2019 CFA level 3 schweser quick sheet

The main differences between the approaches are: Fundamental Quantitative Style Subjective Objective Decision­ making Discretionary Systematic Primary resources Human skill, experience,

C r it ic a l C o n c e pt s f o r t h e 2019 CFA® E x a m

SS1&2: ETHICS AND SS3: THE

ASSET MANAGEMENT INDUSTRY

Review the SchweserNotes™ and work the questions.

SS4: BEHAVIORAL FINANCE

• Bounded rationality — Individuals act as rationally

as possible, but are constrained by lack of

knowledge and cognitive ability.

• Satisfice — Making a reasonable but not necessarily

optimal decision.

The Traditional Finance Perspective

• The price is right — Asset prices reflect and

instantly adjust to all available information.

• No free lunch — No manager should be able to

generate excess returns (alphas) consistently.

M arket Efficiency

• Weak-form efficient — Prices incorporate all past

price and volume data.

• Semi-strong form efficient - Prices reflect all

public information.

• Strong-form efficient - All information reflected

in prices No one can consistently earn excess

returns.

TH E BEHAVIORAL FINANCE

PERSPECTIVE

1 Consumption and savings:

• Framing — The way income is framed affects

whether it is saved or consumed.

• Self-control bias — Favor current consumption

rather than saving income for future goals.

• Mental accounting - Assigning different

portions of wealth to meet different goals.

2 Behavioral asset pricing:

• Sentiment premium — Added to discount rate;

causes price deviation from fundamental values.

3 Behavioral portfolio theory (BPT):

• Investors structure their portfolios in layers

according to their goals.

4 Adaptive markets hypothesis (AMH):

• Apply heuristics until they no longer work, then

adjust them Must adapt to survive.

COGNITIVE ERRORS AND EMOTIONAL

BIASES

• Cognitive errors — Result from incomplete

information or inability to analyze.

• Emotional biases — Spontaneous reactions that

affect how individuals see information.

Cognitive Errors

• Conservatism bias — Emphasizing information

used in original forecast over new data.

• Confirmation bias — Seeking data to support

beliefs; discounting contradictory facts.

• Representativeness bias — If-then stereotype

heuristic used to classify new information.

• Base rate neglect — Too little weight on the base

rate (e.g., probability of A given B).

• Sample size neglect — Inferring too much from

a small new sample of information.

• Control bias — Individuals feel they have more

control over outcomes than they actually have.

• Hindsight bias — Perceiving actual outcomes as

reasonable and expected.

• Anchoring and adjustment — Fixating on a target

Availability bias - Future probabilities are impacted by memorable past events.

• Overconfidence bias — Illusion of having superior information or ability to interpret.

♦ Prediction overconfidence — Leads to setting confidence intervals too narrow.

♦ Certainty overconfidence — Overstated probabilities of success.

• Self-attribution bias — Self-enhancing bias plus self-protecting bias causes overconfidence.

♦ Self-enhancing bias — Individuals take all the credit for their successes.

♦ Self-protecting bias — Placing the blame for failure on someone or something else.

• Self-control bias — Suboptimal savings due to focus on short-term over long-term goals.

• Status quo bias — Individuals’ tendency to stay in their current investments.

• Endowment bias — Valuing an asset already held higher (than if it were not already held).

• Regret-aversion bias — Regret can arise from taking or not taking action.

♦ Error of commission - From action taken.

♦ Error of omission — From not taking action.

INVESTM ENT POLICY AND ASSET ALLOCATION

• Goals-based investing — Building a portfolio in layers, pyramiding up from key base goals.

• Behaviorally modified asset allocation — Constructing a portfolio according to investor’s behavioral preferences.

♦ Standard of living risk - If low, greater ability

to accommodate behavioral biases.

Behavioral biases in DC plan participants:

• Status quo bias — Investors make no changes to their initial asset allocation.

• Naive diversification — 1/n allocation.

• Disposition effect — Sell winners; hold losers.

• Home bias — Placing a high proportion of assets in stocks of firms in their own country.

• Mental accounting — See mental accounting bias.

• Gambler's Fallacy — Wrongly predicting reversal

IPS Objectives and Constraints: Individuals

constraints [taxes, time horizon, legal/regulatory, liquidity, and unique circumstances (other relevant issues presented in the case)] to determine and quantify the objectives (return and risk) This does not mean every step will be asked every time;

answer what is asked It is very important you

review the class slides (or SchweserNotes if you

do not have the slides) to understand how to solve these questions Answers are highly consistent once

you understand how to reach a solution.

Taxes and Private Wealth Management

Future Accumulation Formulas (selected)

annual accrual taxation: FVIF^ = [1 +r(l - t.)]n deferred capital gains taxation:

a t = (1 + r)n( l — tcg) + t

B = cost basis / asset value at start of period n

annual wealth taxation: FVIF,^ = [(1 + r)(l — t )]"AT L x x w 'JAnnual return after taxes on interest, dividends, and realized capital gains:

RAE = (FV at / initial investment)1/n - 1= r (1 - TA£)

Accrual Equivalent Tax Rate

(An overall effective tax)

• Investment horizon f, tax drag f

• Investment return \, tax drag f

Tax-deferred Accounts: Front-end benefits: contrib deer, current taxes, accrue tax free, taxed in future (TDA): FVIFAT = (1 + r)n(l - tn)

Tax-exempt Accounts: Back-end benefits Contrib made after-tax, accrue tax free, tax-free in future FVIFAT = (1 + r)"

IfT 0 >TN => FVTDA>FVN TEA

Investor's Afier-tax Std Dev o f Returns: a ( l —1().

Estate Planning

Calculating core capital

Prob(joint survival) = Prob (husband survives) + Prob (wife survives)

— Prob (husband survives) X Prob (wife survives)

N

CoreCapitalNyears = ^ P(surv; ) (spending)

*=i (1 + r )'

r = real risk-free rate

Relative After-Tax Values Tax-Free Gift:

1 + rg (1 tig nF^tax-free gift

w h ere:

re = p re-tax retu rn if h e ld in th e estate

tje = tax rate on retu rn s in te sta to r’s p o rtfo lio

Tc = estate tax rate

RV, ^^tax-free gift 1 + rg ( 1 _ t ig).

n

tax-free gift p y

bequest [l + re ( l - tic )]" ( l - Tfi )

RV o f a taxable gift, Tg paid by receiver:

K 1 Tg) 1 + rg (1 tig)

n

p y _ ^^taxablegift _

taxable gift r y —

r v bequest l + re ( l - t ie) (l —Te )n

RV o f a taxable gift, Tg paid by giver:

(l — Tg) = the after-tax value o f the gift

rg = pre-tax return on assets held by the gift receiver

t jg = tax rate on returns in gift receiver's portfolio

g/e = percentage o f giver's w ealth being gifted

Relief from Double Taxation

Without tax relief, pay tax to two countries There

are three methods of relief Consider 100 of source

income with t in source (S) and residence (R)

countries of 30% and 40% respectively.

• Deduction: Tax paid to S reduces taxable income to

R Pay 30 to S and (100 — 30)(0.4) to R, the least

favorable method to the tax payer; total tax 58.

• Credit: Tax to S directly offsets the tax that would

have been owed to R Pay 30 to S and another 10

to R; total tax 40.

• Exemption: Income taxed in S is not taxed in R.

Pay 30 to S; total tax 30.

♦ Exemption is always best for the tax payer; but

if the tax rates of S and R were reversed, credit

and exemption would produce the same total

• Monetize the asset: borrow against its value and use

the loan proceeds for client objectives.

• Hedge the asset value using derivatives to limit

downside risk.

Hedging the Asset Value

• Short sale against the box: borrow and short

the stock Uses the short sale proceeds to meet

portfolio objectives.

