2019 CFA level 3 schweser quick sheet

uickSheet

Cr

it ic a l

C o n c e pt

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 EM OTIONAL
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
number once investor has it in mind.
• Mental accounting bias —Each goal, and
corresponding wealth, is considered separately.
• Framing bias - Viewing information differently
depending on how it is received.

s for the

2019 CFA® E x a m

Availability bias - Future probabilities are
impacted by memorable past events.
Emotional Biases
• Loss aversion bias —Placing more “value” on losses
than on a gain of the same magnitude.
♦ Myopic loss aversion —If individuals
systematically avoid equity to avoid potential
short run declines in value (loss aversion),
equity prices will be biased downward (and
future returns upward).

• 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.
IN VESTM EN T 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 D C 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
to the mean.
• Social proof bias —Following the beliefs of a group
(i.e., “groupthink”).
M arket anom alies:
• Momentum effect —Return pattern caused by
investors following others' lead (“herding”).
• Financial bubbles and crashes —Unusual returns
caused by irrational buying or selling.
• Value vs. growth stocks —Value tends to
outperform growth and the market in general.

SS5: PRIVATE WEALTH (1)
IPS Objectives and Constraints: Individuals
The individual IPS has been heavily tested on the
exam. Questions are typically case fact specific.
You must apply taught concepts to the unique
case facts to answer the specific questions asked.
The solution process involves working through the

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 A ccumulation Formulas (selected)
annual accrual taxation: FVIF^ = [1 +r(l - t.)]n
deferred capital gains taxation:
FVIFa t = (1 + r)n( l —tcg) + t B
B = cost basis / asset value at start of period n
annual wealth taxation: FVIF,^
= L[(1
+ r)(l
—tw )]"
AT
x
x
'J
Annual return after taxes on interest, dividends,
and realized capital gains:
r*= r[l - (P^i + Pdtd + pcgtcg)] = r(l - wartr)
effective capital gains tax rate:
T* = tcgLr
[ p deferred eg / ( 1 - wartr)]
FVIFAT = (1 + r*)"(l-T *) +T* - (1 - B)tci?

A ccrual Equivalent After-Tax Return (Return that
produces the same term inal value as the taxable
portfolio)
RAE= (FVat / initial investment)1/n- 1= r (1 - TA£)
Accrual Equivalent Tax Rate
T

1a

e

— 1 — ^"AE

— 1

(An overall effective tax)

Taxable Accounts: usually taxed annually called
accrual taxes
• As the holding period t> TA£ f .
Tax drag % > tax rate
• 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
N => FVTDA>FVTEA

Investor's Afier-tax Std. D ev 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
P(surv; ) (spending)
CoreCapitalNyears = ^
*=i
(1 + r )'
r = real risk-free rate
Relative After-Tax Values
Tax-Free Gift:

n
1 + rg (1 tig
F^tax-free gift
where:
PV = value of the gift (stock) today
r0 = pre-tax return if held by recipient
tio = tax rate if gifted (recipient’s tax rate)


Bequest:
F V bequest = P V [ l

+ te ( l -

t ie ) ] “ ( l - T e )

w h ere:
re = p re-tax re tu rn i f h e ld in th e estate
t je = ta x rate o n re tu rn s in te s ta to r’s p o rtfo lio

Tc = estate tax rate
n

RV,tax-free gift

^^tax-free gift
py
bequest

1 + rg ( 1 _ t ig).
[l + re ( l - tic )]" ( l - Tfi )

R V o f a taxab le gift, Tg p aid by receiver:
py

taxable gift

n
_ ^^taxablegift _ K1 Tg) 1 + rg (1 tig)
ry
—
n

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

R V o f a taxab le gift, Tg p aid by giver:
RV

v taxable gift =

1 —Tg -f- T2Teg
/e
g

n

l +rg(* hg)

l +re(l-tie)]n(l-T e)

w here:
Tg

= the gift tax rate

(l —Tg)
rg
t jg
g/e

= the after-tax v alu e o f the gift
= pre-tax return on assets held by the gift receiver

= tax rate on returns in gift receiver's portfolio
= 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
tax; 40 to S.

L.

SS6: PRIVATE WEALTH (2)

Three Techniques Used to Manage Concentrated
Positions
• Sell the asset, which triggers a tax liability and loss
of control.
• 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
loan will be repaid by delivering shares at a future
date. Delivery of all shares on the repayment date
if the price per share drops but delivery of a smaller
number of shares if the price rises.

