2018 CFA level 3 study note book4 unprotected

Table of Contents
1.
2.
3.
4.

Getting Started Flyer
Table of Contents
Page List
Book 4: Equity Portfolio Management, Alternative Investments, Risk
Management, and Derivatives
5. Readings and Learning Outcome Statements
6. Equity Portfolio Management
1. LOS 25.a: Discuss the role of equities in the overall portfolio.
2. LOS 25.b: Discuss the rationales for passive, active, and semi-active
(enhanced index) equity investment approaches and distinguish among
those approaches with respect to expected active return and tracking risk.
3. LOS 25.c: Recommend an equity investment approach when given an
investor’s investment policy statement and beliefs concerning market
efficiency.
4. LOS 25.d: Distinguish among the predominant weighting schemes used in
the construction of major equity market indexes and evaluate the biases of
each.
5. LOS 25.e: Compare alternative methods for establishing passive exposure
to an equity market, including indexed separate or pooled accounts, index
mutual funds, exchange-traded funds, equity index futures, and equity
total return swaps.
6. LOS 25.f: Compare full replication, stratified sampling, and optimization as
approaches to constructing an indexed portfolio and recommend an

approach when given a description of the investment vehicle and the index
to be tracked.
7. LOS 25.g: Explain and justify the use of equity investment–style
classifications and discuss the difficulties in applying style definitions
consistently.
8. LOS 25.h: Explain the rationales and primary concerns of value investors
and growth investors and discuss the key risks of each investment style.
9. LOS 25.i: Compare techniques for identifying investment styles and
characterize the style of an investor when given a description of the
investor’s security selection method, details on the investor’s security
holdings, or the results of a returns-based style analysis.
10. LOS 25.j: Compare the methodologies used to construct equity style
indexes.
11. LOS 25.k: Interpret the results of an equity style box analysis and discuss
the consequences of style drift.
12. LOS 25.l: Distinguish between positive and negative screens involving
socially responsible investing criteria and discuss their potential effects on


a portfolio’s style characteristics.
13. LOS 25.m: Compare long–short and long-only investment strategies,
including their risks and potential alphas, and explain why greater pricing
inefficiency may exist on the short side of the market.
14. LOS 25.n: Explain how a market-neutral portfolio can be “equitized” to gain
equity market exposure and compare equitized market-neutral and shortextension portfolios.
15. LOS 25.o: Compare the sell disciplines of active investors.
16. LOS 25.p: Contrast derivatives-based and stock-based enhanced indexing
strategies and justify enhanced indexing on the basis of risk control and the
information ratio.
17. LOS 25.q: Recommend and justify, in a risk-return framework, the optimal

portfolio allocations to a group of investment managers.
18. LOS 25.r: Explain the core-satellite approach to portfolio construction and
discuss the advantages and disadvantages of adding a completeness fund
to control overall risk exposures.
19. LOS 25.s: Distinguish among the components of total active return (“true”
active return and “misfit” active return) and their associated risk measures
and explain their relevance for evaluating a portfolio of managers.
20. LOS 25.t: Explain alpha and beta separation as an approach to active
management and demonstrate the use of portable alpha.
21. LOS 25.u: Describe the process of identifying, selecting, and contracting
with equity managers.
22. LOS 25.v: Contrast the top-down and bottom-up approaches to equity
research.
23. Key Concepts
1. LOS 25.a
2. LOS 25.b
3. LOS 25.c
4. LOS 25.d
5. LOS 25.e
6. LOS 25.f
7. LOS 25.g
8. LOS 25.h
9. LOS 25.i
10. LOS 25.j
11. LOS 25.k
12. LOS 25.l
13. LOS 25.m
14. LOS 25.n
15. LOS 25.o
16. LOS 25.p

