Portfolio Management

Construction, optimization, and management of investment portfolios.

Portfolio management involves the construction, optimization, and ongoing management of investment portfolios to meet specific investment objectives and risk tolerances. This includes asset allocation, security selection, performance measurement, and risk management. Analysts use various tools and techniques, such as modern portfolio theory, efficient frontier analysis, and factor investing, to build and manage portfolios effectively.

5 minutes 5 Questions

Portfolio Management is a cornerstone topic in the CFA Level 2 curriculum that builds upon foundational concepts from Level 1. At Level 2, candidates delve deeper into portfolio theory, risk management, and investment strategies with greater analytical complexity. The curriculum explores advanced asset allocation techniques, including strategic and tactical approaches. Strategic allocation focuses on long-term investment goals based on expected returns and correlations, while tactical allocation involves shorter-term adjustments to capitalize on market opportunities. Candiates study the Markowitz portfolio theory in greater mathematical depth, examining efficient frontiers, optimal portfolios, and the capital allocation line. The Capital Asset Pricing Model (CAPM) is expanded to include multi-factor models such as the Fama-French three-factor model. Level 2 introduces more sophisticated risk metrics beyond standard deviation, including Value at Risk (VaR), conditional VaR, and scenario analysis. Portfolio performance measurement includes risk-adjusted metrics like Sharpe ratio, Treynor ratio, and Jensen's alpha, with emphasis on attribution analysis to identify sources of returns. The curriculum covers behavioral finance biases affecting portfolio decisions and methods to address them. Alternative investments (real estate, private equity, hedge funds) are analyzed for their diversification benefits and unique risk characteristics. Portfolio management for institutional investors receives significant attention, including liability-driven investing, pension fund management, and endowment models. Global investing concepts address currency risk management and international diversification benefits. ESG (Environmental, Social, Governance) integration into portfolio construction represents an evolving area of focus. Level 2 portfolio management requires candidates to demonstrate analytical skills through complex calculations and case studies, applying theoretical frameworks to practical investment scenarios.

Concepts covered: Analysis of Active Portfolio Management, Exchange-Traded Funds: Mechanics and Applications, Backtesting and Simulation, Using Multifactor Models, Economics and Investment Markets, Measuring and Managing Market Risk

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CFA Level 2 - Portfolio Management Example Questions

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Question 1

Which of the following scenarios is most likely to increase the value added by an active portfolio manager, according to the fundamental law of active management?

Maintaining a constant number of independent investment decisions and information coefficient while decreasing the transfer coefficient Increasing the number of independent investment decisions while maintaining a constant information coefficient and transfer coefficient Decreasing the number of independent investment decisions while increasing the information coefficient and maintaining a constant transfer coefficient

Correct Answer: Increasing the number of independent investment decisions while maintaining a constant information coefficient and transfer coefficient

According to the fundamental law of active management, the value added by an active portfolio manager can be increased by either increasing the number of independent investment decisions (breadth) or by improving the accuracy of those decisions (skill). In this case, increasing the number of independent investment decisions while maintaining a constant information coefficient (a measure of forecasting skill) and transfer coefficient (a measure of the manager's ability to convert investment insights into portfolio positions) is the most likely scenario to increase the value added by the active manager. Decreasing the number of independent investment decisions would likely decrease the value added, even if the information coefficient is increased. Decreasing the transfer coefficient while keeping the other factors constant would also likely decrease the value added.

Question 2

A multifactor model includes the following factors and their corresponding factor premiums: Value (3.2%), Momentum (2.8%), and Quality (1.6%). Stock A has the following factor exposures: Value (1.1), Momentum (0.9), and Quality (1.2). Stock B has the following factor exposures: Value (0.8), Momentum (1.3), and Quality (0.7). Based on the multifactor model, which statement about the stocks' expected returns is most accurate?

Stock B is expected to have a higher return than Stock A due to its higher exposure to the Momentum factor, which has a factor premium of 2.8%. Stock A is expected to have a higher return than Stock B. The expected returns for Stock A and Stock B are equal, as their factor exposures balance out the differences in factor premiums.

Correct Answer: Stock A is expected to have a higher return than Stock B.

Stock A is expected to have a higher return than Stock B. To calculate the expected return for each stock, we need to multiply the factor exposures by their corresponding factor premiums and sum them up: Stock A: Value: 1.1 * 3.2% = 3.52% Momentum: 0.9 * 2.8% = 2.52% Quality: 1.2 * 1.6% = 1.92% Total expected return for Stock A: 3.52% + 2.52% + 1.92% = 7.96% Stock B: Value: 0.8 * 3.2% = 2.56% Momentum: 1.3 * 2.8% = 3.64% Quality: 0.7 * 1.6% = 1.12% Total expected return for Stock B: 2.56% + 3.64% + 1.12% = 7.32% Stock A has a higher expected return (7.96%) compared to Stock B (7.32%), primarily due to its higher exposure to the Value and Quality factors, which outweighs Stock B's higher exposure to the Momentum factor.

Question 3

An investor is considering adding an Exchange-Traded Fund (ETF) to their portfolio that tracks a basket of high-yield corporate bonds. The ETF has an expense ratio of 0.50% and uses a combination of physical bonds and credit default swaps (CDS) to gain exposure to the underlying high-yield bond market. The ETF's prospectus states that it may invest up to 30% of its assets in CDS. Given this information, which of the following is the most accurate assessment of the risks associated with investing in this ETF?

The ETF's use of a combination of physical bonds and credit default swaps to gain exposure to the high-yield bond market may result in higher tracking error relative to its underlying index compared to ETFs that invest solely in physical bonds. The ETF's exposure to high-yield corporate bonds significantly increases its interest rate risk compared to ETFs that invest in investment-grade bonds, making it more susceptible to price declines when interest rates rise. The use of credit default swaps exposes the ETF to counterparty risk and potential liquidity issues in stressed market conditions, which could negatively impact the ETF's performance and ability to meet redemption requests.

Correct Answer: The use of credit default swaps exposes the ETF to counterparty risk and potential liquidity issues in stressed market conditions, which could negatively impact the ETF's performance and ability to meet redemption requests.

The most accurate assessment of the risks associated with investing in this high-yield corporate bond ETF is that the use of credit default swaps (CDS) exposes the ETF to counterparty risk and potential liquidity issues in stressed market conditions. This could negatively impact the ETF's performance and ability to meet redemption requests. Credit default swaps are derivative contracts that allow the ETF to gain exposure to the underlying high-yield bond market without directly owning the bonds. However, this introduces counterparty risk, as the ETF is relying on the financial stability and ability of the CDS issuer to fulfill their obligations. In stressed market conditions, the liquidity of CDS contracts may also decrease, making it difficult for the ETF to adjust its positions or meet redemption requests. While the ETF's exposure to high-yield bonds does increase its overall risk profile compared to investment-grade bond ETFs, interest rate risk is not the most significant risk factor in this case. The ETF's use of CDS and the associated counterparty and liquidity risks are more pressing concerns. Regarding tracking error, although the use of CDS may contribute to some deviation from the underlying index, it is not the most significant risk highlighted in the given information. The potential impact of counterparty risk and liquidity issues on the ETF's performance and ability to meet redemptions is a more critical consideration for investors.

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