There is one day a year that strikes fear in grown men and women across the globe. No, it’s not Halloween, Friday the 13th or even The Mexican Day of the Dead — it’s June 3rd, CFA Exam day! The Chartered Financial Analyst exams are an academic marathon, putting candidates through a full day of stress and strain. It represents the culmination of months of preparation and studying.
For Level II and III CFA exam takers, failure means they must wait a full year to re-take the exam. Ouch. Only Level I is offered another time (in early December), much to the chagrin of old-time charter holders.
The CFA Institute wants their curriculum (known as the Body of Knowledge) to be as relevant as possible, so every year they solicit input on new material from sources including investment management professionals, academic professors, and financial regulators.
The CFA Institute hopes this keeps the CFA program the gold standard among all the various financial designations. It also ensures that CFA members have the most up-to-date information to best serve their clients.
Three Major 2017 CFA Exam Changes
2017 brings 11 topics with changes from 2016’s exam. We take a look at a few of the coming changes, specifically in the ESG, portfolio management, and derivative areas.
A Focus on Environmental, Social, and Governing Policies
The CFA Institute is increasing its focus on ESG (Environmental, Social, and Governance) policies by corporations. They are wasting no time in implementing the changes, starting right in Level I. A lack of corporate governance played a substantial role in the financial crisis. Recently, a lapse in corporate governance cost Volkswagen (and its shareholders) billions of dollars in market capitalization as a result of their emissions-testing scandal.
Efforts must be made by management to prevent ESG lapses. Realigning executive compensation to mitigate excessive risk-taking, improving Board of Director oversight, and increasing both internal and external auditing are just a few examples.
Weak corporate governance is a negative factor that should be incorporated into the traditional fundamental analysis. It is especially important for credit analysts, tasked with determining a borrower’s ability to service outstanding debt obligations.
The rise of activist investors is one area that can be viewed from an ESG perspective. Critics argue these investors are only interested in benefitting the equity owners (shareholders) at the expense of other stakeholders such as bondholders and employees.
For example, an activist investor such as Carl Icahn may take a sizeable equity stake in a company. Given their new voting power, they can push management on ‘shareholder friendly’ policies like share repurchases and increased dividend payouts. While this may enhance overall shareholder returns, it can have unforeseen consequences.
For one, it may be a short-term benefit at the expense of longer-term investments in Research and Development, sacrificing a company’s future growth engines. Further, the cash outflows used for the dividends could lower the corporation’s debt service ratio to a level that breaches a bond covenant or warrant a credit downgrade. Sometimes the activist levers up the company, using the proceeds of new debt issuance to increase dividend payouts-clearly favoring shareholders in lieu of existing bondholders. The claim on residual cash flows is an ever-evolving tug-of-war between shareholders and bondholders.1
Emphasizing Algorithmic Trading
Falling under Level II’s Portfolio Management section, algorithmic trading is emphasized in greater detail on the CFA exam this year. This is very relevant, considering an estimated 75% of U.S. stock trades are placed by computer algorithms and not humans.2
There are two main types of algorithms, execution algorithms, and high-frequency algorithms. Execution algorithms are utilized by hedge funds and other asset managers to minimize the market impact of a large order.3 It turns one large order into many small orders so as not to disturb the market.
Execution algorithms can also be used to hide an order’s origin. For example, if Ray Dalio of Bridgewater Associates decides to take on a new position in a thinly traded stock, a huge buy order could tip his hand to the market, ruining his chances of buying the security at a reasonable price.
High-frequency algorithms are the wave of the future. These are self-learning strategies that can make decisions and trades on their own, without human interaction.4 These have been a thorn in the side of market makers for decades, scalping profits at their expense.
One unlikely area that is embracing the use of algorithms is the compliance department. Considering the power that these algorithms have, there is concern that a mishap could bring down an entire firm. This happened spectacularly to Knight Capital in 2012. Consequently, compliance algorithms are the newest watchdog in monitoring HFT algorithms-ensuring that operations remain within regulations and don’t endanger the firm.5
Valuation of Contingent Claims
Contingent claims are derivatives that provide the owner the right, but not the obligation, to a payoff depending on the value of an underlying security, benchmark or interest rate.6 Option owners have a claim, contingent, or depending, on whether the option is in, at or out of the money. It is this contingency that allows them to share in the upside while avoiding the downside.7
The newly emphasized material in the derivatives section of Level II reassesses how portfolio managers use options to hedge an investment portfolio. The tried-and-true metric has been to use delta when constructing portfolio hedging strategies. Delta is the predicted change in a portfolio for a given change in an underlying security, all else held equal. The goal of delta hedging is to create a delta neutral portfolio.
The new material posits that incorporating gamma can minimize the error involved in delta hedging strategy. Gamma is the rate of change of delta, given a move in the underlying security. It is known as the ‘delta of delta’.
The proper valuation of options is obviously essential to accurately hedge an investment portfolio. In short, a more accurate estimation of a change in an option’s value must also incorporate gamma, not just delta, in the calculation.8
In other words, portfolio managers may not have been as ‘hedged’ as they thought. A downturn in the markets would surely put these hedging strategies to the test.
Considering a Master’s Degree?
While it’s great that the CFA exam incorporates new material every year, many MBA programs also refresh their curriculum. But while the CFA vs MBA debate rages on among finance professionals, it really isn’t an apples-to-apples comparison. Remember, the CFA program is more focused on investment management while a traditional MBA covers a much broader business curriculum.
A Master’s in Finance (MSF) versus CFA might be a better-fitting debate since the material covered is very similar in nature. While the MSF program is likely the more expensive choice, it can be completed in much less time as the CFA program. But both programs are fantastic, with more and more professionals obtaining both.
Universities are realizing the merits of pursuing both credentials. For example, Creighton University offers a Masters of Investment and Financial Analysis degree in partnership with the CFA Institute. The curriculum for the Master’s program comes directly from the CFA program’s Body of Knowledge so ambitious students can receive a Masters-level finance degree while also preparing for the CFA exam.
This program is also offered online, adding flexibility for working professionals trying to advance their careers. And like the CFA curriculum updates, Creighton’s program is updated annually to keep pace with industry changes.
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