• Equity forward sale contract: sell the stock

forward The investor has a known sale price.

• Forward conversion with options: selling calls

and buying puts with the same strike price used to

establish a hedged ending value of the concentrated

position.

• Total return equity swap: the investor enters a

swap to pay the total return on a stock and receives

LIBOR.

Modified Hedging Minimizes Downside Risk

While Retaining Upside Potential

• Buy protective puts (portfolio insurance).

• Prepaid variable forwards (PVF): The dealer pays

the owner now—equivalent to borrowing The

a broad market index.

• Completeness portfolio: select other

portfolio assets such that total portfolio better approximates desired risk and return characteristics.

2 Cross hedge: use an imperfect hedge if perfect does

not exist or may trigger the tax liability.

3 Exchange funds: multiple investors contribute a

different position and then each holds a pro rata portion of the resulting portfolio with no taxes paid

at initial contribution.

Strategies in Managing a Private Business Position

• Strategic buyers: take a buy and hold perspective.

• Financial buyer or financial sponsor: restructures

the business, add value, and resell the business.

• Recapitalization: owner restructures the company

balance sheet and directs the company to take actions beneficial to the owner, such as paying a large dividend or buying some of owner's shares.

• Sale to (other) management or key employees:

called a management buyout (MBO).

• Divestiture, sale, or disposition of non-core business assets.

• Sale or gift to family members.

• Personal line of credit secured by company shares:

the owner borrows from the company.

• Initial public offering (IPO).

• Employee stock ownership plan (ESOP): the

owner sells stock to the ESOP.

Strategies in Managing a Single Investment in Real Estate

• Mortgage financing: a non-recourse loan would

allow the owner to default without risk to other assets.

• Donor-advised fund or charitable trust: providing

a tax deduction for and with conditions that meet other objectives of the owner.

• Sale and leaseback.

Risk Management for Individuals

• The economic balance sheet (EBS) is superior to the traditional balance sheet for planning resource consumption Total assets are expanded to include human capital (the PV of future earnings) and liabilities to include the PV of future expenses and bequests.

• Market risk can be managed with traditional portfolio tools.

• Idiosyncratic (non-market risks) can be managed with portfolio diversification and insurance products when appropriate.

♦ Life insurance can provide funds to meet expenses that would have been covered in the absence of premature death Temporary insurance is generally less costly but permanent insurance continues for the lifetime of the insured.

♦ Annuities hedge the risk of the individual outliving their assets Immediate annuities provide an immediate income stream while deferred annuities cost less Fixed annuities provide an initially higher income stream while variable annuities may potentially provide higher total return over time and are more likely to keep up with inflation.

SS7: INSTITUTIONAL INVESTORS

and willingness to bear risk is not relevant for institutions As an overview by type:

• Foundations and endowments are asset only

and can take higher risk if otherwise appropriate Return is the compounded distribution, relevant inflation, and expense rate Usually tax exempt and perpetual Higher beneficiary dependency on the portfolio reduces risk tolerance.

Geometric spending rule

spending, = (R ) (spending,^ )(l + It_ i) +

(l — R)(S)(m arket valuet_ j)

• DB portfolios are ALM and liability duration

determines time horizon Discount rate or a bit higher is the usual return objective They are more conservative than most foundations and endowments DB are managed solely for the participants’ benefit and are generally untaxed Risk tolerance is reduced by: underfunding (A < L for —S), a financially weak sponsor, high + correlation of sponsor and portfolio results, and plan/workforce issues that increase liquidity needs

or decrease time horizon.

♦ The liability relative approach and liability

mimicking portfolio are refinements on basic

ALM and duration matching If the liabilities can be broken down into categories use: traditional nominal bonds for fixed future benefits, real rate (inflation indexed) bonds for inflation indexed future benefits, and equity for future benefits linked to future real (above inflation) wage growth Risk due to liability noise cannot be eliminated (e.g., benefits for future new employees, deviations from actuarial assumptions, etc.).

• Insurance portfolios are ALM and usually

taxable to some degree Conservative and fixed income oriented (with perhaps some equity in the surplus) The minimum return is set by the crediting (analogous to discount) rate needed to meet liabilities to policyholders.

♦ Life insurers may face disintermediation risk.

♦ Non-life is more varied, less regulated, and

often has higher and more complex liquidity needs Non-life can be exposed to inflation risk, and an underwriting/profitability/tax cycle.

• Banks are ALM, the most regulated, and

conservative The securities portfolio is a residual

use of funds; managed in order to control total

balance sheet interest rate (duration) risk and provide liquidity while contributing to interest earnings and credit diversification.

SS8: ECONOMIC ANALYSIS

Problems in Forecasting

Limitations to using economic data Data measurement errors and biases Limitations of historical estimates

Ex post data to determine ex ante risk and return Patterns

Failing to account for conditioning information Misinterpretation of correlations

Psychological traps Model and input uncertainty

1 Po + i + g - AS + A

Risk Premium Approach to expected bond return:

A

R Bond = Real risk-free rate + Inflation risk premium +

Default risk premium +

Illiquidity risk premium +

M aturity risk premium + Tax premium

ICAPM:

R; = RF + A (R m — P- f

Singer and Terhaar Analysis

ERP = Equity Risk Premium of a partially integrated

p- m = correlation of market with global portfolio

The Taylor Rule

target ^neutral

^expected - G D P , ren<i

T 0 5 ^ieXpected h target

Cobb-Douglas Production Function, Y = AK'

L3, uses the country’s labor input (L) and capital

stock (K) to estimate the total real economic output

where:

Y = total real economic output

A = total factor productivity (TFP)

a = output elasticity of K (0 < a < 1)

3 = output elasticity of L (a + 3 = 1)

The form of the CD that is used to estimate

expected changes in real economic output:

Relative value models:

Fed model ratio = S&P earnings yield

T reasury yield

A value > 1 indicates that equities are undervalued

and should increase in value.

10-Year Moving Average Price/Earnings Ratio,

P/10-year MA(E), or Cyclically Adjusted P/E

Ratio (CAPE)

current level

rA n c of S&P 500 price index

avg of previous 10 years’

reported S&P earnings (adjusted for inflation) Compares its current value to its historical average

to determine whether the market is over- or under-

priced.

Tobin's q and Equity q

Both ratios are considered mean-reverting, if > 1 the

stock should decline, <1 the stock should increase.

market value of debt + equity

Tobin’s q =

equity q

a s s e t replacement cost market value of equity

deviation.

• Liability-relative: focuses on growth of the surplus

and standard deviation.

• Goals-based: uses sub-portfolios to meet specified

Calendar rebalancing is done at a set frequency

Percentage range rebalancing is when a band is

violated.

Wider bands for: higher transaction cost and correlations between classes, higher risk tolerance, momentum markets, and less volatile asset classes

Basic MVO use E(R), a, and correlations to solve

for the efficient frontier (EF) and asset allocation

Pitfalls of MVO analysis include: estimating the inputs, concentrated allocations, and a single period analysis.

• Reverse optimization solves for the E(R)s based on market weights.

• Black-Litterman view adjusts these returns and then resolves for an EF.

• Monte Carlo simulation models how an allocation may perform over time.

Liability-relative management can use MVO to

analyze the surplus, use one sub-portfolio to hedge the liability and actively manage any surplus, or do

a joint optimization of the assets and liabilities.

SS10: ASSET ALLOCATION (2)

Real world asset allocation is constrained by: the size

of the portfolio, time horizon, liquidity, regulatory, tax, and investor biases.

Foreign Currency Equations

K c = <■♦ M i + R px ) - 1 = R pc + R px + ( M V

^D C ~ ^"FC + R-J X

Rpc = return on the foreign asset and RFX = return

on the foreign currency

a 2(RDC) * ct 2(Rk;) + a 2(RFX) + 2 ct (R fc ) ct (Rfx) P(R f c ,Rfx)

If /V is a risk-free asset:FC

ct (Rdc) = a(R i:v)(l + R „.)FX' FO

Currency Management Strategies

• Passive hedging: eliminates currency risk relative

to the benchmark.