17. LOS 25.q
18. LOS 25.r


19. LOS 25.s
20. LOS 25.t
21. LOS 25.u
22. LOS 25.v
24. Concept Checkers
1. Answers – Concept Checkers
7. Self-Test: Equity Portfolio Management
1. Self-Test Answers: Equity Portfolio Management
8. Alternative Investments Portfolio Management
1. LOS 26.a: Describe common features of alternative investments and their
markets and how alternative investments may be grouped by the role they
typically play in a portfolio.
2. LOS 26.b: Explain and justify the major due diligence checkpoints involved
in selecting active managers of alternative investments.
3. LOS 26.c: Explain distinctive issues that alternative investments raise for
investment advisers of private wealth clients.
4. LOS 26.d: Distinguish among types of alternative investments.
5. LOS 26.e: Discuss the construction and interpretation of benchmarks and
the problem of benchmark bias in alternative investment groups.
6. LOS 26.f: Evaluate the return enhancement and/or risk diversification
effects of adding an alternative investment to a reference portfolio (for
example, a portfolio invested solely in common equity and bonds).
7. LOS 26.g: Describe advantages and disadvantages of direct equity
investments in real estate.
8. LOS 26.h: Discuss the major issuers and suppliers of venture capital, the
stages through which private companies pass (seed stage through exit), the

characteristic sources of financing at each stage, and the purpose of such
financing.
9. LOS 26.i: Compare venture capital funds and buyout funds.
10. LOS 26.j: Discuss the use of convertible preferred stock in direct venture
capital investment.
11. LOS 26.k: Explain the typical structure of a private equity fund, including
the compensation to the fund’s sponsor (general partner) and typical
timelines.
12. LOS 26.l: Discuss issues that must be addressed in formulating a private
equity investment strategy.
13. LOS 26.m: Compare indirect and direct commodity investment.
14. LOS 26.n: Describe the principal roles suggested for commodities in a
portfolio and explain why some commodity classes may provide a better
hedge against inflation than others.
15. LOS 26.o: Identify and explain the style classification of a hedge fund, given
a description of its investment strategy.
16. LOS 26.p: Discuss the typical structure of a hedge fund, including the fee
structure, and explain the rationale for high-water mark provisions.


17. LOS 26.q: Describe the purpose and characteristics of fund-of-funds hedge
funds.
18. LOS 26.r: Discuss concerns involved in hedge fund performance evaluation.
19. LOS 26.s: Describe trading strategies of managed futures programs and the
role of managed futures in a portfolio.
20. LOS 26.t: Describe strategies and risks associated with investing in
distressed securities.
21. LOS 26.u: Explain event risk, market liquidity risk, market risk, and “J-factor
risk” in relation to investing in distressed securities.
22. Key Concepts

1. LOS 26.a
2. LOS 26.b
3. LOS 26.c
4. LOS 26.d
5. LOS 26.e
6. LOS 26.f
7. LOS 26.g
8. LOS 26.h
9. LOS 26.i
10. LOS 26.j
11. LOS 26.k
12. LOS 26.l
13. LOS 26.m
14. LOS 26.n
15. LOS 26.o
16. LOS 26.p
17. LOS 26.q
18. LOS 26.r
19. LOS 26.s
20. LOS 26.t
21. LOS 26.u
23. Concept Checkers
1. Answers – Concept Checkers
9. Self-Test: Alternative Investments Portfolio Management
1. Self-Test Answers: Alternative Investments Portfolio Management
10. Risk Management
1. LOS 27.a: Discuss features of the risk management process, risk
governance, risk reduction, and an enterprise risk management system.
2. LOS 27.b: Evaluate strengths and weaknesses of a company’s risk
management process.

3. LOS 27.c: Describe steps in an effective enterprise risk management
system.
4. LOS 27.d: Evaluate a company’s or a portfolio’s exposures to financial and
nonfinancial risk factors.


5. LOS 27.e: Calculate and interpret value at risk (VaR) and explain its role in
measuring overall and individual position market risk.
6. LOS 27.f: Compare the analytical (variance–covariance), historical, and
Monte Carlo methods for estimating VaR and discuss the advantages and
disadvantages of each.
7. LOS 27.g: Discuss advantages and limitations of VaR and its extensions,
including cash flow at risk, earnings at risk, and tail value at risk.
8. LOS 27.h: Compare alternative types of stress testing and discuss
advantages and disadvantages of each.
9. LOS 27.i: Evaluate the credit risk of an investment position, including
forward contract, swap, and option positions.
10. LOS 27.j: Demonstrate the use of risk budgeting, position limits, and other
methods for managing market risk.
11. LOS 27.k: Demonstrate the use of exposure limits, marking to market,
collateral, netting arrangements, credit standards, and credit derivatives to
manage credit risk.
12. LOS 27.l: Discuss the Sharpe ratio, risk-adjusted return on capital, return
over maximum drawdown, and the Sortino ratio as measures of riskadjusted performance.
13. LOS 27.m: Demonstrate the use of VaR and stress testing in setting capital
requirements.
14. Key Concepts
1. LOS 27.a
2. LOS 27.b, c
3. LOS 27.d

