CFA level 3 secret sauce 2014

• Use reasonable care and exercise independent professional judgment when conducting investment analysis, making investment recommendations, taking investment actions, and engaging in ot

Foreword 3

Echics: SS 1 & 2 4

Behavioral Finance: SS 3 35

Private Wealth Management: SS 4 51

Ponfolio Management for Institutional Investors: SS 5 78

Capital Marker Expectations in Porrfolio Management: SS 6 91

Economic Conceprs for AsseL ValuaLion in Portfolio Management: SS ? 103

Asset Allocation: SS 8 107

Management of Passive and Accive Fixed Income Porrfolios: SS 9 113 Porcfolio Management of Global 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\pplic rion 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

Published in 2013 by Kaplan Schweser

Primed in the United Stares of /1J11erica

ISBN: 978-1-4277-4937-6 I 1-4277-4937-X

PP1\: 3200-4038

If chis book d ocs nor have rhe hologram with t he Kaplan Schwese r logo on the back cover, it was

d i srr i bm c d witho ut permission of Kapl a n Schweser, a Div isio n of Kaplan, Inc., and i s in dirc cr vio l ation of global copyrigl: t l;;ws Your ass i st;rnce in p1mu ing porenrid violators of this law is

gr eatly appreciarcd

Required CFA Institute disclaim er: "C FAl°' an d Char rered l~inancial Analyse® are tra d emarks owned by CFA lns: i tute CFA l nsrirnre (fo rmerly r he Associ21io11 for l nvesm1 enr f.fanagemenr and Research) do es nor e ndorse, promote, review, or warrant th e ac c ura cy of the products o r se rvi ces off ered by f(J pbn Schweser."

C e rtain materia ls comained within this text are th e copyrighted property of CFA Institut e The following is the copyright disclosure for t hese material s: "Copyright, 2013, CFA lnstiture Reproduced and republished from 2014 Learning Outcome Sratemenrs , Level I, II, a nd III questions from CFA® Program Materials , C:FA Insritun: Standa rds of Profe ss ional Con duct, and CFA l nstitute's G lobal I nvestme nt Performance SLanciards wirh permission from CFA Institute All Rights Res e rved."

These materials may not be copied without written permission from the author The unauthoriz e d dup l icat i on of these notes is a vio l at i on of g lobal copyright l aws and the Cf A Institute Code of Ethics Your assistance in pursuing potential violato r s of this law is greatly ap preciated

Discla i mer: Schweser study tools should be used in conjunction with the original readings as set forth by CFA Ins tiru r e in their 2014 CFA Level Ill S tudy Guide The information comained in these materials covers topics contained in the read ing s referenc e d by CFA Insrirute and is believe d

to be accura t e However, their accuracy cannot be guaranteed nor is any warranry convey ed as to your ultimate exam success The aut ho rs of the r e ferenced readings have nor end orsed or S?onso r ed Schweser study too l s

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 do well on the exam But do 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-alo e item set in much the way it was presented in the curriculum At Level III, you \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

Study Sessions 1 & 2

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 & 2

Ethics is covered in Study Sessions 1 and 2 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

do 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 C FA material and then work all of our questions plus the CPA reading questions

end-of-Code of Ethics

Members of CFA Institute, including Chartered Financial Analyst® (CPA®)

charterholders, and Candidates for the CPA designation ("Members and

• 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

1 Copyri~ht 2010, CFA Institute Reproduced and republished from "The Code of Ethics,' from Standards of Practice Handbook, 10th Ed., 2010, with permission from CFA Institute All rights reserved

• 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-VII

I 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 5

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, compensaton, or considerarion that would compromise independence and objcctiviry

Guidance

Do not let the investment process be influenced by any external sources Modest

gifts are permitted i\llocation of sh res in o ersubscribed TPOs ro personal

accounts is KOT permitted Distinguish between gifts from clients and gifts from entities seeking influence to the derrimenc of any client Gifts musr be disclosed to the Member's employer in any case

Guidance- I nvestment-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 b nkers in "road shows" o ly when che conflicts arc adequately and effectively managed and disclosed Be sure there are effectve "firewalls" her.ween

research/invtstmenr management and investment banking activities

Guida 11 o.- Public Companie s

Analysts should n t be pressured to issue favorable research by rhe companies they follow Do not confine research to discussions with company management, but

rarher use a v riety of sources, including suppliers, c stomers, and competitors

Guidance-Bu y - Side Clien t s

Buy-side clients may try to pressure sell-side 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-P aid Research

.Analysts compensation for preparing such research should be limited, and

the preference is for a flat fee, without regard to conclusions or the report's

recommendations

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 o ay if it does

not influence a Member's inde endence or objectivity

•

•

•

Restrict employee investments in equity IPOs and private placements

Have effective supervisory and review procedures

Finns should have formal wrinen policies

• Appoint a compli nce officer; provide 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 misrepresentatio s or give false impressions lvlisrepresenrations

include guaranteeing investment performance <lnd plagiarism Plagiarism

encompasses u:;ing someone else's work with ut giving credit

Recomm ended P rocedures jot Compliance

Avoid misrepresentation by providing employees who deal with clients or

prospects a written lst of the firm's available services and a description of the firm's

qualifications Employee qualifications should be accurately presented as ,.,·ell To avoid plagiarism, mainrain records of all materials used to generate reports or other

firm products and properly cite sources Information from recognized financial and

statistical reporting services need not be cited Firms are encouraged to establish procedures for verifying marketing claims of third parries whose information the

firm provides to clients

I(D) Misconduct Do not engage in any professiunal conduct that involves

dishonesty, fraud, or deceit Do not do anything that reflects poorly on your integrity, good reputation, trustworthiness, or professio al competence

Guidance

Cf A Institute discourages unethical behavior in all aspects of Members' and Candidates' lives Do not abuse CFA lnstitute's Professional Condu t Program by seeking enforcement of this Standard to setde personal, political, or other disputes char are not related to professional ethics

Firms are encouraged to adopt these policies and procedures:

• Develop and adopt a code of erhics and make dear that unethical behavior will

nor be tolerated

• Give employees a list of p tential violations and sanctions, including dismissal

