Overview of the Level III CFA® exam

How do you prepare for the Level III CFA® exam?  Based on my experience with thousands of Level III CFA® candidates and over 25 years of teaching, the key to success is to prepare using the CFA® Program curriculum.  That seems overwhelming especially if you aren’t used to using the curriculum before.  I get that.  That is why I created this video series.  I walk you through each page of the candidate curriculum. I point out and work through white text examples & bliueboxes, concepts and important details while also connecting concepts from one study session to another.  This video below will help give you a taste of things to come, to understand how to use the candidate curriculum and where to focus your efforts as you prepare to make it “One & Done!”

Order Flow of the Level III CFA® exam

Since the mid 1990s the flow of the Level III curriculum went like this: behavioral finance, private wealth, institutional investor, economics, asset allocation, fixed income, equity, alternatives, risk mgt, trading, performance evaluation and GIPS.  Notice how Wealth and Institutional Investor are upfront.  In 2020 the CFA Institute changed the order flow to place Private Wealth and Institutional toward the back of the curriculum.  There are a few risks associated with this approach:

  1.  Leaving the two biggest exam topics (PWealth and Inst) toward the end (April and May) gives you less time to review the topics before the exam
  2. You may not get to these topics if you started late.  In prior years some candidates scramble to finish Perf Eval and GIPS because they ran out of prep time before the exam and just “winged” the topics.

Private wealth and Institutional are the largest topics on the morning essay exam and giving yourself plenty of time to prepare would be prudent.  Lastly, there is noting in the later curriculum you need before you cover those two topics, they can be covered first.

How to Prepare for the Level III CFA® exam

This next video is a 40-minute clip about How to Prepare for Level III. It has been on the Analyst Forum web site and a few candidate have asked where it was located so I popped it into the site here. Let me just say this…this video has some really important data included about the exam and how to best prepare. Be sure to catch the outtakes of candidates that passed last year in the last four minutes.

Behavioral Finance

This study session three has readings:   The Behavioral Finance Perspective, The Behavioral Biases of the Individual and Behavioral Finance and Investment Process.

The Behavioral Finance Perspective

The first 90-minute video on the Behavioral Finance covers the “normative” fundamental tenets of traditional finance – maximization of expected utility, perfect information (EMH) and perfect self-interest.  Pair those concepts with how the actual investor behaves in reality where we act differently (risk aversion) based on whether we experienced gains or losses called Prospect theory, how we “satisfice” when making decisions faced with limited resources, time and information.  In other words, we exhibit bounded rationality. We finish the video with the four approaches to modifying traditional finance models (MVO, EMH and CAPM) with some behaviorally modified methods such as the savings/consumption model, the stochastic discount factor, behaviorally modified asset allocation and the adaptive market model.

CFA Institute Errata3/14/2020.   Reading 7.  • In Example 3 (page 40 of print), the second-to-last sentence of the solution should read, “The portfolio will result in at least 2,067,451 euros with 35 percent probability (i.e., 100% – 65% = 35%) rather than 2,100,000 euros with 80 percent probability.


The Behavioral Biases of Individuals 

This second of three readings in Behavioral Finance covers the behavioral biases exhibited by the individual investor (micro), we will identify those biases as either cognitive errors such as five belief perseverance biases, four information processing biases as well as six emotional biases.  We will define each bias, come up with a method to recognize which biases is which, what are the consequences of the biases and how to remedy them.  The most important element to focus upon in this reading is the application of identifying these biases in the case study at the end of the reading with Mr. Renaldo and Mrs. Maradona.

Errata – CFA Institute (3/14/2020) On page 89 in exhibit 6, the ranges need to change to 0% to 5% for the top left box (Cognitive/high SLR), 0% to 10% for the top right hand box (emotional/high SLR), 0% to 2% for the lower right hand box (cognitive/low SLR) and 0% to 5% for the bottom right hand box (Emotional/low SLR).  LevelUp slide #17 needs to be updated for theses changes

In the second paragraph below Exhibit 6 on page 89, fourth sentence should read as: “If an adjustment is needed a +/– 2 percent maximum asset class adjustment is suggested.”


