Portfolio Construction: CFA® Level II

It is 10–15% of the 2027 Level II exam. 52 learning outcomes across 6 learning modules.

100+ practice questions and 0 formula cards on this topic in the app.

Economics and Investment Markets

• Explain why an economic factor can move market values only by acting on at least one of three channels: default-free rates at each maturity, how large and how soon expected cash flows are, and risk premiums
• Explain how expectations, and revisions to them, drive the prices markets set on assets
• Set out how an economy's long-run growth rate and the volatility of that growth relate to the typical level of real short-term rates
• Explain how each stage of the business cycle shapes policy and short-term rates, the steepness of the yield curve, and how bonds of shorter and longer maturity perform against each other
• Set out what drives the yield gap between conventional bonds and inflation-linked bonds
• Explain how credit spreads, and returns on credit-sensitive fixed-income securities, shift as the business cycle moves through its stages
• Explain how the nature of the markets a company sells into bears on its creditworthiness
• Explain how the equity risk premium is linked to how well equities hedge consumption
• Explain how the stage of the business cycle shapes expectations for earnings growth over both short and long horizons
• Set out how valuation multiples change over the business cycle
• Set out the economic drivers of investment in commercial property

Analysis of Active Portfolio Management

• Explain how the value that active management adds is gauged
• Work out the information ratio on both an ex post and an ex ante basis, explain what it means, and contrast it with the Sharpe ratio
• Set out and explain the fundamental law of active management for portfolios and each of its terms: breadth, the information coefficient, the transfer coefficient, and active risk (aggressiveness)
• Explain how the information ratio can help in picking investment managers and in deciding how much active risk a portfolio should carry
• Contrast active strategies such as security selection and market timing, and use active management's fundamental law to assess shifts in strategy
• Set out where active management's fundamental law is useful in practice and where it falls short

Exchange-Traded Funds: Mechanics and Applications

• Explain how ETF shares are created and redeemed and what role authorized participants play
• Set out how ETF shares change hands on the secondary market
• Set out where ETF tracking error comes from
• Set out what influences the bid–ask spread on an ETF
• Set out why an ETF can trade above or below its NAV
• Set out what an ETF costs to hold
• Set out the risks ETFs carry
• Recognise and explain the ways ETFs can be used in a portfolio

Using Multifactor Models

• Explain arbitrage pricing theory (APT), the assumptions it rests on, and how it connects to multifactor models
• Say what an arbitrage opportunity is and judge whether one is present
• Work out an asset's expected return from its sensitivities to each factor and the risk premium on each factor
• Explain and contrast the three kinds of factor model: macroeconomic, fundamental, and statistical
• Set out how multifactor models are applied and explain what the results of such analyses show
• Explain what investors can gain by modelling asset returns across several dimensions of risk rather than one
• Explain where active risk comes from, and interpret the information ratio and tracking risk

Measuring and Managing Market Risk

• Explain how value at risk (VaR) is applied to gauge the risk of a portfolio
• Contrast three ways to estimate VaR: Monte Carlo simulation, historical simulation, and the parametric (variance–covariance) method
• Estimate VaR by Monte Carlo simulation, by historical simulation, and by the parametric method, and explain what each result means
• Set out the strengths and weaknesses of VaR
• Set out the ways VaR has been extended
• Explain sensitivity and scenario risk measures and weigh them against VaR
• Show how exposure measures for equities, fixed income, and options can help gauge and control market risk and volatility risk
• Set out how sensitivity and scenario risk measures are applied
• Set out the strengths and weaknesses of sensitivity and scenario risk measures
• Explain the limits used to control market risk, among them stop-loss limits, scenario limits, position limits, and risk budgeting
• Explain how risk measures can guide decisions on allocating capital
• Set out the risk measures relied on by insurers, pension funds, asset managers, and banks

Backtesting and Simulation

• Set out what backtesting an investment strategy aims to achieve
• Set out and contrast the stages and procedures involved when a strategy is backtested
• Interpret the metrics and charts that a strategy backtest reports
• Spot flaws in the backtest of a strategy
• Assess and interpret an analysis based on historical scenarios
• Contrast the Monte Carlo approach to simulation with the historical approach
• Explain the inputs and choices a simulation involves and interpret what it produces
• Show how sensitivity analysis is applied