CFA Level 1 Portfolio Management: Our Cheat Sheet

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It is probably no surprise that portfolio management is the most popular career current CFA candidates are interested in exploring further.

Portfolio management is the heart of the CFA program – and they start you light and gentle in Level 1 with a broad strokes introduction, gradually increasing in difficulty and topic weight as you advance to Level 3.

Hence, building a solid foundation in CFA Level 1 Portfolio Management is crucial to getting your CFA charter. That’s why we decided to create our Cheat Sheet series of articles, which focuses on one specific topic area for one specific CFA Level.

More Cheat Sheets will be published in the coming weeks, sign up to our member’s list to be notified first.

By referring to the CFA curriculum’s Learning Outcome Statements (LOS), we prioritize and highlight the absolute key concepts and formula you need to know for each topic. With some tips at the end too!

Use the Cheat Sheets during your practice sessions to refresh your memory on important concepts.

Let’s go! Don’t forget to bookmark this page and (re)visit often! 🙂


CFA Level 1 Portfolio Management: Summary

cfa level 1 portfolio management cheat sheet

Portfolio management is really the end game for the CFA program.

However, this topic’s weighting in Level 1 is deceptively light. Portfolio Management will become exponentially more important as you advance in the CFA program, especially in Level 3 where it accounts for 35-40% of the entire exam. Nearly half!

CFA Level 1 Portfolio Management’s topic weighting is 5-8%, which means 9-14 questions of the 180 questions of CFA Level 1 exam is centered around this topic.

It is covered in 2020/2021’s Study Sessions 18-19, which includes Reading 51-57.

Here’s a summary of Level 1 Portfolio Management chapter readings:

Reading NumberSub-topicDescription
51Portfolio Management: An OverviewWhat is portfolio investing, how is it done, who invests, pension plans and mutual funds.
52Portfolio Risk and Return: Part IHow to measure the performance (returns) of a portfolio, calculate and understand risk metrics (mean, variance, covariance, standard deviation).
53Portfolio Risk and Return: Part IILearn about the capital allocation line (CAL), capital market line (CML), systematic and nonsystematic risk, beta, capital asset pricing model (CAPM), security market line (SML).
54Basics of Portfolio Planning and ConstructionAn introduction to what will be explored in great detail in CFA Level III.

You’ll learn about:
– investment policy statements (IPS), which is sort of a ‘strategy document’ of how each individual investors have decided to invest,
– how different investors can have different abilities and willingness to take on risk, and
– other aspects of portfolio planning, such as investment constraints (liquidity, timelines, tax, regulation), asset classes and asset allocation.
55Introduction to Risk ManagementAll about risk management – what it is, risk management frameworks, how to identify different types of risks and how to manage them.
56Technical AnalysisAn introduction to technical analysis principles, types of charts and how to interpret them.
57Fintech in Investment ManagementA descriptive chapter on what fintech, big data, artificial intelligence, machine learning, distributed ledger technology are.

Once you’ve learnt to value individual securities, evaluating them as a combined portfolio is essential to your capability as an asset or wealth manager. Not only that, but knowing how to tailor the combination of securities to suit different clients’ risk profiles is important to being a good financial advisor.

In short, the CFA Level 1 Portfolio Management readings teaches you:

– How investing via building a portfolio works;
– How to measure how well you’re doing;
– How to be aware of the scale and type of risks your’e taking;
– How to adapt portfolio investment strategies to different types of investor profiles.


Reading 51: Portfolio Management: An Overview

CFA Level 1 Portfolio Management: Our Cheat Sheet 1

Steps in portfolio management process

  • Planning: List client’s objectives and constraints in IPS
  • Execution: This includes asset allocation, security analysis and portfolio construction.
  • Feedback: This includes monitoring/rebalancing and performance measurement and reporting.

Types of investors

ClientInvestment horizonRisk toleranceIncome needsLiquidity needs
Individual investorVaries by individualDepends on the ability and willingness to take riskDepends on investment rationaleVaries by individual.
Defined benefit (DB) pension plansUsually long termHigh for longer investment horizonHigh for mature funds (payouts soon), low for growing funds.Varies by plan maturity
Endowments & foundationsVery long termTypically highTo meet spending commitmentsQuite low
BanksShort termLowPay interest on deposits and operational expensesHigh, to meet daily withdrawals
Insurance companiesShort term for property & casualty (P&C), long term for life insuranceLowLowHigh to meet claims
Investment companiesVaries by fundVaries by fundVaries by fundHigh to meet redemptions
Sovereign wealth fundsVaries by fundVaries by fundVaries by fundVaries by fund

Defined benefit (DB) vs defined contribution (DC) pension plans

  • Defined benefit (DB) plan is where a company promises to makes a pre-defined future benefit payments to the employees. The company bears the investment risk.
  • Defined contribution (DC) plan is where a company contributes an agreed amount to the plan and employees invest part of their wages to the plan. In a DC plan, investment and inflation risk is borne by the employee.

