_Combining individual assets into a portfolio that meets a client's objectives is a critical skill for CFA Level III candidates to master._
Introduction to Portfolio Construction
At CFA Level III, candidates have already learned to value individual assets, including equities, fixed income, derivatives, and alternatives. However, the focus shifts to combining these assets into a portfolio that meets a real client's objectives. This requires a deep understanding of the client's needs and goals, as well as the ability to construct a portfolio that balances return objectives, risk tolerance, time horizon, liquidity needs, taxes, legal constraints, and unique circumstances.
The Three Pillars of Portfolio Construction
Portfolio construction at Level III rests on three pillars. The first pillar is the investment policy statement (IPS), which specifies the client's objectives and constraints. The IPS serves as the foundation for all downstream decisions, including asset allocation, manager selection, and rebalancing. The second pillar is strategic asset allocation, which involves translating the IPS into long-term target weights across asset classes. The third pillar is implementation, which involves choosing between passive and active managers, factor tilts, smart beta, and direct indexing.
Strategic Asset Allocation
Strategic asset allocation is a critical component of portfolio construction. Candidates can use mean-variance optimization as a textbook tool, but they must also consider other approaches, such as:
- Resampled efficient frontiers
- The Black-Litterman model when they have views
- Risk-parity approaches for clients who care more about risk contribution than dollar weight
These approaches can help candidates create a portfolio that balances risk and return and meets the client's objectives.
Implementation and Monitoring
Once the target weights are determined, candidates must implement the portfolio by choosing between different investment strategies and vehicles. This involves making tax-aware decisions in taxable accounts and asset-location decisions across taxable and tax-deferred buckets. Candidates must also rebalance the portfolio to defend the policy weights, but they must do so in a way that minimizes transaction costs and tax consequences.
This loop is critical to mastering portfolio construction, as it allows candidates to continuously monitor and adjust the portfolio to ensure that it remains aligned with the client's objectives.
Common Pitfalls
A common trap for Level III candidates is to treat portfolio construction as a separate topic from the IPS and from monitoring. However, in practice, these topics are closely intertwined. Candidates must master the loop between the IPS, construction, monitoring, and feedback in order to succeed in constructed-response questions.
Frequently Asked Questions
- What is the role of the investment policy statement (IPS) in portfolio construction?
- How do candidates determine the optimal asset allocation for a client?
- What are some common pitfalls to avoid in portfolio construction?
- How do candidates balance risk and return in a portfolio?
Watch the full lesson
To learn more about portfolio construction and how to apply these concepts in practice, watch the full lesson.