• Check references of potential employees

II Integrity of Capital Markets

II(A) Material Nonpublic Information Members and Candidates in possession

of material nonpublic information must not act or induce someone else to act on the information

Guidance

Information is "material" if its disclosure would impact rhe price of a security or

if reasonable investors would want the information before making an investment

decision Information is "nonpublic" until it has been made available to the marketplace

Guidance-Mosaic Theory

There is no violation when a p rceptive analyst reaches an investment conclusion

about a corporate action or event through an analysis of public information

together with items of non-mat eri al nonpublic information

R ecommende d Procedures far Compliance

Make reasonable efforts to achieve public dissemination of the information

En ourage firms to adopt procedures to prevent misuse of material nonpublic

informatio Use a "firewall" within the firm, with elemencs including:

• Substantial control of relevant interdepartmental communications

P age 8 ©2013 Kaplan, lnc

Review employee trades-maintain "watch," "resrricted," and "rumor" lists

• Monitor and restrict proprietary trading while a firm is in possession of material

nonpublic information

Prohibition of all proprietary trading while a firm is in possession of marerial

nonpublic information may be inappropriate, because it may send a signal co the market In these cases, firms should take the contra side of only unsolicited

cuswmer trades

ll(B) Market Manipulation Do not engage in any practices imended to mislead

market participants through distorted prices or artificially inflated trading volume

Gui.dance

This Standard applies ~o transactions that deceive rhe marker by distorting rhe

price-setting mechanism of financial instruments or by securing a controlling

position to manipulate the price of a rdate<l derivative and/or the asset itself

Spreading false rumors is a~so prohibited

III Duties to Clients and Prospective Clients

IIl(A) Loyalty, Prudence, and Care Members must always act for the benefit

of clients and place: clients' interests before their employer's or their own interests

Members must be loyal ro clients, use reasonable care, and exercise pmdenc

judgment

Guidance

Client interests always come fir~ t

Exercise prudence, care, skill, and diligence

• Manage pools of client assets in accordance with the terms of the governing

documents

• Make investment decisions in the context of rhe total portfolio

• Vote proxies in an informed and responsible manner Due to cost benefit

considerations, it may not be necessary to vote all proxies

• Client brokerage, or "soft dollars" or "soft commissions," must be used to benefit the diem

&commended Procedures of Compliance

Submit to clients, at least quarcerly, itemized statements showing all securities in

custody and all debits, credits, and transactions

©2013 Kaplan Inc Page 9

Encourage firms to address these topics when drafting policies and procedures regarding fiduciary duty:

e Follow applicable rules and laws

• Establish client's investment objectives Consider suitability of portfolio relative

to client's needs and circumstances, the investment's basic characteristics, or the basic characteristics of the total portfolio

• Diversify

• Deal fairly with all clients in regard to investment actions

• Disclose conflicts

• Disclose compensation arrangements

• Vote proxies in the best interest of clients and ultimate beneficiaries

• Maintain confidentiality

• Seek best execution

• Place client interests first

III(B) Fair Dealing Members must deal fairly and objectively with all clients and prospects

Guidance

Fairly does not mean equally In the normal course of business, there will be differences in the time emails, faxes, et cetera, are received by different clients Different service levels are okay, but they must not negatively affect or disadvantage any clients Disclose the different service levels to all clients and prospects, and make premium levels of service available to all who wish to pay for them

Give all clients a fair opportunity to act upon every recommendation Clients who are unaware of a change in a recommendation should be advised before the order is accepted

Treat all clients fairly in light of their investment objectives and circumstances Members and Candidates should not take advantage of their position in the industry to disadvantage clients

Recommended Procedures for Compliance

Encourage firms to establish compliance procedures requiring proper dissemination

of investment recommendations and fair treatment of all customers and clients

• Limit the people aware of a pending change in recommendation

• Shorten the time frame between decision and dissemination

• Have in place published guidelines prohibiting discussing or taking action on a pending recommendation

• Simultaneous dissemination

• Maintain list of clients and holdings to ensure that all are treated fairly

• Develop written trade allocation procedures-ensure fairness to clients, timely and efficient order execution, and accuracy of client positions

• Disclose trade allocation procedures

• Establish systematic account review-ensure that no client is given preferred treatment and that investment actions are consistent with the account's

objectives

• Disclose available levels of service

III(C) Suitability

1 When in an advisory relationship with client or prospect:

a Make reasonable inquiry into clients' investment experience, risk and return objectives, and constraints prior to making any recommendations or taking investment action Reassess information and update regularly

b Be sure recommendations and investments are suitable to a client's financial situation and consistent with client objectives

c Make sure investments are suitable in the context of a client's total portfolio

2 When managing a portfolio, investment recommendations and actions must be consistent with stated portfolio objectives and constraints

Guidance

In advisory relationships, be sure to gather client information at the beginning of the relationship If responsible for managing a fund to an index or other stated mandate, be sure investments are consistent with the stated mandate

Recommended Procedures for Compliance

• Put the needs and circumstances of each client and the client's investment

objectives into a written IPS

• Consider the type of client and whether there are separate beneficiaries, investor objectives, investor constraints, and performance measurement benchmarks

• Review the investor's objectives and constraints periodically to reflect any changes in client circumstances

information must be fair, accurate, and complete

performance Do not state or imply the ability to achieve a rate of return similar to char achieved in the past

Recommended Procedures for Compliance

Considering the sophistication of the audience

a single account

Maintaining dara and records used

clients and prospects mmr be kept confidential unless it pertains to illegal activities,

disclosure is required by law, or the client or prospect gives permission for the information to be disclosed

Guidance

If illegal activities by a client are suspected, Members may have an obligation

Recommended Proce dui · es foi- Compliance

Members should avoid disclosing information received from a client, except to

author~zed co-workers who are also working for rhe client Members should follow firm procedures for storage of electronic data a~d recommend adoption of such procedures if they are not in place

before their own and must not deprive their employer of their skills and abilities,

Guidance

Members must not engage in activities that would injure the firm, deprive it of

profit, or deprive it of the advantage of employees' skills and abilities Always place client interests ahove employer interests