4. LOS 27.e
5. LOS 27.f
6. LOS 27.g
7. LOS 27.h
8. LOS 27.i
9. LOS 27.j
10. LOS 27.k
11. LOS 27.l
12. LOS 27.m
15. Concept Checkers
1. Answers – Concept Checkers
11. Self-Test: Risk Management
1. Self-Test Answers: Risk Management
12. Risk Management Applications of Forward and Futures Strategies
1. LOS 28.a: Demonstrate the use of equity futures contracts to achieve a
target beta for a stock portfolio and calculate and interpret the number of
futures contracts required.
2. LOS 28.b: Construct a synthetic stock index fund using cash and stock index
futures (equitizing cash).


3. LOS 28.c: Explain the use of stock index futures to convert a long stock
position into synthetic cash.
4. LOS 28.d: Demonstrate the use of equity and bond futures to adjust the
allocation of a portfolio between equity and debt.
5. LOS 28.e: Demonstrate the use of futures to adjust the allocation of a
portfolio across equity sectors and to gain exposure to an asset class in
advance of actually committing funds to the asset class.
6. LOS 28.f: Explain exchange rate risk and demonstrate the use of forward
contracts to reduce the risk associated with a future receipt or payment in

a foreign currency.
7. LOS 28.g: Explain the limitations to hedging the exchange rate risk of a
foreign market portfolio and discuss feasible strategies for managing such
risk.
8. Key Concepts
1. LOS 28.a
2. LOS 28.b, c
3. LOS 28.d, e
4. LOS 28.f
5. LOS 28.g
9. Concept Checkers
1. Answers – Concept Checkers
13. Risk Management Applications of Option Strategies
1. LOS 29.a: Compare the use of covered calls and protective puts to manage
risk exposure to individual securities.
2. LOS 29.b: Calculate and interpret the value at expiration, profit, maximum
profit, maximum loss, breakeven underlying price at expiration, and
general shape of the graph for the following option strategies: bull spread,
bear spread, butterfly spread, collar, straddle, box spread.
3. LOS 29.c: Calculate the effective annual rate for a given interest rate
outcome when a borrower (lender) manages the risk of an anticipated loan
using an interest rate call (put) option.
4. LOS 29.d: Calculate the payoffs for a series of interest rate outcomes when
a floating rate loan is combined with 1) an interest rate cap, 2) an interest
rate floor, or 3) an interest rate collar.
5. LOS 29.e: Explain why and how a dealer delta hedges an option position,
why delta changes, and how the dealer adjusts to maintain the delta
hedge.
6. LOS 29.f: Interpret the gamma of a delta-hedged portfolio and explain how
gamma changes as in-the-money and out-of-the-money options move

toward expiration.
7. Key Concepts
1. LOS 29.a
2. LOS 29.b
3. LOS 29.c


14.

15.
16.
17.
18.

4. LOS 29.d
5. LOS 29.e
6. LOS 29.f
8. Concept Checkers
1. Answers – Concept Checkers
Risk Management Applications of Swap Strategies
1. LOS 30.a: Demonstrate how an interest rate swap can be used to convert a
floating-rate (fixed-rate) loan to a fixed-rate (floating-rate) loan.
2. LOS 30.b: Calculate and interpret the duration of an interest rate swap.
3. LOS 30.c: Explain the effect of an interest rate swap on an entity’s cash flow
risk.
4. LOS 30.d: Determine the notional principal value needed on an interest
rate swap to achieve a desired level of duration in a fixed-income portfolio.
5. LOS 30.e: Explain how a company can generate savings by issuing a loan or
bond in its own currency and using a currency swap to convert the
obligation into another currency.