Reading 52: Portfolio Risk and Return: Part I

CFA Level 1 Portfolio Management: Our Cheat Sheet 2

Risk aversion

  • Risk aversion is the degree of an investor’s inability and unwillingness to take risk.
  • Risk neutral: an investor who is indifferent about the gamble or a guaranteed outcome, as the investor is only concerned about returns.
  • Risk-seeking: an investor who prefers a gamble, where the indifference curve is downward sloping as the expected return decreases for higher levels of risk. This is uncommon.
  • Risk averse: an investor who expects additional return for taking additional risks, i.e. the indifference curve is upward sloping. Most investors are risk averse, the degree of risk aversion varies. The steeper the indifference curve, the more risk averse they are.

Minimum variance portfolio

CFA Level 1 Portfolio Management: Our Cheat Sheet 3
  • Minimum variance frontier is a line combining all portfolios with a minimum level of risk given a rate of return.
  • Global minimum variance portfolio is the portfolio with the lowest variance amongst the portfolio of all risky assets.
  • The efficient frontier is the part of the minimum variance frontier that is above the global minimum variance portfolio, since it gives the highest return for a given level of risk. Note that efficient frontier only consists of risky assets, there are no risk-free assets here.

Capital allocation line (CAL)

CAL overcomes the shortfall of efficient frontier by showing a line representing possible combinations of risk-free assets and optimal risky asset portfolio.

E[Rp]=Rf+E[Ri]Rfσiσp

Optimal investor portfolio is the point where an investor’s indifference curve is tangential to the optimal CAL.


Reading 53: Portfolio Risk and Return: Part II

CFA Level 1 Portfolio Management: Our Cheat Sheet 4

Capital market line (CML)

If all investors have the same expectations, the capital market line (CML) becomes a special case of optimal CAL, where the tangent portfolio is the market portfolio.

CML is a special case of CAL whereby

E[Rp]=Rf+E[Rm]Rfσmσp

Slope of CML line is the market price of risk, i.e. Sharpe ratio.


Systematic vs non-systematic risk

  • Systematic risk is a non-diversifiable, market risk. Investors should get compensated for taking on systematic risk.
  • Non-systematic risk is a local risk that can be diversified away, investors are not compensated for taking on this risk.
  • A risk-free asset has zero systematic and non-systematic risk.

Beta

Beta is a measure of an asset’s systematic (market) risk, relative to the risk of the overall market.

β=Cov(Ri, Rm)σm2=ρi,mσiσmσm2=ρi,mσiσm


Capital asset pricing model (CAPM)

CAPM is used to calculate an asset’s required return given its beta.

E(Ri)=Rf+βiERmRf

CAPM assumptions:

  1. Investors are rational, risk-averse and utility maximizing individuals.
  2. Frictionless markets
  3. All investors plan for the same holding period
  4. Investors have homogenous expectations
  5. Investors are infinitely divisible
  6. Investors are price takers.

CAPM limitations:

  • Only systematic risk are included
  • Does not consider multi-period implications

Security market line (SML)

SML is a graphical representation of CAPM, which applies to all securities, whether they are efficient or not.

Slope of the SML is market risk premium, E(Rm) – Rf

If an asset’s expected return forecast is higher (lower) than its CAPM required return, the asset is undervalued (overvalued).


Other portfolio performance evaluation measures

Total risk Sharpe ratio RpRfσp
Total risk M-squared RpRfσmσpRmRf
Systematic risk Treynor ratio RpRfβp
Systematic risk Jensen’s alpha RpRf+βpRmRf

Reading 54: Basics of Portfolio Planning and Construction

CFA Level 1 Portfolio Management: Our Cheat Sheet 5

Investment policy statements (IPS)

IPS is a written document detailing the portfolio construction process designed to satisfy a client’s investment objectives.

Major components of an IPS are:

  • Introduction
  • Statement of purpose
  • Statement of duties and responsibilities
  • Procedures
  • Investment objectives
  • Investment constraints
  • Investment guidelines
  • Evaluation of performance
  • Appendices

Assessing overall risk tolerance

  • Usually expressed as average, above average, below average.
  • 2 factors affect investor’s overall risk tolerance:
    • willingness (investor’s intent towards risk)
    • ability to take risk (investor’s capability to take risk, independent of intent)

Investment constraints

Investment constraintsDescription
Time horizonThe longer the time horizon, the greater the ability to take risk and the lower the liquidity needs.
TaxesConsider individual tax status, investment jurisdiction and tax treatment of various types of investment accounts.
LiquidityCash requirements varies by client and need to consider having a portion of assets in liquid investments.
Legal / regulatoryConsider if there are legal restrictions on investments or max percentage allocation on certain assets.
Unique circumstancesUsually individual constraints are present, such as avoid certain class of security or industry, or ethical preferences etc.