Guidance-Independent Practice

Independent practice for compensation is allowed if a notification is provided to the employer fully describing all aspects of the services, including compensation, duration, and the narure of the activities and if the employer consents to all terms

of the proposed independent practice before it begins

Misappropriation of trade secrets

MisLL~e of confidential information

Soliciting employer's clients prior to leaving

Self-dealing

Misappropriation of client Jim

Once an employee has left a firm, simple knowledge of names and existence of

former clients is generally not confidential AJso, there is no prohibition on the use

of experience or knowledge gained >vhile with a former employer

IV(B) Additional Compensation Arrangements Accept no gifts, benefits, compensation, r co sideration that may create a conflict of interest with the

employer's inrere t unless written co sent is received from all parties

Guidance

Compensation includes direct and indirect compensation from a client and other benefits received from third parties Written consent from a Member's employer

includes e-mail communication

Reco mmended Procedures.for Compliance

Make an immediate ·\.vrinen report to employer detailing proposed compensation and services, if additional to that provided by employer Details including any performance incentives should be verified by the offering party

N(C) Responsibilities of Supervisors All Members and Candidates must make reasonable efforts to detect and prevent violations of laws, rules, regulations, and

the Code and Standards by any person under their authority

Guidance

Take steps to prevent employees from violating laws, rules, regulations, or the Code

and Stan ards and make reasonable efforts to derecr violations

Guidance - C., o mpliance Procedu r e s

An adequate compliance system must meet industry standards, regulatory

requirements, and the requirements of the Code and Standards Members with

supervisory responsibilities have an obLgation to bring an inadequate compliance

system to the attention of firm's management and recommend corrective a tion

While inve tigating a possible breach of complance procedures, it is appropriate to

limir the suspected employee's a tivities

Recommen ded Procedures far Compliance

A Member should recommend that his employer adopt a code of ethics Employers should not commingle compliance procedures with the firm's code of ethics-this

can dilute the goal of reinforcing one's ethical obligations Members should

encourage employers to provide their code of ethics to clients

Adequate compliance procedures should:

• Be dearly written

• Be easy to understand

• Designate a compliance officer with authority clearly defined

• Have a system of checks and balances

• Outline the scope of procedures

• Outline what conduct is permitted

• Contain procedures for reporting violations and sanctions

Once the compliance program is instituted, the supervisor should:

Disrribure it to the proper personnel

• Update it as needed

• Continually educate staff regarding procedures

Issue remin ers as necessary

• Require professional conduct evaluations

• Review employee actions to monirnr compliance and identify violations

• Enforce procedures once a violation occurs

If there is a violation, respond prompcly and conduct a thorough investigation

while placing limitations on the wrongdoer's activities

V Investment Analys i s, R eco mmendations , and Action

V(A) Diligence and Reasonable Basis

1 When analyzing investments, making recommendations, and taking

investment acto s, use diligence, independence, and thoroughness

2 Analysis, recommcndaLions, and a tions sh uld have a reasonable and

adequate basis, supp rted by research and investigation

Guidance

The application of chis Standard depends on the investment philosophy ad ered to,

Members' and Candidates' roles in the investmenr decision-making process, and the

resources and support provided by employers These factors dictate the degree of

diligence, thoroughness of research, and rhe proper level of investigation required

Guidance-Usi ng Seconda ry or Th ir d - Par ty Re sear ch

See that the research is sound Examples of criteria to use ro evaluate:

• Review assumptions used

• How rigorous was the analysis?

• How timely is the research?

• Evaluate objectivity and independence of the recommendations

Guidance - Group Research and Decision Making

Even if a Member does not agree with the independent and o jective view of the

group, he does n t necessarily have to decline to be identified with the report, as

long as there is a reasonable and adequate basis

Recommended Procedures for Compliance

Encourage firms to consider the policies and procedures supporting this Standard:

• Have a policy requiring that research repons and recommendations have a basis

th t can be substantiated as reasonable and adequate

• J lave detailed, written guidance for proper research and due diligence

• Have measurable criteria for judging the quality of research

• Have procedures that provide a minirnum acceptable level of scenario testing

for computer-based models, include standards for the ra ge of scenarios, model accuracy over time, and a measure of the sensitivity of cash flows to model assumptions and inputs

• Have a policy for evaluating oucside providers of information that addresses the

reasonableness and accuracy of the information and establishes how often the

evaluatio s should be repeated

• Adopt a set of standards that provides criteria for evaluating external ad.visors

a d states how often they will be reviewed

V(B) Communication \XTith Clients and Prospective Clients

1 Disclose to clients and prospects basic format and general principles of

investment proc sses used to analyze and select securities and construct

porrfolos Promptly disclose a y process changes

2 Use reasonable ju gment in idenrif}ring relevant factors important to

wh n c mmunicating with clients and prospects

3 Investment analyses and recommendations should clearly differentiate

facts from opinions

Guidance

Proper communication with clients is critical to provide quality financial services

Distinguish between opinions and facts and always include the basic characteristics

of the security being analyzed in a research report

Members should communicate risk facrors specific to non-traditional investments,

including potential gains and losses on all investments in terms of total returns

Members should explain the limitations of the projections from quantitative

models and analysis

©2011 Kaplan Inc

Members must illustrate to clients and prospects rhe investment decision-making

the entire portfolio

R ecommende d Procedures for Compliance

Be sure ro maintain records, and be able to supply additional information if ic is

V(C) Record Retention Maintain all records supporting analysis,

clients and prospects

Guidance

Members must maintain research records that support the reasons for the analyst's

conclusions and any investment actions taken Such records are the property of the

Recommended Procedure s for Compliance

VT(A) Disclosure of Conflicts Members and Candidates must make full and

Guidance-Disclosure t o Clients

common conflict that requires disclosure is actual ownership of stock in companies

Guidance-Disclosure of Conflicts to Employers

Members must promptly report potential conflicts and give the employer enough information to judge the impact of the conflict Take reasonable steps to avoid conflicts

Recommended Procedures of Compliance

Disclose any special compens,ation arrangements, bonus programs, commissions, and incentives

VI(B) Priority of Transactions Investment transactions for clients and employers must have priority over those in which a Member or Candidate is a beneficial owner

Recommended Procedures for Compliance

All firms should have in place basic procedures that address conflicts created by personal investing The following areas should be included:

• Limited participation in equity IPOs Members can avoid these conflicts by not participating in IPOs

• Restrictions on private placements Strict limits should be placed on employee acquisition of these securities and proper supervisory procedures should be in place

• Establish blackout/restricted periods Employees involved in investment decision making should have blackout periods prior to trading for clients-no "front running."

