CFA 3 portfolio construction

Role of equity in a portfolio

• Capital appreciation

• Dividend income (+ security lending, option selling)

• Diversification

• Hedge against inflation

ESG Screening approaches

• Negative screening

• Positive screening

• Best in class

• thematic investing

• Impact investing

Type of equity segmentation

• Size/Style (risk factors exposition, diversification, benchmark)

• Segmentation by geography (Developed Market, emerging market, frontier market)

• Segmentation by economic activities (Diversification by industry)

Cost associated with owning equity

• Management fees

• Performance fees

• Admin fees

• Marketing and distribution costs

• Trading costs

Pro and cons of activist shareholding

• Informational and financial knowledge

• Free rider, costly, conflict of interests, short term

Requirements for index bqsed strategies

• Rule based

• Transparent

• Investable

Different weighting methods for indexes

• Market cap (mean variance efficiency, low turnover but concentration)

• Free float market cap (difficult to assess)

• Price weighted index (ignore size qnd impqct of stock split)

• equally weighted (less concentration, exposure to smaller companies, high rebalancing), fundamental weighting

HHI to measure index concentration

sum of squared weight (beetween 0,5 and 1)

Benefits of fixed income

• Diversification

• regular cash flows

• inflation hedge (mainly for floaters and inflation indexed)

• lower volatility

Correlation drivers between fixed income securities

• Duration

• Geography

• Credit quality

But vary with the market regimes (flights to quality)

Different fixed income mandates

• Liability based (Matching, immunisation)

• Total return (Pure indexing, enhanced indexing, active management

Why are bonds less liquids

• Traded OTC

• Held until maturity

• lack of pricing transparency

Alternatives to get bonds exposure

• ETF and mutual funds (economies of scales)

• Exchange traded derivatives

• OTC derivatives

Expected return decomposition for fixed income

coupon income + Rolldown return + change in benchmark + change in credit spread + change in currency

Roll down return formula

Change in price with time

Change in benchmark/credit spread formula

'-ModDur x change in yield/spread + 1/2 x convexity x change in yield/spread²

Limitation of decomposition of expected returns

• Cash flows reinvested at YTM

• Tax

• Only use duration and convexity

Leverage portfolio returns

• Portfolio return / Portfolio equity

• Investment return x (Value of equity + value of borrowing) - Value of borrowing - cost of debt) / Value of equity, return of investment + Vb/Ve(ri-rb)

Leverage calculation on margin

(Notional Value / Margin)/Margin

Rebate rates

collateral earnings - security lending rates

Convexity for different types of FI portfolio

• Barbell (high)

• Ladder (medium)

• Bullet (low)

Benefits of ladder FI portfolio

• REduced investment risk

• regular liquidity

• stable duration

• yield curve diversification

Roles of different asset classes

• Capital growrh (Equity)

• Income (FI, real assets)

• Risk diversificaiton (real assets, HF)

• safety (gold, gov bonds)