Series 65, Unit 21: Portfolio Management

Formula for security market line (SML)

([Return of the market minus the risk-free rate] × beta) + RF rate

Strategies employed by bond buyers:

- barbell strategy - bullet strategy - laddering strategy *all three are considered active rather than passive

What are some technical market theories?

- short interest theory *high-short: bullish, low-short: bearish - odd-lot theory - advance/decline theory

What are the aspects of technical analysis?

- trendlines - support & resistance - breakout - moving averages

What is true about technical analysis?

- tried to identify trend & predict market changes - often accomplished by reviewing data in the form of charts - looks primary at past performance to predict trends - don't rely on financial ratios

Different types of management styles:

1. Buy and Hold (passive) 2. Indexing (passive) 3. Growth Style 4. Value Style 5. Contrarian 6. Income Appreciation 7. Capital Appreciation

What are the classes of diversification?

1. Cash and cash equivalents—passbook savings and checking accounts, money market accounts, money market funds, certificates of deposit, T-bills 2. Fixed-income investments—corporate bonds, municipal bonds, Treasury bonds, bond funds, mortgage-backed securities 3. Equities—preferred and common stocks of all kinds: growth and income appreciation, stock mutual funds 4. Hard assets—real estate, collectibles, precious metals, and stones

What are the three versions of efficient market hypothesis?

1. Weak Form Market efficiency 2. Semi-strong form market efficiency 3. Strong form market efficiency

Security Market Line

Allows us to evaluate individual securities for use in a diversified portfolio Uses: expected return for asset, risk-free rate, return on the market, beta of the asset

Test Topic Alert: Dollar Cost Averaging

Although it is unlikely that you will have to compute the average price or average cost per share, a question may ask the purpose of dollar cost averaging. The purpose of dollar cost averaging is to reduce the investor's average cost to acquire a security over the buying period relative to its average price.

Remembering the differences between market efficiency:

As a base level knowledge of the EMH, you should know that the weak form is based on past security market information; the semi-strong form is based on all public information (including market information); and the strong form is based on both public information and inside or private information.

Professional investment managers believe that a well-diversified portfolio offers protection from which of the following risks? A. Interest Rate risk B. Business risk C. Purchasing power risk D. Market Risk

B. Business risk

You have a client who wishes to manage his own portfolio of individual stocks. The simplest style for him to follow would be...

Buy & hold When it comes to individual stocks, nothing is simpler than buy and hold. If the client wished to have the simplest overall portfolio and didn't want to manage things, then indexing would be the answer.

The technician believes that if a breakout through resistance can be spotted, it represents a good buying opportunity for those quick enough to take advantage

Conversely, a breakout through the support level would represent a good opportunity for short sellers able to move quickly.

What does a portfolio manager focusing on income rely on?

Debt securities *frequently it will lead to foreign securities and high yield bonds*

What is EMH?

Effective market hypothesis maintains that security prices adjust rapidly to new information with security prices fully reflecting all available information. The conclusion is that under all circumstances, there is no way to accurately predict the stocks and that a passive strategy is likely the most suitable.

What is the difference between fundamental and technical analysis?

Fundamental: evaluate broad-based economic trends, current business conditions, & quality of a corporation's business Technical: attempt to predict the direction of prices on the basis of charts reflecting price & trading volume patterns of specific securities

Test Topic Alert: Growth Style

Growth managers are looking for earnings momentum

Test Topic Alert: Dividend Models

If you are asked on the exam, "Which model computes a higher current stock price?" it should be common sense that the answer that factors in "growth" is the correct answer. Remember, you will never have to do this computation on the test. (dividend growth vs. dividend discount)

Test Topic Alert: Growth vs. Value Style

In addition to the pricing models expressed above, growth managers expect to see high P/E ratios (price-to-earnings ratios) or high price-to-book ratios with little or no dividends. On the other hand, value managers expect to see low P/E ratios or low price-to-book ratios and dividends offering a reasonable yield. Another sign of a value stock is a large cash surplus, sometimes referred to as a rainy day fund.

Constant Ratio vs. Constant Dollar

Investment plans that attempt to maintain the type of allocation relationship in a ratio (in dollars for constant dollar)

Test Topic Alert: Value Style

Managers concentrate on undervalued or out-of-favor securities whose price is low relative to the company's earnings or book value and whose earnings are believed to be unattractive by investors & securities analysts.