Behavioral Finance and Investment Process 

The third and final reading in Behavioral Finance introduces the classification of investor types with three models – Barnewall Two-Way (Active/Passive), Bailard, Biehl Kaiser 5-way model and the culmination of the three with the Pompian Behavioral Alpha Approach.  The reading and then covers the (Macro) behavioral biases exhibited in client advisor relationships, portfolio construction (inertia & default, naive diversification, investing in the familiar, excessive trading, home bias and BPT again, analysts forecasts (overconfidence, illusion of control, self-attribution and hindsight biases), committee decision making (framing, anchor & adjust, availability) and the overall market behavior (social proof) and market behavior (anomalies, momentum, herding, regret, bubbles & crashes, value & growth).

Private Wealth Management

This topic has five readings in the individual investor part of the curriculum.  The five readings include:  Overview of Private Wealth Management, Taxes & Private Wealth Management in the Global Context, Estate Planning in a Global Context, Concentrated Single Asset Positions and Risk Management for Individuals.

In addition, Cases in Risk Management: Private Wealth should be a follow on reading after the five readings above are covered.


Day 1 – Session

Taxes and Private Wealth Management in a Global Context

The second reading in study session 5 is “Taxes and Private Wealth Management in a Global Context.” This reading covers a lot of ground in the context of the IPS and the tax constraint. Recall, taxes are a major source of either value lost (cash flow to pay tax liability and reduction in account value) or value added to a taxable private client. The reading begins with a brief description of various tax regimes, both flat tax and progressive tax structures. After-tax accumulation occurs after three types of taxes are explored. First is the accrual tax on interest and dividends where periodic taxes erode the account value over longer periods at high rates of return. The second tax faced by private wealth investors is the capital gains tax. The third tax is the wealth tax applied to the entire portfolio or asset value at a low tax rate. The reading then provides a framework for computing after-tax returns when the various sources of returns (interest, dividend and realized gains) are taxed at different tax rates through blended tax rates. The reading also discusses three “buckets” of account types: taxable, tax deferred and tax exempt and explains the types of assets that should be located in these various account types. Remember asset location is not the same as asset allocation. Lastly, the reading provides methods of adding tax alpha to the client such as trading behavior, asset location, tax loss harvesting, holding period management and after-tax mean-variance optimization. Whew, that was a lotta tax lollapalooza!

Estate Planning in a Global Context

The third reading in this study session is “Estate Planning in a Global Context.” This reading extends the IPS tax constraint material to the multi-generational perspective with estate planning moves to maximize after-tax wealth. The reading initially begins with basic estate planning definitions. After developing a “Hypothetical Life Balance Sheet” where the PV of human capital and the PV of retirement spending needs are defined the reading provides tow approaches to calculate “core capital.” The first method, calculating core capital with mortality tables and the second method calculates core capital using Monte Carlo analysis. Both methods have advantages and weaknesses that you should consider. After core capital is computed and subtracted fro the portfolio of assets one derived “excess capital” that can be distributed to others. The methods used to distribute wealth include: inter vivos gifts, testamentary bequests, generation skipping, spousal exemptions, valuation discounts, deemed dispositions and charitable gifts. Additional estate planning tools such as revocable and irrevocable trusts are highlighted, foundations, life insurance and foreign controlled corporations. Lastly, the reading details three methods to reconcile double taxation conflicts that exist between residency based countries and source based countries. The three methods include the credit, exemption and deduction methods. Again the entire purpose of this reading is to look multigenerational and maximize wealth across time horizons.

Concentrated Single Asset Positions

“Concentrated Single Asset Positions” and although it was new in 2014 the concept has been around for over a decade at Level III. The story goes that we have three types of single concentrated asset positions: publicly traded stock, private company holdings and investment real estate. In each case, our investor is trying (think IPS constraints) to minimize taxes, maximize after-tax proceeds, increase liquidity, diversify idiosyncratic risk and balance the need to retain control of the asset with relinquishment. Please note that not only does behavioral finance cross from study session 3, 4 and 7 (capital market expectations) but also influences the investor in this reading as well. The primary focus is for you to understand the benefits and disadvantages of the various strategies such as outright sale, monetization and hedging the asset. This is the first time at Level III we begin to see another common theme in the curriculum called “hedging.” Various strategies are used for hedging: options, forwards and swaps. These three strategies grow in their details in the derivatives readings so keep a common set of notes where these topics are tied together for review and mastery as you move to the exam. There are eight BlueBoxes that are critical in this reading especially Fred Garcia that begins with Bluebox 2 and continues with 6. There are only 13 practice problems at the end of the reading but they provide a glimpse of how this topic could be tested in the morning essay exam so be sure to practice writing out the answers and “tweeting” your answer to match the problem solution provides by the CFA Institute.

