Your Cheat Sheet to… CFA Level I: Portfolio Management

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By Mike

The Cheat Sheet articles are a series of articles, each focusing on one specific topic area of the CFA exam for one specific CFA level. In each Cheat Sheet article, we will cover the basics of what you need to know before diving into the material – what it’s about in a nutshell, how significant is it in the CFA exams, real-life applications, and tips for the CFA exams. You should aim to read each relevant Cheat Sheet article before you start studying the topic area to get you to a flying start.

For this article, we will look at Portfolio Management for CFA Level I – the last, but highly significant topic area in Level I.

What is the weighting of this topic in the CFA exams?

The Study Session on Portfolio Management has a 7% weighting on the Level I CFA exam. So you can reasonably expect encounter 16-18 questions from this material on exam day – quite an increase, as Portfolio Management only weighed 5% in past CFA Level I curricula.

This Level I weighting is still deceptively light, however. Portfolio Management will become significantly more important, especially in Level III, where it accounts for about half of the entire exam. Half! 

What is Portfolio Management about, in a nutshell?

The Portfolio Management readings for CFA Level I, in a nutshell, teach 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

These are currently split across five readings:

  • Portfolio Management: An Overview: What is portfolio investing, how is it done, who invests, pension plans and mutual funds.
  • Risk Management: An Introduction: All about risk management – what it is, risk management frameworks, how to identify different types of risks and how to manage them.
  • Portfolio Risk and Return: Part I: How to measure the performance (returns) of a portfolio, calculate and understand risk metrics (mean, variance, covariance, standard deviation) .
  • Portfolio Risk and Return: Part II: Learn about the capital allocation line (CAL), capital market line (CML), systematic and nonsystematic risk, beta, capital asset pricing model (CAPM), security market line (SML).
  • Basics of Portfolio Planning and Construction: An 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.

Why should I care about this in real life?

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.

Different toolboxes for different people

Imagine if you’re a hardware store manager, supplying toolboxes to a range of workers. The toolbox you’d assemble for, say, a plumber would be very different to a toolbox for a lumberjack. Or a fireman. This is not a reflection of the quality of the tools in the toolbox – the combination of tools can either make the toolbox very useful, or completely useless.

In a portfolio management situation:

  • Store Manager ➡ Portfolio Manager
  • Toolbox Portfolio
  • Tools Securities
  • Different Workers ➡ Different Clients (young vs old, risk-taking vs conservative, pension vs children’s university fund, etc)

Any tips for the exam I should know about?

Know your terms and definitions
There are a wide range of definitions to be learnt in Portfolio Management. Investment policy statement objectives and constraints, risk types, asset classes – make sure you note and memorize them, as exam questions can baldly ask about any term – see the first question example below.

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).

How does Portfolio Management get tested?

Portfolio Management questions can be definition-type or calculation based. We will go through one of each here. The first question is a typical definition-type question:

Which of the following is most likely to be considered as a constraint in preparing the investment policy statement?

​A. Return objectives
B. Liquidity requirements
​C. Risk tolerance

Risk and return are stated and defined objectives in the investment policy statement. Constraints that you’ll learn about, which limit investment flexibility, are:

  • liquidity requirements,
  • time horizon,
  • taxes,
  • legal & regulatory factors
  • unique needs, preferences and circumstances

The next question is calculation-based:

Estimated Return
Diventures Ltd
Penguin plc
Lewis Mason Ltd

The information above relates to three different stocks. The market risk premium is 6% and the risk-free rate is 4%. Which of the stocks should be selected by a stock picker?

​A. Diventures Ltd
B. Penguin plc
​C. Lewis Mason Ltd

To answer this question, you’ll have to recall the formula to calculate expected (or required) return:
Expected Return = Risk Free Rate + β * Market Risk Premium
Then you’ll need to calculate the expected return for each stock:

  • Expected return of Diventures Ltd = 4% + 1.5 * 6% = 13% 
  • ​Expected return of Penguin plc = 4% + 0.96 * 6% = 9.8%
  • Expected return of Lewis Mason Ltd = 4% + 0.54 * 6% = 7.2%

Comparing the calculated expected returns with the given estimated returns, we see that:

  • Diventures Ltd is estimated to perform as expected
  • Penguin plc is estimated to perform lower than expected
  • Lewis Mason Ltd is estimated to perform better than expected

A stock picker should therefore select Lewis Mason Ltd – the correct answer is therefore C.

More Cheat Sheet articles will be published over the coming weeks. Get ahead of other CFA candidates by: 

Zee Tan
Author: Zee Tan


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