Test Topic Alert: Tactical Asset Allocation

One way to remember that tactical is active is by thinking of the word like this: tACTical, where the act reminds you that it is active portfolio management.

What is active management?

Relies on the manager's stock picking and market timing ability to outperform market indexes. Market timing is the strategy of making buy or sell decisions, generally regarding stocks, by attempting to predict future price movements. Usually, the focus is on timing the overall market rather than a specific security.

Test Topic Alert: Technical Analysis

Remember that the market price of a security (the number that is being charted) is based on supply and demand.

What are the steps of the asset allocation process?

Step 1: Determine the objectives and constraints of the asset owner. Step 2: Create the investment policy statement (IPS). Step 3: Determine the asset allocation based on the IPS. Step 4: Allocate capital. Step 5: Monitor and evaluate investments.

Test Topic Alert: CML vs SML

The CML measures the risk through standard deviation (total risk). The SML measures the risk through beta (systematic risk only).

CAPM

The capital asset pricing model is a securities market investment theory allowing the investor to determine an asset's expected rate of return, a form of risk-adjusted return encapsulating how much risk the investor should assume to obtain a particular return from an investment. **solely on the basis of systematic risk (cannot be diversified)

What is a 'feasible set?'

The feasible set of portfolios represents all portfolios that can be constructed from a given set of stocks

Test Topic Alert: Hedging Strategies

The majority of our students report a question on protecting against loss on a short sale. As shown above, the best way to hedge is to buy a call option on the stock underlying the short sale. This strategy offers full protection against loss. Please notice that in protecting the long or short position, the investor buys an option. It is useful to remember that "you buy protection; you don't sell it." The same logic is true with futures contracts. The way to hedge is to buy. That creates what is called a long hedge.

Test Topic Alert: Long Stock & Long Puts

This strategy is also useful for managers of large portfolios, such as pension funds. If the portfolio consisted of large-cap stocks, a way to hedge against a down market would be to purchase put options on an index that mirrors the portfolio. In the case of large-cap stocks, that would generally be the S&P 500 index

(T/F) A covered call provides partial protection that generates income but reduces the stock's potential gain. Buying puts provides nearly total loss protection that costs money yet does not reduce the stock position's potential gain. The benefit of the covered call is that it does offer some hedging with no cost. In fact, the investor actually receives income in the form of the premium.

True

(T/F) In a fluctuating market, the average cost per share is lower than the average price per share.

True

Test Topic Alert: Capital Market Line equation

Uses expected return of the portfolio, risk-free rate, return on the market, standard deviation of the market, & standard deviation of the portfolio **Please note that alpha and beta are not used in the CML equation, while standard deviation is used.

Test Topic Alert: Strategic Asset Allocation

You may be asked about the relative commission expense when comparing active and passive management. It should be obvious that the more active the portfolio, the greater role commissions will play in determining overall portfolio performance. That is one reason why this style is more appropriate than strategic allocation for wrap-fee accounts.

Followers of the efficient market hypothesis believe that...

an efficient market is one that produces random results "random walk" or "throwing darts"

Modern Portfolio Theory

attempts to quantify and control portfolio risk; does not emphasize particular stocks but focuses on the relationships among all the investments in the portfolio

A technical analyst...

charts a stock's price and volume over a period of time

Dividend discount model

dividing the annual dividend by the expected return

What is the use of dollar cost averaging?

investing consistent amounts of money in a mutual fund or stock at a regular, periodic interval (monthly or quarterly) - reduces timing risk; investor can purchase more when prices are low and less when prices are high

Beliefs of a passive portfolio manager

no particular management style will consistently outperform market averages and therefore constructs a portfolio that mirrors a market index

Covered call

partial protection

Portfolio insurance

protective put

What is tactical asset allocation?

refers to short-term portfolio adjustments that adjust the portfolio mix between asset classes in consideration of market conditions & investor sentiment

What is strategic asset allocation?

refers to the proportion of various types of investments composing a long-term investment portfolio; passive

Beta is a measure of

relative systematic risk for stock or portfolio returns

The 2 most common forms of DCF used in the valuation of common stock are

the dividend discount and dividend growth models.

Growth investors usually seek stocks with high-growth expectations, reflected by a higher-than-normal P/E ratio

typically 20:1 or higher