6.4 Portfolio Management Styles

A number of corporations offer dividend reinvestment plans (DRIPS) where the client's dividends are automatically reinvested in additional shares of the issuer. In the case of a company that pays dividends with some degree of regularity, if the market price per share has declined over the year, an investor participating in one of these plans would find which of the following to be true (assume no splits)? A) There are more shares in the investor's account. B) There are fewer shares in the investor's account. C) The value of the investor's account has gone up. D) The value of the investor's account has gone down.

Answer: A With the dividends reinvested, there will be more shares. Although the market price per share has declined, we don't know the aggregate account value (with the additional shares) so we don't have enough information to tell if the overall value has risen or declined.

Market timing is normally associated with which of the following portfolio management styles? A) Modern portfolio theory. B) Tactical asset allocation. C) Strategic asset allocation. D) Passive management.

Answer: B Tactical asset allocation, which attempts to capitalize on short-term market swings, is a market timing strategy.

Which of the following are asset classes? A) Large cap stock funds B) Forward contracts C) REITs D) Options

Answer: C The general consensus is that the major classes, for purposes of an asset allocation program, are equity, debt, cash (or cash equivalents), real estate, and commodities. Large cap stock funds are not an asset class; they are a way to invest in the asset class known as equity. Derivatives, such as options, are not generally considered an asset class, and it is the actual commodity (precious metals, oil, and so forth), not a forward or futures contract, that is the asset class. Most agree that REITs are a proxy for real estate itself.

Your client is following a constant dollar investment plan and the market value of the equity portfolio has increased from $100,000 to $120,000. To maintain her investment plan, she should: A) increase her bond portfolio so it will also have a market value of $120,000. B) continue to invest a fixed dollar amount each month in specific equity securities. C) continue to invest a fixed dollar amount in both equity and debt securities. D) transfer $20,000 from the equity portfolio to the bond portfolio.

Answer: D In a constant dollar plan, an investor keeps a constant dollar amount of the portfolio in equity securities. If the equities' market value rises, the excess is transferred to fixed-income securities.

If a portfolio manager wished to reduce inflation risk, which of the following would be most appropriate to add to the portfolio? A) AAA bonds. B) Fixed annuities issued by an insurance company with Best's highest rating. C) Preferred stock. D) Tangible assets.

Answer: D Tangible assets, such as real estate, precious metals, and other commodities, tend to keep pace with inflation. Fixed dollar investments do not.

Which of the following characteristics best exemplifies a value stock? A) Low price-to-book, low price-to-earnings ratio. B) Low price-to-book, high price-to-earnings ratio. C) High earnings per share growth, high profitability. D) Low earnings per share growth, high profitability.

Answer: A A value investor focuses on share price in anticipation of a market correction and improving company fundamentals. Therefore, such an investor tends to select a stock featuring lower price-to-earnings and price-to-book value ratios. A growth investor focuses on high earnings per share, growth, and high profitability.

An example of an interest-on-interest reinvestment program is A) interest left to compound on a bank insured certificate of deposit B) reinvesting the dividends paid on a bond fund C) reinvesting the earnings on a bond UIT D) reinvesting the interest received on a bond

Answer: A Interest-on-interest reinvestment is, as the term implies, the practice of compounding earnings by reinvesting them. This is traditionally the way a bank savings account or certificate of deposit builds in value. Reinvesting the dividends on a bond fund is dividend reinvestment, even though most, if not all, of the fund's income is generated by interest. Same with the UIT and there is no program for reinvesting bond interest similar to a DRIP for reinvesting dividends.

The tactical approach to the asset allocation review process: A) intentionally deviates from the normal asset mix to take advantage of market opportunities. B) is designed to maintain a minimum or floor for the value of the portfolio's assets. C) strives to maintain a constant asset mix over a long period of time. D) requires no predictive abilities.

Answer: A The approach to asset review that intentionally deviates from the normal asset mix to take advantage of market opportunities is the tactical approach. Investors using this approach try to use market timing to beat the market, so this approach requires a great deal of predictive ability.

The management style that is most similar to buy and hold is: A) tactical management. B) strategic management. C) active management. D) contrarian.

Answer: B A strategic management style, sometimes referred to as passive, is less apt to have a high degree of portfolio turnover than active or tactical management. Contrarian style generally involves taking positions that are currently out of favor in the market place, but would incur somewhat frequent activity.

