- What does CFA Level III emphasize most?
- Portfolio management and wealth planning. Level III applies the tools from Levels I and II to construct and manage portfolios for clients, using both essay (constructed-response) and item-set questions.
- Economic balance sheet
- A broader view of a client's wealth that adds human capital (the present value of future earnings) and the present value of future liabilities to traditional financial assets and liabilities.
- Human capital
- The present value of an individual's future labor income. Bond-like (stable) human capital supports a higher allocation to risky financial assets; equity-like human capital argues for more conservative financial assets.
- Financial capital
- A person's tradable, investable assets — cash, stocks, bonds, real estate — as distinct from human capital. Total wealth = financial capital + human capital.
- Strategic asset allocation (SAA)
- The long-run policy mix of asset classes set in the IPS to meet the investor's objectives and constraints. It reflects the investor's risk and return needs over the full time horizon.
- Tactical asset allocation (TAA)
- Short-term, deliberate deviations from the strategic policy weights to exploit perceived near-term opportunities. It introduces active risk relative to the policy portfolio.
- Mean-variance optimization (MVO)
- A method that finds the asset weights producing the highest expected return for a given level of risk (the efficient frontier), using expected returns, variances, and correlations.
- Investor utility (asset allocation)
- Utility = expected return − ½ × risk-aversion (λ) × variance. The optimal portfolio maximizes utility; a more risk-averse investor (higher λ) accepts lower return for less risk.
- Asset-only approach
- An allocation approach that optimizes the assets in isolation, ignoring any liabilities. Standard mean-variance optimization on the assets alone.
- Liability-relative (surplus) approach
- Allocates assets relative to the present value of liabilities, optimizing the surplus (assets − PV of liabilities). Used by pensions and insurers whose obligations drive the portfolio.
- Surplus
- The market value of assets minus the present value of liabilities. Surplus optimization minimizes the volatility of this surplus rather than the volatility of assets alone.
- Goals-based asset allocation
- Builds sub-portfolios for distinct goals, each with its own time horizon and required probability of success. More important or near-term goals get a higher required probability and safer assets.
- Risk budgeting
- Allocating a portfolio's total risk across asset classes, factors, or active managers so that the use of risk is deliberate and aligned with where the investor expects to be rewarded.
- Calendar rebalancing
- Rebalancing the portfolio back to target weights on a set schedule (e.g., the first day of each quarter), regardless of how far weights have drifted. Simple but ignores intra-period drift.
- Percentage-of-portfolio (corridor) rebalancing
- Rebalancing only when an asset class drifts outside a set tolerance band (corridor) around its target weight. Responds to market moves rather than the calendar.
- Rebalancing corridor width — what affects it?
- Wider corridors suit asset classes with higher transaction costs, higher volatility, lower correlation to the rest of the portfolio, and higher risk tolerance. Narrow corridors increase trading and costs.
- Why do higher-volatility asset classes often get wider corridors?
- Frequent rebalancing of a volatile class triggers many trades and high transaction costs relative to the diversification benefit, so a wider tolerance band reduces costly turnover.
- Strategic currency hedging — purpose
- Deciding how much of a portfolio's foreign-currency exposure to hedge to reduce the volatility added by exchange-rate movements, separate from the underlying asset decision.
- When might a manager leave foreign exposure unhedged?
- When the manager judges the cost of hedging exceeds the benefit, expects currency gains, or believes currency adds diversification — an active currency-management decision.
- Reverse optimization
- Starts from observed market-cap weights and implied equilibrium returns, then reverse-engineers the expected returns consistent with those weights. The basis of the Black-Litterman model.
- Black-Litterman model
- Combines the market-implied (equilibrium) returns from reverse optimization with the investor's own views, producing more stable, intuitive allocations than raw mean-variance optimization.
- Monte Carlo simulation (asset allocation)
- Generates thousands of random return paths to estimate the probability a portfolio meets a goal, capturing path dependency, sequencing risk, and non-normal outcomes that single-period MVO misses.
- Liquidity considerations in asset allocation
- The portfolio must hold enough liquid assets to meet spending, capital calls, and obligations. Illiquid alternatives (private equity, real estate) require sizing for the investor's liquidity needs.
- Risk-parity asset allocation
- Allocates so that each asset class (or factor) contributes equally to total portfolio risk, typically increasing the weight of low-volatility assets like bonds, often with leverage.
- What is rebalancing's effect on portfolio risk?