6. LOS 30.f: Demonstrate how a firm can use a currency swap to convert a
series of foreign cash receipts into domestic cash receipts.
7. LOS 30.g: Explain how equity swaps can be used to diversify a concentrated
equity portfolio, provide international diversification to a domestic
portfolio, and alter portfolio allocations to stocks and bonds.
8. LOS 30.h: Demonstrate the use of an interest rate swaption 1) to change
the payment pattern of an anticipated future loan and 2) to terminate a
swap.
9. Key Concepts
1. LOS 30.a
2. LOS 30.b
3. LOS 30.c
4. LOS 30.d
5. LOS 30.e
6. LOS 30.f
7. LOS 30.g
8. LOS 30.h
10. Concept Checkers
1. Answers – Concept Checkers
Self-Test: Risk Management Applications of Derivatives
1. Self-Test Answers: Risk Management Applications of Derivatives
Formulas
Cumulative Z-Table
Copyright


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BOOK 4 – EQUITY PORTFOLIO MANAGEMENT,
ALTERNATIVE INVESTMENTS, RISK MANAGEMENT,
AND DERIVATIVES
Readings and Learning Outcome Statements
Study Session 12 – Equity Portfolio Management
Self-Test – Equity Portfolio Management
Study Session 13 – Alternative Investments Portfolio Management
Self-Test – Alternative Investments Portfolio Management
Study Session 14 – Risk Management
Self-Test – Risk Management
Study Session 15 – Risk Management Applications of Derivatives
Self-Test – Risk Management Applications of Derivatives
Formulas
Cumulative Z-Table


READINGS AND LEARNING OUTCOME STATEMENTS
READINGS
The following material is a review of the Equity Portfolio Management, Alternative
Investments, Risk Management, and Derivatives principles designed to address the
learning outcome statements set forth by CFA Institute.

STUDY SESSION 12
Reading Assignments
Equity Portfolio Management, CFA Program 2018 Curriculum, Volume 4, Level III
25. Equity Portfolio Management

STUDY SESSION 13
Reading Assignments
Alternative Investments for Portfolio Management, CFA Program 2018 Curriculum,
Volume 5, Level III
26. Alternative Investments Portfolio Management

STUDY SESSION 14
Reading Assignments
Risk Management, CFA Program 2018 Curriculum, Volume 5, Level III
27. Risk Management

STUDY SESSION 15
Reading Assignments
Risk Management Applications of Derivatives, CFA Program 2018 Curriculum,
Volume 5, Level III
28. Risk Management Applications of Forward and Futures Strategies
29. Risk Management Applications of Option Strategies
30. Risk Management Applications of Swap Strategies

LEARNING OUTCOME STATEMENTS (LOS)


X VY

The CFA Institute learning outcome statements are listed in the following. These are
repeated in each topic review. However, the order may have been changed in order to
get a better fit with the flow of the review.

STUDY SESSION 12
The topical coverage corresponds with the following CFA Institute assigned
reading:
25. Equity Portfolio Management
The candidate should be able to:
a. discuss the role of equities in the overall portfolio. (page 1)
b. discuss the rationales for passive, active, and semi-active (enhanced index)
equity investment approaches and distinguish among those approaches
with respect to expected active return and tracking risk. (page 2)
c. recommend an equity investment approach when given an investor’s
investment policy statement and beliefs concerning market efficiency.
(page 3)
d. distinguish among the predominant weighting schemes used in the
construction of major equity market indexes and evaluate the biases of
each. (page 4)
e. compare alternative methods for establishing passive exposure to an equity
market, including indexed separate or pooled accounts, index mutual
funds, exchange-traded funds, equity index futures, and equity total return
swaps. (page 6)
f. compare full replication, stratified sampling, and optimization as approaches
to constructing an indexed portfolio and recommend an approach when
given a description of the investment vehicle and the index to be tracked.
(page 8)
g. explain and justify the use of equity investment-style classifications and
discuss the difficulties in applying style definitions consistently. (page 10)
h. explain the rationales and primary concerns of value investors and growth

investors and discuss the key risks of each investment style. (page 10)
i. compare techniques for identifying investment styles and characterize the
style of an investor when given a description of the investor’s security
selection method, details on the investor’s security holdings, or the results
of a returns-based style analysis. (page 12)
j. compare the methodologies used to construct equity style indexes. (page 18)
k. interpret the results of an equity style box analysis and discuss the
consequences of style drift. (page 19)


