_Equities at Level III involve a more nuanced approach to portfolio management, focusing on the strategic allocation of equity investments rather than individual stock valuation._
Introduction to Equities at Level III
At CFA Level III, the approach to equities differs significantly from that at Level II. While Level II focuses on valuation models such as multi-stage dividend discount models, residual income, and free cash flow valuation, Level III assumes that the equity can be valued and instead focuses on how to incorporate it into a portfolio. This involves deciding whether to own the equity directly, through an index fund, or through an active manager, and understanding how it fits within the overall portfolio strategy.
Passive vs. Active Management
The first key concept in equities at Level III is the choice between passive and active management. Active equity management has a low base rate of success after fees, particularly in large-cap US markets. As a result, the default approach for a Level III portfolio is to use broad market index exposure, with active management only used where there is a genuine reason to believe in the manager's edge. This approach helps to minimize costs and maximize returns.
Factor Tilts
Another important idea at Level III is factor tilts. Value, momentum, quality, low-volatility, and size are all documented risk premia that can be captured cheaply through smart-beta funds. By tilting towards factors that are not already represented in the liability or other holdings, it is possible to improve the risk-adjusted return of the equity sleeve. This approach allows investors to target specific factors that are expected to outperform the broader market.
International Diversification
International diversification is also a critical concept at Level III. Home bias is the tendency for investors to over-allocate to their domestic market, which can result in a concentrated portfolio even if the investor holds a large number of stocks. For example, a US investor with 90% of their portfolio allocated to US equities is concentrated, even if they hold 500 different stocks. To address this, Level III candidates should consider adding international developed and emerging exposure to their portfolios, and decide how much to currency-hedge. They should also select between regional and global mandates to achieve optimal diversification.
Implementation Cost
The final key idea at Level III is implementation cost. This refers to the gap between a strategy on paper and the strategy in the client's account, and includes costs such as bid-ask spread, market impact, taxes, fees, and tracking error. A good Level III answer should estimate these costs and explain how they affect manager selection. By understanding the implementation costs associated with different strategies, investors can make more informed decisions about how to allocate their portfolios.
FAQ
- What is the default approach to equity management at Level III?
- How can factor tilts be used to improve portfolio returns?
- What is home bias and how can it be addressed through international diversification?
- How do implementation costs affect manager selection and portfolio optimization?
Watch the full lesson
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