• Reporting requirements Supervisors should establish reporting procedures, including duplicate trade confirmations, disclosure of personal holdings/beneficial ownership positions, and pre-clearance procedures

• Disclosure of policies When requested, Members must fully disclose to investors their firm's personal trading policies

VI(C) Referral Fees Members and Candidates must disclose to their employers,

clienrs, and prospects any compensation consideration or benefit received by, or

paid to, orhers for recommendations of products and services

Guidance

Members must inform employers, clients, and prospects of any benefit received for referrals of customers and clients, allowing them to evaluate the full cost of the service as well as any potencial paniality

Re commen ded Procedures for Complianc e

firms that do not prohibit referral fees should have clear procedures for approval, and members should provide their employers with updates at least quarterly

regarding the nature and value of referral compensation received

VIL Responsibilities as a CPA In s titute Member or CFA Candidate

VIl(A) Conduct as Members and Candidates in the CFA Program Members

and Candida res must nor engage in conduct that compromises the reputation

or integriry of CFA Institute or the CFA designation or the integrity, validity, or securiry of the Cf A Exams

This Standard applies to conduce that includes:

•

•

•

Cheating on the Cl-A Exam or any exam

Nor following rules and p licies of the CFA program

Giving confidencial information on the CFA program to anyone

Improperly using the designation for p rson l gain

• Misrepresenting information on the Professional Conduct tatement (PCS) or

the CFA Institute Professional Developmenc Program

Members and Candidates are not precluded from expressing their opinions

regarding the exam program or CFA Institute

VII(B) Reference to CFA Institute, the CFA designation, and the CFA Program Members and Candid tes must not misrepresent or exaggerate the meaning or

implications of memb rship in CFA Institute, holding the CFA designation, or

candidacy in rhe program

©2013 Kaplan, Inc Page 19

Guidance

Members must not make promorional promises or guarantees tied to the CFA

designation Do not:

• Over-promise individual competence

• Over-promise invescmem results in the future

Members muse sign PCS annually and pay CFA Inscicuce membership dues

annually If they fail to do this, they are no longer active Members

Guidance-Using the CFA Designation

Do not misrepresent or exaggerate the meaning of the designation

Guidance-Referencing Candidacy in the CFA Program

There is no partial designation It is acceptable to state that a Candidate successfully

complcred the program in three years, if in fact the Candidate did, ut claiming

superior ability because of chis is not permirted

Guidance-Proper Usage of the CFA Marks

The Chartered Financial Analyst and Cf A marks must always be used either after a

charterholder's name or as adjectives but not as nouns

R ecommended Pi-ocedures Joi· Compliance

Make sure chat Members' and Candidates' firms are aware of rhe proper references

to a Member's CFA designation or candidacy

STUDY SESSION 2 - ETHICAL AND PROFESSIONAL STANDARDS

2 Investment professionals should place personal interests below the interest of clients and the integrity of the investment profession

3 Investment professionals should act with care and maintain independent judgment \Vhen applying investment analysis, recommendations, and actions Analysts must use independent judgment when engaging in activities that will ultimately affect client interests

4 Analysts should not only act in an ethical manner, but should promote ethical actions of others within the profession

5 Investment professionals should contribute to well-functioning markets by

respecting the applicable rules and promoting those rules to others

6 Investment professionals should strive to maintain and improve their

professional competence, as well as the competence of others within the

Standard I (A) Knowledge of the Law

Know the law, and when confronted with differences between the applicable law or regulation and the Code and Standards, honor the stricter of the two

e Do not participate/assist in violations If needed, dissociate

• In cases of observed violations, report it to a supervisor and compliance officer, if necessary Extreme cases may require resignation and/ or reporting the violation to the proper authorities

Standard I(B) Independence and Objectivity

0 The client's best interest always comes first Maintaining independence and objectivity is paramount Do not accept any consideration that may interfere with this Use judgment concerning what is a "threshold" of improper consideration

• This Standard applies not only to investment managers, but to plan

sponsors, investment consultants, investment bankers, and dealmakers Stand~rd I(C) Misrepresentation

0 An analyst has a duty of competence and dil~gence to make sure that her analysis is properly documented and supported There should be no guarantees or assurances An accurate description of facts is permitted

0 Plagiarism is prohibited Give credit and cite the sources of ideas, facts, and opinions taken from others

0 Do not misrepresent your own or your firm's experience or qualifications

Standard I (D) Misconduct

0 Investment professionals must not do anything that reflects poorly on their professional reputation, integrity, or competence

• Trust must not be violated

Standard II: Integrity of Capital Markets

Standard II(A) Material Nonpublic Information

Defined as "information that could affect an investment's value." Covered persons must not act or cause others to act on material, nonpublic

• If accidentally encountering material nonpublic information, encourage the public release of the information from the subject firm

Standard II(B) Market Manipulation

• This Standard prohibits any practices that inflate or misstate trading volume

or mislead market participants

0 Deceptive practices interfere with fair/ efficient financial markets

Standard III: Duties to Clients

Part of the definition of a profession is dedication to a greater good

(i.e., performance in the best interests of clients rather than the practitioner)

Standard III(A) Loyalty, Prudence, and Care

0 Always act with the client's best interest in mind, even if the employer

is disadvantaged There is a duty of loyalty to clients, and investment recommendations and actions must be sound

° Fiduciary responsibility is needed Client loyalty also extends to mutual fund managers

Standard III(B) Fair Dealing

• There can be no special treatment for favored clients

It is acceptable to offer premium services as long as the availability, nature, and cost of these services are fully disclosed

Premium services should benefit those who utilize them but cannot unfairly disadvantage any other investor classes

