Chapter 16 - The Portfolio Management Process

An asset allocation for a $100,000 portfolio is determined to be Cash = 5% Fixed Income = 35% fixed income Equtiy = 60% equity. Over the course of the year, the portfolio will have the following returns: Cash = 2.5% Fixed Income = 6.0% Equity = 12.5% . What is the total value of the portfolio at year end? A. ($5,000 x 1.025) + ($35,000 x 1.06) + ($60,000 x 1.125) B. ($5,000 x 1.005) + ($35,000 x 1.035) + ($60,000 x 1.0.5)

A. ($5,000 x 1.025) + ($35,000 x 1.06) + ($60,000 x 1.125)

This is the long-term mix that will be adhered to by regular monitoring and periodic rebalancing when the asset mix no longer represents the base asset allocation. It does not imply a buy-and-hold strategy. Different returns within asset classes will cause the allocations to "drift" from the strategic mix. A. Strategic Asset Allocation B. Dynamic Asset Allocation C. Tactical Asset Allocation D. Integrated Asset Allocation

A. Strategic Asset Allocation

Determine the largest typical contributor to the total return of a bottom-up investment manager's portfolio. a. Interest income. b. Capital gains appreciation. c. Dividend income. d. Foreign exchange gains.

B. A bottoms-up manager would be utilizing a growth focus to invest in equities. The growth style holds greater potential for capital appreciation because of faster earnings growth. More of the total return of the portfolio is derived from capital appreciation rather than more stable dividend income.

This portfolio management involves systematically adjusting the asset mix to rebalance the portfolio back to its long-term target or strategic allocation when an asset class's weighting increases or decreases beyond a stipulated range. A. Strategic Asset Allocation B. Dynamic Asset Allocation C. Tactical Asset Allocation D. Integrated Asset Allocation

B. Dynamic Asset Allocation

If you're retiring to minimize risk, to generate income, which should you weight your portfolio mix higher towards. A. Cash B. Fixed Income C. Equities

B. FIxed INcome

This style of growth management investing applies a top down approach, and focuses on analyzing the prospects for the overall economy. It is primarily interested in sectors rather than individual companies. This style is called: a. Sector Selection. b. Sector Rotation. c. Value Management. d. Economic Sector Selection.

B. This form of growth investing applies a top down approach which analyzes the prospects for the overall economy. Based on that assessment, the managers invest in the industry sectors expected to outperform. These managers typically buy large cap stocks to maximize their liquidity. They are not as concerned with individual stock characteristics. Their primary focus is to identify the current phase of the economic cycle, the direction the economy is headed and the various sectors affected. In other words, industry selection is more important than stock selection and the manager often tries to identify emerging themes.

An investment policy statement contains the objective "the portfolio will achieve a modest level of income and aggressive long-term growth" Select the asset allocation most suitable for this objective. a. 5% cash;5% fixed-income; 90% equity. b. 5% cash;15% fixed-income; 80% equity. c. 10% cash; 5% fixed-income; 85% equity. d. 15% cash; 15% fixed-income; 70% equity.

B.An investment policy statement provides guidelines for investment. In this instance, the client's needs for modest level of income and aggressive long-term growth would be best achieved, of the listed choices, by b. The 5% cash allows for a degree of liquidity and some diversification, without overweighting the portfolio, while the 15% fixed income should provide a low level of income plus diversification, while the 80% equity would be suitable for an individual seeking aggressive long-term growth.

This strategy involves adjusting the asset mix to systematically re-balance the portfolio back to its long-term target. This type of strategy refers to: a. Passive Asset Allocation. b. Dynamic Asset Allocation. c. Tactical Asset Allocation. d. Integrative Asset Allocation.

B.Dynamic asset allocation is a portfolio management technique that involves adjusting the asset mix to systematically re-balance the portfolio back to its long-term target or strategic asset mix. Re-balancing may be necessary for a variety of reasons: There is a build-up of idle cash reserves, possibly from dividends or interest income cash flows, that have not been re-invested; or There are movements in the capital markets. These movements can cause abnormal returns, such as the 1987 market crash or the 1998 Asian flu crisis.