A portfolio manager, putting most of his focus on the financial statements of the companies he is analyzing, is most likely using which management style? A) Growth. B) Tactical. C) Indexing. D) Value.

Answer: D Value managers seek to find companies that the market has ignored and primarily rely on information found in the financial statements of those companies.

One of your clients has been following a dollar cost averaging plan for the past five months. During that time, she has invested $200 each month on the 12th of the month. If the 12th was a non-business day, she invested the funds on the next available business day. Her monthly purchases were 30 shares, 22.5 shares, 25 shares, 20 shares and 18.1 shares. If she were to sell today at $10 per share, her cost basis is approximately: A) $23.12. B) $8.65. C) $4.62. D) $8.91.

Click for Answer and Explanation Answer: B The investor's cost basis is her average price per share. This is computed by taking the total investment for the 5 months ($1,000) and dividing it by the total number of shares acquired (115.6). $1,000/115.6 = $8.65.

Two of the more popular investment styles are growth and value. If you were to take the growth approach, you would be most interested in: A) book value per share. B) earnings momentum. C) market capitalization. D) dividend yield.

Answer: B Growth managers place their emphasis on earnings growth. Positive momentum means the growth is occurring at an increasing rate.

Although most investors are buying common stock issued by LMN corporation, Jack is selling it short. In this action, Jack appears to be a(n): A) fundamentalist. B) institutional investor. C) contrarian. D) writer.

Answer: C Investors who take positions opposite most other investors are generally regarded as contrarian investors.

There are several financial models that refer to the "risk-free" rate of return. Which of the following instruments is used to measure that rate? A) 1-year CD. B) 90-day Treasury bill. C) 30-year Treasury bond. D) Federal funds.

Answer: B The standard benchmark used to measure the "risk-free" rate of return is the 90-day Treasury bill.

A successful dollar cost averaging strategy requires stable market conditions. volatile market conditions. a fixed dollar amount invested monthly. a fixed number of shares purchased monthly. A) I and III. B) I and IV. C) II and IV. D) II and III.

Answer: D Dollar cost averaging requires a fixed dollar investment on a periodic or monthly basis. This strategy is most effective when prices in the market are volatile.

A well-diversified investor following a rebalancing portfolio strategy in a rising market will most likely: A) write covered calls on the long stock currently in the portfolio. B) sell part of the stock in the portfolio. C) sell all the stock in the portfolio. D) purchase additional stock.

Answer: B Portfolio rebalancing is a strategy that seeks to maintain a constant ratio (percentage) of a portfolio's original investment allocation. If stock increases in value, some of it will be sold to maintain the proportion of stock in the portfolio.

Which of the following is NOT a characteristic of the active management approach to investing? A) Higher expenses as compared to passive approaches. B) Belief in random walk theory and efficient markets. C) Attempt to predict market changes. D) Focus on beating the market.

Answer: B Proponents of the active management approach do not believe that markets are completely efficient or random. Instead, they feel that it is possible to predict market movements and to achieve returns that beat the market. Because an active approach to investment management involves more frequent trading and research than passive approaches, the active approach is generally more expensive to maintain.

Which of the following attributes best describes a tactical asset allocation portfolio style? A) Employs a strategic management style. B) Employs an active management style. C) Has an aggressive growth objective. D) Employs a passive management style.

Answer: B Tactical asset allocation managers actively manage their portfolios, switching the percentage of holding in each asset category according to the performance of the asset class. An aggressive growth manager would actively pursue specific growth securities such as stocks and not allocate funds between bonds, real estate, or other asset categories. A passive or strategic style is, as the name implies, relatively inactive rather than active.

An investment adviser is doing some research on a company and notices that the current market price is $21 per share. The most recently reported EPS is $3 and the company is paying a 19 cent quarterly dividend. On the balance sheet, the company is carrying a significant amount of cash. This company would probably be attractive to this adviser if his investment style was: A) contrarian. B) value. C) growth. D) micro-cap.

Answer: B This is an example of the kind of company appealing to those who follow a value style of portfolio management. The company is selling at a low P/E ratio of 7 to 1 ($21/3) with a liberal dividend yield of 3.62% (.76/$21). The high cash balance only adds to the value.