Reading 55: Introduction to Risk Management

CFA Level 1 Portfolio Management: Our Cheat Sheet 6

Risk management framework

  • Risk governance: a top-down process that defines risk tolerance and provides guidance to align risk with company goals
  • Risk identification and measurement
  • Risk infrastructure
  • Defined policies and processes
  • Risk monitoring, mitigation and management
  • Communications
  • Strategic analysis or integration

Other risk definitions

  • Risk tolerance: what risks are acceptable and how much risk should be taken
  • Risk budgeting: how and where the risks are taken and quantifies tolerable risk by specific metrics
  • Financial risk: risks that originate from financial markets such as change in interest rates. 3 major types of financial risk are market risk, credit risk and liquidity risks.
  • Non-financial risk: risks that arise from within an entity or externally. Examples of non-financial risks are: operational risk, solvency risk, settlement risk, legal risk, regulatory, accounting and tax risk, model risk, tail risk, political risk.
  • Methods of risk measurements: standard deviation, beta, duration, delta, gamma, VaR, CVaR, etc.
  • Methods of risk modification: risk prevention/avoidance, risk acceptance (self-insurance and diversification), risk transfer (insurance), risk shifting/modification (via derivatives).

Reading 56: Technical Analysis

CFA Level 1 Portfolio Management: Our Cheat Sheet 7

Technical analysis assumptions

  • Supply and demand determine prices.
  • Changes in supply and demand can cause changes in prices.
  • Prices can be projected with charts and other technical tools.
  • Investors are often irrational, hence preventing market efficiency.

Technical analysis tools

Charts

Line chartsimple graphical display of price trends over time.
Bar chartshows open, close, low and high prices for each data point.
Candlestick chartalso shows open, close, low and high prices for each data point. White body means closing price > opening price (i.e. market closed higher), dark body means closing price < opening price (i.e. market closed lower).
Point and figure chartX means an increase in price whilst O means a decrease in price.

Trend analysis

Uptrendsecurity prices are reaching higher highs and higher lows
Downtrendsecurity prices are reaching lower highs and lower lows
Supporta price level where there is sufficient buying pressure to stop a further decline in prices.
Resistancea price level where there is sufficient selling pressure to stop a further increase in prices.
Change in polarityonce a support level is breached, it often becomes the new resistance level, and vice versa.

Common chart patterns

Reversal patterns (signalling the end of a trend):

Head and shoulders (H&S) patternconsists of a left shoulder, head and right shoulder. This pattern indicates the end of an uptrend.
Inverse head and shoulders patternthis is a mirror image of the H&S pattern and indicates an upcoming uptrend following a preceding downtrend.
Double/triple topsprices hit the same resistance level twice/thrice before falling down, indicating the end of an uptrend.
Double/triple bottomsprices bounces back from the same support level twice/thrice before going up, indicating the end of a downtrend.

Continuation patterns (signals a temporary pause in the trend):

TrianglesOne trend line connects the highs, another trend line connects the lows.
3 types:
– Ascending: Highs form a horizontal line, lows form uptrend.
– Descending: Lows form a horizontal line, highs form downtrend.
– Symmetrical: Highs from downtrend, lows form uptrend.
RectanglesHighs and lows form horizontal lines.
FlagsSimilar to rectangles, but parallel trend lines over a short period
PennantsConverging trend lines over a short period.

Technical indicators

Price-based indicators

Moving averageAverage closing price over a specified number of periods.
Bollinger bandsLines representing moving average and moving average +/- set number of standard deviation from average price.

Momentum oscillators

Rate of change (ROC) oscillator When ROC oscillator crosses 0 into the positive (negative) territory, it is considered bullish (bearish).
Relative strength index (RSI) Graphically compares a security’s gains vs losses over a time period (typically 14 days).

RSI value ranges between 0-100. Value >70 indicates overbought, value<30 indicates oversold.
Stochastic oscillator

%K = 100Last closing price  Low in past 14 daysHigh in past 14 days  Low in past 14 days%D, signal line = average of last 3 daily %K values

When %K line moves from below to above %D line, this is considered bullish. Vice versa.

