Portfolio Construction L2

Section: Portfolio Construction — Level 2 Estimated study time: 60 minutes Content: Portfolio construction at CFA Level 2 applies the mean-variance optimization (MVO) framework of Markowitz to practical portfolio management, including the capital market line, the efficient frontier, and the role of risk-free assets. The efficient frontier represents all portfolios that maximize expected return for a given level of risk (standard deviation) or minimize risk for a given expected return, when only risky assets are considered. Adding a risk-free asset creates the Capital Market Line (CML): E(Rp) = rf + [(E(Rm) - rf) / sigma_m] * sigma_p, where the slope is the Sharpe ratio of the market portfolio. All investors, regardless of risk preferences, hold a combination of the risk-free asset and the tangency portfolio (which has the highest Sharpe ratio on the efficient frontier). Risk preferences determine the proportion allocated to each. The Capital Asset Pricing Model (CAPM) extends this by identifying the market portfolio as the tangency portfolio when all investors face identical expectations and the same opportunity set. CAPM: E(Ri) = rf + beta_i * [E(Rm) - rf], where beta_i = Cov(Ri, Rm) / Var(Rm). Alpha (Jensen's alpha) = Actual Return - CAPM Expected Return = Ri - [rf + beta*(Rm - rf)]. Positive alpha indicates the security outperformed its risk-adjusted expected return; negative alpha indicates underperformance. At Level 2, candidates must evaluate active investment strategies by computing information ratio, Sharpe ratio, and alpha, and understand how the Fundamental Law of Active Management connects an analyst's forecasting skill (IC) to portfolio performance: IR = IC * sqrt(breadth), where IC is the information coefficient (correlation between forecasts and outcomes) and breadth is the number of independent investment…