Investment Strategies and Philosophies Exam 1

Mutual fund fee structure back-end load

"Exit" fee incurred when selling shares

In the U.S., corporations are moving away from offering Defined Benefit Retirement plans and are increasingly using Defined Contribution plans. True False

True

Many of the most successful active institutional investors view ________ as opportunity. Volatility All answers are correct Market Efficiency Hedging Speculation

Volatility

Essence of Intuitive Heuristics

When faced with a mentally tough question, humans often decide to answer an easier question (without noticing the substitution).

In the U.S., long-term capital gains receive favorable tax treatment compared to short-term capital gains. What is the required holding period in equities to qualify for the lower capital gains tax rate? 1 year 5 years 90 days 60 days

1 year

During the Covid monetary stimulus the fed funds rate cut ___ to range a ____ - ______

1.5% 0%-.25%

When investors gauge what should be considered a long-term investing time horizon in stocks, a consideration is the longest period of historic negative returns. Based on the data presented in the Credit Suisse Yearbook and lecture slides, what was the longest period that the U.S. equity market experienced a cumulative negative real return? 22 years 8 years 16 years 54 years

16 years

Which of the following is an explicit trading cost? Price impact Bid Ask Spread Trading commissions Opportunity cost

Trading commissions

Based on the 121 year history in the Credit Suisse Yearbook, U.S. equities had an annual return of ____ in nominal terms. 10.6% 9.7% 6.2% 12.5%

9.7%

Inverted yield curve 3 month vs 10 year for ____ means recession

90 days

__________is a strategy that imagines why a decision failed and then works backward to determine the potential obstacles and reasons that lead to a bad outcome. It can help the investment process by determining the appropriate position size and by reducing the emotional impact inherent in investing. An Investment Thesis An investment audit A premortem A postmortem

A premortem

Which Fixed Income Fund Strategy seeks consistent and attractive returns across all market environments and is not tied to a benchmark. This strategy has no constraints regarding geography, sector, credit rating, or maturity. Absolute Return Core Total Return Core Plus

Absolute Return

Active Management

Active Management objective is to outperform a market benchmark (often represented by an index) or to achieve a specific investment objective. Potential Benefits of Active Management •Opportunity for outperformance •Utilizes in-depth research •Defensive measures - attempt to minimize losses by avoiding certain securities, sectors, or regions Potential Risks of Active Management •Underperformance •Higher expenses

Mutual fund fee structure 12b-1 charges

Annual fees charged by mutual fund to pay for marketing/distribution costs

During the pandemic, home prices in the U.S. appreciated rapidly due to record-low mortgage rates and the low supply of homes. In 2022, home prices started to fall due to declining home affordability which was caused by rising mortgage rates. The 10 year treasury yield is the base rate for the 30 year mortgage. What is the current yield on the 10 year treasury? Between 1 - 1.75% Between 3.26 - 4% Between 2.51 - 3.25% Between 1.76 - 2.50%

Between 3.26 - 4%

How does the need for speed impact investment strategy?

Breaking up trades can reduce the price impact. Investment strategies that require immediate execution will be affected the most by price impact

During the Covid monetary stimulus the fed used quantitative easing by

Buying at least $80B of treasuries and $40B of MBS per month

What was a takeaway from the failure of the Nifty 50 investment strategy that was popular in the 1960s and early 1970s? A great company is always a great investment The fastest growing companies consistently outperform the broad market Buying fast growing companies regardless of the price/valuation is not a sustainable long-term strategy for outperformance All answers are correct

Buying fast growing companies regardless of the price/valuation is not a sustainable long-term strategy for outperformance

Mutual fund fee structure front-end load

Commission or sales charge paid when purchasing shares

Mutual fund fee structure operating expenses

Costs incurred by mutual fund in operating portfolio

Mutual fund fee structure expense ratio

Covers the operating costs of running the mutual fund. This includes management fees (salaries & research), administration fees, and marketing fees (12b-1)

Value Investing

Focuses on buying a business only if it trades at less than the value of the assets in place and view growth as an added benefit but not a requirement.

Growth Investing

Focuses on buying growth companies where the value of growth potential is being underestimated.

Which of the following comprises the FED's dual mandate? I. Stable and positive stock market returns II. Full Employment III. 1% Inflation Target IV. 2% Inflation Target V. 3% GDP growth I & III II & IV II & III I & V IV & V

II & IV

Which of the following is an investment philosophy (as opposed to an investment strategy)? Invest on the belief that investors overreact to important news and announcements and that markets correct themselves over time. Invest in only companies that are undervalued Invest in stocks based on technical analysis Invest in high dividend paying stocks

Invest on the belief that investors overreact to important news and announcements and that markets correct themselves over time.

Fund of Funds

Is a fund that invests in multiple underlying hedge funds. FOF investors achieve fund diversification across strategies, but pay an extra layer of fees.

