Two Quotes

A few days back I finished my first pass through CFA study guide Volume 5: Alternative Asset Valuation and Fixed Income. That is usually the point where I take some time to write and rave about what I learned and how exciting it all was.

But Volume 5 was not one of my favorites so I’ve been putting it off. Now I’m already 200 pages into Volume 6: Derivatives and Portfolio Management. I reckon I’d better write something, anything about Volume 5 before I forget what it was all about!

All Seasons
An Alternative Asset Class for All Seasons

In starting Volume 5, I wasn’t too juiced about the fixed income material but did have high hopes for the alternative assets part, an area of personal interest. “Alternative” of course means different things to different people. I was sort of hoping for something along the lines of movies, wine, and art. Instead I got apartments, hotels, shopping centers, private equity, commodities, and hedge funds. That was good enough for me though, and I enjoyed the readings. But the fun came to an end at only 1/3 of the way through the 500-page volume when I hit fixed income.

Fixed income is not my nemesis because it’s hard, but because I just don’t find it exciting. All this stems from a very broad brush I paint fixed income with:

    Limited Upside: If all goes as planned, you recover the periodic coupons and then the principal at maturity. Fluctuations in interest rates may make the bond worth slightly more (or slightly less) than what you paid for it should you decide to sell early.
    Unlimited Downside: If all doesn’t go as planned, the bond writer defaults, causing the loss of most or all of your coupon payments and principal.

So, slim to no opportunities for hitting a home-run combined with the possibility of taking a big loss. OK, the downside is not truly unlimited, but we’re talking about a rate of return probability distribution with a long tail on the left, short tail on the right, a.k.a. negative skewness. Boo! Sure bonds make up part of my asset allocation scheme, but I just mix in a little BND with a pinch of TIP and a dash of BWX and call it a day.

Apart from bonds, a lot of the fixed income part of Volume 5 is about asset-backed securities (CDO’s, CMO’s, MBS’s). It was actually nice to take a deeper look at some of these persona non grata’s of the current financial crisis. The diversification through loan pooling, and prepayment & default risk management through tranching, certainly made sense to me and I finished the reading thinking that if I was looking for fixed income, I wouldn’t be scared of ’em!

I guess the big problem is that just as owning a bunch of different stock tickers doesn’t guarantee diversification, neither does owning a pool of loans. Couple that with questionable credit ratings and the result is that you don’t really know what you’re buying these days. The CFA readings focus more on prepayment risk, with your greatest concern being the early return of your principal if interest rates drop, so you end up shopping for new investments right at the time when yields are low.

Before I leave Volume 5, let me just say that if you enjoyed the abridged Reading 53: The Liquidity Conundrum, you can download an unabridged podcast lecture by the same author here. It’s the humorous Paul McCulley from PIMCO speaking, but if you close your eyes and do a little visualization, you’ll swear it’s Tommy Lee Jones!

Want to end today with two tidbits of advice that might be helpful to fellow candidates.

First, if you hit a slow chapter or even a slow whole volume in the CFA curriculum, make sure you spend an hour on it every day so that you eventually make it on to something else more interesting! Otherwise the pain just drags on and on. Or, more succinctly…

“If you’re going through hell, keep going.”
Winston Churchill (not Rodney Atkins!)

And second, since we’re speaking of regular study routines, you should have every intention of spending 1-2 hours a day on your CFA studies, just to make sure that you actually log 4-5 hours per week. Or, more poetically…

“One must think like a hero to behave like a merely decent human being.”
May Sarton (not John le Carré!)

The derivatives volume is proving interesting and I’ll write more about it when I come out the other side. Is it exciting? Let’s just say that after years of dragging my feet, I’m finally filling out the paperwork to enable options trading for my online account. Financial weapons of mass destruction? Bah!

My logged study time so far for the Level 2 exam:

Read/Work Problems of Volume 1: 26 hours
Read/Work Problems of Volume 2: 15 hours
Read/Work Problems of Volume 3: 13 hours
Read/Work Problems of Volume 4: 32 hours
Read/Work Problems of Volume 5: 19 hours
Total Preparation Time So Far: 105 hours

Update: I finally passed all the CFA exams and wrote an eBook about the program. If you’re interested, click here.