Tax-Optimization Strategies
1. Combining tax planning with investment strategy.
• Index tracking with active tax management:
cash from a monetized position invested to track

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
Factors Affecting Investment Policies of
Institutional Investors
The institutional IPS follows the same general
construction process used for individuals but with

specific issues by institution type. Be sure and
review the class slides for institutional IPS as well
as for individuals. Questions are usually very case
specific. Generally legal/regulatory can be important
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
Forecasting Tools
Statistical tools:

Rj = «;+ $ ,! Fj + A)2F2 +£\
Discounted cash flow models:
Div,
*
Div,
po
— L=> R i = - r - L+ g
0

Ri-g


SS9: ASSET ALLOCATION (1)

Grinold Kroner model:

R - Divl + i + g - AS + A

P

1
Po
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
market:
degree of \
I
,

6
• )X(Ji x P i m x --------- ' + tsegmen ration/ X (7 . X\ a
^integration/
’
\ crm

I degree of ^

= 1.

p- m = correlation of market with global portfolio

m

The Taylor Rule
^expected - G D P , rentarget

^neutral

T 0 .5 ^ieXpected

htarget

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:
AY
AA
AK ,
, AL
+ a —77- + (l —a )
Y “ A
K
L
H-model:

Po =

D

o

r “ gL

N
( ! + gL ) + ^ - ( §S — g L )

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.
Yardeni Model:
if jy- —[Yg —d(LTEG)] > 0 =>-market is
0
under-valued
if | P - [Y B -d (L T E G )] < 0
0

market is
over-valued

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 underpriced.
Tobin's q and Equity q
Both ratios are considered m ean-reverting, if >1 the
stock should decline, <1 the stock should increase.
Tobin’s q =
equity q

market value of debt + equity
asset

replacement cost

market value of equity
replacement value of assets —
liabilities

Asset Allocation Approaches
• Asset-only: focuses on asset return and standard
deviation.
• Liability-relative: focuses on growth of the surplus
and standard deviation.
• Goals-based: uses sub-portfolios to meet specified
goals.
Asset classes:
• Assets within a class are similar and don’t fit in
more than one class.
• Classes have low correlation to other classes, cover
all investable assets, and are liquid.
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 + Rpx) - 1 = Rpc + Rpx + ( 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 f c ) ct (Rfx)
P(Rf c ,Rfx)
If /V.

is a risk-free asset:
FC
ct (Rdc) = a(R FX'
i:v)(l + RFO
„.)
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
management.

Tactical Currency Management
• Economic Fundamentals: in the long term,

relative currency values will converge to their fair
values. Increases in currency values are associated
with currencies:
♦ That are undervalued relative to their
fundamental value.
♦ That have the greatest rate of increase in
fundamental value.
♦ W ith higher real or nominal interest rates.
♦ W ith 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:

A long

forward
position in
currency B the
hedge earns:

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

Negative roll
yield, which
increases
hedging cost
and discourages
hedging._____
A short
Positive roll yield,
which decreases
forward
hedging cost
position in
currency B the and encourages
hedging._______
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[Xand 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.
• Advantages: places more emphasis on smaller cap
securities that may offer a return advantage.
• Disadvantages: biased to the performance of
smaller issuers, requires constant rebalancing to
maintain equal weight.


SS11 & 12: FIXED INCOME
Liability-based mandates:
• Cash-flow matching directly funds liabilities with
coupon and par amounts.
• Duration matching requires:
♦ PVA = PVL; there are exceptions when asset
and liability discount rates differ.
♦ DA = D L,, or BPVA = BPV,.
L
♦ Minimize portfolio convexity but make it
greater than that of the liabilities.
♦ Portfolio-based IRR and statistics should be
used.

♦ Regularly rebalance the portfolio:
BPV
/CF
♦ BPVfutures OA
V CTD 7 ^ r CTD
♦ N,1 = (BPV,
x
L - current BPV)7 / BPVf
futures
♦ Non-parallel yield curve shifts can be a
problem.
♦ 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)]

SS13&14: EQUITIES

Constructing and maintaining the Index involves:
• The weighting method to construct the index:
(1) market-cap weighting, (2) price weighting,
(3) equal weighting, or (4) fundamental weighting.
• 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 w f effective number of stocks =
HHI
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

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

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:

Excess return can be modeled as:
(s x t) - (As x SD) - (t x p x L).
Liquidity risk is significant for both IG and HY, but
more so for HY.

