Module 5: Investment Strategies
Which of the following statements regarding passive portfolio management is NOT correct? A) It is an attempt by the investment manager to outperform, on a risk-adjusted basis, a passive benchmark portfolio that has average characteristics that match the risk and return objectives of the client portfolio. B) It requires occasional rebalancing because dividends must be reinvested, and stocks may merge or drop out of the target index. C) It has grown in popularity because investors are recognizing that the market is fairly efficient and that the costs of an actively managed portfolio may be significant. D) It is a long-term buy-and-hold strategy designed to produce a portfolio's returns that will track those of an index over time.
a, The correct answer is "it is an attempt by the investment manager to outperform, on a risk-adjusted basis, a passive benchmark portfolio that has average characteristics that match the risk and return objectives of the client portfolio." This is the definition of active portfolio management. The other statements correctly describe passive portfolio management.
Which one of the following statements concerning an active portfolio management strategy is CORRECT? A) The goal of active portfolio management is to earn a return that exceeds the risk-adjusted return of a passive benchmark portfolio. B) The key to success for an actively managed portfolio is to minimize trading activity whenever possible. C) An actively managed portfolio has lower total transaction costs and is therefore more administratively efficient. D) An actively managed portfolio has lower risk than a passive benchmark portfolio in most cases.
a, The goal of active portfolio management is to earn a portfolio return that exceeds the return of a passive benchmark portfolio, net of transaction costs, on a risk-adjusted basis. Such a strategy also involves higher transaction costs and, usually, risk.
If a mutual fund's cash position is high, a contrarian investor is likely to do which one of the following with respect to the overall market? A) Sell B) Buy C) Sell short D) Remain in a hold position
b, High cash positions in mutual funds usually indicate that portfolio managers are getting out of the market. Accordingly, a contrarian investor is likely to buy.
What is a primary difference between the underlying assumptions of technical analysis versus those of fundamental analysis? A) Technical analysts maintain that stock prices adjust quickly to the dissemination of public information. B) Technical analysts believe the trend in security prices is determined solely by the interaction of economic supply and demand. C) Technical analysts hold that the price of a security is established by the expected investor return and a combination of risk factors. D) Technical analysts argue that the market only weighs irrational factors, and, therefore, the psychology of investors will produce a herd effect.
b, Technical analysts believe that the market price of securities is determined solely by the interaction of economic supply and demand (e.g., company financial statements play a much less important role). Stock prices move in trends, and, therefore, market price adjustments occur gradually over time.
Which of the following accurately describes a bond barbell? A) Substituting one bond for another B) Acquiring a portfolio of bonds consisting of both very long-term and very short-term maturities C) Periodic and systematic purchasing of shares of stock or securities at regular intervals D) Purchasing a series of bonds with similar maturities focusing around one point in time
b, The correct answer is "acquiring a portfolio of bonds consistent of both very long-term and very short-term maturities." A bond barbell refers to a strategy of initially acquiring a portfolio of bonds consisting of both very long-term and very short-term maturities. For example, if an investor has $100,000 to invest, he might expend $50,000 to purchase bonds with maturities of 1 year and the other $50,000 to purchase bonds with 30-year maturities.
What type of investment strategy is being used when an investor seeks to purchase securities at below-market prices that are neglected by the majority of investors and then wait for the market to recognize their value? A) Bond strategy B) Contrarian strategy C) Buy-and-hold strategy D) Value and growth strategy
b, The correct answer is "contrarian strategy." The objective of the contrarian investor is to purchase, at below-market prices, securities that are neglected by the majority of investors and then wait for the market to recognize their value. At that point, the contrarian hopes to sell the neglected securities for a significant profit. Also, a contrarian investor attempts to sell today's hot stock and then buy it back later at a lower price.
Which of the following strategies involves purchasing the same number of shares regardless of the market price? A) Dividend reinvestment programs (DRIPs) B) Share averaging C) Dollar cost averaging D) Averaging down
b, The correct answer is "share averaging." Share averaging is purchasing the same number of shares regardless of the market price. When using this strategy, the dollars invested may vary, but the number of shares will remain constant. However, in dollar cost averaging, the number of shares may vary, but the total dollars invested remain constant.