- Rebalancing keeps the portfolio near its target risk level. Without it, a rising asset (often equities) grows as a share of the portfolio and the risk profile drifts away from the policy.
- Constraints that shrink the opportunity set
- Real-world limits — taxes, liquidity needs, legal/regulatory rules, asset-class minimums/maximums, and unique circumstances — narrow the set of feasible allocations from the unconstrained frontier.
- Capital market expectations (CME)
- Forecasts of expected returns, risks, and correlations for asset classes that feed the allocation process. Errors in CMEs are a major source of suboptimal allocations.
- Time horizon and asset allocation
- A longer time horizon generally supports a larger allocation to risky assets, because there is more time to recover from drawdowns and human capital is larger relative to financial capital.
- Passive equity investing
- Seeks to track a benchmark index's return rather than beat it, minimizing cost and tracking error. Implemented by full replication, stratified sampling, or optimization.
- Full replication
- Holding every security in an index at its index weight. Achieves the lowest tracking error for liquid indexes but incurs transaction costs, cash drag, and fees that still cause slight underperformance.
- Stratified sampling (indexing)
- Holding a representative subset of an index's securities that matches the index across key dimensions (sector, size, style). Lowers costs versus full replication at the price of some tracking error.
- Tracking error
- The standard deviation of the difference between a portfolio's return and its benchmark's return. Low tracking error means the portfolio closely follows the index.
- Cash drag
- The performance shortfall a fund suffers from holding uninvested cash (for liquidity/redemptions) while the market rises. A source of tracking error for index funds.
- Active Share
- The fraction of a portfolio's holdings that differ from the benchmark, from 0% (index) to 100% (no overlap). High Active Share means many different positions, but they may still offset to low active risk.
- Active risk vs Active Share
- Active risk (tracking error) measures return deviation from the benchmark; Active Share measures holdings deviation. A fund can have high Active Share but low active risk if its differing bets are diversified and offsetting.
- Smart beta / factor-based investing
- A rules-driven, transparent strategy that systematically tilts toward factors such as value, momentum, size, quality, or low volatility, rather than picking stocks discretionarily.
- Factor tilts
- Deliberate, persistent over- or under-weights to rewarded factors (value, momentum, size, quality, low volatility). The core of factor-based smart-beta portfolios.
- Fundamental vs quantitative active management
- Fundamental managers use judgment and deep research on fewer names; quantitative managers use data-driven models across many names. They differ in breadth, depth, and how decisions are made.
- Liability-driven investing (LDI)
- A fixed-income approach that structures assets to fund a known set of future liabilities (e.g., pension payments), focusing on matching the interest-rate sensitivity of assets and liabilities.
- Immunization
- Building a bond portfolio so that its value will meet a future liability regardless of interest-rate moves, by matching the portfolio's duration to the liability and minimizing cash-flow dispersion.
- Cash-flow dispersion (immunization)
- How spread out a portfolio's cash flows are around the liability date. For a single liability, minimizing dispersion (and matching duration) reduces structural and reinvestment risk.
- Cash-flow matching
- Building a bond portfolio whose coupons and principal arrive exactly when liabilities are due, eliminating reinvestment risk without relying on duration matching. More restrictive and costly than immunization.
- Duration matching
- Setting the portfolio's duration equal to the liability's duration so equal-and-opposite price and reinvestment effects offset for small parallel rate shifts, immunizing the liability.
- Yield-curve strategies
- Positioning a bond portfolio for expected curve changes: bullet (concentrated near one maturity), barbell (short + long), or ladder (evenly spaced) to profit from steepening, flattening, or curvature shifts.
- Credit strategy (active fixed income)
- Over- or under-weighting spread sectors (corporates, high yield) versus the benchmark based on the credit-spread outlook, while controlling duration. Overweight spread when spreads are expected to tighten.
- Implementation shortfall
- The difference between the value of a paper (decision-price) portfolio and the actual executed portfolio. It captures explicit costs plus market-impact and delay (timing) costs.
- Market impact cost
- The adverse price movement a large order causes by consuming available liquidity. Bigger and less liquid trades have higher market impact — a major component of implementation shortfall.
- Delay (timing) cost
- The cost of price movement between the investment decision and the start of trading. Part of implementation shortfall, distinct from the impact of the trade itself.
- Receive-fixed interest-rate swap overlay (LDI)
- Adding a receive-fixed, pay-floating swap to a bond portfolio to extend its hedged duration toward a long-duration liability without buying more physical long bonds.