A tactical asset allocation manager has a strategic asset allocation of 10% cash, 30% fixed-income and 60% equity. Select the asset mix the manager might utilize if she anticipates a decline in the equity markets. a. 5% cash, 20% fixed-income and 75% equity b. 5% cash, 10% fixed income and 85% equity c. 10% cash, 45% fixed-income and 45% equity d. 10% cash, 30% fixed-income and 60% equity

C. A tactical asset allocation manager is able to deviate from the strategic asset allocation where there are opportunities to capitalize on investment opportunities in one asset class. After the opportunity, the manager will revert back to the long-term strategic allocation mix. This enables the manager to exercise any market timing skills he or she may have, while investing for the expected return indicated by the strategic mix. In this example, the manager would temporarily underweight equities until such time as equity markets are again perceived as attractive for investment.

11. (Points: 1) Which of Stock A (high beta, high dividend yield); Stock B (low beta, high price/cash flow); Stock C (low dividend yield, high price-earnings ratio); or Stock D (low standard deviation, low price/book value) would a growth manager likely choose? a. Stock A b. Stock B c. Stock C d. Stock D

C. Typically, growth managers focus on current and future earnings of individual companies. Stocks in this type of portfolio usually have a lower dividend yield, high price-earnings ratios, high price/book value and high price/cash flow. Of the four securities, only Stock C has two characteristics that would be attractive to a growth manager. Score:

If a fund manager invested in junk bonds how might she mitigate the risk? a. Invest in bonds with terms to maturity of greater than 10 years. b. Invest only in bonds of companies that she knows well. c. Invest only in bonds with short terms to maturity, e.g. less than 3 years. d. Invest only in the contraction phase of the cycle when bond prices are increasing.

C. Bonds with shorter terms to maturity have lower risk. This lower maturity risk could partly offset the higher default risk of the junk bond.

The strategy allows for a short-term deviation in one asset class from the base strategic asset allocation in order to take advantage of market opportunities. Once the expected opportunity is achieved or the trend has run its course, the portfolio is returned to its long-term strategic allocation. A. Strategic Asset Allocation B. Dynamic Asset Allocation C. Tactical Asset Allocation D. Integrated Asset Allocation

C. Tactical Asset Allocation

Select the cash allocation that a very risk averse investor would typically have in a diversified portfolio. a. 0% b. 5% c. 10% d. 25%

C.In general terms, cash usually makes up at least 5% of a diversified portfolio's asset mix. Investors who are very risk averse may hold as much as 10% in cash. While cash levels may temporarily rise greatly above these amounts during certain market periods or portfolio rebalancings, normal long term strategic asset allocations for cash are often within the 5%-10% range.

An investment manager with a dynamic asset approach reviews his portfolio following an equity market decline. His asset mix is set at 50% equities, 40% fixed income and 10% cash. Currently, the portfolio value is $450,000 equities, $500,000 fixed income and $40,000 cash. Calculate the adjustment that he would make to the asset categories of the portfolio. a. Increase equities by $50,000, decrease fixed income by $50,000. b. Increase equities by $25,000, decrease fixed income by $25,000. c. Increase equities by $45,000, decrease fixed income by $104,000, increase cash by $59,000. d. Increase equities by $30,000, decrease fixed income by $20,000, decrease cash by $10,000.

C.The overall portfolio value is $450,000 + $500,000 + $40,000 = $990,000. 50% of $990,000 = $495,000; 40% = $396,000; and 10% = $99,000. Therefore, the equities would be increased by $495,000 - $450,000=$45,000; fixed-income decreased by $500,000-$396,000 = $104,000; and cash increased by $99,000-$40,000 =$59,000.

7. (Points: 1) Select the bond category that would have the lowest degree of liquidity in a declining market. a. Provincial government Bond. b. AAA Corporate Bond. c. BBB (low) Corporate Bond. d. High-yield bond.

D. High-yield bonds are bonds that are not investment grade. They are often called junk bonds. Bonds in this category should have a higher yield, but they face greater credit risk. Lower-rated bonds have less liquidity than government issues. In a declining market, it may be difficult to find a buyer for this type of bond.

