CFA Level 3 Equity Portfolio Management

Below, you’ll find my personal CFA level 3 equity portfolio management notes…

You can find a list of the other categories here: CFA Level 3 Notes, Formulas, and Weights.

Portfolio Management Objectives and Constraints (IPS)

  • Risk Objective
  • Return Objective
  • Liquidity Requirement
  • Time Horizon
  • Tax Concerns
  • Legal/Regulatory Factors
  • Unique Circumstances

Tracking Risk is the annualized standard deviation of Active Returns (which are excess returns over the benchmark).

Information Ratio is the portfolio mean active return divided by tracking risk.

Index WeightingPrice Weighted, Value Weighted (Self Rebalancing), and Equal Weighted

Full Replication isn’t possible with large indexes so portfolio managers often use Stratified Sampling (cell matching) or Optimization (minimize tracking error… risk factor matching… including covariance). Optimization seeks to lower tracking error by factoring in covariance.

Uptick Rules don’t allow the short sale on a downtick relative to the last trade at a different price.

Equity Styles

Traditional equity styles are Value Investing (low P/E, contrarian, high yield) and Growth Investing (consistent growth, earnings growth, RSI). Styles that don’t fit clearly are considered Market Oriented.

Returns-Based Style Analysis focuses on overall portfolio realized returns.

Holdings-Based Style Analysis focuses on individual positions and combines the results.

Buffering helps to reduce turnover (expenses) by accounting for temporary Style Drift.

Alpha is the value added by a portfolio manager above their benchmark returns. Portable Alpha comes from long-short (zero beta) positions and can be added to other risk exposures.

Fundamental Law of Active Management

Information Ratio CFA Formula with Information Coefficient

Example: A portfolio manager follows 200 stocks and the IC is 0.05…

Expected Active Return Formula with IC and Breadth

Ad Valorem Fees = AUM Fees

Herfindahl–Hirschman Index (HHI) = Summation of Weights Squared

Herfindahl–Hirschman Index CFA Formula and Effective Number of Stocks

Tracking Error Formula

Tracking Error Formula

Common sources of tracking error are fees, trading costs, and Cash Drag.

Sector Attribution Analysis: Compare Portfolio and Benchmark Sector Return Contributions (Sector Return * Sector Weight)

Growth at a Reasonable Price (GARP) is a sub-category of growth investing (often rely on PEG ratios) and more common in bottom up analysis

Thematic Investing is a top-down approach that tries to find and profit on both short-term and long-term (structural) themes.

Value Trap occurs when a value investor buys stock that looks undervalued but the business continues to deteriorate. The Growth Trap is similar but expected growth after investing doesn’t come to fruition.

Equity Universe Segmentation

  • Size and Style
  • Geography
  • Economic Activity

Three Portfolio Construction Building Blocks

  1. Alpha Skills
  2. Positions Sizing
  3. Factor Weighting Rewards

Free-Rider Problem occurs when shareholders benefit from activist investors.

Two more pitfalls… Look-Ahead Bias and Data Mining (can lead to Overfitting).

Slippage Cost is the difference between the middle of the bid-ask when the trade was entered and the execution price.

Active Share measures how similar a portfolio is to its benchmark (0 Active Share if full replication and 1 if no common holdings).

Benchmark-Agnostic managers tend to have greater active share and active risk.

Active Share and Active Risk CFA Formulas

Portfolio Variance Contribution of Each Asset

Portfolio Variance Contribution of Each Asset

Closet Indexer is a fund that is “actively managed” but is actually similar to the index fund.

Basis Risk occurs when a hedging instrument doesn’t perfectly match the investment being hedged. Some examples that can lead to basis risk are stock splits and dividends.

Additional Risk Measures

Conditional Value at risk (CVaR) is not a true VaR measure but it looks at average loss if VaR cutoff is exceeded. Aka Expected Tail Loss or Expected Shortfall

Incremental Value at risk (IVaR) measures change when portfolio when adding a new security.

Marginal Value at risk (MVaR) measures the effect of a small position size change.


Please comment below if you have any suggestions or questions. Also, the next category in my CFA level 3 study list is Alternative Investments.

Invest mindfully,

Brian Kehm

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