Standard III(C) Suitability

0 Before giving any investment advice or talcing investment action, inquire about the client's investment experience and objectives and constraints

• Judge investments in the context of the total portfolio The importance of diversification must be stressed If a client suggests imprudent investment actions, the investment advisor must advise the client in plain language

Standard III(D) Performance Presentation

Performance results must be presented fairly, accurately, and completely

Adherence to GIPS is strongly encouraged

Standard III(E) Preservation of Confidentiality·

All information concerning past, present, or prospective clients must be kept confidential unless it concerns illegal activities

Standard IV: Duties to Employers

Standard IV(A) Loyalty

Covered persons must always act for the benefit of their employer

If an employee chooses to join another firm, the employee cannot remove

or copy the firm's property and represent it as his own Furthermore, the employee cannot take client lists, software, files, et cetera, with the intent of competing with the former employer

Standard IV(B) Additional Compensation Arrangements

Covered individuals should not accept any form of additional compensation that competes with the employer's interest and may produce a conflict Written consent must be obtained from all parties involved

Standard IV( C) Responsibilities of Supervisors

e A covered person who is a supervisor must make reasonable efforts to detect and prevent violations of laws and regulations

Adequate training and continuing education of employees subject to

supervision is crucial

• Advise subordinates of the provisions of the Code and Standards

0 Delegation of work responsibilities does not relieve the supervisor of his or her responsibilities

Standard V: Investment Analysis, Recommendations, and Actions

Standard V(A) Diligence and Reasonable Basis

e Covered persons must strive to protect their independent professional judgment and must be diligent and thorough in their work

" Investment conclusions must be supported by facts, and analysts should make reasonable inquiries regarding reliability of sources

Standard V(B) Communication With Clients and Prospective Clients

It is important that any communication with a client regarding investment decisions is not biased or misleading in any way and that all decisions are based upon the client's interests The analyst should ascertain that all relevant information is included

Part 1: Covered persons must explain their investment decision-making process

Part 2: Covered persons must include relevant factors in their analyses, recommendations, or investment actions The "communication" should include the reasonable and adequate basis for the conclusion reached When deciding what topics to cover, consider the audience

• Part 3: Covered persons must separate fact from opinion in presenting analysis and recommendations

Standard V(C) Record Retention

Records must be retained to support analyses and recommendations

Standard VI: Conflicts of Interest

Conflicts of interest, perceived or real, can undermine clients' trust in investment professionals and the entire investment profession

Standard VI(A) Disclosure of Conflicts

" Covered persons must disclose any matters that would adversely affect their independence and objectivity

Disclosures must be in clearly understood, plain language

Standard VI(B) Pr~ority of Transactions

Transactions for clients and employers ahvays come before the investment professional's transactions

Standard VI(C) Referral Fees

Compensation received by covered persons as a result of referring or

recommending a product or service must be disclosed

Standard VII: Responsibilities as a CFA Institute Member or CFA

Candidate

Standard VII(A) Conduct as Members and Candidates in the CPA Program Covered persons may not do anything to compromise the reputation/integrity

of CFA Institute, the designation, or the CFA Exam

Standard VII(B) Reference to CFA Institute, the CFA Designation, and the CFA Program

Covered individuals are barred from misrepresenting or exaggerating the CFA designation and program

INTERPRETING THE CODE AND STANDARDS

Following the Code and Standards and interpreting and applying them to real situations often involves real investments, strategies, and several different, perhaps competing, parties at interest Real, ethical wisdom may be needed Practice is needed to determine the principles/values at stake, come up with alternatives, and decide a course of action Here are a few helpful guidelines:

1 Is the course of action consistent with the intent of the Code and Standards?

2 Would the client agree that this action is the best alternative?

3 Once the circumstances of the situation are disclosed, will the firm's reputation for fair dealing be enhanced or compromised?

4 Is the decision consistent with what would be expected from a leader?

VIOLATIONS AND CORRECTIVE ACTIONS

The assigned article concludes with several cases designed to demonstrate how to recognize violations of the Code and Standards and determine what actions are necessary to correct the vi.olatio.ns It is instructive to review the cases in order to develop your ability to spot violations and suggest corrective measures

Argent Capital Management

Case Facts

Francoise Vandezande, CPA, senior relationship manager in Argent's New York office, must meet with a defined benefit pension client whose portfolio has lost value over the last quarter due to foreign currency transactions that may have violated portfolio restrictions She first calls the client's portfolio manager, Aidan McNamara, CFA, who explains that the Global Markets group manipulated the Investment Council into taking a large bet on the euro-yen exchange rate (long euro/ short yen) that turned out to be ·wrong and negatively affected all portfolios During the call, McNamara was unable to say if the strategy \Vas consistent with his client's investment policy statement (IPS)

Vandezande reviews the client's IPS and determines that:

The portfolio benchmark is the MSCI EAFE® Index

"' Currency risk may be managed, but no currency speculation is allowed Futures and forwards hedges are limited to I 00% of underlying exposure

e The portfolio must be managed according to original mandate No extreme positions that would be inconsistent with the original mandate are allowed

Case Discussion

The portfolio manager is unfamiliar with the IPS, which is a violation of

Standard III(C.1.b) related to suitability The benchmark does not hold short currency positions, and the IPS prohibits speculation McNamara has not respected the constraints of the client's IPS

Suggested Actions

Vandezande should:

e Give the client a thorough explanation of the events, investment

decision-making process, and rationale for recommending the unusual foreign exchange position

Explain how the situation will not be repeated in the future

Senior management should:

e Modify the investment decision process to exclude certain portfolios

Re-educate portfolio managers on the importance of complying \Vith the IPS

0 Periodically audit portfolios for compliance with client guidelines

River City Pension Fund

Case Facts

Jack Aldred, CFA, is Chief Investment Officer of the River City Pension Fund He must decide what to do about Nortlnvest Capital Advisors, a small-cap value equity manager used by the pension fund

Roger Gray, CFA, is Northwest's CEO Northwest employees have contributed large amounts to local election campaigns (including Aldred's manager, the city Treasurer), a practice which, a few years ago, was made illegal for corporate officers doing business with the municipality