Active share measures the degree to which the number
and sizing of the positions in a managers portfolio
differ to those of a benchmark:

E(Ra ) ^

c

V br c t ^

t c

Active share = “ ^T|Wpi - W b i
i=l

Active risk (tracking error), is the standard deviation
of active returns (portfolio returns minus benchmark
returns):
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):
E L ( r a .) _
= ^T —1
!ctr a H
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.
Active risk

• 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 C i 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 highconviction 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
less risky with somewhat shorter time horizons,
but are generally leveraged. PE has some similarity
to equity but is more manager skill than asset class
based.


Commodities have inherent asset class

characteristics with lower return (and risk) but
with good diversification. There are liquid,
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:
VaR =

V.

• 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.
Measures to help control credit risk are limiting
exposure to any single debtor, marking to market,
assigning collateral to loans, payment netting
agreements, setting credit standards, and using
credit derivatives.

Risk-Adjusted Performance Measures:
R„
RoMAD =
max. drawdown
Sortino

R p -M A R
downside deviation

SSI 7: RISK AND DERIVATIVES
Changing Portfolio Duration with Bond Futures
contracts

MDpay Floating = MDFixed —MDFloating > 0

MD-p —MDp

V,

MDp

Pf (multiplier)

Changing Portfolio Beta with Equity Futures
# contracts =

f ij -f3 p

vp

Pp (multiplier)

1

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).
Option Strategies
Know the inherent payoff patterns of the option
combinations, then:
• Calculate profit/loss at any ending price for the
underlying as sum of initial investment versus
ending value of the positions held.
• 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.
Protective Put
• Covered Call

z

Bull Spread

Collar: Payoff pattern is
identical to a bull spread

but includes owning the
underlying.
Butterfly Spread

Interest Rate Options
• Call: Used to limit the cost of borrowing. If rates
rise, call pays off, reducing effective loan rate,
interest rate call payoff = (NP)[max(0, LIBOR —
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

M DPay Fixed = M D Floating —M D Fixed < 0
NP = V

MDt - MDV

MD Floating

MD Swap
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, orderdriven, 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.
Implicit costs include the bid-ask spread, market
or price impact costs, opportunity costs, and
delay costs (a.k.a. slippage costs).


备考CFA的8大最有效资料和工具
教材/notes/核心词汇手册/考纲及解析手册/计算器讲
解、历年全真模拟题/真题/道德手册/QuickSheet/等等

泽稷网校2017-2018年最新CFA一级二级考点汇总中
文版根据CFA最新考纲编写，比看notes还有效率

全套资源获取方式随新考
季更新，永久有效！
PD
F里
所
有
资
料

扫
码
获
得

史上最全的学霸学渣党CFA考经笔记分享

扫码关注以上微信公众号：CFAer，回复
【资料】即可免费获取全套资源！此活动
永久有效！资料会常年实时更新！绝对全
面！

2017-2018年泽稷网校CFA视频音频课程及指南

除CFA资料外赠送金融、财会技能视频包+热门书籍
+1000G考证资料包

【CFA万人微信群】
需要加入我们CFA全球考友微信群的请添加CFA菌的微信号：374208596，备注需要加哪些群~或直接
扫下方CFA菌菌二维码即可~
所有人均先加入CFA全球考友总群再根据您的需求加入其他分群~
（2017年12月，2018年6打卡签到监督群，一级、二级、三级分群、上海、武汉、北京、成都、南
京、杭州、广州深圳、香港、海外等分群）！
备考资料、学霸考经、考试资讯免费共享！交流、答疑、互助应有尽有！快来加入我们吧！群数量
太多，文件中只是部分展示~有困难的话可以随时咨询我哦！

【CFA免费资料共享QQ群：526307508】
免费分享2018年CFA全套备考资料，含最新CFA网课视频，考友交流互助答疑、考试指导、考经分享、
资料共享、官方考试资讯发布！快来加入我们吧！2018年CFA资料共享群Q`Q群号：526307508，招募正
在CFA备考路上的你！

让你CFA备考路上不再孤独！不再艰难！


Trading Tactics
• Volume weighted average price (VWAP) is a
weighted average of execution prices during a day.
Advantages of VWAP:
♦ 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 p rice (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 o f implementation shortfall:
• May be unfamiliar to traders.
• Requires considerable data and analysis.
Major Trader Types
M otivation

Time o r P rice
P reference

P referred
O rder Types

Informationmotivated

Time-sensitive
information

Time

Market

Valuemotivated

Security
misvaluations

Price

Limit

Liquiditymotivated

Reallocation 6c
liquidity

Time

Market

Passive

Reallocation 6c
liquidity

Price

Limit

Trader Types

Trading
Strengths
Weaknesses
Tactic
Liquidity-at- Quick, certain High costs 6c leakage
r
•
execution

orf.information
any-cost
Quick, certain
CostsLoss of control of
execution at
are-nottrade costs
important
market price
Broker uses skill Higher commission
Needtrustworthy- 6c time to obtain 6c potential leakage
r
i •
•
lower price
of trade intention
agent_____
Advertiseto-drawliquidity