- Why does even a full-replication index fund underperform its index?
- Transaction costs, management fees, and cash drag. The index itself is costless on paper; a real portfolio incurs trading and operating costs that create a small, persistent shortfall.
- Active management — sources of value
- Security selection, factor/style tilts, sector or country allocation, and timing. The information ratio measures how much active return a manager earns per unit of active risk.
- Tracking-error budget
- The maximum active risk an investor allows a manager to take. Setting it controls how far the manager can deviate from the benchmark in pursuit of active return.
- Long-only constraint
- A restriction against short selling. It limits a manager's ability to underweight small benchmark names below zero, capping potential active return from negative views.
- Equitizing cash with futures
- Using equity-index futures to gain market exposure on cash holdings, reducing cash drag and keeping a fund fully invested while preserving liquidity.
- Covered call
- Owning a stock and writing (selling) a call option on it. The premium adds income and provides limited downside cushion, but caps the upside at the strike price.
- Protective put
- Owning a stock and buying a put option on it. The put sets a price floor, limiting downside losses while keeping full upside (minus the premium paid). Like buying insurance.
- Collar
- Owning a stock, buying a protective put, and writing a covered call to help pay for it. The result is a bounded outcome: limited downside and limited upside, often at low or zero net cost.
- Long straddle
- Buying a call and a put with the same strike and expiration. It profits from a large price move in either direction; it loses if the underlying stays near the strike. A bet on volatility, not direction.
- Long strangle
- Buying an out-of-the-money call and an out-of-the-money put. Cheaper than a straddle but needs a larger move to profit. Also a long-volatility, direction-neutral position.
- Bull call spread
- Buying a lower-strike call and selling a higher-strike call. Lowers the cost of a bullish position and caps both the gain and the loss within the strike range.
- Interest-rate swap
- An agreement to exchange interest-rate cash flows — typically fixed for floating — on a notional amount. A floating-rate borrower can pay fixed via a swap to lock in its rate.
- Pay-fixed swap to hedge a floating loan
- A borrower with a floating-rate loan enters a pay-fixed, receive-floating swap. The received floating offsets the loan's floating payments, leaving a synthetic fixed-rate exposure.
- Swaption
- An option on a swap. A payer swaption gives the right (not the obligation) to enter a pay-fixed swap; useful when a manager wants flexibility, not a commitment, in an uncertain rate environment.
- Value at Risk (VaR)
- An estimate of the minimum loss expected over a set period at a given confidence level. A 1-day 95% VaR of $2 million means a 5% chance of losing at least $2 million over one day.
- How to read a 1-day 95% VaR of $2 million
- There is a 5% probability the portfolio loses $2 million or more over one day. VaR states a threshold loss at a confidence level — not the maximum possible loss.
- Limitations of VaR
- VaR ignores the size of losses beyond the threshold (tail risk), can understate risk if based on a calm period, assumes the chosen distribution, and varies with the method used to compute it.
- Conditional VaR (CVaR / expected shortfall)
- The expected loss given that the loss exceeds the VaR threshold — the average of the tail. It addresses VaR's blind spot about how bad losses get beyond the cutoff.
- Methods to estimate VaR
- Parametric (variance-covariance, assumes normality), historical simulation (uses past returns), and Monte Carlo simulation (random scenarios). Each makes different assumptions about the return distribution.
- Delta hedging
- Offsetting an option position's directional risk by holding an opposite position in the underlying equal to the option's delta, so small moves in the underlying are neutralized.
- Option delta
- The change in an option's price for a $1 change in the underlying. A call's delta runs 0 to 1; a put's −1 to 0. Delta approximates the hedge ratio.
- Equity futures to adjust beta
- Buying or selling stock-index futures changes a portfolio's effective beta quickly and cheaply, raising or lowering market exposure without trading the underlying stocks.
- Currency forward
- A contract to exchange currencies at a set rate on a future date, used to hedge known foreign-currency cash flows or portfolio exposures back to the base currency.
- Scenario analysis and stress testing
- Estimating portfolio losses under specific adverse scenarios (a rate shock, a market crash) rather than relying on a single probabilistic measure like VaR. Complements VaR for tail risk.
- Notional principal
- The reference amount on which a swap's or derivative's payments are calculated. It is generally not exchanged in an interest-rate swap; only the net interest difference changes hands.