Which type of hedge fund equity strategy combines long and short positions that vary based on market conditions and where a portfolio manager sees differences between a stock's value and market price? Equity Market Neutral Convertible Arbitrage Short Biased Funds Long/Short Funds

Long/Short Funds

How does the size of portfolio impact investment strategy?

Many investment strategies can deliver high risk-adjusted returns on a small scale but fail in larger portfolios because the price impact costs increase

If you are an active investor in U.S. large cap equities, which of the following propositions about market efficiency would you need to subscribe to? Markets are for the most part efficient, but have periods and pockets of inefficiency Markets are inefficient and stay inefficient in the long term Markets are always efficient Markets are almost always inefficient, but have short periods and pockets of efficiency

Markets are for the most part efficient, but have periods and pockets of inefficiency

____________ can guide an individual's perception of the world, but may limit the amount and type of information used when making investment decisions. Hindsight bias The Voice of Judgement Mental models System 2 thinking

Mental models

What are ordinary dividends?

Ordinary Dividends refer to any form of dividends that a shareholder receives from a company as a benefit for holding shares in the firm. As ordinary dividends are taxed at the same ordinary income tax rate as your marginal tax rate.

Passive Management

Passive Management's objective is to match the return of a market index. Potential Benefits of Passive Management •Diversification •Lower costs •Simplicity Potential Risks of Passive Management •Total market risk •Lack of defensive measures •Performance constraints

An Investment Philosophy is...

Philosophy is a coherent way of thinking about financial markets, how they work, and the types of mistakes that you believe they make. Foundation of every IP is a view on human behavior. Assume that markets are inefficient (at least some of the time). One IP can have multiple investment strategies.

What are the FED's dual mandates?

Price stability Maximum employment

On February 1st, the FED ________ and forecasted _____________. Kept the Fed Funds Rate unchanged, one additional rate increase this year Raised the Fed Funds Rate by 25 bps, no further rate increases this year Raised the Fed Funds Rate by 25 bps, further rate increases (multiple) this year Raised the Fed Funds Rate by 50 bps, a cut in rates by the end of the year Raised the Fed Funds Rate by 50 bps, no further rate increases this year

Raised the Fed Funds Rate by 25 bps, further rate increases (multiple) this year

Passive funds that track same index can have different performance due to:

Replication strategy Transaction costs Expense Ratio

Multiple recent economic data points could cause the FED to raise rates more than the market is currently pricing in. Which of the following would be the least likely to impact the FED needing to raise rates higher than market expectations? Reports that more than two-thirds of Americans are living paycheck to paycheck A decline in mortgage rates leading to an increase in demand in the housing market January's payrolls report that showed the U.S. economy added 517,000 jobs and the unemployment rate fell to 3.4% A 2.5% rise in used car prices in January

Reports that more than two-thirds of Americans are living paycheck to paycheck

___________ funds use a set of investment strategies that emphasizes capturing investment factors or market inefficiencies in a rules-based way. Actively managed Liquid Alternatives Smart beta Momentum Thematic

Smart beta

Steps to developing an investment philosophy

Step 1: Acquire the tools of the trade •Be able to assess risk and incorporate into investment decisions •Understand financial statements and valuations 2: Develop a point of view about how markets function and where they might break down 3: Find the philosophy that provides the best fit for you, based on your •Do you have a competitive advantage? •Risk Aversion (Willingness and Ability) •Time Horizon •Tax Status

How do the type of stocks impact investment strategy?

Stocks with high bid-ask spreads also tend to be stocks that trading can have a significant price impact. Therefore, strategies that invest disproportionately in these types of stocks should be met with skepticism

Which of the following would not currently be considered a headwind for the U.S equity market? The U.S. economy is in a recession with high unemployment Rising Interest Rates (compared to one year ago) A Hawkish FED Strong Dollar (compared to one year ago)

The U.S. economy is in a recession with high unemployment

Asset Allocation

The allocation of an investment portfolio across multiple asset classes

Price Impact

The price impact that an investor can create by trading on an asset, pushing the price up when buying the asset and pushing it down while selling

Bid-Ask Spread

The spread between the price at which you can buy an asset and the price at which you can sell the same asset at the same point in time. Remember Banks have Brokers who Buy at the Bid (BBBB)

Technical analysis

The study and interpretation of the historic behavior of securities in order to predict future trends.

Opportunity Cost

There is the opportunity cost associated with waiting to trade. While being a patient trader may reduce the previous two components of trading cost, the waiting can cost profits both on trades that are made and in terms of trades that would have been profitable if made instantaneously but which became unprofitable as a result of the waiting.

Brokerage Cost or Trading Commissions

This is the most explicit of the costs that any investor pays but it is usually the smallest component.

What are soft dollars?

additional payments made by a fund managers to a brokerage firm during trading to receive kick-backs to pay for the research offered by the firm.