Risk Management for Individuals

“Risk Management of Individuals” was introduced in 2017 and has been heavily tested sinceits  introduction. The topic and concepts are very similar to the reading it replaced. The article titled Risk Management for Individuals” runs parallel to the reading in Study Session 16 called “Cases in Portfolio Management & Risk Management. Here the focus is the individual investor and the primary two risks we face as human: mortality risk and longevity risk. The reading outlines an economic or “holistic” balance sheet Exhibit 1 & 2that differs from a traditional balance sheet in that we now include the present value of human capital (mortality weighted present value of future labor income discounted by a nominal risk-free rate adjusted for income volatility) in Blue Box 1 on the asset side of the B/S and the PV of consumption on the liability side. Other non-traditional assets (pension benefits) and liabilities (retirement expenses, education funding and bequests) are added. The reading covers the basics of either whole (permanent) or term (temporary) insurance. There are some very important places to focus upon and those include the cost comparisons of whole life policies (net payment cost vs. surrender cost index). Also very important in the reading is the determination of the amount of life insurance one needs. This is found in Section 5.2 and is a case study regarding Jacques & Marion Perrier. The amount of life insurance can be determined two ways (1) human life value method and (2) needs analysis. Both methods are very important to be able to compute for examination purposes. The next topic covers annuities or hedges for longevity risk where both immediate and deferred annuities are covered along with either fixed or variable payments. The purpose of this material is to make a recommendation for a client given certain PS objectives and constraints and then determine which insurance product best meets the client’s objectives. Lastly the reading discusses the diversification between human capital and financial capital and low the higher correlation between HC & FC would require more of the financial assets be in assets unlike HC. For example, if HC was bond-like then the financial assets could be more heavily exposed to equities.

Private Wealth Case Study

Portfolio Management for Institutional Investors

This is a brand new reading/video for 2020.  The institutional investor has been heavily tested in the morning portion of the Level III exam and is considered by the CFA Institute part of the core “Candidate Body of Knowledge.” In other words, you gotta know this material!

The first topic in the reading is the common characteristics of the institutional investor such as scale, investment time horizon, regulations, governance and the principal-agent conflicts. Pay close attention throughout the reading with regard to the P-A conflicts for each investor.

The second topic covers the basic types of models used to manage institutional investor portfolios including the Norway model, Endowment (Yale) model, Canada model and finally the Liability Driven Investing model (LDI) which ties close to the fixed income reading on L-D investing.  Know the each model, the use of public or private investments and the advantages and disadvantages of each model (see exhibit 1).

The most frequent question in the morning essay comes from defined benefit/pensions.  Between 2/3 and 3/4 of the time the morning essay has (for the past 8 years) had a pension related question. The topics to focus upon would be the liquidity factors, PBO liability input factors and how risk tolerance is determined for the plan.  The DB vs. DC is also a good question for the exam (see exhibit 2).

A new topic area for this subject is the Sovereign Wealth funds and they various types (exhibit 8).  Grasping the investment objectives, liquidity, time horizon and typical asset allocations would be material for an afternoon item set question or two.

Knowing the similarities and differences in the IPS for the endowment and foundation is critical.  These longer time horizon, more aggressive assets allocation investors have a very different asset only approach to investing versus the Asset/Liability approach we see with DB plans.

The last topic in the reading is financial institutions where we cover insurance companies (life vs P&C) and banks.  As financial intermediaries the investment objectives are very different from endowments and foundations. The nature of managing an investment portfolio relative to a specificities liability requires a very different IPS.  The “meat & potatoes” of the reading begins in section 7.9 with balance sheet management for thebans ind insurer.  Making sure you understand exhibits 22-27 and bluebooks 7 & 8 are critical to exam success.  Equation 8 and equation 9 are also very important formulas to add to your war chest of formulas to score big on exam day.