- CFA Institute Code of Ethics
- Six aspirational principles requiring members and candidates to act with integrity, competence, diligence, and respect, and to place the integrity of the profession and clients' interests above their own.
- The seven Standards of Professional Conduct
- I Professionalism, II Integrity of Capital Markets, III Duties to Clients, IV Duties to Employers, V Investment Analysis, Recommendations and Actions, VI Conflicts of Interest, VII Responsibilities as a Member or Candidate.
- Standard II(A) — Material Nonpublic Information
- Members must not act, or cause others to act, on material nonpublic information. The correct response on receiving it is to refrain from trading and not pass it on until it is publicly disseminated.
- Material information
- Information a reasonable investor would want before making a decision, or that would affect a security's price if disclosed. Materiality plus non-public status triggers Standard II(A).
- Mosaic theory
- Reaching an investment conclusion by combining public information with non-material non-public information is permitted and is a defense against an insider-trading allegation.
- Soft dollars
- Client brokerage commissions used to buy research and services. Under the Soft Dollar Standards, these commissions are an asset of the client that the manager must use for the client's benefit.
- Soft Dollar Standards — key principle
- Brokerage is the client's property. The manager must seek best execution, use soft-dollar research to benefit the client, and disclose its soft-dollar practices.
- Asset Manager Code of Professional Conduct
- A voluntary code for firms covering six areas: Loyalty to Clients; Investment Process and Actions; Trading; Risk Management, Compliance, and Support; Performance and Valuation; and Disclosures.
- Best execution
- The duty to seek the most favorable terms reasonably available for client trades. A manager receiving a gift from a routing broker must still place trades to obtain best execution and disclose the gift.
- Standard III(D) — Performance Presentation
- Members must make reasonable efforts to ensure performance information is fair, accurate, and complete. It is the basis for not guaranteeing returns and for using time-weighted returns.
- Why a manager cannot guarantee a return
- Guaranteeing a specific return misrepresents the uncertainty of investing and violates the duty to present fair, fact-based expectations (Standards I(C) Misrepresentation and III(D)).
- Standard III(C) — Suitability
- Recommendations must fit the client's written objectives, constraints, and risk tolerance as set out in the IPS. The manager must reassess suitability when the client's situation changes.
- Standard VI(A) — Disclosure of Conflicts
- Members must fully and fairly disclose all matters that could impair their independence or objectivity, or interfere with duties to clients, employers, and prospects — for example, gifts or ownership stakes.
- Standard III(B) — Fair Dealing
- Members must deal fairly and objectively with all clients when providing investment analysis, recommendations, or taking action. Fair means equitable, not necessarily identical, treatment.
- Information barriers (firewalls)
- Procedures that restrict the flow of material non-public information between departments (such as investment banking and research) to prevent misuse and comply with Standard II(A).
- GIPS (Global Investment Performance Standards)
- Voluntary ethical standards for calculating and presenting investment performance so results are fair and comparable across firms. Only a firm, not a product, can claim compliance.
- GIPS composite
- A grouping of all of a firm's actual, fee-paying, discretionary portfolios managed to a similar strategy. To claim GIPS compliance a firm must include every such portfolio in at least one composite.
- Prudence and loyalty (Standard III(A))
- Managers must act with loyalty, prudence, and care, placing clients' interests before their own and the firm's, and managing assets in the clients' best interest.
- Sharpe ratio
- (Portfolio return − risk-free rate) ÷ standard deviation. It measures excess return earned per unit of total risk and is used to rank portfolios on a risk-adjusted basis.
- Information ratio
- Active return (portfolio minus benchmark) ÷ tracking error (active risk). It measures active reward per unit of active risk. An IR of 2.4% ÷ 4.0% = 0.60.
- Sharpe ratio vs information ratio
- The Sharpe ratio uses total risk and the risk-free rate; the information ratio uses active risk versus a benchmark. Sharpe evaluates standalone risk-adjusted return; IR evaluates active management.
- Treynor ratio
- (Portfolio return − risk-free rate) ÷ beta. It measures excess return per unit of systematic risk, appropriate when the portfolio is one part of a diversified whole.
- Jensen's alpha
- The portfolio's return minus the return CAPM predicts for its beta. A positive alpha means outperformance after adjusting for systematic risk.
- Brinson performance attribution
- Decomposes a portfolio's excess return versus a benchmark into an allocation effect (sector/asset-class weighting decisions) and a selection effect (security picking within groups).