Venture Capital

an investment in a start-up business that is perceived to have excellent growth prospects, but does not have access to capital markets. This type of financing is sought by early-stage companies seeking to grow rapidly.

Equity market-neutral funds

attempt to identify both overvalued and undervalued stocks while neutralizing the fund's exposure to market risk by combining long and short positions.

security selection

choice of specific securities within each asset class

Long/Short

combination strategy where a portfolio manager buys equities expected to rise in value and shorts stocks that are expected to fall in value. Stock-picking ability is the key measure of the strategy's success or failure

BofA ICE (previously Merrill Lynch) High Yield Master II Index:

created in 1989 and tracks below-investment grade debt in the United States. The components of the index are weighted based upon their market capitalization weights

Buyout

debt and equity investments used to purchase the shares of a mature public company, effectively changing the ownership structure, often with the use of high leverage.

Managed Futures invest in

futures and options contracts of equity and debt securities, commodities and currencies.

S&P U.S. High Yield Corporate Bond Index:

launched in 2013. The bonds in the index can have a maximum rating of BB+, Ba1 or BB+. This index is also weighting by market capitalization.

Behavioral finance is a mixture of

psychology, sociology, and finance that attempts to explain why investors behave the way they do and the consequences for investment strategies.

Convertible Arbitrage

relative value strategy with the objective of profiting from arbitrage opportunities arising from mispricing of a company's convertible bonds and equity. The typical strategy buys underpriced convertible bonds and shorts overpriced equity shares

Total Return

strategy designed to seek consistent, attractive returns across all market cycles, while attempting to outperform a benchmark.

Unconstrained or Absolute Return

strategy designed to seek consistent, attractive returns across all market environments. Unconstrained funds are not tied to a benchmark and has no constraints regarding maturity, sector, or geography.

30 year mortgage rate is determined by

the 10 year plus credit spread

Mental Chatter

the constant internal conversation within the mind.

Merger Arbitrage

typically involves taking a long position in the shares of a target company after a merger announcement and taking a short position in the shares of the acquiring company. The strategy is profitable if the deal actually completes. Otherwiselosses on both the short and long side are likely In a more sophisticated variant in stock mergers (where shares of the acquiring company are exchanged for shares in the target company), the arbitrageur will sell the acquiring firm's stock in addition to buying the target firm's stock

The investment strategy that focuses on investing in a company's common stock at a significant discount to underlying business assets is referred to as _________. distressed investing risk adjusted arbitrage investing value investing growth investing

value investing

Examples of defined contribution retirement investments

•401k •Traditional & Roth IRAs •Taxable Accounts

postmortem

•A postmortem is a process to audit past investment decisions to revise and improve the investment process. •It provides review of the accuracy or flaws of an investment thesis. •It can assist in reducing the impact of cognitive and emotional biases.

premortem

•A premortem is a strategy that imagines why a decision failed and then works backward to determine the potential obstacles and reasons that lead to a bad outcome. •Writing a premortem prior to making an investment makes the possibility of loss more noticeable.

What are ways to mitigate hindsight bias?

•A reliable way to mitigate this bias is to have a fully developed (written) investment thesis prior to making an investment that includes: •The data analyzed in the decision-making process •Interpretation of the data •Probabilities assigned to different outcomes •The drivers of those probabilities •The catalysts for either meeting or missing investment expectations

Inherent Weaknesses with Mental Models

•Can be out of touch with reality •Cause people to ignore, suppress, or forget observations that are different than their beliefs •Can be in direct conflict with each other •Limit the information used when making decisions

Fixed Income Strategies

•Core IG •Core Plus •High Yield •Duration Target •Global DM EM •Domestic Tax-Exempt (Municipal Bonds)

A Portfolio Manager's job can be broken down into a few fundamental aspects:

•Developing a view on an investment, which we will refer to as an investment thesis •Deciding on how to express the view •The timing and size of the investment •How and when to exit the investment

Alternative risk measures

•Equity Screening with Accounting Based Measures •Proxy Models •Market - Implied Measures •Risk-adjusted Cash Flows •Margin of Safety

Riskier investments should entail

•Higher expected returns •The possibility of lower returns •In some cases the possibility of losses

What are different investing edges?

•Informational Advantage •Analytical Advantage •Time-horizon Advantage •Other Quantifiable Advantage

What factors impact the bid-ask spread?

•Liquidity: Increased liquidity leads to smaller spreads •Riskiness: Riskier assets tend to have higher spreads •Price Level: The spread as a % of the price increases as the price level decreases •Trading Volume •Size of trade (i.e., odd lots) •Ownership structure •Market Microstructure •Info transparency & Corporate Governance

Common Characteristics of Active Outperformance

•Low fees and expenses •Low turnover •High Active Share •Firm-wide focus on a core competency •Close alignment of interests

paper alpha and cost drag

•Many investment strategies appear to beat the market on paper, but actually underperform when implemented in the real world. •Major factors that affect performance is trading costs and taxes. •Many investors underestimate trading costs. •Trading costs are a critical component to any investment strategy.