Errata – Slide 8 “Defined Benefit Risk Tolerance” under Firm Financial Data, Plan size, change lower to higher in the risk tolerance column.

Please see exhibit 5 in the reading, second category “Sponsor Financial Status” and look to the explanation column.

“Large sponsor company size relative to pension plan size implies greater risk tolerance”

Capital Market Expectations (CME)

Capital Market Expectations is oh so long and arduous so grab a cup’o coffee, sit back and let me do some of the hard work for you. But…if you work hard at this material in addition to what I show you then the exam will be so much easier in June.

Capital Market Expectations, Part I: Framework and Macro Considerations

The primary purpose of the reading is to provide the tools necessary to estimate the inputs for mean-variance optimization; expected return, expected risk and correlations for the permissible asset classes used in the optimization that will construct the portfolio outlined in the client’s IPS. The reading first tackles the 15 challenges of economic forecasting, don’t skip these, they are kinda interesting and fun to be honest.  The next section covers the basic essentials of economic data (long term growth trends, shocks, cycles, fiscal policy, monetary policy, structural policies, inflation, deflation, ect…all necessary to forecast returns, risk and correlations for various asset classes.

CFA Institute errata (3/14/2020) –  In the Summary, fourth bullet from the end (page 213 of print), the first sentence should read, “Two countries will share a default-free yield curve if (and only if) there is perfect capital mobility and the exchange rate is credibly fixed forever.”

Capital Market Expectations (CME)

Capital Market Expectations, Part II: Forecasting Asset Class Returns

This second reading in CME builds on the idea of establishing expectations for various asset classes that are typically used in the asset allocation MVO.  We take the macro analysis from the prior reading and now apply the economic growth trends, business cycles, inflation (deflation), fiscal and monetary policy environment and look to see how the macro environment impact various asset classes.  The asset classes we cover include fixed income, equities, real estate, currency and volatility.  In each asset class we strive to identify the expected return as that is a primary input factor in the MVO, then we look to variance and then correlation.  With each asset class we look at several common ways to establish expected returns.  We first look to the past and use historical return estimates but of course we know from CME part I that is fraught with sampling errors and other time period biases.  We can look to DCF modes for bonds (YTM) and equities using Grinold Kroner and real estate with NOI and cap rates.  We can also utilize risk premium build up methods for both equities and bonds.  Forecasting currency (using trade flows, PPP, competitiveness and sustainability) coupled with forecasting currency might be best left to a period when you are fresh and ready to tackle some “different” material than bond, equity and real estate expected returns.  It is not hard just requires a fresh mindset.

CFA Institute Errata (3/14/2020) – In Example 8 (page 253 of print), first sentence should read, “After many years of running moderately high current account deficits (2%–4% of GDP) but doing little infrastructure investment, Atlandia plans to increase the yearly government deficit by 3% of GDP and maintain that level of deficit for 10 years, devoting the increase to infrastructure spending.”

LevelUp Errata – on slide 21 titled “3 Methods Fcst’ing Fixed-Income Returns” on the right side green box where I work out Bluebox 1 I have a multiplication sign in the 2 year annual return calculation when it should be an addition sign.  Correct:  Annual return = [YTM + (Cap G/L + reinvest)/2]

Asset Allocation and Related Decisions in Portfolio Management (I) & (II)