Which of the following tends to support those investors who practice a buy-and-hold investment strategy? A) The capital asset pricing model B) The efficient market hypothesis C) The efficient frontier D) Modern portfolio theory
b, The efficient market hypothesis, which maintains that the current prices of securities reflect all information available to investors, supports a long-term buy-and-hold investment strategy. Buy-and-hold implies remaining in the market regardless of underlying market conditions.
Which of the following statements best explains the concept of dollar cost averaging as an investment strategy? A) A purchase of the same number of shares is made regardless of the direction of overall market indices. B) A purchase of a fixed dollar amount of shares is made at regular intervals. C) A purchase of additional shares is completed through the reinvestment of dividends. D) A purchase of additional shares is made only as the price of each share declines.
b, Under the concept of dollar cost averaging, an individual purchases additional shares of stock or a mutual fund through the investment of a fixed dollar amount regardless of market conditions.
All of the following constitute reasons for a bond swap EXCEPT A) to increase bond yields B) to take advantage of interest rate shifts C) to supplement a buy-and-hold trading strategy D) to achieve investor or portfolio tax savings
c, A bond swap is an active investment strategy done for various reasons; among them, to increase bond yields, take advantage of interest rate changes, and achieve tax savings. A buy-and-hold strategy is a passive investment strategy and not a reason for a bond swap.
A growth stock is best characterized as one that A) carries a low amount of systematic risk for the investor B) is undervalued by the market in relation to other stocks C) exhibits a higher beta coefficient than other stocks D) possesses a high probability of a negative rate of return
c, A growth stock is more volatile than other stocks and thus exhibits a higher beta coefficient. A defensive stock carries a low amount of systematic risk, and a speculative stock possesses a high probability of a negative rate of return.
What are the advantages for investors who participate in a dividend reinvestment program (DRIP) offered by a company or mutual fund? A) An automatic and forced savings program B) Dollar cost averaging C) All of these are correct D) Reduced brokerage commissions
c, The correct answer is "all of these are correct." Investors who participate in a DRIP obtain the advantages of an automatic and forced savings program, the benefits of dollar cost averaging, and reduced brokerage commissions.
Contrarians use certain technical indicators as reference points for their own buying and selling of securities. This includes which of the following? A) Short selling B) Put-call ratios C) All of these D) Investment advisory opinions
c, The correct answer is "all of these." Short selling, put-call ratios, and investment advisory opinions are all used in contrarian investing. Other indicators include mutual fund cash positions and credit balances in brokerage accounts.
Which of the following is NOT an advantage of bond laddering? A) The total amount of interest earned on bonds in a laddered portfolio tends to be greater. B) Bond proceeds are available for use if the investor needs liquidity; if the investor does not need the funds, the proceeds may be reinvested. C) Bond laddering offers the advantages of an automatic and forced savings program and reduced brokerage commissions. D) If interest rates change, the prices of the bonds with shorter maturities will fluctuate less than the prices of the bonds with longer maturities.
c, The correct answer is "bond laddering offers the advantages of an automatic and forced savings program and reduced brokerage commissions." This is an advantage of a DRIP. The other statements are advantages of bond laddering.
The periodic and systematic purchase of shares of stock or securities at regular intervals, no matter the share price, is called A) share averaging B) averaging down C) dollar cost averaging D) dividend reinvestment programs (DRIPs)
c, The correct answer is "dollar cost averaging." Dollar cost averaging is the periodic and systematic purchase of shares of stock or securities at regular intervals. These purchases take place regardless of whether the share price goes up or down. If the price is down, additional shares are purchased, which in turn can be leveraged for future growth.
What does a growth investing style assume about the current level of the P/E ratio and the future price of the stock? A) Growth investing assumes the P/E ratio is above its natural level and that an efficient market will soon recognize this situation causing stock prices to decrease. B) Growth investing assumes the P/E ratio is below its natural level and that an efficient market will soon recognize this situation and drive the stock price upward. C) Growth investing assumes the P/E ratio will remain constant over the near term, with the stock price in an efficient market increasing as the forecasted earnings growth is realized.
c, The correct answer is "growth investing assumes the P/E ratio will remain constant over the near term, with the stock price in an efficient market increasing as the forecasted earnings growth is realized." Value investing assumes the P/E ratio is below its natural level and that an efficient market will soon recognize this situation and drive the stock price upward. Growth investing assumes the P/E ratio will remain constant over the near term, with the stock price in an efficient market increasing as the forecasted earnings growth is realized.