The client's risk/return objectives (risk tolerance) The client's changing nature and needs through different life stages and events The mathematically forced principle of selling high and buying low to secure gains, acquire investments based on value, and lower overall portfolio risk (strategic and dynamic management) Taking advantage of capital market expectations within set limits to control risk (tactical management) A. Strategic Asset Allocation B. Dynamic Asset Allocation C. Tactical Asset Allocation D. Integrated Asset Allocation

D. Integrated Asset Allocation

Why does the Dividend Discount Model (DDM) suggest that stocks should be purchased at the market trough? a. "r" is increasing and "g" is decreasing. b. "r" is increasing and "g" is increasing at a slower rate. c. "r" is stable and "g" is decreasing. d. "r" is decreasing and "g" is decreasing at a slower rate.

D. The DDM is based on the relationship, P = (dividend/( r - g)). Dividends are usually fairly stable so prices will change based on changes in the denominator. If the denominator decreases, stock prices should increase. At the stock market trough, "r" is declining due to declines in interest rates and "g" is declining due to the economic slowdown. But, "r" is declining faster than "g" so stock prices increase.

12. (Points: 1) An investment portfolio of $20,000 earns $2 in interest on cash, $225 on fixed income securities, and $325 on equities. Calculate the total return on the portfolio. a. $227 b. $325 c. $550 d. $552

D. he total return would include all income earned on the portfolio. In this example, $2 + $225 + $325 = $552.

What is an example of the diversification achieved by bond laddering in a portfolio? a. Inclusion of preferred shares. b. Inclusion of federal, provincial and corporate bonds. c. Inclusion of convertible debentures. d. Inclusion of bonds with a variety of consecutive terms to maturity.

D.Bond laddering is the inclusion of bonds with a variety of consecutive terms to maturity. For example, the portfolio might have bonds maturing in 2012, 2014, 2016, 2008 and 2020. This reduces the interest rate risk of the portfolio as only a portion of the bond portfolio is maturing at any one time. Further, if interest rates increase, parts of the portfolio mature and can be reinvested at higher rates over time.

Which 2 Equtiy cycle lasts the shortest?

Expansion Equtiy Cycle : last 6 to 9 months. Stock Market Trough: last 5 to 13 months.

Which 2 Equtiy cycle lasts the longest?

Expansion Phase Peak lasts one to 3 years, profit driven cycle decline.Contraction Phase : last 1 to 2 years

What is one risk feature of the growth style of investing? a. These securities can be volatile and vulnerable to changes in the market cycle. b. Lower standard deviation. c. Volatility due to industry concentration. d. Stock prices are already low, may have lower downside risk.

What is one risk feature of the growth style of investing? A. The growth style of manager focuses on earnings momentum and is willing to pay a higher price for a company with high growth potential. These stocks can be volatile if EPS are above or below expectations. They are also more vulnerable to changes in the economic cycle.

What is concered witih trying to outperform the market averages such as the S&P TASX Compositie, and to try to shift back between cyclical and defensive industries. a. Industry Rotation Strategy. b. Equtiy Manager Style c. Bottom Up investment

a. Industry Rotation Strategy.

Contraction Phase : last 1 to 2 years. End of equity cycle. Recession related decline in stocks. a. low P = Div /high r - low g b.high p = Div/lower r - lowg c. low p = Div1/ higher r - high g. d. high p = Div1/high r - higher

a. low P = Div /high r - low g

To maintain a stable economy, the Bank of Canada can intervene by ___short-term interest rates to slow down economic activity. a. raising b. lowering

a. raising

Why does the Dividend Discount Model (DDM) suggest that stocks should be purchased at the equity cycle? a. "r" is increasing and "g" is decreasing. b. "r" is increasing and "g" is increasing at a slower rate. c. "r" is stable and "g" is decreasing. d. "r" is decreasing and "g" is decreasing at a slower rate.

b. "r" is increasing and "g" is increasing at a slower rate. lasting 6 to 9 months.

Which of the following are not fixed-income products. a. Bonds due in 3 years. b. Bonds due in 3 months. c. Strip Bonds d. Mortage Backed Securities e. Convertible Securities f. ETFs

b. Bonds due in 3 months (need to be more than one year) e. Convertible Securities.