• Discretionary hedging allows the manager to deviate modestly from passive hedging The goal is risk reduction.

• Active currency management allows a manager to

have greater deviations from passive hedging The goal is adding value.

• Currency overlay is the outsourcing of currency management to another manager.

Factors That Shift the Strategic Decision Toward

a Benchmark Neutral or Fully Hedged Strategy

• A short time horizon for portfolio objectives.

• High risk aversion.

• Little weight given to the opportunity costs of missing positive currency returns.

• High short-term income and liquidity needs.

• Significant foreign currency bond exposure.

• Low hedging costs.

• Clients who doubt the benefits of discretionary

♦ With higher real or nominal interest rates.

♦ With lower inflation relative to other countries.

♦ Of countries with decreasing risk premiums.

• Carry Trade: borrow in a lower interest rate

currency and invest in a higher interest rate currency.

• Volatility Trading: profit from predicting changes

in currency volatility If volatility is expected to increase, purchase an at-the-money call and put (long straddle) Sell volatility by selling both options (a short straddle).

Note clearly that the evidence rejects using F() as

a valid way to predict the future movement of a currency Based on IRP a currency with a higher interest rate will trade at a forward discount (F < S ) but more often than not the currency will appreciate, ST will end up above SQ.

Forward Premiums or Discounts and Currency Hedging Costs

If the hedge requires:

F > S

1 P/B J P/B: * b < h ^ p / b < Sp/B’ is > ip The forward price The forward price curve is upward curve is downward sloping sloping.

A long forward position in currency B the hedge earns:

Negative roll yield, which increases hedging cost and discourages hedging. _

Positive roll yield, which decreases hedging cost and encourages hedging.

A short forward position in currency B the hedge earns:

Positive roll yield, which decreases hedging cost and encourages hedging. _

Negative roll yield, which increases hedging cost and discourages.

The minimum-variance hedge ratio (MVHR): a

regression of past changes in value of the portfolio

to past changes in value of the foreign currency The hedge ratio is the beta (slope coefficient) of that regression.

• Strong positive correlation between R and R

increases the volatility of RDC resulting in a hedge ratio > 1.0.

• Strong negative correlation between R[X and RfC

decreases the volatility of R resulting in a hedge ratio < 1.0.

Capitalization weighted index: Weight of each

security based on its price multiplied by shares outstanding, performance influenced by securities with largest market cap.

• Advantages: based on market price, float adjusted reflects what is available for investors to own, does not require rebalancing for stock splits and dividends.

• Disadvantages: can lead to overconcentration in a few securities.

Price-weighted index: reflects owning one share of

each stock Performance heavily influenced by the securities with the highest price.

• Advantages: easy to construct.

• Disadvantages: stocks that appreciate are more likely to split in price reducing the impact of that security on the index.

Equal-weighted index: reflects the same initial

investment in each security.

coupon and par amounts.

• Duration matching requires:

♦ PVA = PVL; there are exceptions when asset

and liability discount rates differ.

♦ D = D ,, or A L BPV = BPV,.A L

♦ Minimize portfolio convexity but make it

greater than that of the liabilities.

♦ Portfolio-based IRR and statistics should be

♦ Horizon match: cash flow match nearer and

duration match longer-term liabilities.

♦ Contingent immunization: active management

if the surplus is positive.

Return can be decomposed as:

1 Yield income:

annual coupon amount / current bond price

2 Rolldown yield: (projected ending bond price (BP)

- beginning BP) / beginning BP

3 Price change due to investor yield change

predictions: (-M D AY) + (Vi C AY2)

4 Less credit losses: predicted default adjusted for the

recovery rate

$ Currency G/L: projected change in value of

foreign currencies weighted for exposure to the

currency

Leveraged return = r( + [(VB / V|;) x (r( - rB)]

Index funds provide low cost diversification

Enhanced indexing allows small deviations from the

benchmark (but matches duration).

Active management for a stable upward sloping

yield curve:

• Buy and hold: extend duration to get higher yields.

• Roll down the yield curve: portfolio weighting

highest for securities at the long end of the steepest

yield curve segments, maximize gains on securities

from declines in yield as time passes.

• Sell convexity to increase yield.

• Carry trade: borrow at lower rates to purchase

securities with higher rates.

Active management for a changing yield curve:

• Increase (decrease) portfolio duration if rates are

expected to decrease (increase).

Nfto change duration =

target portfolio PVBP — current portfolio PVBP * •

PVBP futures contract

• Increase (decrease) portfolio exposure to key rate

durations where relative decreases (increases) in

key rates are expected.

• Increase portfolio convexity (decreasing yield)

when large changes in rates are expected.

• Bullet portfolios have more yield, but barbells have

more convexity and also tend to outperform in

curve-flattening environments.

• Long (short) option positions is a more effective

way to add (reduce) convexity.

High yield (HY) bonds are more affected by spread

change and investment grade (IG) by general

market (risk-free) interest rate changes:

• %A value = —MD A y

• %A relative value = —SD As

• spread = yhigher yield ^government

Excess return can be modeled as:

• Considering the level of stock concentration The

“effective number of stocks” can be determined as the reciprocal of the Herfindahl-Hirschman index (HHI).

n i HHI = ^2 wf effective number of stocks =

Common equity risk factors: growth, value, size,

yield, momentum, quality, and volatility.

Factor-based strategies: return oriented, risk oriented,

and diversification oriented.

Common approaches to passive equity investing use: (1) pooled investments, such as open-end mutual

funds and ETFs, (2) derivatives-based strategies, and (3) separately-managed index-based portfolios.

Three methods of constructing passively managed index-based equity portfolios: (1) full replication,

(2) stratified sampling, often based on cell matching, (3) technical and quantitative approach (optimization)

Fundamental managers use discretionary judgment

vs quantitative managers use rules-based (systematic)

data-driven models The main differences between the approaches are:

Fundamental Quantitative Style Subjective Objective

Decision­

making Discretionary Systematic

Primary resources

Human skill, experience, judgment

Expertise

in statistical modeling

Information used Research Data and statistics

Analyst focus

Conviction of insight into smal number

of investments

Application

of ‘rewarded’

factors over large number

of securities

Purpose of analysis

Forecast future corporate performance

Find historical relationships between factors and performance likely to persist

Portfolio construction

Judgment and conviction within portfolio risk parameters

Optimization

Monitoring and rebalancing

Continuous monitoring:

rebalancing according to views

Automatic systematic periodic rebalancing

The quantitative active investment process includes

the following steps:

• Define the market opportunity.

:quire and process data

Back-test the strategy.

• Evaluate the strategy.

• Portfolio construction.

The two main approaches used in style analysis are

holdings-based and returns-based Holdings-based

approaches aggregate the style scores of individual holdings, while returns-based approaches analyze the investment style of portfolio managers by regressing historical portfolio returns against a set of style indexes

Fundamental law of active management:

E ( R a ) ^ c V b r c t ^ t c

Active share measures the degree to which the number

and sizing of the positions in a managers portfolio

Active risk has two sources: active factor exposure (active beta) and idiosyncratic risk from concentrated positions (variance from both the skill and luck of the manager): Active risk ! ctr a H E L (T —1r a.) _= ^<l2(E(fYk_f3bk)xFk| + CT.

Risk budgeting is the process by which the contribution

to total risk of the portfolio is allocated to constituents

of the portfolio in the most efficient manner

Contribution to portfolio variance can be calculated on

an absolute or relative basis.