l. distinguish between positive and negative screens involving socially
responsible investing criteria and discuss their potential effects on a
portfolio’s style characteristics. (page 20)
m. compare long–short and long-only investment strategies, including their
risks and potential alphas, and explain why greater pricing inefficiency may
exist on the short side of the market. (page 21)
n. explain how a market-neutral portfolio can be “equitized” to gain equity
market exposure and compare equitized market-neutral and shortextension portfolios. (page 22)
o. compare the sell disciplines of active investors. (page 25)
p. contrast derivatives-based and stock-based enhanced indexing strategies
and justify enhanced indexing on the basis of risk control and the
information ratio. (page 26)
q. recommend and justify, in a risk-return framework, the optimal portfolio
allocations to a group of investment managers. (page 28)
r. explain the core-satellite approach to portfolio construction and discuss the
advantages and disadvantages of adding a completeness fund to control
overall risk exposures. (page 29)
s. distinguish among the components of total active return (“true” active
return and “misfit” active return) and their associated risk measures and
explain their relevance for evaluating a portfolio of managers. (page 32)

t. explain alpha and beta separation as an approach to active management and
demonstrate the use of portable alpha. (page 34)
u. describe the process of identifying, selecting, and contracting with equity
managers. (page 35)
v. contrast the top-down and bottom-up approaches to equity research. (page
37)

STUDY SESSION 13
The topical coverage corresponds with the following CFA Institute assigned
reading:
26. Alternative Investments Portfolio Management
The candidate should be able to:
a. describe common features of alternative investments and their markets and
how alternative investments may be grouped by the role they typically play
in a portfolio. (page 53)
b. explain and justify the major due diligence checkpoints involved in selecting
active managers of alternative investments. (page 54)


c. explain distinctive issues that alternative investments raise for investment
advisers of private wealth clients. (page 55)
d. distinguish among types of alternative investments. (page 56)
e. discuss the construction and interpretation of benchmarks and the problem
of benchmark bias in alternative investment groups. (page 61)
f. evaluate the return enhancement and/or risk diversification effects of
adding an alternative investment to a reference portfolio (for example, a
portfolio invested solely in common equity and bonds). (page 65)
g. describe advantages and disadvantages of direct equity investments in real
estate. (page 71)
h. discuss the major issuers and suppliers of venture capital, the stages

through which private companies pass (seed stage through exit), the
characteristic sources of financing at each stage, and the purpose of such
financing. (page 71)
i. compare venture capital funds and buyout funds. (page 72)
j. discuss the use of convertible preferred stock in direct venture capital
investment. (page 72)
k. explain the typical structure of a private equity fund, including the
compensation to the fund’s sponsor (general partner) and typical
timelines. (page 73)
l. discuss issues that must be addressed in formulating a private equity
investment strategy. (page 74)
m. compare indirect and direct commodity investment. (page 74)
n. describe the principal roles suggested for commodities in a portfolio and
explain why some commodity classes may provide a better hedge against
inflation than others. (page 75)
o. identify and explain the style classification of a hedge fund, given a
description of its investment strategy. (page 75)
p. discuss the typical structure of a hedge fund, including the fee structure,
and explain the rationale for high-water mark provisions. (page 77)
q. describe the purpose and characteristics of fund-of-funds hedge funds.
(page 78)
r. discuss concerns involved in hedge fund performance evaluation. (page 78)
s. describe trading strategies of managed futures programs and the role of
managed futures in a portfolio. (page 80)
t. describe strategies and risks associated with investing in distressed
securities. (page 81)
u. explain event risk, market liquidity risk, market risk, and “J-factor risk” in
relation to investing in distressed securities. (page 82)