Usual Trade
M otivation
Tr
Information
Variety of
motivations
N ot

. r
information

A, ,

Higher administrative
XT
Market&
,
...
Not
,
,
costs and possible
. c
determined price
r
r .
information
1
front running

Low-costwhateverthe-liquidity

Low trading
costs

Uncertain timing
Passive and
of trade 6c possibly
value
trading into weakness

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, a n d 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 o f 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 ~Rf
----------------

M 2 compares the risk-adjusted portfolio return to
the market return:

Information Ratio is excess
deviation of excess return.
active return
IRn =
active risk

Market, Style, and Active Management.
Rp= M + S+A
Benchmarks
• A valid benchmark should meet the following:
1. Specified in advance
2. Appropriate
3. Measurable
4. Unambiguous
5. Reflect current investment opinions
6. Accountable
7. Investable
• Common benchmarks:
1. Absolute return
2. Manager universes
3. Broad market indexes
4. Style indexes
5. Factor-model-based
6. Returns-based

7. Custom security-based
• A custom security-based benchmark is the most
appropriate as it meets all the benchmark criteria.
• 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:
♦ Net contributions.
♦ Risk free asset.
♦ Asset categories.
♦ Benchmarks.
♦ Investment managers.
♦ Allocation effects.
• 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
s__________________
j

Ex Post Alpha:
A

v

a A = R At _ R A

pure sector allocation
S

where:
a A = ex post alpha on the account
R At = actual return on the account in period t

+

r f

+ 3a (r

m

_

r f

(WP>j “ WB,j) (R P,j “ R B,j)
j= l

v---------------- :------------- V------ :------------:----------'

A

=

Rp —Rg
a(Rp-Rg)

A portfolio return has 3 components:

ctA

r a

return per standard

)

S

predicted account return

+S

allocation/selection interaction

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

ISBN: 978-1-4754-8097-9

SS19: GIPS®
“ —
-

-

-

-

-

-------------------

Know:
• The required disclosures that must appear versus
those that must appear but only if relevant.
• How to identify and correct errors and omissions in
Performance Presentations.


Schweser's
Secret Sauce®
eBook

®KAPLAN\)
UNIVERSITY

SCHOOL OF PROFESSIONAL

AND CONTINUING EDUCATION

SCHWESER



Le v e l III S c h w e s e r ’s S e c r e t Sa u c e ®

Foreword...................................................................................................................................iii
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 & 1 1 .........................................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

©2018 Kaplan, Inc.

SCHWESER’S SECRET SAUCE®: 2018 LEVEL III CFA®
©2018 Kaplan, Inc. All rights reserved.
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.

Page ii

©2018 Kaplan, Inc.


Fo r

ewo r d

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
Kaplan Schweser

©2018 Kaplan, Inc.

Page iii



Et

h ic s
Study Sessions 1 and 2

St

udy

S e s s i o n 1 - Et

h ic a l a n d

Pr

o f e ssio n a l

St

an dar ds

CFA In st i t u t e C o d e o f Et h i c s a n d S t a n d a r d s o f P r o f e s s i o n a l

Co 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
•
•
•

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.
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.

©2018 Kaplan, Inc.

Page 1


Study Sessions 1 and 2
Ethics

•
•
•

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.

Gu id a n c e
I.

for

St

an dar ds

I-VII

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.

Page 2

©2018 Kaplan, Inc.


Study Sessions 1 and 2
Ethics

Recommendations fo r Firms

•
•
•

Have a code of ethics.
Provide employees with information on laws, rules, and regulations governing
professional activities.
Have procedures for reporting suspected violations.

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

Do not let the investment process be influenced by any external sources. Modest
gifts are permitted. Allocation of shares in oversubscribed IPOs to personal
accounts is NOT permitted. Distinguish between gifts from clients and gifts from
entities seeking influence to the detriment of any client. Gifts must be disclosed to
the Members employer in any case.
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.

©2018 Kaplan, Inc.