• The contribution of asset i to absolute portfolio variance = CVj = E ”=1 WjWjCjj = WjQp

• The contribution of factor i to absolute portfolio variance = CV) = E “=1 PifyQj = (3jCip

• The contribution of asset i to relative portfolio variance =

n

C A V i = E ( W pi ~ w b i ) ( w pj - w b j ) R Q j = ( w pi - w b i ) R Ci p

j=l Long extension portfolios guarantee investors 100% net

exposure with a specified short exposure A typical 130/30 fund will have 130% long and 30% short positions

Market-neutral portfolios aim to remove market exposure

through offsetting long and short positions Pairs trading

is a common technique in building market-neutral portfolios, with quantitative pair trading referred to as

statistical arbitrage.

Benefits of long/short strategies include the ability to better express negative views, the ability to gear into high- conviction long positions, the removal of market risk

to diversify, and the ability to better control risk factor exposures.

Drawbacks of long/short strategies include potential large losses since share prices are not bounded above, negative exposures to risk premiums, potentially high leverage for market-neutral funds, and the costs of borrowing securities and collateral demands from prime brokers Being subject to a short squeeze on short positions is also

a risk.

SSI5: ALTERNATIVE INVESTMENTS

Alternative investments often:

• Have low correlation to traditional investments, providing a diversification benefit.

• Lack information transparency and have higher due diligence costs.

• Are less liquid.

• Lack investable benchmarks.

• Lack inherent asset class characteristics and instead reflect manager skill.

• Are infrequently traded and/or use appraisal pricing; leading to an artificially low, reported standard deviation (and oftentimes low to negative correlation).

Specific issues by A1 type include:

• Real estate has inherent asset class characteristics

with low correlation and good diversification Diversified, direct investment in properties requires larger amounts of funds REITS are liquid, with investable benchmarks but REITS are more equity like (not true RE) CREFS are classified as indirect investment but provide true

RE exposure Unsmoothed CREF data provides true measures of RE characteristics.

• Private equity offers higher return and risk.

Venture capital is typically high risk with long

time horizons Buyout investments are somewhat

investable benchmarks A fully collateralized long

position in commodity futures earns the risk-free

rate, roll return, and change in the spot price

Storable commodities linked to economic activity

have provided desirable, positive correlation to

inflation.

Hedge funds (HF) appear to offer positive value

added and good diversification but there are

significant challenges in interpreting the data

(self-reporting, survivorship bias, skewed returns)

and with significant due diligence issues Return

is based largely on manager skill Benchmarks

are more akin to manager universes and are not

investable.

Managed futures have many similarities to HFs

Systematic (rule following) strategies may be

replicable and investable.

Distressed securities are also similar to or a subset

of HFs.

SS16: RISK MANAGEMENT

A centralized Risk Management System (an

enterprise risk management system or ERM)

provides a better view of how business units are

correlated than a decentralized system.

Some of the most common risks include:

Market risk (Financial)

Liquidity risk (Financial)

Credit risk (Financial)

Settlement risk (Non-Financial)

Operations risk (Non-financial)

Model risk (Non-financial)

Regulatory risk (Non-financial)

Sovereign risk (Financial and non-financial)

VaR is used as an estimate of the minimum

expected loss (alternatively, the maximum loss) over

a set time period at a desired level of significance

(alternatively, at a desired level of confidence).

Computing VaR:

• Analytical VaR:

• Historical VaR ranks actual past returns.

• Monte Carlo is computer intensive but allows

assumptions of any distributions and correlations.

Extensions to VaR:

• Incremental VaR (IVaR) is the effect of an

individual asset on the overall VaR.

• Cash flow at risk (CFAR) is VaR applied to the

company’s cash flows.

• Earnings at risk (EAR) is analogous to CFAR only

from an accounting earnings standpoint.

• Tail value at risk (TVaR) is VaR plus the expected

value in the lower tail of the distribution.

Credit VaR (a.k.a Credit at Risk or Default VaR) is

like VaR, but focuses on the upper tail of returns

Methods for Managing Market Risk: Position

limits, liquidity limits, performance stopouts, and

risk factor limits.

Risk Budgeting — The process of determining

which risks are acceptable and how total enterprise

risk should be allocated across business units or

portfolio managers.

Sortino R p -M A R

downside deviation

SSI 7: RISK AND DERIVATIVES

Changing Portfolio Duration with Bond Futures

contracts

MD-p — MDp MDp

Altering Debt and Equity Allocations

From equity to bonds: sell equity futures and buy bond futures.

From bonds to equity: sell bond futures and buy equity futures.

Synthetic positions are also based on the same

equity hedging formula:

• Vp is replaced with the FV of Vp:

Vp (1 + r( periodic)

• If betas are not given, it is presumed the desired change in beta is the same as contract’s beta.

For synthetic equity, buy contracts and hold the PV

(discounted at r( periodic) of the full contract price

x number of contracts in cash equivalents.

For synthetic cash, sell contracts and hold sufficient

shares that with dividends reinvested, shares can be delivered to close the contract position (i.e., hold the multiplier x number of contracts “discounted by” the dividend yield periodic).

• Max gain: examine the payoff pattern and, from that underlying’s price, sum the initial investment versus ending value of the positions held.

• Max loss: examine the payoff pattern and, from that underlying’s price, sum the initial investment versus ending value of the positions held.

• Breakeven(s): examine the payoff pattern and, from either max gain or loss, determine how much the underlying must increase or decrease.

• Covered Call Protective Put

z

Bull Spread Collar: Payoff pattern is

identical to a bull spread but includes owning the underlying.

Butterfly Spread

strike rate)](D / 360)

• Put: Used to maintain the return on an asset (e.g.,

floating rate loan) If rates fall, the option pays off interest rate put payoff = (NP)[max(0, strike rate

- LIBOR)(D / 360)]

• Cap: Series of calls (caplets).

• Floor: Series of puts (floorlets).

• Interest Rate Collar: Combination of cap and

floor.

Change Portfolio Duration with Swaps

MDpay Floating = MDFixed — MDFloating > 0

MDPay Fixed = M DFloating — M DFixed < 0

NP = V MDt - M DV

MDSwap

MDFloating o

♦ To lower asset duration, pay fixed.

♦ To raise asset duration, receive fixed.

• Currency Swap — The standard currency swap

has two notional principals The counterparties usually exchange the principals on the effective date and return them at maturity Periodic interest payments are not usually netted.

• Equity Swap — One counterparty makes payments based on an equity position Counterparty makes payments based on another equity, a bond, or fixed payments.

• Swaptions — An option on a swap.

Interest Rate Swaptions

• Payer Swaption — gives the buyer the right to be

the fixed-rate payer.

• Receiver Swaption — gives the buyer the right to

be the fixed-rate receiver.

SS18: TRADING

effective spread = 2 x | (execution price) —

(midquote) |

Market Structures

• Quote-driven markets: traders transact with

dealers who post buy and sell prices.

Order-driven: traders transact with traders Auction market: traders post their orders to

compete against other orders for execution.

Automated auctions: also known as electronic

limit-order markets.

Brokered markets: brokers act as traders’ agents

to find counterparties.

Hybrid markets: combine quote-driven, order-

driven, and broker markets.

Market Quality

A liquid market has (1) small bid-ask spreads,

(2) market depth, and (3) resilience.

Transparent market: investors can obtain pre­

trade and post-trade information.

Assurity of completion.

Execution Costs Explicit costs in a trade include commissions,

taxes, stamp duties, and fees.

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♦ Easily understood.

♦ Simple to compute.

♦ Can be applied quickly to enhance decisions.

♦ Most appropriate for comparing small trades in

nontrending markets.

Disadvantages of VWAP:

♦ Not informative for trades that dominate

trading volume.

♦ Can be gamed by traders.

♦ Does not evaluate delayed or unfilled orders.