Introduction to Asset Allocation

This new reading is an “introduction” to the asset allocation process, it tells us where we are going with the next two follow-on asset allocation readings.  The first topic is the process of corporate governance, this is NOT a topic you want to skip over lightly.  Corporate governance discusses the roles and responsibilities of those that handle and manage financial assets for clients.  The reading then covers the economic balance sheet where the inclusion of implied assets (human capital, etc…) and implied or extended liabilities is added to the balance sheet in determing the economic net worth of the investor.  It is this implied asset – human capital, that could add an equity and fixed income related exposure to the asset allocation modeling.  Three case studies are presented to cover the three primary approaches to asset allocation:  asset only (mean-variance optimization), liability relative or liability drive which we cover extensively in the fixed income readings and a new topic to the Level III material, goals-based investing.  Covering the three cases is important to grasp not only the basics but also the nuances that could be tested.  The reading delves into the implementation of the asset weight selection between a tactical or dynamic approach and once the asset weights are determined are they actively or passively managed.  Lastly, once the market moves, as it always does, how do we manage the risk of the portfolio with regard to rebalancing.  Three rebalancing methods are discussed, calendar, percentage and cost-benefit where each approach has various ways to determine the ranges/corridors to which the asset class would trigger or tigger 😉 a rebalancing.

CFA Institute Errata (3/14/2020)

  • In the text at the beginning of Section 7 (page 43 of print), the following sentences should be removed: “The first dimension is covered in Section 5.1. The second dimension is the subject of Section 5.2.” The sentences should be replaced with: “Each of these are covered in the sections that follow.”
  • The last sentence of the first paragraph of 7.2 (page 44 of print) “(Risk budgeting…” should be removed.
  • In the fourth paragraph of 7.2, the phrase “discussed in Section 4.1” should be removed.

Derivatives & Fixed Income

Alternative Investments for Portfolio Management

This topic has two readings:  Hedge Fund Strategies and Asset Allocation to Alternative Investments. These readings are new for 2020.  HF Strategies is all about the difference between traditional assets classes and the characteristics that make HFs different.  We then move to the 6 classifications of hedge funds and we review each keeping in mind how the strategies work, liquidity (important for an institutional investor case study tie in) if they use leverage and the types of returns they provide (correlated or uncorrelated).  The reading then moves to the difference between funds of funds and multi manager strategies. Pay close attention to these differences and the impact of fees on each new return.  The readings final two topics are very important:  Conditional FactorModels where we time series regress various HF returns with 4 primary factors (equity, interest rates, currency and volatility) to determine their exposure in normal periods and crisis periods.  Being able to understand the factor loads is a very testable topic.  Lastly the impact of adding a 20% equal weighted mix of HFs to a traditional 60% equity 40% fixed portfolio and analyze the impact to Sharpe, Sortino, and max drawdown is a very practical analysis I’d want to be able to understand and justify on an exam. This reading has 15 Bluebox examples, I’d say 12 of them are of critical learning importance for possible exam questions.

Alternative Investments for Portfolio Management

Asset Allocation to Alternative Investments is new for 2020 and the summary will soon be posted.

Introduction to Equity Portfolio Management

There are four new readings in Equity Portfolio Management for 2019.  The first reading is Introduction to Equity Portfolio Management.  The intro covers basic topics we saw before in Level I and Level II.  We first discuss the role of equities in a portfolio (capital appreciation, dividend yield, diversification potential, possible inflation hedge and IPS mandate for the asset class.  The next section breaks down the investable universe into market capitalization (size), style (based on P/B, P/E), geographical region, currency, sector, benchmark inclusion, and economic activity.  Stocks include various methods of increasing income:  dividends, special dividends, security lending income, dividend recapture and selling both calls and puts to generate additional income sources.  Sources of expenses include ad velorum fees (AUM), performance fees (Hedge Funds) administration, marketing, distribution, custody and trading expenses.  Lastly, the reading turns to the role of activist equity investors covering the advantages and disadvantages of shareholder engagement, the role of the activist manager and the types of activities and roles they will take.

