01 -r 0.447 = 0.22 Sometimes when there are several managers, each pursuing a unique style, there is a need for a completeness fund This fund is designed to offset the extra risk taken by active portfolio managers during deviations from the benchmark It works almost like a hedge and the goal of a completeness fund is to reduce or even eliminate misfit risk It is important to remember that eliminating misfit risk might not be optimal, if the manager is successful LOS 25t: Explain alpha and beta separation as an approach to active management and demonstrate the use of portable alpha Vol 4, pg 313 Alpha and Beta Separation It is possible to separate the systematic risk component (beta) of an aggregate portfolio from its actively managed component (alpha) One strategy is to pursue a market-neutral position, in which there is little if any beta exposure, but the returns are generated by the alpha from the active manager This is an alpha strategy Another strategy is to hire a low cost indexer to gain exposure to beta combined with hiring an active manager who can use market-neutral positions to gain alpha exposure Consequently, the manager can separate alpha and beta and choose both exposure levels This type of risk management is not possible in a long-only strategy Of course, the risk structure of the alpha beta match must be consistent with the terms of the investor’s policy statement One important part of this strategy is when an active manager can add value to a variety of beta exposures When an active manager can respond to changes in systematic risk of the underlying core index, it is known as a portable alpha This allows the investor the opportunity to respond to changes in economic conditions and changes in manager skill set, allowing the investor to manage both systematic and active risks For example, a reasonable goal could be to generate a return equal to a benchmark return (beta) plus an active return (alpha) © W iley 221 EQUITY PORTFOLIO MANAGEMENT LESSON 6: IDENTIFYING, SELECTING, AND CONTRACTING WITH EQUITY PORTFOLIO MANAGERS LOS 25u: Describe the process of identifying, selecting, and contracting with equity managers Vol 4, pp 314-322 PORTFOLIO MANAGERS AND EQUITY RESEARCH Equity Portfolio Managers Investors must identify, select and contract with equity portfolio managers Identifying Managers A large number of potential candidates should be evaluated on a global basis There are many consultants who specialize in scrutinizing the universe of active managers, using both qualitative and quantitative tools The important end result is for the investor to find managers whose established investment philosophy is consistent with the investor’s goals Selecting Managers Portfolio managers are typically selected on their ability to match philosophies and goals One critical tool employed by consultants is a manager questionnaire that has multiple sections in an attempt to narrow the field down to those that can be pursued Sections of the questionnaire include: • • • • • Organization, structure, and personnel Investment philosophy Research capabilities Historical performance Fees Contracting Managers Part of the selection process includes an evaluation of the fee structures charged by the manager, especially in comparison to the competition and expectations on performance Managers may charge ad valorem asset under management (AUM) fee, which is determined as a percentage of the value of the assets managed Others use a simple performance based fee which generally consists of a flat fee plus a share in the excess performance over a predetermined benchmark 222 © W iley EQUITY PORTFOLIO MANAGEMENT LESSON 7: DISTRESSED SECURITIES LOS 25v: Contrast the top-down and bottom-up approaches to equity research Vol 4, pp 322-324 Equity Research While specific research styles and approached vary among firms, there are two general approaches Top-Down Approach Top-down research is a study of macro down to micro variables The approach begins with a study of macroeconomic variables, including global economies and domestic industries The final part is then a study of individual firms to arrive at the best stocks for the portfolio Bottom-Up Approach Bottom-up research is performed in the opposite direction, with the beginning and major part being the study of individual securities This typically involves a study of growth and value firms using traditional fundamental analysis as well some technical analysis The final piece is a study of industries and economies Finally, note the differences between sell-side and buy-side analysts Sell-side analysts issue research reports to generate trades for the brokerage firms that they work for Buy-side analysts research companies to include (or exclude) from a portfolio Buy-side analysts typically have to convince an investment committee of the merits of their research ideas The recommendations of buy-side analysts are typically not available outside their own firms © W iley 223 ... Wiley Study Guide for 2018 Level III CFA Exam Review Complete Set Thousands of candidates from more than 100 countries have relied on these Study Guides to pass the CFA Exam Covering... 978-1-119- 436 11-9 (ePub) ISBN 978-1-119- 436 10-2 (ePDF) Contents About the Authors xi Wiley Study Guide for 2018 Level III CFA Exam Volume 1: Ethical and Professional Standards & Behavioral Finance Study. .. Securities 197 197 198 204 215 218 222 2 23 Wiley Study Guide for 2018 Level III CFA Exam Volume 4: Alternative Investments, Risk Management, & Derivatives Study Session 13: Alternative Investments for