CFA (Chartered Financial Analyst) Portfolio Management and Wealth Planning Syllabus

What are the key assumptions underlying the CAPM?

Investors are risk-averse, utility-maximizing, rational mean-variance optimizers; markets are frictionless (no taxes/transaction costs); investors can borrow and lend at the risk-free rate; investors have homogeneous (identical) expectations over a single period; all assets are marketable/divisible.

State the Capital Asset Pricing Model (CAPM) equation.

$$E(R_{i}) = R_{f} + \beta_{i}\,[\,E(R_{m}) - R_{f}\,]$$ where $\beta_{i}$ is the asset's systematic risk and $[E(R_{m})-R_{f}]$ is the market risk premium.

How is beta ($\beta$) defined?

$$\beta_{i} = \frac{\mathrm{Cov}(R_{i},R_{m})}{\sigma_{m}^{2}} = \rho_{i,m}\,\frac{\sigma_{i}}{\sigma_{m}}$$ It measures an asset's sensitivity to market movements; the market beta is $1$, the risk-free asset's beta is $0$.

What is the Security Market Line (SML)?

The graphical representation of the CAPM, plotting expected return against beta. Its intercept is $R_{f}$ and its slope is the market risk premium $[E(R_{m})-R_{f}]$. All correctly priced assets (not just efficient portfolios) lie on the SML.

How do the CML and SML differ in what they plot and which assets lie on them?

The CML plots return against total risk ($\sigma$) and holds only for efficient portfolios. The SML plots return against systematic risk ($\beta$) and holds for all assets and portfolios, whether efficient or not. Under CAPM both intersect the same market portfolio.

How do you identify an undervalued or overvalued asset using the SML?

Compare the asset's expected (forecast) return with the CAPM required return. If forecast return is above the SML (positive alpha), the asset is undervalued (buy); if below the SML (negative alpha), it is overvalued (sell).

What is Jensen's alpha?

$$\alpha_{i} = R_{i} - [\,R_{f} + \beta_{i}(R_{m} - R_{f})\,]$$ It is the portfolio's return in excess of its CAPM-required return — a measure of risk-adjusted (systematic-risk-adjusted) performance. Positive alpha indicates outperformance.

What is the Treynor ratio and how does it differ from the Sharpe ratio?

$$\text{Treynor} = \frac{R_{p} - R_{f}}{\beta_{p}}$$ It measures excess return per unit of systematic risk (beta), whereas the Sharpe ratio uses total risk ($\sigma$). Treynor is appropriate for well-diversified portfolios where unsystematic risk is negligible.

What is the M-squared ($M^{2}$) measure?

A risk-adjusted performance measure that leverages or de-leverages a portfolio to match the market's standard deviation, then compares its return to the market: $$M^{2} = (R_{p} - R_{f})\frac{\sigma_{m}}{\sigma_{p}} - (R_{m} - R_{f})$$ It is stated in percentage-return units, making rankings intuitive.

State the general multifactor (macroeconomic) model for asset returns.

$$R_{i} = E(R_{i}) + \beta_{i1}F_{1} + \beta_{i2}F_{2} + \dots + \beta_{iK}F_{K} + \varepsilon_{i}$$ where $F_{k}$ are surprises (actual minus expected) in each factor, $\beta_{ik}$ are factor sensitivities, and $\varepsilon_{i}$ is firm-specific error.

State the Arbitrage Pricing Theory (APT) expected-return equation and its assumptions.

$$E(R_{i}) = R_{f} + \lambda_{1}\beta_{i1} + \dots + \lambda_{K}\beta_{iK}$$ where $\lambda_{k}$ is the risk premium for factor $k$. Assumptions: returns follow a factor model, no arbitrage opportunities exist, and investors can form well-diversified portfolios. APT does not require the market portfolio or a normal-return assumption.

How does APT differ from CAPM?

CAPM is a single-factor (market) equilibrium model requiring the true market portfolio and strict assumptions; APT is a multifactor model derived from a no-arbitrage condition that does not specify the number/identity of factors and does not need the market portfolio or mean-variance investors.

In the Fama-French three-factor model, what are the three factors?

(1) Market risk premium (RMRF), (2) SMB (Small Minus Big) — size factor capturing small-cap excess return, and (3) HML (High Minus Low) — value factor capturing high book-to-market (value) excess return. Carhart's four-factor model adds (4) WML/momentum.

What are the four steps in the portfolio construction (planning and construction) process per CFA?

(1) Specify the capital market expectations (long-run risk/return of asset classes); (2) determine the strategic asset allocation that meets the IPS objectives and constraints; (3) implement via security selection/portfolio construction; (4) monitor and rebalance over time.

What is strategic asset allocation (SAA)?

The long-term target allocation across asset classes derived by combining the IPS objectives/constraints with capital market expectations. It reflects the policy portfolio (the investor's neutral mix) and typically accounts for the majority of return variability over time.

Distinguish strategic from tactical asset allocation (TAA).

Strategic asset allocation sets long-term policy weights aligned to the IPS. Tactical asset allocation makes short-term, deliberate deviations from those policy weights to exploit perceived temporary mispricing or shifting market conditions; TAA introduces active risk relative to the policy portfolio.

Compare asset-only, liability-relative, and goals-based asset allocation approaches.

Asset-only (e.g., mean-variance optimization) ignores liabilities and maximizes risk-adjusted asset return. Liability-relative allocation chooses assets to fund and hedge specific liabilities (common for pensions/insurers). Goals-based allocation builds sub-portfolios with distinct risk levels matched to individual goals (typical for private wealth).