STUDY SESSION 14
The topical coverage corresponds with the following CFA Institute assigned
reading:
27. Risk Management
The candidate should be able to:
a. discuss features of the risk management process, risk governance, risk
reduction, and an enterprise risk management system. (page 97)
b. evaluate strengths and weaknesses of a company’s risk management
process. (page 99)
c. describe steps in an effective enterprise risk management system. (page 99)
d. evaluate a company’s or a portfolio’s exposures to financial and
nonfinancial risk factors. (page 99)
e. calculate and interpret value at risk (VaR) and explain its role in measuring
overall and individual position market risk. (page 102)
f. compare the analytical (variance–covariance), historical, and Monte Carlo
methods for estimating VaR and discuss the advantages and disadvantages
of each. (page 103)
g. discuss advantages and limitations of VaR and its extensions, including cash
flow at risk, earnings at risk, and tail value at risk. (page 107)
h. compare alternative types of stress testing and discuss advantages and
disadvantages of each. (page 108)
i. evaluate the credit risk of an investment position, including forward
contract, swap, and option positions. (page 110)
j. demonstrate the use of risk budgeting, position limits, and other methods
for managing market risk. (page 115)
k. demonstrate the use of exposure limits, marking to market, collateral,
netting arrangements, credit standards, and credit derivatives to manage
credit risk. (page 116)
l. discuss the Sharpe ratio, risk-adjusted return on capital, return over
maximum drawdown, and the Sortino ratio as measures of risk-adjusted

performance. (page 118)
m. demonstrate the use of VaR and stress testing in setting capital
requirements. (page 119)

STUDY SESSION 15
The topical coverage corresponds with the following CFA Institute assigned
reading:


28. Risk Management Applications of Forward and Futures Strategies
The candidate should be able to:
a. demonstrate the use of equity futures contracts to achieve a target beta for
a stock portfolio and calculate and interpret the number of futures
contracts required. (page 138)
b. construct a synthetic stock index fund using cash and stock index futures
(equitizing cash). (page 142)
c. explain the use of stock index futures to convert a long stock position into
synthetic cash. (page 147)
d. demonstrate the use of equity and bond futures to adjust the allocation of a
portfolio between equity and debt. (page 148)
e. demonstrate the use of futures to adjust the allocation of a portfolio across
equity sectors and to gain exposure to an asset class in advance of actually
committing funds to the asset class. (page 151)
f. explain exchange rate risk and demonstrate the use of forward contracts to
reduce the risk associated with a future receipt or payment in a foreign
currency. (page 153)
g. explain the limitations to hedging the exchange rate risk of a foreign market
portfolio and discuss feasible strategies for managing such risk. (page 155)
The topical coverage corresponds with the following CFA Institute assigned
reading:

29. Risk Management Applications of Option Strategies
The candidate should be able to:
a. compare the use of covered calls and protective puts to manage risk
exposure to individual securities. (page 170)
b. calculate and interpret the value at expiration, profit, maximum profit,
maximum loss, breakeven underlying price at expiration, and general
shape of the graph for the following option strategies: bull spread, bear
spread, butterfly spread, collar, straddle, box spread. (page 175)
c. calculate the effective annual rate for a given interest rate outcome when a
borrower (lender) manages the risk of an anticipated loan using an interest
rate call (put) option. (page 187)
d. calculate the payoffs for a series of interest rate outcomes when a floating
rate loan is combined with 1) an interest rate cap, 2) an interest rate floor,
or 3) an interest rate collar. (page 193)
e. explain why and how a dealer delta hedges an option position, why delta
changes, and how the dealer adjusts to maintain the delta hedge. (page
199)


X VY

f. interpret the gamma of a delta-hedged portfolio and explain how gamma
changes as in-the-money and out-of-the-money options move toward
expiration. (page 205)
The topical coverage corresponds with the following CFA Institute assigned
reading:
30. Risk Management Applications of Swap Strategies
The candidate should be able to:
a. demonstrate how an interest rate swap can be used to convert a floatingrate (fixed-rate) loan to a fixed-rate (floating-rate) loan. (page 214)
b. calculate and interpret the duration of an interest rate swap. (page 216)

c. explain the effect of an interest rate swap on an entity’s cash flow risk. (page
217)
d. determine the notional principal value needed on an interest rate swap to
achieve a desired level of duration in a fixed-income portfolio. (page 218)
e. explain how a company can generate savings by issuing a loan or bond in its
own currency and using a currency swap to convert the obligation into
another currency. (page 222)
f. demonstrate how a firm can use a currency swap to convert a series of
foreign cash receipts into domestic cash receipts. (page 223)
g. explain how equity swaps can be used to diversify a concentrated equity
portfolio, provide international diversification to a domestic portfolio, and
alter portfolio allocations to stocks and bonds. (page 224)
h. demonstrate the use of an interest rate swaption 1) to change the payment
pattern of an anticipated future loan and 2) to terminate a swap. (page
227)


The following is a review of the Equity Portfolio Management principles designed to address the learning
outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #25.