- Allocation effect
- The portion of active return from over- or under-weighting sectors or asset classes relative to the benchmark, regardless of which securities were chosen within them.
- Selection effect
- The portion of active return from picking securities that out- or under-perform their group's benchmark, holding the group weights at benchmark levels.
- Valid benchmark properties (SAMURAI)
- Specified in advance, Appropriate, Measurable, Unambiguous, Reflective of current investment opinions, Accountable, and Investable. A good benchmark is set in advance and is investable.
- Why must a benchmark be specified in advance?
- So performance can be measured objectively against a standard chosen before the period, preventing managers from selecting a flattering benchmark after the fact.
- Time-weighted return (TWR)
- The compound growth rate of one unit of money, removing the effect of cash-flow timing. It is the standard for evaluating manager skill and is required under GIPS.
- Money-weighted return (MWR)
- The internal rate of return on a portfolio, reflecting the size and timing of investor cash flows. It measures the investor's actual experience, not the manager's skill.
- When does TWR differ most from MWR?
- When large external cash flows occur just before strong or weak performance. TWR neutralizes their timing; MWR is affected by it.
- Macro vs micro performance attribution
- Macro attribution analyzes a fund's results at the sponsor level (across managers and asset classes); micro attribution analyzes an individual manager's results against a benchmark.
- Risk-adjusted performance — why it matters
- Raw returns ignore the risk taken to earn them. Risk-adjusted measures (Sharpe, information ratio, Treynor, alpha) let investors compare managers on a fair, like-for-like basis.
- Custom (strategy) benchmark
- A benchmark built to reflect a manager's specific style or mandate when no standard index fits. It must still meet the SAMURAI properties to be valid.
- M-squared (M²)
- Adjusts a portfolio to the market's risk level using the risk-free asset, then compares returns. It restates the Sharpe ratio in percentage-return terms for easier interpretation.
- Investment policy statement (IPS) for a private client
- The formal document recording a client's return objectives, risk tolerance, and constraints — time horizon, taxes, liquidity, legal, and unique circumstances. It governs all portfolio decisions.
- Tax-loss harvesting
- Selling a security at a loss to realize a capital loss that offsets capital gains (and some ordinary income), reducing the client's current tax bill while keeping a similar market exposure.
- Behavioral bias — emotional vs cognitive
- Emotional biases stem from feelings and impulses (loss aversion, overconfidence, regret) and are hard to correct; cognitive errors stem from faulty reasoning or information processing and are easier to correct with education.
- Disposition effect
- The tendency to sell winners too early and hold losers too long to avoid realizing a loss. It is an emotional bias rooted in loss aversion.
- Loss aversion
- Feeling the pain of a loss more strongly than the pleasure of an equal gain. It leads investors to hold losing positions and take too little risk after losses. An emotional bias.
- Overconfidence bias
- Overestimating one's own knowledge or forecasting ability, leading to excessive trading and under-diversification. An emotional bias common among investors.
- Anchoring bias
- Relying too heavily on an initial reference point (such as a purchase price) when making decisions. A cognitive error that can be mitigated with discipline and data.
- Goals-based wealth management
- Organizing a client's plan around distinct goals (retirement, education, legacy), each with its own time horizon, priority, and sub-portfolio, rather than a single risk-return objective for all assets.
- Estate planning
- Structuring how a client's wealth will be transferred at death — through wills, trusts, and beneficiary designations — to carry out wishes, minimize taxes, and avoid probate delays.
- Wealth transfer
- Moving appreciated assets to the next generation or to charity in a tax-efficient way, using tools such as gifts, trusts, and the lifetime exemption, to maximize what heirs ultimately receive.
- Ultra-high-net-worth (UHNW) complexity
- Beyond larger portfolios, UHNW clients require integrated management of complex tax, estate, governance, and concentrated-position issues — often coordinated through a family office.
- Concentrated position
- A large, often low-basis holding in a single asset (e.g., founder stock) that creates outsized risk. Strategies include staged sales, exchange funds, hedging with options, and gifting.
- Leveraged buyout (LBO)
- Acquiring a mature, cash-generative company using a large amount of borrowed money secured against the target's assets and cash flows, aiming to improve it and exit at a profit.
- Venture capital
- Private financing for young, high-growth, often unprofitable companies in exchange for equity. High risk, illiquid, and reliant on a few large successes to drive returns.