Page 3


Study Sessions 1 and 2
Ethics

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.
Guidance

Do not make misrepresentations or give false impressions. Misrepresentations
include guaranteeing investment performance and plagiarism. Plagiarism
encompasses using someone else’s work without giving credit.
Recommendations fo r Members

•
•
•
•
•

Understand the scope and limits of the firm’s capabilities to avoid inadvertent
misrepresentations.
Summarize your own qualifications and experience.
Make reasonable efforts to verify information from third parties that is provided
to clients.
Regularly maintain webpages for accuracy.
Avoid plagiarism by keeping copies of all research reports and supporting documents
and attributing direct quotes, paraphrases, and summaries to their source.

Page 4

©2018 Kaplan, Inc.

Study Sessions 1 and 2
Ethics

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

•
•
•
II.

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.
Integrity o f 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.
Guidance—Mosaic Theory

There is no violation when a perceptive analyst reaches an investment conclusion
about a corporate action or event through an analysis of public information
together with items of non-m aterial nonpublic information.

©2018 Kaplan, Inc.

Page 5


Study Sessions 1 and 2
Ethics

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.

Recommendations fo r Firms

•
•
•

•
•
•
•
•
•
•

Issue press releases prior to analyst meetings to assure public dissemination of
any new information.
Adopt procedures for equitable distribution of information to the market place
(e.g., new research opinions and reports to clients).
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.
Physically separate departments.
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.

Page 6

©2018 Kaplan, Inc.


Study Sessions 1 and 2
Ethics

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.
Establish investment objectives of client.
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 conflicts of interest.
Disclose manager compensation arrangements.
Regularly review actions for consistency with documents.
©2018 Kaplan, Inc.

Page 7

Study Sessions 1 and 2
Ethics

•
•
•
•

Vote proxies in the best interest of clients and ultimate beneficiaries.
Maintain confidentiality.
Seek best execution.
Put client interests first.

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

Fairly does not mean equally. In the normal course of business, there will be
differences in the time emails, faxes, et cetera, are received by different clients.
Different service levels are okay, but they must not negatively affect or disadvantage
any clients. Disclose the different service levels to all clients and prospects, and
make premium levels of service available to all who wish to pay for them.
Give all clients a fair opportunity to act upon every recommendation. Clients who
are unaware of a change in a recommendation should be advised before the order is
accepted.
Treat all clients fairly in light of their investment objectives and circumstances.
Members and Candidates should not take advantage of their position in the
industry to disadvantage clients.
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 available levels of service and the associated fees.

Page 8

©2018 Kaplan, Inc.


Study Sessions 1 and 2
Ethics

•
•

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.
♦ Allocate partially filled orders.
♦ 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 clients5investment 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.
Recommendations fo r Members

•
•
•

Establish a written IPS, considering type of client and account beneficiaries, the
objectives, constraints, and the portion of the clients assets managed.
Review the IPS annually and update for material changes in client and market
circumstances.
Develop policies and procedures to assess suitability of portfolio changes.
Consider the impact on diversification, risk, and meeting the clients investment
strategy.

©2018 Kaplan, Inc.

Page 9


Study Sessions 1 and 2
Ethics

III(D). Performance Presentation. Presentations of investment performance
information must be fair, accurate, and complete.
Guidance

Avoid misstating performance or misleading clients/prospects about investment
performance. Do not misrepresent past performance or reasonably expected
performance. Do not state or imply the ability to achieve a rate of return similar to
that achieved in the past. Abbreviated presentations must include an offer that full
details are available.
Recommendations fo r Members

•
•
•
•
•
•

Encourage firms to adhere to Global Investment Performance Standards.
Consider the sophistication of the audience to whom a performance
presentation is addressed.
Present the performance of a weighted composite of similar portfolios rather
than the performance of a single account.
Include terminated accounts as part of historical performance and clearly state

when they were terminated.
Include all appropriate disclosures to fully explain results (e.g., model results
included, gross or net of fees, etc.).
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.
Assure client information is not accidentally disclosed.

Page 10

©2018 Kaplan, Inc.


Study Sessions 1 and 2
Ethics

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 employees5skills 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.
Misuse of confidential information.
Soliciting employers clients prior to leaving.
Self-dealing.
Misappropriation of client lists.

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.

©2018 Kaplan, Inc.

Page 11


Study Sessions 1 and 2
Ethics

Guidance

—

Whistleblowing

There may be isolated cases where a duty to ones employer may be violated in
order to protect clients or the integrity of the market and not for personal gain.
Recommendations fo r Members

•
•

Keep personal and professional social media accounts separate. Business-related
accounts approved by the firm constitute employer assets.
Understand and follow the employer’s policies regarding competitive activities,
termination of employment, whistleblowing, and whether you are considered a
full- or part-time employee, or a contractor.

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
hired and abide by any limitations their employer identifies.
Page 12

©2018 Kaplan, Inc.