Equity strategies

•Market Cap Focus •Domestic, International DM, and EM •Targeting Factors (Smart Beta) •Momentum •Value •Size •Low Volatility •Income

What to manage taxes

•Minimal Turnover •Tax-Based Trading •Tax Arbitrage Strategies based on how an investor is taxed

Types of Funds

•Money Market Funds •Equity Funds •Specialized Sector Funds •Bond Funds •Real Estate Investment Trusts (REITs) •International Funds •Balanced Funds - Hold both equities and fixed-income securities in stable proportion

Fiduciary

•One who acts in utmost good faith, in a manner he or she reasonably believes to be in the best interest of the client. •Legal obligation to put you in only the very best products they can •Must act in your best interest, not their own

Margin of Safety

•Only investing is stocks that trade at significant discounts to intrinsic value. Buying assets at a significant discount to underlying business value, and giving preference to tangible assets over intangibles.

Determinants of the cost of waiting to invest

•Private vs. Public Information •How Active is the Market for Information •Length of Investment Strategy •Contrarian vs. Momentum Strategy

What are qualified dividends?

•Qualified Dividends are taxed at lower rates but must meet the following criteria: •Dividends paid by a corporation operating in the US, or by a qualified foreign company •The shares should have been held at least 60 days during the 121-day period which starts 60 days prior to the ex-dividend date

Real Assets

•Real Estate •Infrastructure Assets •Farmland •Timberland •Intellectual Property •Art

Trending Fund Strategies

•Smart Beta •Thematic Funds •Environmental & Social Governance (ESG) •Target Date funds become more conservative as investor ages. Used in 401k plans as a set it and forget it retirement solution without considering an individual's personal risk tolerance.

System 1 Decision Making

•System 1 is an automatic, quick, and often unconscious way to make decisions. •"Fast Thinking" is efficient because it requires little cognitive energy or attention. •System 1 controls most of the decisions we make everyday. •System 1 relies on automatic processing, feelings, impulses, instincts, and intuition. •Unfortunately, System 1 is prone to biases and systematic errors.

System 2 Decision Making

•System 2 is a controlled way of thinking that requires significant mental energy. •"Slow Thinking" is conscious, deliberate, and analytical method of processing information. •System 2 is too slow and inefficient for making routine decisions. •The key is to learn to identify situations in which mistakes are likely and to avoid significant mistakes when the stakes are high.

Active Fund Concerns

•Tax Impact •High Cash Holdings •Style Drift •Herd Behavior •Closet Indexing •Window Dressing

Prior to making an investment a fully developed (written) investment thesis at a minimum should include:

•The data analyzed in the decision-making process •Interpretation of the data •Probabilities assigned to different outcomes •The drivers of those probabilities The catalysts for either meeting or missing investment expectations

What is risk?

•Total Risk vs. Downside Risk •Stand Alone Risk vs. Portfolio Risk

Robo Advisers

•Use algorithms and model portfolios to allocate investments according to a client's particular objectives and risk tolerance •Lower fees than a human investment adviser •Automated solution for portfolio asset allocation, rebalancing, reinvest dividends, and minimize the effects of taxes (via tax-loss harvesting) •Hybrid models (i.e., Vanguard's Personal Advisor)

Fixed Income Arbitrage funds

•attempt to identify overvalued and undervalued fixed income securities and profit from small price discrepancies while limiting interest rate risk. •Fund can combine long and short positions to neutralize against directional market movements.

Distressed Debt (or Securities) funds

•invest in debt (and equity) of companies that are in or near bankruptcy. Typically, long only strategies (due to illiquidity of distressed debt and difficulty shorting distressed equity)

Voice of Judgment

•is the internal dialog that judges yourself as well as others. •Ranges from 20 - 60% of mental chatter •Negative judgments typically outweigh positive ones for most people (but the range can be anywhere from 2 to 1 - 10 to 1)

Quantitative Funds select securities based on

•quantitative analysis. •Typically, rely on proprietary computer based models to determine if an investment is worth investing in. •Some quant shops rely 100% on the model for buy and sell decisions. Other quant funds incorporate human judgement in addition to quantitative models.

Suitability

•requires the individual handling your money to invest in products that are suitable for your objectives, means, and age •Does not require brokers to find the best products, but rather only ones that are seemingly suitable for the individual •Low bar - suitability is subjective

Hindsight Bias

•the tendency of people to view events as more predictable than they actually were before knowing the outcome. •Can result in an oversimplification of past market events in relation to cause and effect. •Can lead investors away from a more objective analysis of a potential investment.