- Private equity
- Investing in companies that are not publicly traded, chiefly through buyouts (mature firms) and venture capital (early-stage), typically via funds with long lock-ups and the J-curve return pattern.
- Distressed debt investing
- Buying the bonds or bank loans of companies in or near bankruptcy at deep discounts, aiming to profit from a turnaround, restructuring, or control of the reorganized business.
- Mezzanine debt
- Subordinated financing that ranks below senior debt but above equity, often with equity-like features (warrants). Used in buyouts; higher yield compensates for higher risk.
- Infrastructure investing
- Long-lived investment in physical assets such as toll roads, regulated utilities, airports, and pipelines. It offers stable, often inflation-linked cash flows and diversification, but is illiquid.
- Private real estate
- Direct or fund ownership of property. Compared with public REITs, it has lower liquidity and appraisal-based (rather than market-priced) valuations, but provides diversifying, income-producing exposure.
- Appraisal-based valuation
- Valuing illiquid private assets (real estate, infrastructure) by periodic appraisal rather than market trades. It smooths reported returns and understates true volatility and correlation.
- The J-curve (private equity)
- The pattern where a private-equity fund shows early negative returns (fees and write-downs before value is created), then rising returns as portfolio companies mature and exit.
- Private wealth vs institutional management
- Private wealth addresses individual concerns — personal taxes, life stages, behavioral biases, and estate goals; institutional management serves entities with defined objectives, longer horizons, and formal governance.
- After-tax return for a private client
- The return that remains after taxes on income, dividends, and realized gains. Private-wealth management emphasizes after-tax results because taxes materially reduce a taxable client's wealth.
- Asset location
- Placing tax-inefficient assets (bonds, REITs) in tax-deferred accounts and tax-efficient assets (low-turnover equities) in taxable accounts to maximize a client's after-tax return.
- Family governance
- The structures and agreements (family councils, charters, education) that help a wealthy family make collective decisions, prepare heirs, and preserve wealth across generations.
- Capital call (private markets)
- A demand by a private fund for committed capital from investors when an investment is made. Investors must hold enough liquidity to meet calls over the fund's life.
- Lifetime gifting vs bequest
- Gifting appreciated assets during life can remove future appreciation from the taxable estate and use the annual exclusion, often transferring more after-tax wealth than waiting to bequeath at death.
- Specialized pathways at Level III
- Candidates choose one of three pathways — Portfolio Management, Private Markets, or Private Wealth — accounting for 30–35% of the exam. The other ~65–70% is the core, taken by everyone.
- Roll yield (currency/commodity hedging)
- The return from the price difference between an expiring forward/futures contract and the new one rolled into. It can add to or subtract from a hedged or commodity position's return.
- Strategic vs tactical — risk source
- Strategic asset allocation sets the policy risk; tactical asset allocation adds active risk by deviating from policy to exploit short-term views. Performance is measured against the policy benchmark.
- Mental accounting (goals-based)
- Treating money differently based on its assigned goal or source. Goals-based allocation harnesses this by building a dedicated sub-portfolio for each goal rather than fighting the bias.
- Required probability of success
- In goals-based investing, the confidence level a client needs for a goal. Essential, near-term goals get a high required probability (safer assets); aspirational goals can accept a lower one.
- Liquidity-return trade-off
- Less-liquid assets (private equity, real estate) should offer an illiquidity premium. Investors with stable, long horizons can capture it; those needing cash soon cannot.
- Heuristic (cost-based) corridor
- Setting rebalancing bands by rules of thumb (e.g., ±5% of target) rather than formal optimization. Simple and common, but ignores correlations and transaction-cost differences across classes.
- Volatility drag on a portfolio
- Because losses require larger gains to recover, higher volatility lowers compounded (geometric) return for the same average return. Rebalancing and diversification help reduce it.
- Endowment / institutional time horizon
- Endowments have effectively perpetual horizons, supporting heavy allocations to equities and illiquid alternatives, balanced against an annual spending requirement.
- Pension liability duration
- The interest-rate sensitivity of a pension's promised payments. Surplus risk falls when asset duration is matched to this liability duration.
- Inflation and asset allocation
- Real assets (real estate, infrastructure, commodities, inflation-linked bonds) hedge inflation; long nominal bonds are most exposed to it. Allocations reflect the investor's inflation sensitivity.
- Sampling vs optimization (indexing)
- Stratified sampling matches an index across cells (sector, size); optimization uses a risk model to minimize tracking error for a chosen number of holdings. Both reduce holdings versus full replication.
