The CFA Level III exam is the last in the series of three exams conducted by the CFA Institute. Coupled with at least 48 months of relevant work experience, successful completion of the final level yields a charter membership. While the first two levels revolved around basic financial knowledge, investment valuation comprehension and the application of both, the CFA Level III exam focuses on portfolio management and wealth planning.
The format of the exam, which is only offered in June, is a mix of item set questions (similar to Level II) and essay type questions. Like the other exams, the Level III exam is also conducted in two parts - the morning and afternoon session. In the morning session, there are 10 to 15 essay type questions. Each question consists of multiple parts such as A, B, C, etc., which help you organize your answer in a template. These questions may provide you with a situation and ask you to develop your own recommendation or solution. In the afternoon session, there will be 10 item sets. Each item set consists of a case statement followed by six multiple-choice questions. The exam is graded for 360 points, which corresponds to one point per minute.
As mentioned earlier, the focus of the exam is on portfolio management and wealth planning, but it also covers seven topics that are grouped into two other areas, namely, Ethical and Professional Standards and Asset Classes. The following table provides weighting of these topics and broad areas for the exam:
|Topic Area||Level III|
|Ethical and Professional Standards (total)||10|
|Investment Tools (total)||0|
|Financial Reporting and Analysis||0|
|Asset Classes (total)||35-45|
|Portfolio Management and Wealth Planning (total)||45-55|
As is evident from the table, the Ethics and Professional Standards gets as much importance as in the other levels of the exam. The investment tools are not tested separately, except economics, which is a part of the portfolio management and wealth planning section for level III. The majority of the exam revolves around portfolio management and asset classes in the portfolio context.
In level III, standards primarily consist of the Code of Ethics and Global Investment Performance Standards (GIPS). Standards account for 10% (i.e., 36) of the 360 possible points. The Code of Ethics section will most likely be an item set in the afternoon session. However, GIPS could be tested either as an essay question in the morning session or as an item set in the afternoon session.
The exam tests your knowledge on all of the major asset classes, including alternative investments, derivatives, equity investments and fixed-income investments. However, the focus is now on the portfolio management aspects of these investments. For example, a whole session is dedicated to the management of active and passive fixed-income portfolios, covering investment objectives, benchmarking, return analysis, portfolio immunization strategies, relative value analysis and so on. The syllabus also covers strategies used in international and emerging markets and how derivatives are used to manage interest rate and credit risks in fixed-income portfolios.
The second asset class is equity securities, which are an essential component of most investment portfolios and crucial for the portfolio's success. The discussion here surrounds equity investment strategies, evaluation of equity fund managers and equity indexes. The syllabus also discusses the corporate governance issues related to conflicts between managers and shareholders that erode value and have a direct impact on equity portfolio managers. Finally, there is discussion on measuring and managing portfolios in international and emerging markets.
The section on alternative investments primarily discusses the alternative investment classes and how derivative instruments such as swaps, futures and forwards are used to manage some alternative investments.
Portfolio Management and Wealth Planning
This comprises the largest portion of the exam and will account for at least 180 points out of the 360 possible points. Portfolio management concepts will dominate both the morning and afternoon sessions. The syllabus is very comprehensive and introduces new concepts such as behavioral finance, which forms the basis for financial decision making. Risk management concepts, covering tools and techniques for measuring and managing risk are also discussed. Apart from these, you are likely to be tested on questions related to individual and institutional wealth.
The number of concepts that can be tested are limited but are important. One such important concept is the Investment Policy Statement and its components, which is highly testable. Economics, which was a part of the investment tools in level I and II, is included under portfolio management in the exam. Other important concepts are managing portfolios of institutional investors, asset allocation, risk management applications and evaluating portfolio performance.
Within the portfolio management section, the CFA Institute provides no hints about which topics are more important. However, it does make available essay questions from previous years, which can be very useful for practicing and developing your exam strategy.
The Bottom Line
The Level III exam is considerably one of the tougher exams for the CFA, as many of the questions are posed in essay format. The key to success is to practice as many essay type questions as possible and master topics specifically related to portfolio management, which is at the heart of this exam.
While I’m generally not one to recommend ‘gaming’ the CFA exams, knowing which topic areas and material has a better chance at showing up on the essay section of the Level 3 exam can help out big time. The afternoon section is worth just as many points and you still need to master all of the curriculum, but the morning section can make or break your day.
First, a disappointing experience in the morning can devastate your confidence and ruin your concentration during the afternoon. You need to go into the exam feeling like you’re going to pass and carry that optimism all the way through. Secondly, there are questions that are more suitable and do show up in the essays. Preparing for these through practicing old exams will put you way ahead anyone on test day.
Your first question on the exam will always be an individual portfolio management question. The individual management question is usually around 12% of the exam (44 points) and will either be a multi-period return or a single-period return. Within the question you’ll often see questions on taxes, investor behavior and estate planning but the core is built around the return objective, risk tolerance and the five constraints. We’ve covered a few of these in the past, linked here and here for review.
An institutional portfolio management question usually follows directly but last year it didn’t come until #6, but you will always see one. It is usually around 36 points (10% of the total exam) but ranges from 24 to 49 points. There’s really no way of knowing which institution type will show up but make sure you know the basic comparisons between them all for the IPS components. We’ve done a couple of past questions, linked here.
Practicing several (at least) old individual and institutional questions from past exams will make your day on that first Saturday of June. Imagine starting the exam being totally confident and easily completing the first two questions and knowing you’ve just aced about 20% of the exam!
Economics has been in the morning section in each of the last four years and has been worth an average of 11% of your morning score. Biases and sources of error in data is a popular topic along with one of the economic measurement tools (tobin’s q, fed model, cobb douglas, h-model, yardeni ). We ran through the 2011 Economics question here.
Risk management is often in the morning section, though it skipped last year. The question is usually about 10% of your morning score and often has a question about hedging with options, forwards, futures or swaps.
Asset allocation is another that usually shows up but was skipped last year. Some will say that this makes it more likely to show up in an essay this year but there’s no real proof of it (though I would agree from what I’ve seen in the past tests). The question is around 15 points (about 8% of your morning score) and will often be a selection of an appropriate portfolio or calculation of corner portfolios. The basic concepts, differences and advantages/disadvantages of the portfolio techniques is also something that has come up in the past (Black-Litterman, Mean Variance Opt., resampled efficient frontier, Monte Carlo). Linked here is the 2011 Asset Allocation Question.
Performance evaluation and the material on monitoring/rebalancing are also frequent essay questions. Each has had a question in three of the last four years with an average of about 15-17 points. Make sure you can do a micro- and macro-attribution for performance evaluation as well as breaking total return down into its components. The buy/hold, constant mix, and cppi methods of rebalancing often show up as questions so make sure you spend some time there as well.
The material on fixed income and equity investments also frequently find themselves into an essay question though no specific formulas or processes jump out as regulars. Even if you receive a question in the morning section, the topics are a fairly large percent of your total score so you may get a question in the afternoon as well.
The material in corporate finance, financial reporting & analysis, and quantitative methods don’t usually show up in the morning section. The material in alternative investments shows up only rarely, with a question on swaps and futures in 2009 (question #8).
We cover study session 18 next week and will spend the last few weeks reviewing and talking about test day. Let me know if you have any questions,
‘til next week, happy studyin’
Joseph Hogue, CFA
Last updated: October 27, 2017 at 2:50 am