What is the difference between the rebalancing approaches of calendar rebalancing and percentage-of-portfolio (corridor) rebalancing?

Calendar rebalancing restores target weights at fixed intervals (e.g., quarterly) regardless of market moves — simple but ignores intra-period drift. Percentage-of-portfolio rebalancing sets tolerance corridors around each target and rebalances only when a weight breaches its band — more responsive to volatility but requires continuous monitoring.

What is risk budgeting in asset allocation?

The process of allocating a portfolio's total risk (e.g., total variance or active risk) across asset classes, factors, or strategies to achieve the highest expected return per unit of risk consumed. It makes explicit how much risk each position contributes to the total.

Define capital market expectations (CME) and list the steps to formulate them.

CME are an investor's forecasts of risk and return for asset classes used in strategic allocation. Steps: (1) specify the expectations needed and time horizon; (2) research historical/current conditions; (3) select forecasting models; (4) collect data and apply judgment; (5) formulate the expectations; (6) monitor and refine.

List common problems/biases analysts face when formulating capital market expectations.

Limitations of historical data, data-measurement errors/biases, the use of nonstationary data, ex-post (survivorship) bias, biases in analysts' methods, and psychological/behavioral biases such as anchoring, status quo, confirmation, overconfidence, prudence, and availability biases.

What is Value at Risk (VaR) and how is it interpreted?

VaR is the minimum loss expected over a given time horizon at a stated probability (confidence) level. E.g., a 5% one-day VaR of \$1 million means there is a 5% probability of losing at least \$1 million in a day. It conveys an estimate of tail loss magnitude and frequency but not the size of losses beyond it.

What are the three main methods of estimating VaR, and a key limitation of VaR?

Methods: (1) parametric/variance-covariance, (2) historical simulation, (3) Monte Carlo simulation. Key limitation: VaR does not describe the magnitude of losses in the tail beyond the threshold (addressed by Conditional VaR / expected shortfall) and is sensitive to estimation assumptions.

Define the components of a risk management framework.

(1) Risk governance — establishing the enterprise risk tolerance and oversight; (2) risk identification and measurement; (3) risk infrastructure (people, systems, data); (4) defined policies and processes; (5) risk monitoring, mitigation, and management; (6) communication; and ongoing strategic risk analysis/integration.

Distinguish among the main types of order in trade execution: market, limit, and the difference between them.

A market order executes immediately at the best available price, prioritizing certainty of execution over price. A limit order executes only at a specified price or better, prioritizing price over certainty of execution (it may not fill). Market orders bear price risk; limit orders bear execution (non-fill) risk.

What is implementation shortfall as a measure of trading cost?

The difference between the return on a hypothetical 'paper' portfolio (executed at the decision-price with no costs) and the actual portfolio. It captures explicit costs (commissions, fees, taxes), and implicit costs: delay cost, realized/execution price impact (market impact), and opportunity (missed-trade) cost.

What are the three components of performance evaluation?

(1) Performance measurement — calculating the rate of return; (2) performance attribution — identifying the sources of return (allocation, selection, interaction); (3) performance appraisal — determining whether returns were due to skill or luck (risk-adjusted assessment).

Differentiate time-weighted from money-weighted rate of return.

The time-weighted rate of return (TWR) compounds period returns and removes the effect of cash-flow timing, making it the standard for comparing managers. The money-weighted rate of return (MWR/IRR) is the internal rate of return that accounts for the size and timing of external cash flows, reflecting the investor's actual experience.

In macro performance attribution, how is the value added by asset allocation versus security selection conceptually separated?

Allocation effect measures return from over/under-weighting asset classes relative to the benchmark (benchmark-weight differences applied to benchmark returns). Selection effect measures return from picking securities that out/under-perform within each class (return differences applied at portfolio weights). An interaction term captures the combined effect.

List the key behavioral biases that affect individual (private wealth) investors, grouped by type.

Cognitive errors: conservatism, confirmation, representativeness, anchoring/adjustment, mental accounting, framing, availability, illusion of control, hindsight. Emotional biases: loss aversion, overconfidence, self-control, status quo, endowment, regret aversion. Cognitive errors can often be mitigated with information; emotional biases are usually accommodated.

How should an advisor generally moderate or adapt to a client's behavioral biases?

Cognitive errors (information-processing/memory errors) are typically corrected through education and better information. Emotional biases are harder to correct and are usually accommodated within the IPS. The level of wealth relative to needs determines whether to moderate (when standard of living is at risk) or adapt to the bias.

What is the difference between tax-deferred and tax-exempt accounts, and the principle of asset location?

Tax-deferred accounts defer taxes until withdrawal (taxed then); tax-exempt accounts are funded with after-tax money and grow/withdraw tax-free. Asset location places the most heavily/ordinarily-taxed assets (e.g., bonds, high-turnover strategies) in tax-advantaged accounts and tax-efficient assets (e.g., low-turnover equities) in taxable accounts to minimize the overall tax drag.

Compare a defined benefit (DB) pension plan's risk tolerance and return objective to those of a typical endowment.

A DB plan's objective is liability-relative — it must fund promised benefits; risk tolerance depends on funded status, surplus, plan/sponsor financials, and workforce age (younger workforce, higher surplus → higher risk tolerance). An endowment has a long/perpetual horizon, a spending-rate-plus-inflation return objective, generally high risk tolerance, low liquidity needs, and faces tax-exempt status with intergenerational equity goals.