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CFA Level III Updated
What are the key limitations of the Sharpe ratio as a performance measure?
The Sharpe ratio assumes normal returns, treats upside and downside volatility equally, is susceptible to manipulation through return smoothing or option selling, gives meaningless rankings when negative, and ignores benchmark-relative performance.
How do I decompose implementation shortfall into its components, and what does each piece represent?
Implementation shortfall measures the total cost of executing an investment decision by comparing the paper portfolio return to the actual portfolio return. It decomposes into explicit costs, delay cost, market impact cost, and opportunity cost.
What are the main portfolio rebalancing strategies and how do you choose between them?
Rebalancing realigns portfolio weights back toward the strategic asset allocation after market drift. The three main approaches are calendar rebalancing, percentage-of-portfolio (threshold) rebalancing, and tactical rebalancing, each with distinct tradeoffs between simplicity, cost, and risk control.
How should risk management for individuals consider human capital and financial capital together?
Risk management for individuals recognizes that total wealth includes both human capital and financial capital. The nature of a person's human capital — whether bond-like or equity-like — should drive financial portfolio allocation and insurance decisions.
What is the endowment model of diversification?
Endowment model (Yale/Swensen): heavy alternatives (PE, VC, HF, real assets), illiquidity premium, active management in inefficient markets. Hard to replicate at small scale.
What is the step-by-step process for creating an Investment Policy Statement for a private client?
The IPS creation process follows a systematic eight-step flow: client discovery, objectives setting, constraint identification, asset allocation, drafting, client approval, implementation, and ongoing monitoring. The key exam focus is the interaction between return and risk objectives and the five constraints.
What is tax-efficient asset location and how do I apply it to a client portfolio?
Tax-efficient asset location optimizes which assets are held in taxable versus tax-deferred versus tax-exempt accounts to maximize after-tax wealth...
How do bond indices handle illiquid issues?
Indices screen for minimum outstanding size, maturity, and rating to ensure replicability. Liquidity declines sharply with bond age and off-the-run status; 'liquid subset' indices trade cheaper but diverge from full universe.
How does a firm define composites under GIPS?
Composites defined by mandate, objective, or strategy. Every discretionary portfolio must belong to at least one. Definitions consistent over time, all composites listed and provided to prospects. Cannot create composites ex-post...
What process do skilled managers use for credit selection in corporate bonds?
Systematic credit selection: screening, fundamental analysis, structural review, relative value, sizing, monitoring. Alpha persists in complex caps structures, small issuers, sector specialization. Top-quartile IR 0.5-1.0; consistency across regimes proves skill.
What is surplus optimization in asset-liability management?
ALM measures surplus volatility (assets minus liabilities), not asset volatility alone. Liability-driven investing matches duration via long bonds/swaps to immunize surplus.
How do I assess risk tolerance when ability and willingness conflict?
Ability (objective) and willingness (subjective) are separate dimensions of risk tolerance. If they conflict, use the lower, educate the client, and document. Both must be assessed separately on the exam.
How does risk-based lending work in private credit and what returns does it target?
Risk-based lending in private credit prices loans based on borrower-specific credit risk, collateral, and structural protections rather than reference-rate benchmarks alone...
How should a portfolio manager monitor factor exposures, and what tools are used to decompose portfolio risk into factor contributions?
Factor exposure monitoring involves defining target factor tilts with tolerance bands, estimating current exposures through holdings-based or returns-based analysis, and decomposing portfolio risk into factor and specific components. When actual exposures breach tolerance bands, the PM investigates the cause and rebalances if the deviation is structural.
What is alpha decay, how is it measured, and why does it determine optimal trading urgency?
Alpha decay measures how quickly a trading signal's expected return diminishes as information is absorbed into prices. It is estimated by plotting realized alpha against execution delay and fitting an exponential curve to determine the half-life. Short half-life signals demand aggressive execution despite higher market impact, while slow-decaying signals favor patient, cost-minimizing algorithms.
What are capacity constraints in equity strategies, and how does growing AUM erode alpha?
Strategy capacity is limited by market impact (larger orders move prices), crowding (competitors replicate signals), and universe shrinkage (illiquid names excluded at scale). Alpha typically decays with the square root of AUM, and managers estimate capacity using average daily volumes, participation rate limits, and market impact models.
What is transaction cost analysis, and how is implementation shortfall decomposed into its component costs?
Transaction cost analysis using implementation shortfall decomposes total execution costs into explicit costs (commissions, fees), delay cost (price drift before order submission), market impact cost (price movement caused by the order), and opportunity cost (returns missed on unfilled portions). The sum represents the gap between the hypothetical paper return and the actual portfolio return.
What is the adaptive markets hypothesis, and how does it reconcile efficient markets with behavioral finance?
The Adaptive Markets Hypothesis applies evolutionary biology to finance, proposing that market efficiency varies over time as participants adapt, compete, and evolve. Strategies that exploit anomalies attract capital until crowding eliminates profits, at which point new anomalies emerge in changed environments.
What are semi-liquid alternative investment vehicles, and what trade-offs do investors face compared to traditional locked-up structures?
Semi-liquid alternatives offer periodic redemption opportunities (quarterly or monthly) while investing in illiquid assets like PE, real estate, and private credit. Investors trade some illiquidity premium for greater flexibility, but face return dilution from cash buffers, NAV smoothing risks, and potential gating during market stress.
How do you isolate credit spread return from total corporate bond return in attribution analysis?
Credit spread return is isolated by multiplying negative spread duration by the change in OAS. This separates the credit-specific price impact from the benchmark rate effect, allowing managers to measure value added through credit selection independently of interest rate movements.
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