♦ Does not account for market movements or

trade volume.

Implementation shortfall (IS) measures transaction

cost as the difference in performance of a

hypothetical portfolio (trade is fully executed with

no cost) and actual portfolio results Total IS can be

calculated as an amount.

• For per share: divide by the number of shares in

the initial order.

• For percentage or basis point (bp): divide by the

market value of the initial order.

Data required:

• Decision p rice (DP): The market price of the

security when the order is initiated If the market

is closed, use the previous closing price.

• Execution p rice (EP): The price or prices at which

the order is executed.

• Revised benchmark price (BP*): This is the market

price of the security if the order is not completed

in a timely manner as defined by the user If not

otherwise stated, timely is within the trading day.

• Cancelation p rice (CP): The market price of the

security if the order is not fully executed and the

remaining portion of the order is canceled.

IS component costs:

• Explicit costs: Cost per share x # of shares

executed.

• Missed trade: |CP — DP| x # of shares canceled.

• Delay: |BP* — DP| x # of shares later executed.

• Market impact: |EP — DP or BP*| x # of shares

executed at that EP.

Note that trading cost can be negative, an account

benefit:

• An increase in price while selling.

• A decrease in price while buying.

Advantages of implementation shortfall:

• Portfolio managers can see the cost of

implementing their ideas.

• Demonstrates the tradeoff between quick

execution and market impact.

• Decomposes and identifies costs.

• Can be used to minimize trading costs and

maximize performance.

• Not subject to gaming.

Disadvantages of implementation shortfall:

• May be unfamiliar to traders.

• Requires considerable data and analysis.

Major Trader Types

Trader Types M otivation Time or Price

Costs-Quick, certain execution at market price

Loss of control of trade costs motivationsVariety of Need-

trustworthy- agent _

Broker uses skill

6c time to obtain

lower price

Higher commission N ot 6c potential leakage r r i • • information

of trade intention Advertise-

liquidity

to-draw-A, , Higher administrative XT

, , costs and possible c

determined price 1 front r r running information

whatever- the-liquidity

Low-cost-Low trading costs

Uncertain timing

of trade 6c possibly

trading into weakness

Passive and value

Algorithmic trading is a form of automated

trading The motivation for algorithmic trading is

to execute orders with minimal risk and costs

Algorithmic trading strategies are classified into

logical participation, opportunistic, and specialized strategies. There are two subtypes of logical participation strategies: simple logical participation strategies and implementation shortfall strategies.

• Simple logical participation strategies (SLP) trade

with market flow to minimize market impact.

♦ SLP strategies break the trade into small pieces that are each a small part of trading volume, minimizing market impact costs.

♦ VWAP SLP: Order is broken up over the course of a day to match the day’s VWAP.

♦ In a time-weighted average price strategy (TWAP), trading is spread out evenly over the whole day to equal a TWAP benchmark.

• Implementation shortfall (arrival price) strategies:

♦ Focus on trading early to minimize opportunity costs Typically execute the order quickly.

SS19: PERFORMANCE EVALUATION

Measures of Risk-Adjusted Return:

Treynor Measure shows the excess return (over the

risk-free rate) earned per unit of systematic risk.

Sharpe Ratio excess return per unit of total risk.

c _ R a ~ R f

ctA

-Ex Post Alpha:

A

a A = R At _ R A where:

ISBN: 978-1-4754-8097-9

Information Ratio is excess return per standard

deviation of excess return.

active return Rp — Rg IRn =

active risk a( R p - R g )

A portfolio return has 3 components:

Market, Style, and Active Management.

• Good benchmarks should exhibit:

1 Minor systematic bias between the account and the benchmark returns.

2 Minimal tracking error.

3 Strong correlation with the manager’s universe.

4 Low turnover.

Macro and Micro Performance Attribution

• M acro attribution is performed at the fund sponsor

level Levels of analysis include:

• M icro attribution analyzes individual portfolios

rather than the whole fund The manager’s value-added return is the difference between the portfolio and benchmark returns.

Micro Performance Attribution

S

R v = X ! ( WP>j_ W B,j)(R B,j_ R B) j= l

pure sector allocation S

+ (WP>j “ WB,j) (R P,j “ R B,j) j= l

v - : -V - : -: -'

allocation/selection interaction S

+ S WB,j(R P,j- R B,j) within-sector selection

SS19: GIPS®“ —

Secret Sauce®

eBook

Ethics: SS 1 & 2 1

Behavioral Finance: SS 3 24

Private Wealth Management (1, 2): SS 4 & 5 40

Portfolio Management for Institutional Investors: SS 6 64

Applications of Economic Analysis to Portfolio Management: SS 7 71

Asset Allocation and Related Decisions in Portfolio Management (1,2): SS 8 & 9 86

Fixed-Income Portfolio Management (1, 2): SS 10 & 11 107

Equity Portfolio Management: SS 12 120

Alternative Investments for Portfolio Management: SS 1 3 130

Risk Management: SS 14 141

Risk Management Applications of Derivatives: SS 1 5 148

Trading, Monitoring, and Rebalancing: SS 1 6 162

Performance Evaluation: SS 17 175

Global Investment Performance Standards: SS 18 182

Essential Exam Strategies 191

Index 205

Published in 2018 by Kaplan Schweser.

Printed in the United States of America

ISBN: 978-1-4754-6197-8

If this book does not have the hologram with the Kaplan Schweser logo on the back cover, it was distributed without permission of Kaplan Schweser, a Division of Kaplan, Inc., and is in direct violation of global copyright laws Your assistance in pursuing potential violators of this law is greatly appreciated.

Required CFA Institute disclaimer: “CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by Kaplan Schweser CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.”

Certain materials contained within this text are the copyrighted property of CFA Institute.

The following is the copyright disclosure for these materials: “Copyright, 2017, CFA Institute Reproduced and republished from 2018 Learning Outcome Statements, Level I, II, and III questions from CFA® Program Materials, CFA Institute Standards of Professional Conduct, and CFA Institute’s Global Investment Performance Standards with permission from CFA Institute All Rights Reserved.”

These materials may not be copied without written permission from the author The unauthorized duplication of these notes is a violation of global copyright laws and the CFA Institute Code of Ethics Your assistance in pursuing potential violators of this law is greatly appreciated.

Disclaimer: Schweser study tools should be used in conjunction with the original readings as set forth by CFA Institute in their 2018 Level III CFA® Study Guide The information contained in these materials covers topics contained in the readings referenced by CFA Institute and is believed

to be accurate However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam success The authors of the referenced readings have not endorsed or sponsored Schweser study tools.

The Secret Sauce is a summary of the high points in the Level III CFA®

Curriculum It builds on the 2018 Level III SchweserNotes™ It is best used after reading that material, attending class, working on Class Discussion Questions, and using the QBank for initial practice

It cannot cover everything in the roughly 2,000 pages of CFA text It is a review tool to solidify the important issues the text emphasized When you find something you are shaky on, go back to the SchweserNotes™ and/or class slides for more detail

Candidates who study and practice the material have every reason to do well on the exam But do not fall into the trap of expecting exam questions to be exactly like practice questions Learn the underlying concepts, apply the concepts in practice questions, and expect surprises on exam day The CFA Institute always finds a way

to throw in a few twists

At Level I, you largely memorized facts and then regurgitated them on the exam

At Level II, the topical coverage was more difficult, but each topic was tested in

a stand-alone item set in much the way it was presented in the curriculum At Level III, you can be expected to integrate different concepts from different parts of the curriculum to understand a single, multi-part question

The other major challenge is constructed response You must know the material, think logically, and then respond directly to what is asked in the question The CFA Institute does not award points for a general display of knowledge Our coaching using the old exam questions, Weekly Class Workbooks, Mock Exam, and Practice Exams illustrate how to answer constructed response questions It is a skill learned through preparation and then practice

