Module 11: Portfolio Management
Portfolio Management in CFA Level 2 focuses on advanced portfolio construction techniques, institutional investing, and performance evaluation.
Unlike Level 1, which introduces basic concepts, Level 2 emphasizes:
- managing large institutional portfolios
- applying risk budgeting techniques
- evaluating active vs passive strategies
- measuring performance using risk adjusted metrics
This module is essential for careers in asset management, wealth management, and institutional investing.
Portfolio construction involves selecting assets and allocating capital in a way that maximizes returns for a given level of risk.
At Level 2, the focus is on building portfolios using structured frameworks.
Risk budgeting involves allocating risk across different assets rather than simply allocating capital.
Instead of asking
How much money should be invested in each asset
The focus is
How much risk should each asset contribute to the portfolio
Key Concept
Total portfolio risk is distributed among different investments.
For example:
- equities may contribute higher risk
- bonds may contribute lower risk
Risk budgeting ensures that no single asset dominates overall portfolio risk.
Benefits of Risk Budgeting
- better control over portfolio risk
- improved diversification
- more efficient allocation of capital
Portfolio managers can follow either active or passive investment strategies.
Active Management
Active management involves selecting securities with the goal of outperforming the market.
Characteristics include:
- frequent trading
- higher research costs
- potential for higher returns
Risks include:
- underperformance
- higher fees
Passive Management
Passive management involves replicating a market index.
Characteristics include:
- lower costs
- minimal trading
- consistent market returns
Passive strategies are widely used in index funds and exchange traded funds.
Comparison
Active management aims to generate excess returns, while passive management aims to match market performance.
Investors choose between the two based on their risk tolerance, cost considerations, and belief in market efficiency.
Asset allocation is the process of distributing investments across different asset classes such as equities, bonds, and alternative investments.
It is one of the most important decisions in portfolio management because it determines the overall risk and return profile.
Strategic asset allocation is a long term approach where target weights are assigned to different asset classes.
Example:
- 60 percent equities
- 30 percent bonds
- 10 percent alternatives
These allocations are based on:
- investor goals
- risk tolerance
- investment horizon
Tactical asset allocation involves short term adjustments based on market conditions.
Example:
- increasing equity exposure during economic expansion
- shifting to bonds during market downturns
Tactical allocation allows portfolio managers to take advantage of market opportunities.
Over time, asset weights may change due to market movements.
Rebalancing involves adjusting the portfolio back to its target allocation.
Benefits include:
- maintaining desired risk level
- enforcing disciplined investment strategy
Performance measurement evaluates how well a portfolio has performed relative to its risk.
In Level 2, the focus is on risk adjusted performance metrics.
Risk adjusted return measures how much return is generated for each unit of risk.
Sharpe Ratio
Sharpe Ratio measures excess return per unit of total risk.
Sharpe Ratio Formula
Sharpe Ratio = (Portfolio Return − Risk Free Rate) / Standard Deviation
A higher Sharpe ratio indicates better risk adjusted performance.
Treynor Ratio
Treynor Ratio measures return relative to systematic risk.
Treynor Ratio Formula
Treynor Ratio = (Portfolio Return − Risk Free Rate) / Beta
This is useful for well diversified portfolios.
Jensen Alpha
Jensen Alpha measures the excess return generated by a portfolio compared to expected return.
Positive alpha indicates outperformance.
Negative alpha indicates underperformance.
Performance measurement helps investors:
- evaluate portfolio managers
- compare investment strategies
- assess whether returns justify risk taken
This module is important because it helps candidates:
- construct efficient portfolios
- manage institutional investments
- evaluate active and passive strategies
- measure performance accurately
In CFA Level 2, questions often require candidates to analyze portfolio strategies and interpret performance metrics, making this a high scoring conceptual module.