Passive Equity Investing

This new reading for 2019 covers the topic of passive equity investing.  If you think of the spectrum of active to passive investing similar to what we covered on fixed income in this reading we cover how passive investing works in the realm of equities.  Please keep in mind passive does not mean any activity, in fact passive investing can be quite complex and require constant monitoring to maintain the passive portfolio from drifting from the benchmark or index it intends to mirror.  The first task is to understand various benchmarks, how to select them and how they are constructed with free float adjustments, weighting schemes such as price, equal or fundamentally weighted and the pros and cons of each methodology.  The reading goes on to discuss various methods to passively invest including open-ended mutual funds and ETFs as pooled methodologies, separately managed accounts for long-term asset class exposure but also the short-term use of equity futures, options on index futures and total return swaps.  These derivative methods have risks that are very different than the longer term approaches and investors should be aware of these incremental risk exposures.  The focus of prior exam coverage comes this the discussion of passive portfolio construction methodologies including full replication, stratified sampling, mathematical optimization and a blend of these methods.  Knowing the advantages and disadvantages and the effect on the information ration (active return and tracking error trade of with expenses).  The important topic of tracking error is so often mentioned in the curriculum but not always lined out as the detail provided in this section.  Please cover this area with close attention.  Lastly identifying where the passive portfolio deviated from the index or benchmark and knowing was sector weight differential or not to determine the tracking error that occurred.  This methodology called attribution analysis is a foreshadowing of things to come in the reading in performance evaluation just prior to GIPS.

Active Equity Investing:  Strategies

Active Equity Investing:  Portfolio Construction

This new reading for 2019 covers the topic of active equity portfolio construction.

Trade Strategy & Execution

This new reading in 2020 discusses trading and execution from the portfolio manager’s perspective.  The reading has two big topic areas (1) the qualitative material through sections 1-4 and then the quantitative material in the later sections.  The qualitative material is all about motivations for trading, inputs for trading, trading strategy prices before, during and after the trade, and finally trading benchmarks.  The later parts of the reading covers trade evaluation after the trade and we discuss implementation shortfall down three ways (1) paper less actual portfolio return (2) execution + opportunity and fess and (3) we break out execution costs into delay costs + trading costs + opportunity + fees.  I/S has been on the CFA exam many times over the years so please master that core body of knowledge.  Evaluating trade execution evaluates trades relative to a benchmark such as arrive prices, VWAP, TWAP, MOC or closing prices, the calculations would also be good to master as well. Finally the last part of the reading covers ethics in trading, best execution and what a firm should do to ensure ethical trading policies.

Manager Selection

Manager selection is about the complex and detailed process involved in selecting an investment manager to follow the mandate of the client’s IPS.  The primary focus of the reading is understanding how the investment results were obtain, whether they will be consistent and repeatable in the future.

The first section of the reading covers defining the investment universe for manager selection.  This can be achieved by looking to a benchmark managers use to manage their assets, third party consultants and hybrid techniques are used to narrow down and define a field of managers to evaluate.  The second part of this section covers the two types of errors that could be made in the manager selection.  Type I errors are hiring or retaining managers that don’t add value and fail to meet expectations.  Type II errors are not hiring or selecting a manager that does add value.  In determining the effects of these choices the size, shape, mean and dispersion of the manager’s returns will determine the cost of these mistakes.  Also pay close attention to the effect of mean reverting markets on these Type I and Type II errors.

The second section of this reading is all about the quantitative elements of manager selection.  As we discussed in Equity Portfolio Management two methods used to identify manager style is Returns Based Style Analysis (RBSA) looks at historical returns and portfolio holdings while Holdings Based Style Analysis (HBSA) evaluates current portfolio positions but is susceptible to window dressing.  Making sure you understand how each works, the advantages and the disadvantages of each approach is key for the exam. Also know that neither approach is better than the other.  Another “review” topic in this section is capture ratios and drawdown.  Capture ratios and drawdown were covered in detail in the Performance Evaluation reading.

The next section is the qualitative elements of the investment process, people and investment portfolio.  A rigors evaluation of the investment philosophy determining is the inefficiencies of the market arising from behavioral or structural inefficiencies.  Other investment philosophy elements include is the approach clear and consistent, what are the strategy assumptions, how have things changed over time and is the approach credible and does it have capacity to earn alpha in excess of fees and is it repeatable.  A look into the investment personnel and the investment decision making process is also explored.  Operational due diligence and evaluation of the firm itself, the investment vehicles offered (SMA or pooled), liquidity and important;y management fees.  Please pay close attention to the fee calculation replicated from the practice problems 21-26.

Case Study in Portfolio Management: Institutional

Global Investment Performance Standards (GIPS)

Last study session ever has one reading: Overview of the Global Investment Performance Standards.

Last Words of Wisdom

Hey!  Don’t let me scare you ;-))