Level III provides its own unique challenges Prepare properly, practice, and you can make your own good luck

I wish you all the best on exam day

'D avid

David Hetherington, CFA

Vice President and Level III Manager

Study Sessions 1 and 2

S t u d y S e ssi o n 1 - E t h i c a l a n d P r o f e s si o n a l S t a n d a r d s

CFA I n st i t u t e C o d e o f E t h i c s a n d S t a n d a r d s o f P r o f e ssi o n a l

C o n d u c t

Cross-Reference to CFA Institute Assigned Readings #1 & 2

Ethics is covered in Study Sessions 1 and 2 Ethics will comprise 10-15% of the exam and could be tested in two selected response item sets like Level II or a

combination of constructed response and item set questions 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 CFA material and then work all of our questions plus the CFA end-of-reading questions

Code of Ethics

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

charterholders, and Candidates for the CFA designation (“Members and

Candidates”) must:1

• 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 activities

1 Copyright 2014, CFA Institute Reproduced and republished from “The Code of Ethics,” from Standards o f Practice Handbook, 11th Ed., 2014, 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 and viability of the global capital markets for the ultimate benefit of society

• Maintain and improve their professional competence and strive to maintain and improve the competence of other investment professionals

G u i d a n c e f o r S t a n d a r d s I-VII

I Professionalism

1(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 not 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 department Inaction with continued association may be construed as knowing participation

Recommendations fo r Members

• Establish, or encourage employer to establish, procedures to keep employees informed of changes in relevant laws, rules, and regulations

• Review, or encourage employer to review, the firms written compliance

procedures on a regular basis

• Maintain, or encourage employer to maintain, copies of current laws, rules, and regulations

• When in doubt about legality, consult supervisor, compliance personnel, or a lawyer

• When dissociating from violations, keep records documenting the violations, encourage employer to bring an end to the violations

• There is no requirement in the Standards to report wrongdoers, but local law may require it; members are 'strongly encouraged” to report violations to CFA Institute Professional Conduct Program

Recommendations fo r Firms

• Have a code of ethics

• Provide employees with information on laws, rules, and regulations governing professional activities

1(B) Independence and Objectivity Use reasonable care to exercise

independence and objectivity in professional activities Do not offer, solicit, or accept any gift, benefit, compensation, or consideration that would compromise independence and objectivity

Guidance— Investment-Banking Relationships

Do not be pressured by sell-side firms to issue favorable research on current or prospective investment-banking clients It is appropriate to have analysts work with investment bankers in uroad shows” only when the conflicts are adequately and effectively managed and disclosed Be sure there are effective “firewalls” between research/investment management and investment banking activities

Guidance— Public Companies

Analysts should not be pressured to issue favorable research by the companies they follow Do not confine research to discussions with company management, but rather use a variety of sources, including suppliers, customers, and competitors

Guidance— Buy-Side Clients

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-Paid 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

Recommendations fo r Members

Members or their firms should pay for their own travel to company events or tours when practicable and limit use of corporate aircraft to trips for which commercial travel is not an alternative

Recommendations fo r Firms

• Establish policies requiring every research report to reflect the unbiased opinion

of the analyst and align compensation plans to support this principal

• Establish and review written policies and procedures to assure research is

independent and objective

• Establish restricted lists of securities for which the firm is not willing to issue adverse opinions Factual information may still be provided

• Limit gifts from non-clients to token amounts

• Limit and require prior approval of employee participation in equity IPOs

• Establish procedures for supervisory review of employee actions

• Appoint a senior officer to oversee firm compliance and ethics

1(C) Misrepresentation Do not misrepresent facts regarding investment

analysis, recommendations, actions, or other professional activities

• Make reasonable efforts to verify information from third parties that is provided

to clients

• Regularly maintain webpages for accuracy

1(D) Misconduct Do not engage in any professional conduct that involves dishonesty, fraud, or deceit Do not do anything that reflects poorly on your

integrity, good reputation, trustworthiness, or professional competence

Guidance

CFA Institute discourages unethical behavior in all aspects of Members’ and

Candidates’ lives Do not abuse CFA Institute’s Professional Conduct Program by seeking enforcement of this Standard to settle personal, political, or other disputes that are not related to professional ethics

Recommendations fo r Firms

• Develop and adopt a code of ethics and make clear that unethical behavior will not be tolerated

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

• Check references of potential employees

II Integrity of Capital Markets

11(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 the 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 This Standard does not apply to using material nonpublic information for its intended purpose, such as an investment banker using information from a firm (the client) in order to advise or act for that client in ways that are otherwise ethical

Recommendations fo r Members

• Make reasonable efforts to achieve public dissemination by the firm of

information they possess

• Encourage their firms to adopt procedures to prevent the misuse of material nonpublic information

• Establish firewalls within the organization for who may and may not have access

to material nonpublic information Generally, this includes having the legal or compliance department clear interdepartmental communications, reviewing employee trades, documenting procedures to limit information flow, and

carefully reviewing or restricting proprietary trading whenever the firm possesses material nonpublic information on the securities involved

• Ensure that procedures for proprietary trading are appropriate to the strategies used A blanket prohibition is not required

• Develop procedures to enforce firewalls with complexity consistent with the complexity of the firm

• Have a compliance (or other) officer review and authorize information flows before sharing

• Maintain records of information shared

• Limit personal trading, require that it be reported, and establish a restricted list

of securities in which personal trading is not allowed

• Regularly communicate with and train employees to follow procedures

11(B) Market Manipulation Do not engage in any practices intended to mislead market participants through distorted prices or artificially inflated trading volume

Guidance

This Standard applies to transactions that deceive the market by distorting the price-setting mechanism of financial instruments or by securing a controlling position to manipulate the price of a related derivative and/or the asset itself Spreading false rumors is also prohibited Actions that affect price and volume but are not done with misleading intent to deceive are not a violation

III Duties to Clients and Prospective Clients

111(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 to clients, use reasonable care, and exercise prudent

judgment

Guidance

Client interests always come first

• Exercise prudence, care, skill, and diligence

• Manage pools of client assets in accordance with the terms of the governing documents The client can be a specific individual, group, or even the general investing public

• Make investment decisions in the context of the total portfolio

• Advise clients of any limitations on the advice, such as only recommending products of the advisor

• 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 client

Recommendations fo r Members

Submit to clients, at least quarterly, itemized statements showing all securities in custody and all debits, credits, and transactions Disclose where client assets are held and if they are moved Keep client assets separate from others’ assets

If in doubt as to the appropriate action, what would you do if you were the client?

If still in doubt, disclose and seek written client approval

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

• Follow applicable rules and laws

• Consider suitability of a portfolio relative to the client’s needs and

circumstances, the investment’s basic characteristics, or the basic characteristics

of the total portfolio

• Diversify unless account guidelines dictate otherwise

• Deal fairly with all clients in regard to investment actions

• Disclose manager compensation arrangements

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

• Seek best execution

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

Recommendations fo r Members

• Encourage firms to establish compliance procedures requiring proper

dissemination of investment recommendations and fair treatment of all

customers and clients

• Maintain a list of clients and holdings—use to ensure that all holders are treated fairly

Recommendations fo r Firms

• Limit the number of people who are aware that a change in recommendation will be made

• Shorten the time frame between decision and dissemination

• Publish personnel guidelines for pre-dissemination—have in place guidelines prohibiting personnel who have prior knowledge of a recommendation from discussing it or taking action on the pending recommendation

• Disseminate new or changed recommendations simultaneously to all clients who have expressed an interest or for whom an investment is suitable

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

objectives

• Disclose trade allocation procedures.

