CFA Level I Exam · Basics of Portfolio Planning and Construction

Portfolio Construction Approaches and ESG Integration for CFA Level 1

Updated 7 October 2026 · Fact-checked

Portfolio construction approaches describe how a manager builds a portfolio. Top-down starts with macro views and works down to securities. Bottom-up starts with individual securities. Active tries to beat a benchmark, passive tracks it, and core-satellite combines both. ESG integration adds environmental, social and governance factors to analysis and selection.

Understand Portfolio Construction Approaches and ESG

A portfolio manager makes two kinds of decisions: which broad exposures to hold (countries, sectors, asset classes) and which securities to hold within them. The approach you choose decides where the process starts and how much effort goes into each decision.

Top-down investing starts with the macro picture: economic growth, interest rates, inflation and currencies. From that view the manager chooses asset classes, regions and sectors, and only then picks securities. Bottom-up investing starts with individual companies. The manager analyses business quality, financials and valuation, and lets the sector and country weights result from the stock choices.

Passive management aims to match the return of a benchmark index at low cost, usually by holding the index constituents or a sample of them. Active management aims to beat the benchmark after fees by deviating from it. Active management has higher fees and turnover, and it carries active risk (tracking error). Passive has low cost and low tracking error, but it cannot outperform the index and offers no protection when the index falls.

Core-satellite combines the two. The core is a large, low-cost, usually passive or low-active-risk holding that delivers broad market exposure. Satellites are smaller positions, often actively managed, that seek extra return or specific exposures. The aim is to spend the active-risk budget only where the manager has an edge, while keeping total fees down.

ESG stands for environmental, social and governance factors. ESG integration means considering these factors in analysis and portfolio construction because they may affect risk and return. Common approaches are negative screening (excluding sectors or companies), positive or best-in-class screening, thematic investing, impact investing, and engagement or active ownership through voting and dialogue. Integration can be applied inside a top-down or a bottom-up process, and with active or passive mandates.

Key formulas to remember

Active return: Active return = Portfolio return − Benchmark return; Positive means the portfolio beat the benchmark. Tracking error is the standard deviation of active returns.
Core-satellite portfolio return: Rp = wcore × Rcore + wsat × Rsat; Weights sum to 1. Use it as the usual weighted average.
Top-down vs bottom-up order: Top-down: macro → asset class/sector → security. Bottom-up: security → portfolio; The order of the decisions is the distinguishing feature.
Active vs passive trade-off: Active: higher fees, higher active risk, potential alpha. Passive: low fees, low tracking error, no alpha; Active return after fees must beat the benchmark for active to add value.

How to solve Portfolio Construction Approaches and ESG questions

Most questions give a short description of a manager or a mandate and ask you to classify it or judge its fit. Use this routine.

1Find the starting point of the process. Macro or asset-class view first means top-down. Company analysis first means bottom-up.
2Identify the objective: match the benchmark (passive), beat it (active), or both (core-satellite).
3Look for clues on cost, turnover and tracking error. Low cost and low tracking error point to passive or the core.
4If the portfolio has a large stable part and smaller opportunistic parts, think core-satellite.
5For ESG, name the method used: negative screening, best-in-class, thematic, impact, or engagement. Check whether it excludes, selects or influences.
6Check the investor's constraints in the stem, such as cost sensitivity, values or risk budget.
7Eliminate the two options that contradict a definition, then choose the best match.

Quickest way: Keyword matching for approach questions

When to use it: Use for classification questions where you have about 90 seconds.

Underline the first thing the manager does: macro view or company research.
Underline the goal: track, beat, or both.
Map ESG wording: exclude = negative screening; best scores in each sector = best-in-class; change company behaviour = engagement; measurable outcomes = impact.
Pick the option that fits all clues and drop the rest.

Common mistakes in Portfolio Construction Approaches and ESG

Calling a manager bottom-up because they pick stocks at the end.
Both approaches end in security selection.
Fix: Look at where the process starts. If macro views set sector weights first, it is top-down.
Assuming passive means no decisions or no risk.
Passive sounds hands-off.
Fix: Passive still has market risk and decisions on index choice and replication. It only has low active risk.
Thinking the core-satellite core must be actively managed.
Students confuse the satellite role with the core.
Fix: The core is typically passive or low-cost. Satellites carry the active bets.
Treating ESG integration as only exclusion of sinful sectors.
Negative screening is the best-known method.
Fix: Remember the full list: screening, best-in-class, thematic, impact and engagement. Integration means ESG factors enter the financial analysis.
Assuming ESG investing always sacrifices return.
Mixing up values-based goals with financial analysis.
Fix: ESG can be used purely to assess risk and return. Do not accept absolute claims in either direction.

Worked examples

Example 1

A manager first forecasts that global growth will slow and interest rates will fall. She then overweights defensive sectors and finally selects stocks within those sectors. Which approach does she use? A) Bottom-up active B) Top-down active C) Passive indexing

Show the solution

The process starts with a macro forecast, so it is top-down.
She deviates from the market weights on a view, so it is active.
Option A starts with companies, which contradicts the stem. Option C has no views, which also contradicts the stem.

Answer: B) Top-down active

Example 2

A portfolio holds 70% in a low-cost index fund returning 6.0% and 30% in actively managed satellites returning 9.0%. The benchmark returned 6.5%. What is the portfolio's active return? A) 0.4% B) 0.8% C) 2.7%

Show the solution

Portfolio return = 0.70 × 6.0% + 0.30 × 9.0% = 4.2% + 2.7% = 6.9%.
Active return = 6.9% − 6.5% = 0.4%.
Option C is only the satellite contribution to return, not the active return.

Answer: A) 0.4%

Exam tips

Questions are three-option and standalone, so identify the defining feature of each approach and eliminate on it.
Expect definitions in context: the stem describes behaviour and you name the approach.
For ESG, learn each method's one-line definition. Options often differ by only one word, such as exclude versus engage.
Core-satellite arithmetic is a weighted average. Do it carefully and then subtract the benchmark if asked for active return.
Watch for absolute words like always or never in options. They are often the trap.

Practice questions from Basics of Portfolio Planning and Construction

Portfolio Construction Approaches and ESG in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Portfolio Construction Approaches and ESG: frequently asked questions

What is the difference between top-down and bottom-up investing?

Top-down starts with economic and market views and moves to sectors and then securities. Bottom-up starts with analysis of individual companies and builds the portfolio from those choices. Both can be used by active managers.

How does a core-satellite portfolio work?

A large core gives low-cost broad market exposure, often through passive funds. Smaller satellites hold actively managed or specialised positions that try to add return. This limits fees while using active risk only where the manager has an edge.

What is ESG integration in portfolio construction?

It means including environmental, social and governance factors in analysis and security selection because they can affect risk and return. Methods include screening, best-in-class, thematic, impact investing and engagement.

What is the difference between active and passive management?

Passive management tracks a benchmark at low cost with low tracking error. Active management tries to beat the benchmark, which costs more and brings active risk. Whether active adds value depends on returns after fees.