- Risk budgeting (active management)
- Allocating a fund's active-risk (tracking-error) budget across managers or strategies in proportion to their expected information ratios, to maximize active return per unit of active risk.
- Fundamental law of active management
- Expected active return ≈ information coefficient × √breadth × active risk. Skill (IC) and the number of independent bets (breadth) drive value added.
- Breadth (active management)
- The number of independent active decisions a manager makes per year. Greater breadth, at the same skill level, raises the information ratio.
- Information coefficient (IC)
- The correlation between a manager's forecasts and actual outcomes — a measure of forecasting skill in the fundamental law of active management.
- Completeness portfolio
- A portfolio added alongside active managers to neutralize unintended factor or sector bets, so the overall fund's misfit risk versus the benchmark is removed.
- Bullet portfolio
- A bond portfolio concentrated around a single maturity. It outperforms when the yield curve flattens via the long end or steepens via the short end, depending on positioning.
- Barbell portfolio
- A bond portfolio split between short and long maturities, with little in the middle. It tends to benefit from increased curvature (the middle cheapening) relative to a bullet.
- Laddered portfolio
- Bonds spread evenly across maturities. It offers steady reinvestment, liquidity, and diversification of reinvestment risk, sitting between bullet and barbell in behavior.
- Contingent immunization
- A hybrid: manage actively while a surplus cushion exists, but switch to strict immunization if the portfolio falls to the level just sufficient to fund the liability.
- Multiple-liability immunization
- Immunizing a stream of future liabilities by matching the portfolio's duration to the liabilities' duration, ensuring the present value of assets covers each obligation as it comes due.
- Structural risk (immunization)
- The risk that a non-parallel yield-curve shift breaks an immunized portfolio. Minimized by keeping cash flows concentrated near the liability date (low dispersion).
- Active return
- The difference between a portfolio's return and its benchmark's return over a period. Positive active return means the manager added value relative to the index.
- Misfit (style) risk
- Active risk caused by a manager's portfolio differing from the broad benchmark because of a style or sector tilt, rather than from security selection.
- Index reconstitution effect
- The trading and price pressure when an index changes its constituents. Full-replication funds must trade at reconstitution, creating costs and tracking error.
- Risk governance
- The top-down framework — policies, risk appetite, oversight by the board and risk committee — that sets how an organization identifies, measures, and controls risk.
- Financial vs non-financial risk
- Financial risks (market, credit, liquidity) arise from markets and counterparties; non-financial risks (operational, model, legal, regulatory) arise from people, processes, and systems.
- Credit risk
- The risk a counterparty or issuer fails to make a promised payment. Managed with collateral, netting, diversification, and credit derivatives such as credit default swaps.
- Liquidity risk
- The risk of being unable to sell or fund a position without a large price concession. Managed by holding liquid reserves and matching asset and funding liquidity.
- Credit default swap (CDS)
- A derivative that transfers the credit risk of a reference entity: the buyer pays a premium and the seller pays out if a credit event (default) occurs. Used to hedge or take on credit risk.
- Beta adjustment with futures
- To raise portfolio beta from current to target, buy index futures equal to (target − current) × portfolio value ÷ futures price × futures beta; sell to lower it.
- Gamma
- The rate of change of an option's delta as the underlying moves. High gamma means delta shifts quickly, so a delta hedge must be rebalanced more often.
- Vega
- An option's sensitivity to a change in implied volatility. Long options are long vega — they gain when volatility rises, all else equal.
- Theta (time decay)
- The loss in an option's value as time passes, all else equal. Option buyers fight theta; sellers earn it.
- Cash-flow-at-risk (CFaR)
- A risk measure estimating the worst expected shortfall in operating cash flow over a horizon at a confidence level — used by corporations rather than VaR on a trading book.
- Hedging vs speculation with derivatives
- Hedging uses derivatives to reduce an existing exposure; speculation uses them to take on exposure for profit. The same instrument can serve either purpose depending on intent.
- Standard I(C) — Misrepresentation
- Members must not knowingly make any misrepresentation about investments or services, including guaranteeing returns or misstating performance or qualifications.
- Standard IV(A) — Loyalty to employer
- Members must act for their employer's benefit and not deprive it of their skills or divulge confidential information; this limits actions while still employed and around departure.