• Develop written trade allocation procedures to:

♦ Document and time stamp all orders

♦ Bundle orders and then execute on a first come, first fill basis

♦ Provide the same net (after costs) execution price to all clients in a block trade

III(C) Suitability

1 When in an advisory relationship with client or prospect:

a Make reasonable inquiry into clients5 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 clients financial situation and consistent with client objectives

c Make sure investments are suitable in the context of a clients total portfolio

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

Guidance

In advisory relationships, gather and maintain relevant client information If responsible for managing a fund to an index or other stated mandate, be sure investments are consistent with the stated mandate

If a manager receives an unsolicited trade request from a client and determines the trade is not suitable, discuss the situation with the client If the request does not have a material effect on the client, the trade may be executed after the discussion

If the trade has a material effect, work with the client to change the IPS or make the trade in a client-directed account

III(D) Performance Presentation Presentations of investment performance

information must be fair, accurate, and complete

Recommendations fo r Members

• Encourage firms to adhere to Global Investment Performance Standards

• Consider the sophistication of the audience to whom a performance

• Maintain data and records used to calculate the performance being presented

III(E) Preservation of Confidentiality All information about current and former

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

to report the activities to authorities The requirements of this Standard are not intended to prevent Members and Candidates from cooperating with a CFA Institute Professional Conduct Program (PCP) investigation

Recommendations fo r Members

• Members should avoid disclosing information received from a client except to authorized coworkers who are also working for the client Consider whether the disclosure is necessary and will benefit the client

• Members should follow firm procedures for storage of electronic data and recommend adoption of such procedures if they are not in place

IV Duties to Employers

IV(A) Loyalty Members and Candidates must place their employers interest

before their own and must not deprive their employer of their skills and abilities, divulge confidential information, or otherwise harm their employer

Guidance

Members who are employees must not engage in activities that would injure their firm, deprive it of profit, or deprive it of the advantage of employees5 skills and abilities Always place client interests above employer interests Members who are independent contractors do not owe this presumption of exclusivity to those who hire them for services Those members must adhere to the terms of their contract(s)

Members must also comply with their employers policies regarding social media

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 nature of the activities and if the employer consents to all terms

of the proposed independent practice before it begins

Guidance— Leaving an Employer

Members must continue to act in their employers best interests until resignation is effective Activities that may constitute a violation include:

• Misappropriation of trade secrets

• Soliciting employers clients prior to leaving

• Self-dealing

Once an employee has left a firm, simple knowledge of names and existence of former clients is generally not confidential Also, there is no prohibition on the use

of experience or knowledge gained while with a former employer

Recommendations fo r Firms

Employers should not have incentive and compensation systems that encourage unethical behavior

• Establish codes of conduct and related procedures

IV(B) Additional Compensation Arrangements Accept no gifts, benefits,

compensation, or consideration that may create a conflict of interest with the employers interest unless written consent is received from all parties An offer from

a client that is contingent on future performance is a form of compensation and requires the disclosure and approval conditions of this Standard, IV(B) In contrast,

an offer from a client that is based on past performance is a gift (not compensation) and must meet the provisions of Standard 1(B), maintaining Independence and Objectivity

Guidance

Compensation includes direct and indirect compensation from a client and other benefits received from third parties Written consent from a Members employer includes e-mail communication

Recommendations fo r Members

Make an immediate written report to the employer detailing any proposed

compensation and services, if additional to that provided by the employer It should disclose the nature, approximate amount, and duration of compensation

Members and candidates who are hired to work part time should discuss any arrangements that may compete with their employers interest at the time they are

IV(C) Responsibilities of Supervisors Members and Candidates must make

reasonable efforts to ensure that anyone subject to their supervision or authority complies with applicable laws, rules, regulations, and the Code and Standards

Guidance

Members must make reasonable efforts to prevent employees from violating laws, rules, regulations, or the Code and Standards, as well as make reasonable efforts to detect violations

Guidance— Compliance Procedures

An adequate compliance system must meet industry standards, regulatory

requirements, and the requirements of the Code and Standards Members with supervisory responsibilities have an obligation to bring an inadequate compliance system to the attention of firms management and recommend corrective action.When a violation is discovered, the supervisor should:

• Respond promptly and investigate thoroughly

• Supervise the accused closely until the issue is resolved

Conduct regular ethics and compliance training

Design incentive compensation plans to support ethical behavior (e.g., don’t incent inappropriate risk taking or other actions detrimental to the clients)

Recommendations fo r Members

A member should recommend that his employer adopt a code of ethics Members should encourage employers to provide their codes of ethics to clients

Once the compliance program is instituted, the supervisor should:

• Distribute it to the proper personnel

• Review employee actions to monitor compliance and identify violations

• Respond promptly to violations, investigate thoroughly, increase supervision while investigating the suspected employee, and consider changes to prevent future violations

• Designate a compliance officer with authority clearly defined.

• Have a system of checks and balances

• Outline the scope of procedures

• Contain procedures for reporting violations and sanctions

Ethics education will not deter fraud, but it will establish an ethical culture and alert employees to potential ethical and legal pitfalls Reinforce the culture with incentive compensation plans that align employee incentives with client best

interests

V Investment Analysis, Recommendations, and Action

V(A) Diligence and Reasonable Basis

1 When analyzing investments, making recommendations, and taking investment actions, use diligence, independence, and thoroughness

2 Analysis, recommendations, and actions should have a reasonable and adequate basis, supported by research and investigation

Guidance

The application of this Standard depends on the investment philosophy adhered to, Members5 and Candidates5 roles in the investment decision-making process, and the resources and support provided by employers These factors dictate the degree of diligence, thoroughness of research, and the proper level of investigation required

Guidance— Using Secondary or Third-Party Research

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

• How timely is the research?

• Evaluate objectivity and independence of the recommendations

Guidance— Group Research and Decision M aking

Even if a Member does not agree with the independent and objective view of thegroup, he does not necessarily have to decline to be identified with the report, aslong as there is a reasonable and adequate basis

Recommendations fo r Members

supporting this Standard:

• Have a policy requiring that research reports and recommendations have a basis that can be substantiated as reasonable and adequate

• Have detailed, written guidance for proper research, supervision, and due diligence

• Have measurable criteria for judging the quality of research, and base analyst compensation on such criteria

• Have written procedures that provide a minimum acceptable level of scenario testing for computer-based models and include standards for the range 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 outside providers of information that addresses the reasonableness and accuracy of the information provided and establishes how often the evaluations should be repeated

• Adopt a set of standards that provides criteria for evaluating external advisers and states how often a review of external advisers will be performed

V(B) Communication With Clients and Prospective Clients

1 Disclose to clients and prospective clients the basic format and general principles of the investment processes they use to analyze investments, select securities, and construct portfolios and must promptly disclose any changes that might materially affect those processes

2 Disclose to clients and prospective clients significant limitations and risks associated with the investment process

3 Use reasonable judgment in identifying which factors are important

to their investment analyses, recommendations, or actions and include those factors in communications with clients and prospective clients

4 Distinguish between fact and opinion in the presentation of investment analysis and recommendations

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 factors specific to non-traditional investments, including potential gains and losses on all investments in terms of total returns Members are required to communicate significant changes in the risk characteristics

of an investment or strategy and to update clients regularly about changes in the investment process

Members should explain the limitations inherent to an investment and the

limitations of the projections from quantitative models and analysis

Members must illustrate to clients and prospects the investment decision-making process utilized The suitability of each investment is important in the context of the entire portfolio

Recommendations fo r Members

Selection of relevant factors in a report can be a judgment call so members should maintain records indicating the nature of the research, and be able to supply

additional information if it is requested by the client or other users of the report

Encourage the firm to establish a rigorous method of reviewing research work and results

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

recommendations, actions, and all other investment-related communications with 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 firm If no other regulatory standards are in place, CFA Institute recommends at least a 7-year holding period