Northwest's always mediocre performance has become substantially worse Aldred observes that the returns calculated by Northwest do not match the returns

calculated by the custodian bank (Northwest's figures are higher) and that Northwest has strayed from its small-cap value mandate (value being an out-of-favor style) to include growth stocks

Aldred is also concerned that one of Northwest's three original principals left the firm Gray has personally assumed responsibility for River City's pension plan Aldred expresses his concerns to his manager and states that he feels action is necessary He further states that he has some suggestions as to how to proceed but would do whatever the manager wished

fiduciary duty and act for pension beneficiaries' benefit) He may also have violated Code and Standard I(B) - Independence and Objectivity by compromising his independent judgment

Roger Gray, CFA: Gray may have violated Standard III(D) - Performance

Presentation for not presenting fair, accurate, and complete performance Gray may have violated Standard III(C.2) related to suitability by not taking action consistent

of the Law (if he himself made illegal campaign contributions) and

Standard IV(C) - Responsibilities of Supervisors Gray may have also misstated asset values in violation of Standard III(D)

Suggested Actions

Jack Aldred, CFA, should:

Decide which performance figures to use

Evaluate the impact of the principal's departure on future results

Roger Gray, CPA, should:

Review pricing sources and methods to assess their fairness and accuracy Ensure portfolio holdings are consistent with the portfolio mandate

Stop the illegal campaign contributions from employees and/or himself

Macroeconomic Asset Management

Case Facts

Alice Chapman, CFA, Director of Marketing for Macroeconomic Asset

Management (MAM) is reviewing a letter from Arlington Verification Service stating that Arlington cannot issue a verification report for MAM because the review of policies, processes, sample portfolios, and composites revealed the

following:

•

Poor quality or missing documentation

Fee-paying discretionary p·orrfolios excluded from composites

Inconsistent implementation of policies on asset valuation and external cash

Rows

Incomplete performance presentations

Chapman considers continuing to claim compliance while challenging the verifier's report

Standard I (A) - Knowledge of the Law by helping the firm make a false claim and would also violate Standard I(C) - Misrepresentation Standard III(D)

Performance Presentation doesn't require compliance with GIPS but does require that Chapman not convey performance information to potential clients without determining that the information is a fair, accurate, and complete representation of 1v1AM's performance Chapman is aware of the significant shortcomings of MAM's performance presentation

Suggested Actions

Alice Chapman should:

0 Determine \lirhether Arlington Verification Service's report is correct

Not make statements claiming compliance with GIPS unless the firm meets all requirements

0 Make a reasonable effort to ensure performance presentations are fair, accurate, and complete

Bob Ehrlich

Case Facts

Bob Ehrlich, a performance analyst for a custodial bank's U.K division, goes to

a lunch meeting for investment professionals While at the luncheon, Ehrlich meets Peter Neustadt who suggests they meet later at a pub At the pub, Neustadt explains that his small firm has many contacts and a promising future bur lacks technological support Neustadt suggests that Ehrlich work for him as a part-time consultant because he has analytical talent and access to information Neustadt explains that his business represents newly created investment management

firms with portfolio management and trading experience but no marketing or performance analytics skills Neustadt states that he can put together the necessary marketing packages but needs performance data (benchmark returns, attributions, style analyses, etc.) that Ehrlich and his firm are good at producing

Case Discussion

Neustadt's proposal is unacceptable because it requires the use of assets belonging

employer's assets for personal benefit without authorization, he would violate Standard I(D) - Misconduct and Standard IV(A) - Loyalty (to employer) by violating his employer's trust for personal gain and misusing the employer's physical and intellectual property He also risks divulging confidential information, which could compromise his employer's financial position and damage his employer's reputation Distributing research purchased by his employer may violate legal restrictions and allow Neustadt to represent the data or research as his own

Standard IV(B) Additional Compensation Arrangements requires Members

compensation To avoid violating the Standard, Ehrlich must disclose Neustadt's proposal in full, including rhe use of the employer's resources

addition, the arrangement with Neustadt would compete directly with the services

Kaye asks four team leaders to submit status reports and shortens time frames for completion

Nelson responds with an e-mail to Kaye The e-mail states that before he could revise the timeline for Argent Asset Management, he needs guidance on n:vo issues:

1 Documentation for two-thirds of the accounts is not available The available one-third meets the discretionary status, and Argent maintains that the

remaining two-thirds do as well Nelson is unsure whether to wait for the documents, use what is availa?le, or take Argent's word

2 Treatment of several large external cash flows was inconsistent with stated policy for specific composites These instances would have produced higher or lower composite returns if the cash flows were treated properly Nelson wants to know if he can assume the errors are offsetting, making the composite returr+s reasonably correct

Case Discussion

The Code requires Kaye and Nelson to act with competence and diligence, exercise reasonable care and independent judgment in their professional activities, and maintain and improve their professional competence Standard I(A) - Knowledge

of the Law requires Kaye and Nelson to understand and comply with applicable laws, rules, and regulations governing their professional activities In this case, GIPS requirements, recommendations, and verification procedures would be applicable regulation Two GIPS standards are applicable:

1 Verifiers must be sure that all discretionary-fee-based portfolios are included

in a composite and that the discretion distinction is applied consistently over time

2 Verifiers must sample from the entire list (not just a sub-sample) of

discretionary portfolios to determine the consistency of discretionary/

non-discretionary classification as evidenced by the account agreement and the firm's guidelines

Poor planning or intentional deception may be the reason Argent's account

documents are unavailable, and taking Argent's word doesn't fulfill the duty to exercise care and independent judgment In addition, GIPS indicate a larger sample is warranted or additional verification procedures are needed in light of the inconsistent external cash flow treatment

Standard III(A) - Loyalty, Prudence, and Care requires Kaye and Nelson to act for the benefit of their clients Kaye is potentially telling employees to shortcut their verification in the interest of time, placing his and his employer's interests ahead of the clients' interests

Standard IV(C) - Responsibilities of Supervisors requires Kaye to take reasonable measures to detect violations of laws, rules, regulations, and the Code and