EQUITY PORTFOLIO MANAGEMENT
Study Session 12

EXAM FOCUS
Don’t be misled. Candidates expect to see equity security valuation with lots of math
and models, like Level II. Instead this is portfolio management. There is a little math to
know, but pay attention to all the softer discussion issues. For example, there is a long
discussion of index construction methodologies; the math could be tested, but the
implications of the methodologies are as likely to be important. There is repetition of
other topic areas on active versus passive management styles and benchmarks, as

these are common exam topics. Also important are discussions of style and style
analysis.
There is a lot of terminology and often passing references to complex techniques and
issues which are not explained. A common mistake of Level III candidates is to fixate on
things not explained in the CFA text. The exam focus has been on a working knowledge
of terminology, the ability to assess the pros and cons of alternatives, and calculations
that are taught. Focus on what is here, not on what the readings did not cover.

EQUITIES IN A PORTFOLIO
LOS 25.a: Discuss the role of equities in the overall portfolio.
CFA® Program Curriculum, Volume 4, page 255

Equities are a substantial portion of the investment universe, and U.S. equity typically
constitutes about half of the world’s equity. The amount of equity in an investor’s
portfolio varies by location. For example, U.S. institutional investors often exceed 50%
of their portfolio invested in equities, while their European counterparts may be under
25% invested in equities. Regardless of these starting allocations, investing
internationally provides diversification as well as the opportunity to invest in
companies not available in the investor’s home market.
An inflation hedge is an asset whose nominal returns are positively correlated with
inflation. Bonds have been a poor inflation hedge because their future cash flows are
fixed, which makes their value decrease with increased inflation. This drop in price
reduces or eliminates returns for current bondholders. The historical evidence in the
United States and in other countries indicates that equities have been a good inflation
hedge. There are some important qualifiers, however. First, because corporate income
and capital gains tax rates are not indexed to inflation, inflation can reduce the stock


investor’s return, unless this effect was priced into the stock when the investor bought
it. Second, the ability of an individual stock to hedge inflation will depend on its

industry and competitive position. The greater the competition, the less likely the firm
will be able to pass inflation on to its consumers, and its stock will be a less effective
hedge.
Examining the historical record in 17 countries from 1900–2005, equities have had
consistently positive real returns. Equities have also had higher real returns than bonds
in all 17 countries. 1

ACTIVE, PASSIVE, AND SEMIACTIVE STRATEGIES
LOS 25.b: Discuss the rationales for passive, active, and semi-active (enhanced
index) equity investment approaches and distinguish among those approaches
with respect to expected active return and tracking risk.
CFA® Program Curriculum, Volume 4, page 257

Passive equity managers do not use forecasts to influence their investment strategies.
The most common implementation of passive management is indexing, where the
manager invests so as to mimic the performance of a security index. Though indexing is
passive in the sense that the manager does not try to outperform the index, the
execution of indexing requires that the manager buy securities when the security’s
weight increases in the index (e.g., the security is added to the index or the firm sells
new stock) or sell stock when the security’s weight decreases in the index (e.g., the
security is dropped from the index or the firm repurchases stock). Indexing has grown
in popularity since the 1970s and often constitutes an investor’s core holding.
Active equity management is the other extreme of portfolio management. Active
managers buy, sell, and hold securities in an attempt to outperform their benchmark.
Even with the growth of indexing, active management still constitutes the vast
majority of assets under management.
The middle road between the two previous approaches is semiactive equity
management (a.k.a. enhanced indexing or risk-controlled active management). A
semiactive manager attempts to earn a higher return than the benchmark while
minimizing the risk of deviating from the benchmark.

There are not really three approaches, but a scale from pure passive to full blown
unrestricted active management. The more a portfolio moves towards active
management, the higher the expected active return should be, but the higher return
will carry higher tracking risk. Where a portfolio falls on the scale is often reflected in
how high or low the active return. This scale is summarized in Figure 1.
Active return is the excess return of a manager relative to the benchmark. Tracking risk
is the standard deviation of active return and is a measurement of active risk (i.e.,
volatility relative to the benchmark).