Recommendations fo r Members

Recommendations fo r Firms

If no regulatory standards or firm policies are in place, the Standard recommends a seven-year minimum holding period

VI Conflicts of Interest

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

fair disclosure of all matters that may impair their independence or objectivity or interfere with their duties to employer, clients, and prospects Disclosures must be prominent, in plain language, and effectively communicate the information

Guidance— Disclosure to Clients

The requirement allows clients and prospects to judge motives and potential

biases for themselves Disclosure of broker/dealer market-making activities would

be included here Board service is another area of potential conflict The most common conflict that requires disclosure is actual ownership of stock in companies the Member recommends or clients hold Incentive compensation plans that may put member and client interests in conflict must be disclosed to clients by their advisors

Guidance— Disclosure o f 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

Recommendations fo r Members

Any special compensation arrangements, bonus programs, commissions,

performance-based fees, options on the firms stock, and other incentives should be disclosed to clients If the firm refuses to allow this disclosure, document the refusal and consider disassociating from the firm

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

Client transactions take priority over personal transactions and over transactions made on behalf of the Members firm Personal transactions include situations where the Member is a “beneficial owner.” Personal transactions may be undertaken only after clients and the Members employer have had an adequate opportunity

to act on a recommendation Note that family-member accounts that are client accounts should be treated just like any client account; they should not be

disadvantaged

Recommendations fo r Members

Members should encourage their firms to adopt the procedures listed in the

following recommendations for firms and disclose these to clients

Recommendations fo r Firms

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

• Establish limitations on employee participation in equity IPOs and

systematically review such participation

• Establish restrictions on participation in private placements Strict limits should

be placed on employee acquisition of these securities and proper supervisory procedures should be in place Participation in these investments raises conflict

of interest issues similar to those of IPOs

making should have blackout periods prior to trading for clients—no front running (i.e., purchase or sale of securities in advance of anticipated client or employer purchases and sales) The size of the firm and the type of security should help dictate how severe the blackout requirement should be

• Establish reporting procedures, including duplicate trade confirmations,

disclosure of personal holdings and beneficial ownership positions, and

preclearance procedures

• Disclose, upon request, the firms policies regarding personal trading

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

clients, and prospects any compensation consideration or benefit received by, or paid to, others for recommendations of products and services

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 potential partiality

Recommendations fo r Members

Members should encourage their firms to adopt clear procedures regarding

compensation for referrals

Recommendations fo r Firms

Have an investment professional advise the clients at least quarterly on the nature and amount of any such compensation

VII Responsibilities as a CFA Institute Member or CFA Candidate

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

and Candidates must not engage in any conduct that compromises the reputation

or integrity of CFA Institute or the CFA designation or the integrity, validity, or security of the CFA Institute Programs

This Standard applies to conduct that includes:

• Revealing anything about either broad or specific topics tested, content of exam questions, or formulas required or not required on the exam

• Cheating on the CFA Exam or any exam

• Not following rules and policies of the CFA program

• Misrepresenting information on the Professional Conduct Statement (PCS) or the CFA Institute Professional Development 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 Candidates must not misrepresent or exaggerate the meaning or implications of membership in CFA Institute, holding the CFA designation, or candidacy in the program

Members must not make promotional promises or guarantees tied to the CFA designation Do not:

• Over-promise investment results in the future

Guidance— CFA Institute Membership

Members must sign PCS annually and pay CFA Institute 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 completed the program in three years, if in fact the Candidate did, but claiming superior ability because of this is not permitted

Guidance— Proper Usage o f the CFA M arks

The Chartered Financial Analyst and CFA marks must always be used either after a charterholders name or as adjectives but not as nouns

Recommendations fo r Members

Members should be sure that their firms are aware of the proper references to a members CFA designation or candidacy, as errors in these references are common

Cross-Reference to CFA Institute Assigned Reading #4

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) Risk Management, Compliance, and Support, (5) Performance and Valuation, and (6) Disclosures.2 Related to these six components are ethical responsibilities:

• Always act ethically and professionally

• Act in the best interest of the client

• Act in an objective and independent manner

2 Investment Process and Actions

• Act as a professional using reasonable care and judgment for clients

• Do not manipulate market price and volume with intent to deceive

• Deal fairly with clients Different levels of service are allowed if disclosed and available to all clients willing to pay

2 CFA Institute Asset Manager Code of Professional Conduct, including Appendix A CFA Institute, Centre for Financial Market Integrity, 2005

• Have a reasonable and adequate basis for recommendations and use of third- party research Managers must be knowledgeable, particularly if using complex strategies, and the strategies must be explained in ways understandable to the clients.

• Portfolios managed to specific styles or strategy must be adequately explained

to the client but do not require determining suitability for the client

Recommendation: Disclose any permitted deviations from the strategy and allow client withdrawal without undue penalty if the strategy changes

• Portfolios managed for a specific client must be suitable for that client

Recommendation: Establish a written IPS Establish performance benchmarks

3 Trading

• Do not act or cause others to act on material nonpublic information Set up suitable P&P Recommendation: Set up firewalls between those with reasons to have the information and all others

• Give clients priority over the firm Establish P&P to limit personal trading by employees and have a compliance officer review the trades Establish a watch list

• Use client commissions only for investment uses related to that client

Recommendation: Consider eliminating soft dollars or, if not, follow the CFA Institute Soft: Dollar Standards

• Seek best trade execution Recommendation: Advise clients who direct trades that this may compromise best execution

• Establish P&P for fair trade allocation Recommendations: Group suitable accounts for block trade execution and use prorated allocation for partial trade executions Address how to handle IPOs and private placements

4 Risk Management, Compliance, and Support

• Develop detailed P&P to meet the AMC plus all legal and regulatory issues

• Appoint a suitable compliance officer Recommendations: The compliance officer is independent of investments and operations The officer reviews all firm and employee transactions Require all employees to understand and complywith the AMC

firm to clients is accurate and complete Verification cannot depend only on internal firm records

• Maintain records to document investment actions Recommendations: Retain compliance records Document violations and corrective actions Retain records for at least 7 years or as required by law and regulations

• Employ sufficient, qualified staff to meet the AMC and provide the services promised

• Establish a firmwide risk management plan Recommendations: Outsource if

5 Performance and Valuation

Recommendation: Adopt GIPS

• Use fair market price for valuation if available or fair value otherwise

Recommendation: Use independent third parties for valuation

6 Disclosures

Maintain timely client communication using plain language that is true, accurate,and complete Include all material facts, including information about the firm.Disclose:

• All conflicts of interest, regulatory and disciplinary actions

• All management fee and client cost information

• All soft dollar and bundled fee information, including what is received in return and the benefit to the client

• Client account performance with quarterly (within 30 days) reporting

recommended

• Investment valuation methods used

• P&P for shareholder voting, with particular attention to how controversial votes are handled

• Review and audit results for client funds and accounts

• Significant firm personnel and organizational changes

• The firms risk management process, changes to the process, and what regular communication the client will receive Regular disclosure of client-specific risk information is recommended

Study Session 3

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

T h e B e h a v i o r a l F i n a n c e P e r spe c t i v e

Cross-Reference to CFA Institute Assigned Readings #5

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 investors 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:

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 vs Prospect Theory

Utility theory (and TF) assumes investors are risk averse and feel diminishing marginal utility of wealth This has two implications First, an investors

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 will 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 investors level of satisfaction (utility) increases but at a diminishing rate

Risk-Averse* Risk-Neutral

Risk-Seeking

Utility

* 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

Double Inflection Utility Function Prospect Theory Value Function

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

• 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)

BF Details: Decision Making in Two Phases

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

that assigns greater loss in utility for losses in wealth than gains in utility for an equivalent gain in wealth

U = w(p1)v(x1) + w(p2)v(x2) +

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 clients 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, making 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