30 essential terms and definitions for CFA Level III: Portfolio Management. Each definition is written for exam preparation, covering the concepts as they are tested on the 2026 syllabus.
Active return is the difference between a portfolio's return and the return on its benchmark over the same period. It is the value created by active investment decisions and the numerator of the information ratio.RA=Rp−Rb
Active risk is the standard deviation of active returns, also called tracking error. It quantifies the dispersion around the benchmark and serves as the risk budget for active management decisions.
Asset allocation is the long-run mix of asset classes that determines most of a portfolio's risk and return profile. Strategic asset allocation sets the policy mix; tactical asset allocation tilts away from it for short-term opportunities.
The Black-Litterman model blends investor views with equilibrium expected returns to produce more stable optimization inputs than raw historical estimates. It addresses the corner-solution and extreme-tilt problems of unconstrained mean-variance optimization.
Capital market expectations are forward-looking estimates of returns, volatilities, and correlations across asset classes. They drive strategic asset allocation choices and update with macro and valuation signals.
A strategy that borrows or sells a low-yielding currency or asset and invests the proceeds in a higher-yielding one, capturing the interest rate differential. It profits when uncovered interest rate parity fails to hold ex post.Rcarry≈ihigh−ilow−%ΔS
A liability-driven fixed income strategy that builds a bond portfolio whose coupon and principal payments coincide with the amount and timing of future liabilities. It eliminates reinvestment and interest rate risk for the matched horizon.
Currency hedging reduces the impact of foreign-currency volatility on foreign-asset returns. The minimum-variance hedge ratio depends on the correlation between the currency and the local asset and on relative volatilities; full hedging is optimal only when that correlation is zero.h∗=σC2σRC
The fundamental law relates expected active performance to the manager's forecasting skill (the information coefficient), the number of independent bets (breadth), and the transfer coefficient that captures implementation constraints.IR≈IC⋅BR⋅TC
A predetermined schedule that gradually shifts a portfolio's asset allocation, typically from growth assets toward fixed income, as an investor approaches a target date such as retirement or a defined benefit plan's de-risking trigger.
Goals-based investing organizes a client's wealth into sub-portfolios mapped to specific objectives (retirement, education, legacy), each with its own time horizon and risk tolerance. It accepts that mean-variance efficiency is sacrificed for psychological and behavioral fit.
A fixed income strategy that sets portfolio duration equal to the investment horizon (or liability duration) and matches present values so that price and reinvestment risk offset. Convexity and dispersion conditions ensure the portfolio remains immunized against parallel rate shifts.Dportfolio=Dliability
The information coefficient is the correlation between a manager's forecasts and the realized returns of the assets being forecast. A small positive IC, applied to enough independent bets, can produce attractive active performance under the fundamental law.
The information ratio is active return divided by active risk. It measures the consistency with which a manager creates value relative to the benchmark and is a key signal in manager evaluation.IR=σ(Rp−Rb)Rp−Rb
An investment policy statement codifies an investor's return objectives, risk tolerance, time horizon, liquidity needs, taxes, legal constraints, and unique circumstances. It also specifies the strategic asset allocation, rebalancing rules, and performance benchmarks.
LDI is a portfolio strategy that explicitly hedges the present value and duration of projected future liabilities. It is common at defined-benefit pensions and insurance general accounts, where the surplus relative to liabilities is the relevant risk metric.
Manager selection is the due-diligence process used to identify, evaluate, and monitor external portfolio managers. It covers investment philosophy and process, organizational stability, key-person risk, fee structures, and operational integrity.
A quantitative framework that constructs portfolios maximizing expected return for a given level of variance by combining expected returns, variances, and covariances. Outputs the efficient frontier but is highly sensitive to input estimation error.U=E(Rp)−0.5λσp2
Performance attribution decomposes a portfolio's active return into contributions from allocation, selection, and interaction effects relative to a benchmark. Brinson-Fachler is the canonical equity-attribution framework.
Rebalancing returns portfolio weights toward strategic targets after market movements have shifted them. Common methods include calendar-based, threshold-based (corridor), and percentage-range approaches; choice involves a tradeoff between drift risk and transaction costs.
Risk budgeting allocates total portfolio risk to asset classes, strategies, or managers rather than allocating capital. It treats active risk as a scarce resource and disciplines how much tracking error each component is permitted to consume.
Risk parity is a portfolio construction approach that equalizes the risk contributions of asset classes rather than their dollar weights. It typically overweights bonds (often with leverage) relative to a 60/40 baseline to balance equity and rate risks.
The return earned on a futures or forward position from the convergence of the futures price to the spot price as expiration approaches. It is positive in backwardation and negative in contango, and is a key driver of commodity and currency carry trades.
A measure that ranks portfolios by the number of standard deviations the expected return lies above a minimum acceptable return (shortfall threshold). The portfolio with the highest ratio minimizes the probability of returns falling below the threshold under a normality assumption.SF=σpE(Rp)−RL
The Sharpe ratio is excess return over the risk-free rate per unit of total volatility. It is the canonical risk-adjusted performance measure for total portfolios but penalizes upside and downside volatility equally.S=σpRp−Rf
The Sortino ratio is a variant of the Sharpe ratio that penalizes only downside volatility (returns below a minimum acceptable return). It reflects the asymmetric way investors experience loss versus gain.Sortino=σdownRp−MAR
Strategic asset allocation is the long-term target mix of asset classes intended to meet an investor's objectives over the planning horizon. It is the policy anchor against which tactical tilts and active manager risk are measured.
An asset allocation approach for institutions with liabilities that maximizes the expected return on the surplus (assets minus liabilities) per unit of surplus volatility. It explicitly incorporates the liability as a short position in the optimization.
Tactical asset allocation involves short-term deviations from the strategic mix to exploit perceived mispricings or market-timing signals. The size of permitted tilts is bounded by the IPS to prevent style drift.
Tracking error is the standard deviation of active returns. It measures how closely a portfolio follows its benchmark and serves as both a constraint and a budget for active management.
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