Standards Kaye must prevent Nelson from violating the Code and Standards as well as GIPS

Suggested Actions

Alex Kaye should:

Stop taking on new clients until capacity warrants it

e Make sure the staff is properly trained in GIPS verification procedures

• Inform the staff that every assignment must receive due care

Give Nelson appropriate guidance to the issues raised in his e-mail

AssET MANAGER ConE OF PROFESSIONAL CoNnucT

There are six components to the (voluntary) Asset Manager Code of Professional Conduct (the "Code"): (1) Loyalty to Clients, (2) Investment Process and Actions, (3) Trading, (4) Compliance and Support, (5) Performance and Valuation, and (6) Disclosures.2 Related to these six components are ethical responsibilities: Al·ways act ethically and professionally

Act in the best interest of the client

Act in an objective and independent manner

Perform actions using skill, competence, and diligence

Communicate accurately with clients on a regular basis

Comply with all legal and regulatory requirements

PREVENTING VIOLATIONS

maintaining the confidentiality of client information, and not engaging in any business relationship or accepting gifts from others that could affect your judgment and objectivity Appropriate procedures include:

" Designing salary arrangements that align the interests of the client with those of the manager without the manager taking undue risks that would conflict with the client's interests

• Creating a procedure that delineates how confidential client information should

be collected, utilized, and stored The confidential information policy does not preclude disseminating necessary information to legal authorities in the event of

an investigation

2 CFA Institute Asset Manager Code of Professional Conduct, including Appendix A

CFA Institute, Centre for Financial Market Integrity, 2005

Creating an anti-money-laundering policy to detect and help prevent firms from being used for money laundering or other illegal activities

Determining what constitutes a token gift and allowing only token gifts from outside business relationships as to limit the influence of these individuals over the asset manager Cash should never be accepted, and employees should always notify their supervisor in writing ·when they accept any gifts

Investment process and actions deals with being competent and taking reasonable action that would not cause any harm to the client while still balancing the client's risk and return objectives:

111 Never engage in market manipulation of security prices

Deal fairly with all clients when disseminating information, making

recommendations, and placing trades as to not favor or disadvantage one client over another

" Thoroughly investigate and research different investment options to have a reasonable basis for a recommendation

Appropriate procedures include having different levels of service and products available to all clients as long as they are fully disclosed The manager must analyze and understand the different investment options available and can also rely on third-party research as long as the manager has verified that this research is correct When using complex derivative products, the manager should conduct stress testing

to determine hmv the investment will react under different scenarios

Risk management, compliance, and support deals with:

0 Ensuring compliance with the Code and legal and regulatory requirements and appointing a compliance officer

Ensuring that portfolio information disseminated to clients is accurate and complete and reviewed by an independent third party

& Appropriately maintaining records

Employing qualified staff along with adequate resources

Instituting a contingency plan in the event of a natural disaster

Establish a firm-wide risk management process

Procedures include having documentation that ensures adherence to the Code, along with internal controls and self assessment mechanisms A compliance officer who reports directly to the CEO or board of directors and who is responsible for making sure compliance procedures are in place and followed should be designated The compliance officer is also responsible for employee training related to

compliance procedures and policies and on-going self evaluations They should also review employee trading practices to ensure client trades are placed before employee trades The compliance officer should also provide a copy of the Code to all

employees and document that the employees have read and understand the Code

Companies should develop contingency plans, also called disaster-recovery planning

or business-continuity planning, in the event of a disruption in normal business operations such as a power outage, fire, natural disaster, or acts of terrorism

Disclose potential conflicts of interest, such as soft or bundled commissions, referral fees, sales incentive programs, brokerage arrangements, and stocks held

by clients that are also held by firm employees

Any regulatory disciplinary actions taken against the manager or his

The method used to determine the value of the client's assets

Proxy voting policies of the manager

How shares of stock are allocated

The results of any audits performed on the client's account or fund

Managers must disclose their risk management processes to clients

Professor's Note: Be sure to use the Schweser Online Library to review Study Sessions I, 2, and 18

Study Session 3

· TC>pic Weight on Exarri 5%

SthweserNotesTM··Referern:e .• Book l, Pages 160'-:-:233

Expect behavioral finance to make up approximately 5% of the exam Item set questions and material integrated into IPS constructed response questions are equally probable Behavioral Finance concepts are not complicated but there is a lot

of overlapping terminology

THE BEHAVIORAL FINANCE PERSPECTIVE

Cross-Reference to CFA Institute Assigned Readings #7

Behavioral finance (BF) is descriptive of how investors behave It assumes investors have cognitive limits and emotional biases Therefore, market prices may not be efficient The focus of behavioral finance is how to help investors make decisions that more closely approximate the "optimal" decisions of traditional finance in spite

of the investor's biases and failings

Traditional finance (TF) is normative, describing what investors should do

TF assumes investors are rational, risk-averse, apply utility theory to maximize satisfaction, and that market prices are efficient

Four axioms of utility theory:

1 Completeness: Choices and preferences are known

2 Transitivity: Rankings are applied consistently

3 Independence: Utilities are additive and divisible

4 Continuity: Indifference curves are smooth and unbroken

With the receipt of new, relevant information, the rational investor will revise his expectations utilizing a Bayesian framework Bayes' formula:

Bayes' formula provides analysts with the ability to place a revised probability on a forecast, such as the direction of the market or an individual stock given a revised probability of some event For example, P(A given B) could be the probability,

P, that a stock will rise (event A) given a decrease in interest rates (event B) In determining whether the forecast should be revised, the analyst determines a new probability of an increase in the stock using a revised probability of a decrease in interest rates, P(B)

Utility Theory Versus Prospect Theory

Utility theory (and TF) assumes investors are risk averse and feel diminishing marginal utility of wealth This has two implications Fir~t, an investor's

indifference curves will be convex In order to accept additional equal increments

of risk, an investor must expect increasing increments of return Investors will vary

in their risk aversion and those with high risk aversion will select portfolios with lower risk and return while investors with low risk aversion ""1,1i'ill select portfolios with higher risk and return Second, investors will have concave utility functions (see the utility function graph) As an investor adds equal increments of wealth, the investor's level of satisfaction (utility) increases but at a diminishing rate