Which of the following statements best describes the risk-free rate of interest? A) Rate of interest on a municipal security. B) Rate of interest in excess of the pure time value of money. C) The rate of interest earned on short-term U.S. Treasury securities. D) The rate of interest earned on a corporate bond that is guaranteed by a highly rated insurance company.

Answer: C The rate of interest earned on short-term U.S. Treasury securities, generally the 90-day T-bill, is referred to as the risk-free rate. The rate of interest in excess of the pure time value of money is called the risk premium, not the risk-free rate.

A popular funding technique that involves investing the same amount at regular intervals is known as dollar cost averaging. Participating in this funding approach tends to lessen which risk? A) Inflation. B) Market. C) Timing. D) Credit.

Answer: C Timing risk, sometimes called market timing risk, is the uncertainty that an investor will be buying at the market top or selling at the market bottom. In other words, at the wrong time. When one dollar cost averages, that risk is lessened because you automatically acquire more shares when the market is down and less when it is high. Is it foolproof? No, but it does take some of the timing risk away.

Which of the following is NOT associated with passive investment management approaches? A) Belief in efficient markets. B) Belief in the random walk theory. C) Use of index investing. D) The belief that the market can be timed.

Answer: D Proponents of passive management approaches believe in the random walk theory (market movements are unpredictable) and efficient markets (any information that could affect a stock's value is quickly reflected in its price). As a result, they feel it is impossible to consistently beat the market.

Based on the following information, which stock is most likely to appeal to a growth investor? A) Book value of $22 per share, current market value of $17 per share. B) Dividend payout ratio of 65%. C) Dividend yield of 0.3%. D) P/E ratio of 8:1.

Answer: C Growth investors usually seek out stocks with high growth expectations, reflected by a higher than normal P/E ratio, typically 20:1 or higher, and a low dividend yield, usually caused by a low dividend payout ratio. It would be unlikely to find a growth stock selling for close to its book value and certainly not below it. Reference: 6.4.2.1 in the License Exam Manual.

Formula methods of investing that involve selling equities in rising markets and buying them in falling markets would include constant dollar plan constant ratio plan dollar cost averaging DRIPs A) II and III B) III and IV C) I and II D) I and IV

Answer: C In both a constant dollar plan and a constant ratio plan, the goal is to maintain a balance between equity and debt securities in the portfolio. This is done by selling equities as their price rises (the proportion has now changed) and buying equities when the prices fall to get back to the constant dollar or ratio.

An investor does not wish to attempt to time the market, so she invests $300 each month into the GEMCO Growth Fund. Over the past 5 months, her purchase prices have been $10, $12, $15, $20, and $25. On the basis of this information, if she were to stop investing at this point and sell her shares 2 months from now when the NAV is $15 per share and the public offering price is $15.79, it would be correct to state that her average cost per share was $16.40. average price paid per trade was $16.40. cost basis for tax purposes was $14.71. realized loss would be $1.40 per share. A) II and IV. B) II and III. C) I and III. D) I and IV.

Answer: B This client is taking advantage of dollar cost averaging. Each month, the $300 investment acquires a different number of shares. In order, she bought 30 shares ($300 divided by $10), 25, 20, 15, and 12 shares for a total of 102 shares. Her total investment was $1,500, giving her an average cost per share (cost basis) of $14.71. If we take the 5 different purchase prices and divide them by 5, the average price paid per visit to the market was $16.40. There is no loss here because the proceeds of $15 per share exceed the cost of $14.71.

Which of the following describes an investment management style? A) Rebalancing B) Margin C) Large capitalization D) Current income

Answer: C Large capitalization style distinguishes between investing in a small cap company versus a large capitalization company. Current income is an investment objective and not an investment management style. Rebalancing is used to bring asset allocations back to their desired weightings. Margin can be used in a number of investment management styles.

Which of the following does NOT refer to a style of investing? A) Growth. B) Value. C) Passive. D) Equity.

Answer: D The term "equity" does not refer to an investment style, but to ownership in a company. There can, however, be many different styles in which equities are employed. Growth refers to an investment style that seeks companies with growth rates in excess of the market to capture superior returns. Value refers to an investment style that seeks undervalued or out-of-favor companies in order to capitalize on their return to profitability. Value investors, for example, would seek out securities with high book values relative to their market prices. Passive investing maintains that securities are fairly priced and that the best alternative is to passively invest in an index to avoid the pitfalls of active security selection.