This style of growth management investing applies a bottom up investment approach , where the focus will be on current and future earnings such as the earnings per share, and are looking for "earnings momentum". a. Sector Selection. b. Equtity Manager Style. c. Value Management. d. Economic Sector Selection

b. Equtity Manager Style.

What are the risk characteristics of the conservative equity category? a. Limited earnings record, P/E of little significance, no dividend. b. Predictable earnings, lower P/E ratio, high dividend payout. c. Above average earnings growth, higher P/E, low dividend payout. d. No earnings, P/E ratio not significant, no dividends.

b. Predictable earnings, lower P/E ratio, high dividend payout. The conservative type of equity has low risk and low price volatility. This stems from predictable earnings, high dividend payout and high capitalization.

A tactical management approach would call for minimizing cash holdings (cash has only been paying 2% to 2.5% throughout the period) and substantially reducing fixed-income holdings to increase portfolio exposure to the energy, discretionary, manufacturing, gold, and materials sectors of the market. Since this would be _______strategy to substantially enhance portfolio return at the cost of increased risk exposure, the portfolio manager and client would have to monitor performance and the economy more closely, with plans to quickly return to the base strategic asset allocation if conditions warranted a. a short only b. a short- to mid-term c. a mid-term to long d.a long only

b. a short- to mid-term

What term describes that sometimes gold stocks are occasionaly inversesly related to the S&P. Stock prices occasionaly rice during recessions while stock market average price levels are falling. a. interest rate sensitivity. b. counter cyclical or lag the market averages. c. sustained growth in corporate profits.

b. counter cyclical or lag the market averages.

Stock Market Trough: last 5 to 13 months. a. low P = Div /high r - low g b.high p = Div/lower r - lowg c. low p = Div1/ higher r - high g. d. high p = Div1/high r - higher g

b.high p = Div/lower r - lowg

The implications of this economic analysis for dynamic and tactical portfolio management approaches are: The analysis and forecast indicate interest rates are stable and ________ is not expected to be a factor for the foreseeable future. a. equity b. inflation c.capital gains

b.inflation

This style of growth management investing focuses on specific stock selection. They are bottom up stock pickers as well. a. Sector Selection. b. Equtity Manager Style. c. Value Management. d. Economic Sector Selection

c. Value Management.

Expansion Equtiy Cycle : last 6 to 9 months. Early cycle interest rate shock and brief decline in stock prices. a. low P = Div /high r - low g b.high p = Div/lower r - lowg c. low p = Div1/ higher r - high g. d. high p = Div1/high r - higher g

c. low p = Div1/ higher r - high g.

14. (Points: 1) Select the Sharpe ratio that shows outperformance in comparison with an applicable benchmark return of 5%. a. -4% b. 0% c. 2% d. 6%

d. If a manager is being measured against a benchmark, the portfolio's Sharpe ratio can be compared to the Sharpe ratio of the applicable benchmark. The larger the Sharpe ratio, the better the portfolio performed. A money manager with a Sharpe ratio greater than the Sharpe ratio of the benchmark outperformed the benchmark. A portfolio's Sharpe ratio that is smaller than the benchmark's signals underperformance. A negative Sharpe ratio means the portfolio had a return less than the risk-free return.

The implications of this economic analysis for dynamic and tactical portfolio management approaches are: The ________ outlook for the Canadian dollar suggests the Bank of Canada may have leeway to _____interest rates to maintain the global value of the dollar at current levels. a. bearish higher b. bullish higher c. bearish lower d. bulllish lower

d. bullish CAD, lower interest rates

Expansion Phase Peak : last one to 3 years, profit driven cycle in stock prices. a. low P = Div /high r - low g b.high p = Div/lower r - lowg c. low p = Div1/ higher r - high g. d. high p = Div1/high r - higher g

d. high p = Div1/high r - higher g

The implications of this economic analysis for dynamic and tactical portfolio management approaches are: The equity maximum of 14.25% and minimum of 2.00% is highly indicative of continued economic ___________ a. contraction b. expansion c. trough

expansion or a drawing out of the peak phase of the business cycle.