/

*Generally assumed for Traditional Finance Theory

Behavioral finance assumes investors may at times be risk averse and at other times risk neutral (constant marginal utility of wealth and straight utility function) or risk seeking (increasing marginal utility of wealth and convex utility function) This can produce complex double inflection utility functions

decline

smaller gain in value and value maxes out

Gains

Value Prospect Theory Value Function

As an alternative to utility theory and its focus on an investor's level of wealth, BF proposes that prospect theory may better explain investor behavior Prospect theory assumes:

0 Investors focus on perceived gain or loss (changes in wealth), not the level of wealth

Perception of gain or loss depends on the reference point used (e.g., year-end price or original cost basis)

Gain or loss is not "real" until it is realized

Subjective decision weights (low probability events are given too much weight) replace objective probability

• Decisions are made in stages

The result is that prospect theory assumes investors are risk averse when facing gains (and therefore sell winners too soon) but are loss averse and risk seeking when facing losses (and therefore hold losers too long)

TF Details: Decision Making in Two Phases

Editing phase includes: Codification, combination, segregation, cancellation, simplification, and dominance This can lead to an anomaly known as

the isolation effect, where investors focus on one factor or outcome while unconsciously eliminating or subconsciously ignoring others As a result, the presentation of the data can affect the decision made even if the underlying economics are the same

• In the evaluation phase, investors probability weight expected outcomes to determine utility However, the probabilities are not the simple objective probabilities p ofTF but adjusted probabilities wpv w is an overweighting (underweighting) oflow (high) probability outcomes, and vis a value function that assigns greater loss in utility for losses in wealth than gains in utility for an equivalent gain in wealth

Bounded Rationality and Satisficing

BF assumes bounded rationality investors have limits in their ability to reach optimal decisions As a result they satisfice They gather enough information and perform enough analysis to reach an acceptable (but not optimal) decision

Capital Markets and Portfolio Construction

TF leads to the conclusion that markets are efficient:

• The Price is Right suggests asset prices reflect all available information and adjust instantaneously to fully incorporate the value of new information Therefore, the function of the portfolio manager is to allocate an investor's portfolio to asset classes that are consistent with the client's objectives and constraints

" No Free Lunch implies managers cannot generate excess returns (alphas) consistently All information is instantaneously and accurately incorporated into prices, so whether asset prices change depends on the release of new information Because information enters the market randomly, changes in prices must also be random, malcing excess returns impossible to forecast consistently

Market Efficiency (Efficient Markets Hypothesis, EMH)

• Weak-form efficiency: Prices reflect all past price and volume data Managers cannot consistently generate excess returns using technical analysis

• Semi-strong form efficiency: Prices reflect all public information (includes past price and volume data) New information is immediately reflected in asset prices Managers cannot consistently generate excess returns using technical or -fundamental analysis

• Strong-form efficiency: Prices reflect all information, public and private No analysis based on inside and/ or public information can consistently generate excess returns

Market Anomalies; Abnormal Returns That Seem to Persist

Anomalies to the EMH exist when investors consistently generate excess return, after adjusting for risk The empirical evidence generally supports the weak form of the EMH but there are more persistent anomalies to the semi-strong form These are called fundamental anomalies because they suggest fundamental data can be used to generate excess return The most well known are the value and small cap biases

Four Behavioral Finance Models

BF challenges the TF assumption of market efficiency and has proposed four alternatives:

1 Consumption and Savings

The behavioral life-qcle model says that individuals are subject to framing, self-control bias, and mental accounting Therefore, they will not achieve the optimal balance of short-term consumption and long-term investing

& Framing: individuals may "frame" income as something they can spend and, therefore, under save for retirement

e Self-control bias: individuals overvalue the immediate gratification of consumption and, therefore, under save

• Mental accounting: individuals classify their assets and income into

different buckets or tiers This ignores that all wealth is fungible and is inefficient from a TF perspective, but it may be a rational way to deal with

an investor's lack of self-control

2 Behavioral Asset Pricing

The required return on an asset is the risk-free rate, plus a fundamental risk premium, plus a sentiment premium The sentiment premium can be estimated

by considering analysts' forecasts The greater the dispersion of analysts'

forecasts, the greater the sentiment premium If these sentiment premiums are random and unpredictable, they complicate asset allocation

3 Behavioral Portfolio Theory (BPT)

BPT assumes investors structure their portfolios in layers according to their goals The composition of each layer of the portfolio is determined by the interaction of five factors:

If higher return is the goal, more assets are allocated to the higher return layer

& The higher return layer will hold higher risk assets

•

Lower risk investors will hold more diversified portfolios

Investors with a perceived information advantage will hold more

concentrated positions

Investors who are highly l?ss averse will be reluctant to hold risky assets BPT portfolios can appear to be diversified and hold many assets but are sub-optimal from a TF perspective because the correlation among asset layers is not considered However, from a TF perspective, a slightly less efficient portfolio investors can live with is better than an optimal portfolio they abandon during a market setback

4 The Adaptive Markets Hypothesis leads to five important conclusions:

• Investors make decisions to help them survive (satisfice) rather than to maximize utility (make theoretically optimal decisions)

• Investors must adapt to survive

Because participants adapt, no investment strategy can continually perform

out-• Risk premiums will vary over time as (1) the general level of investor risk aversion increases or decreases and (2) the level of competition in the market decreases or increases

• Assets can be temporarily mispriced, allowing active management to add value

THE BEHAVIORAL BIASES OF INDIVIDUALS

Cross-Reference to CFA Institute Assigned Reading#S

Emotional biases are caused by individuals' psychological predispositions

Emotional bias is not deliberate; it is more of a spontaneous reaction and it is more difficult to overcome

Cognitive errors are the result of mechanical or physical limitations; they result from the inability to analyze all information or from basing decisions on incomplete information Cognitive errors are easier to overcome than emotional biases and respond to education

Cognitive errors stemming from believe perseverance:

• Conservatism bias A view is formed based on initial information and then maintained

+ Implications: Investors are to slow to update views and may hold securities too long To mitigate, seek new information and alternative views