Sunday 14 September 2014

The Value of a CFA Education

I took a course in Masters in Applied Finance and sat for the Chartered Financial Analyst (CFA) examinations in 2004 - 2006. The purpose of studying and sitting for the CFA exams was to understand the various economics, accounting and investment concepts so as to be a better investor. Hence, the topic of this blog post applies to an investor rather than a person working in the financial industry.

The CFA programme covers very wide topics, as follows:
  • Ethical and Professional Standards
  • Quantitative Analysis
  • Economics
  • Financial Statement Analysis
  • Corporate Finance
  • Portfolio Management
  • Equity Analysis
  • Fixed Income Analysis
  • Derivatives
  • Alternative Assets
  • Portfolio Performance Measurement & Reporting
  • Risk Management

Note that there have been some changes to the curriculum since I sat for the exams. You can find the latest curriculum at CFA Program Study Sessions.

Has the programme been useful to an investor who starts from scratch and has no formal education in investing previously? I describe some of the more relevant topics to investors and their usefuln below.

Financial Statement Analysis (FSA) is by far the most important topic as investors need to read financial statements regularly to understand how the companies are doing. FSA teaches how to understand the various items in the financial statements and the various accounting methods. For example, inventory could be recorded as first-in-first-out, last-in-first-out, or weighted-averaged. The different accounting methods will lead to different values in the balance sheet depending on whether prices are rising or falling. Adjustments will therefore need to be made when comparing companies adopting different inventory accounting methods. Also covered in FSA is how to identify red flags where there could be accounting irregularities. However, although providing the basic grounding necessary for understanding companies, FSA does not discuss what are the important items that investors should look out for when prospecting for a company, such as having low debt, high free cash flow, etc.

Equity Analysis teaches the various valuation methods that you can use to determine the intrinsic value of a stock, such as Discounted Dividend Valuation, Free Cashflow Valuation, Market-Based Valuation (e.g. Price/Earnings, Price/Book multiples, etc.) and Residual Income Valuation. However, it does not advise what kind of input parameters (e.g. dividend growth rate, rate of discount for Discounted Dividend Valuation) you should use for each stock analysis. You need to assume the input parameters and hope that they turn out to be correct. 

Portfolio Management teaches about the Modern Portfolio Theory, which is based on that fact that when 2 risky assets are put together in a portfolio, the combined risk (volatility) is less than that of the individual risky assets. It also discusses the Efficient Market Hypothesis (EMH), on whether the market prices reflect all known (including private) information about the economy, industry and company. Here, it discusses and concludes that the market generally reflects all known information and hence, Technical Analysis should not work. However, there are anomalies running counter to EMH such as the calendar effects and small-sized/ neglected companies producing better returns than larger companies with better analyst coverage. Portfolio Management also discusses the Capital Asset Pricing Model (CAPM), which essentially says that to get better returns, you need to take higher risks (beta). 

Risk Management (which was taught more in-depth during the Masters course) discusses what are the potential risks based on past case studies and teaches how to measure risk exposure using the Value-at-Risk method. 

The above are some of the more relevant topics to a investor. As an investor, I find the following topics to be most useful: 
  • Financial Statement Analysis (for finding companies to buy)
  • Fixed Income Analysis (for analysing bond prices & understanding bond features) - see Fixed Income blog posts
  • Risk Management (for computing risk exposure) - see Risk Management blog posts
  • Economics (for understanding how the economy works)
  • Derivatives (for understanding the effects of structured warrants) - see Structured Warrant blog post

Due to the short space allocated for each topic above, I cannot completely describe what these topics teach. Generally, the CFA curriculum is useful for providing a basic grounding on the various concepts and methods, but it does not show what an investor should look out for. As an example, after passing my CFA exams in 2006, I still have investments that were completely wiped out. However, there also have been benefits from the programme. I narrowly avoided the Mini-bonds after reading through their prospectus and understood the effects of structured warrants that were prevalent in Singapore just several years ago. See Investing Is A Life-Long Learning Journey for more info.

In conclusion, CFA builds up your foundations, but do not expect the market to give you additional respect simply because you pass your CFA exams.

See related blog posts:

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