- Standard V(A) — Diligence and reasonable basis
- Recommendations and actions must rest on diligent research and a reasonable, adequate basis supported by appropriate investigation.
- Standard VII(B) — Reference to the CFA designation
- Members must not misrepresent or exaggerate the meaning of CFA Institute membership, the CFA designation, or candidacy in the program.
- Pension/fiduciary duty
- Acting solely in the interest of plan beneficiaries, with the care a prudent expert would use. A core duty that overrides the interests of the plan sponsor.
- Investment Process and Actions (Asset Manager Code)
- The Code section requiring managers to use reasonable care, prudent judgment, a reasonable basis, and to act in clients' best interests when managing portfolios.
- Trading priority (Standard VI(B))
- Client and employer transactions take priority over a member's personal transactions; personal trading must not disadvantage clients.
- GIPS verification
- An independent third-party review of whether a firm's policies and procedures for composite construction and performance calculation comply with GIPS. Recommended, firm-wide, but not required.
- Composite dispersion
- The spread of returns among the individual portfolios within a GIPS composite for a period — a measure of how consistently the strategy was applied.
- Required vs effective benchmark return
- Attribution compares a portfolio to a benchmark; using an inappropriate benchmark distorts the allocation and selection effects and can mislead the evaluation.
- Interaction effect (attribution)
- A residual attribution term capturing the combined impact of allocation and selection decisions — the part of active return not cleanly assigned to either alone.
- Gross-of-fees vs net-of-fees return
- Gross-of-fees returns exclude management fees; net-of-fees deduct them. GIPS requires clear labeling, and clients ultimately experience net-of-fees results.
- Appraisal vs transaction-based returns
- Illiquid assets reported on appraisals show smoothed, understated volatility versus transaction-based prices, complicating risk-adjusted performance comparisons.
- Survivorship bias
- Overstating average performance by excluding funds or portfolios that closed or failed. GIPS composites must include terminated portfolios for the periods they were managed to avoid it.
- Cognitive bias examples
- Conservatism, confirmation, representativeness, anchoring, availability, and framing — errors in reasoning or processing information that education and discipline can reduce.
- Risk profiling a private client
- Assessing both the ability (capacity, given wealth, horizon, goals) and the willingness (psychological tolerance) to take risk, then planning to the lower of the two and educating the client.
- Stages of the investor life cycle
- Accumulation (building wealth, higher risk capacity), consolidation/maintenance (preserving wealth nearing retirement), and spending/gifting (drawing down and transferring).
- Tax-deferred vs tax-exempt account
- Tax-deferred accounts tax withdrawals later; tax-exempt accounts are funded with after-tax money and grow tax-free. Asset location decisions exploit the difference.
- Charitable remainder trust
- An estate tool that pays the donor income for life, then leaves the remainder to charity, providing a current tax deduction and removing the asset from the taxable estate.
- Grantor retained annuity trust (GRAT)
- A wealth-transfer trust that pays the grantor a fixed annuity for a term, passing the remaining appreciation to heirs with little or no gift tax if the assets outgrow the IRS rate.
- Exchange (swap) fund
- A vehicle that lets holders of concentrated low-basis stock pool shares with others to gain a diversified position without immediately triggering capital-gains tax.
- Direct indexing
- Holding the individual securities of an index in a separate account to allow tax-loss harvesting at the security level and customization a pooled fund cannot offer.
- Carried interest
- The share of a private fund's profits (typically ~20%) paid to the general partner above a hurdle, aligning the manager's incentives with investors.
- Hurdle rate (private equity)
- The minimum return a private fund must deliver to limited partners before the general partner earns carried interest. Protects investors' preferred return.
- Vintage year
- The year a private-markets fund makes its first investments. Comparing funds by vintage year controls for the market environment when capital was deployed.
- Family office
- A private organization that manages the investments, taxes, estate, philanthropy, and governance of a wealthy family, integrating the many complexities UHNW clients face.
- Liquidity needs of a private client
- Cash required for spending, taxes, emergencies, and known outlays. Sizing illiquid alternatives must respect these needs, which differ greatly across clients.
- Behavioral coaching value
- Helping clients avoid panic selling and performance chasing — keeping them invested through volatility — is one of the largest sources of value a private-wealth adviser adds.
- Concentrated stock — monetization strategies
- Outright sale, hedging with a collar or prepaid variable forward, borrowing against the position, exchange funds, and charitable gifting each balance tax, risk, and liquidity differently.