Which of the following believe that past price movements may be used to predict the future direction of the market? A) Fundamentalists B) Value and growth investors C) Technical analysts D) Traditionalists
c, The correct answer is "technical analysts." The principal contention of technical analysts is that stock prices move in trends that persist for a long period. Accordingly, because these trends persist and happen more than once, they may be detected by analyzing past price movements and extrapolating them to predict future prices and market conditions. Fundamentalists disagree that these trends persist over long periods of time and contend that price adjustments are much more rapid. Therefore, investors need to move quickly to take advantage of a market run-up in prices.
The efficient market hypothesis (EMH) states that A) investors are most likely to invest during an upturn in prices B) buying securities that the rest of the market seems to ignore while selling securities that are today's hot stock will offer the most return on investment C) the current market prices of securities reflect all information presently available to investors D) very low credit or cash balances will indicate that investors have a bullish outlook, while increasing balances indicate a bearish outlook
c, The correct answer is "the current market prices of securities reflect all information presently available to investors." The efficient market hypothesis (EMH) states that the current market prices of securities reflect all information presently available to investors. Therefore, attempting to achieve superior market returns through active portfolio management is futile. EMH fits well with the buy-and-hold strategy where an investor remains invested in the market regardless of conditions and focuses primarily on his long-term financial goals.
A conservative investor interested in equities would prefer which of the following investment styles? A) None of these B) Growth C) Value D) Contrarian
c, The correct answer is "value." A conservative investor interested in equities would likely prefer the value style of investing. Stocks selected under this method do not generally experience as much volatility as those chosen under the growth style. In addition, value stocks will also increase in price during the best years of the market, although the increase is less than with growth stocks.
An investor who practices value investing is most likely to purchase a stock A) that exhibits strong potential for capital appreciation B) with a superior earnings growth rate C) with a low price-to-earnings ratio D) with a low historical dividend payout ratio
c, Value investors generally look for stocks with low price-to-earnings (P/E) ratios. Such a style of investing assumes that the P/E ratio is below its natural level and that an efficient market will soon recognize this situation. Accordingly, the price of the stock should then rise, resulting in a profit to the investor.
Which of the following statements regarding portfolio management techniques is/are CORRECT? Passive portfolio management is a long-term buy-and-hold strategy. Active portfolio management is an attempt by the manager to outperform, on a risk-adjusted basis, a passive benchmark portfolio. A) Neither I nor II B) II only C) I only D) Both I and II
d, Both statements I and II are correct. Passive portfolio management is a long-term buy-and-hold strategy. Usually, stocks are purchased with the belief that the portfolio's returns will track those of an index over time. Active portfolio management is an attempt by the manager to outperform, on a risk-adjusted basis, a passive benchmark portfolio. A benchmark portfolio is a passive portfolio whose average characteristics—including such factors as beta coefficient, dividend yield, industry weighting, and firm size—match the risk and return objectives of the client.
An investor wants all of her bonds to mature in 10 years. She buys 2 bonds immediately, 2 bonds 2 years from now, and 2 more bonds 4 years from now. As a result, the bonds purchased immediately have a maturity of 10 years, the bonds purchased 2 years later have a maturity of 8 years, and the bonds purchased 4 years later have a maturity of 6 years. This is an example of A) bond swapping B) bond laddering C) a bond barbell D) bond bulleting
d, The correct answer is "bond bulleting." In this strategy, an investor purchases a series of bonds with similar maturities focused on one point in time. This strategy may be an effective method in matching duration to the cash needs of an investor.
Which of the following is used by a security's analyst who believes in fundamental analysis? A) Efficient market hypothesis B) Passive diversified portfolio approach C) Supply and demand analysis D) Financial statement review
d, The correct answer is "financial statement review." Fundamental analysis is based on comparing the intrinsic value of securities to the market value to determine which securities are undervalued. As a result, this type of analysis requires the review of a company's financial statements.
All of the following statements pertaining to dividend reinvestment programs (DRIPs) are correct EXCEPT A) the investor acquires new shares representing additional ownership in the company B) these plans may act as a forced savings for otherwise undisciplined investors C) these plans avoid brokerage commissions on the purchase of additional shares D) the investor is not in constructive receipt of the dividend and will not pay current income taxes on the distribution
d, The investor is in constructive receipt of the cash dividend and must pay taxes annually on the amount received.