Moving average convergence/divergence oscillator (MACD)

Consists of the MACD line and signal line:

  • MACD line is the difference between 2 exponentially smoothed averages (12 days and 26 days usually)
  • Signal line is the exponentially smoothed average of MACD line (9 days usually)

Sentiment indicators

Opinion pollsRegular polls gauging market sentiment
Put/call ratioVolume of puts traded divided by volume of calls traded. High ratio means market is bearish.
CBOE volatility index (VIX)A measure of near-term market volatility calculated from S&P 500 stock options. High VIX indicates when investors are fearful of a market decline.
Margin debtLoans taken out by investors to fund stock purchase. When margin debt is increasing, investors are buying aggressively and this will drive up stock prices.
Short interestNumber of shares sold short relative to daily trading volume. A high short interest ratio indicates a negative outlook on the security.

Flow of funds indicators

Arms index
(or TRIN)
Measures the relative extent to which money is moving into and out of rising and declining stocks.

– Value = 1 means market is in balance.
– Value above (below) 1 means there is more volume in declining (increasing) stocks and the market is in selling (buying) mood.
Margin debtMargin loans may increase stock purchases and declining margin balances may force stock sale.
Mutual fund cash position% of mutual fund assets held in cash. During bullish (bearish) market, cash position tends to be low (high).
New equity issuanceIPOs are often timed when market is bullish for best valuations.
Secondary offeringSimilar to IPOs, secondary offerings are monitored to gauge changes in equities supply.

Cycles

Kondratieff wave54 year long economic cycles, known as the K wave.
18 year cycleOften associated with real estate and equities.
Decennial patternYears ending in 5 have shown the best performance.
Presidential cycleThe 3rd year following an election tends to show the best performance.

Elliott Wave Theory

  • This theory states that market moves in regular waves or cycles.
  • Market waves follow patterns that are ratios of the Fibonacci sequence
  • The Fibonacci sequence starts with the numbers 0, 1, 1, and each subsequent number in the sequence is the sum of 2 preceding numbers: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34 …

Reading 57: Fintech in Investment Management

CFA Level 1 Portfolio Management: Our Cheat Sheet 8
  • Fintech refers to the technological innovation in the design and delivery of financial products and services.
  • Big data refers to a mix of structured and unstructured datasets that can come from a variety of sources such as individuals, business processes and sensors.
  • Artificial intelligence (AI) computer systems perform tasks that traditionally required human intelligence. They display cognitive and decision-making ability comparable or superior to humans. E.g. Apple’s Siri digital assistant.
  • Machine learning (ML) is a computer-based technique that extracts knowledge and learns from a large amount of dataset, then applying this pattern to generate predictions on another dataset.
  • 3 main approaches to ML:
    • Supervised learning: inputs and outputs are identified and labelled.
    • Unsupervised learning: inputs and outputs are not labelled. ML algorithm will seek or identify the relationships by itself.
    • Deep learning: neural networks are used by computers to perform multi-stage, non-linear data processing to identify patterns and relationships.
  • Fintech applications:
    • robo-advisory services: low cost, automated advice process for investments
    • risk analysis: monitoring risks in real time
    • algorithmic trading: automated trading based on pre-specified rules
  • Financial applications of distributed ledger technology (DLT):
    • Cryptocurrencies
    • Tokenization: the process of representing ownership rights to physical assets on a blockchain. DLT can streamline this process of physical asset verification (e.g. real estate) by creating a single digital record of ownership.
    • Post-trade clearing and settlement: DLT can simplify the currently cumbersome post-trade clearing and settlement process by providing near real-time trade verification, reconciliation and settlement.
    • Compliance: stricter regulatory reporting requirements have made the cost of compliance higher. DLT can streamline the compliance process by providing near real-time access to transaction and compliance data.

CFA Level 1 Portfolio Management Tips

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Know your terms and definitions

There are a wide range of definitions to be learnt in Portfolio Management.

Investment policy statement (IPS) objectives and constraints, risk types, asset classes – make sure you note and memorize them, as exam questions can baldly ask about any term.

Know your lines (CAL, CML, SML) and CAPM

The security market line (SML) and how it relates to capital asset pricing model (CAPM) calculations is a popular question topic, so make sure you’re very familiar with that.

Be sure to also know how to explain the capital allocation line (CAL) and the capital market line (CML), and how the SML is derived from the CML.

Calculation, calculation, calculation

Portfolio management questions can contain calculation-heavy questions, usually centering around risk or return calculations.

Make sure you get lots of practice on calculating and comparing returns (such as expected return), as well as calculating risk metrics (such as variance, covariance, standard deviation, beta).


More Cheat Sheet articles will be published over the coming weeks. Get ahead of other CFA candidates by signing up to our member’s list to get notified.

Meanwhile, here are other related articles that may be of interest:

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