FIN 331 Final Pt. 1, Jean Snavely, Western Kentucky University

What are the Five Steps in implementing a Passive Management Plan?

1. Determine a portolio's objective by understanding the investor's income needs, time horizon, tax situation, ability to handle risk, and unique circumstances 2. Analyze various asset classes to estimate their long term risks and returns, correlations with other asset classes, and tax efficiency, if applicable 3. Create an appropriate strategic asset allocation that reflects the investment opportunities 4. Choose securities that best represent each asset class. Low-cost index funds and select ETFs make good choices because they offer broad diversification and closely track market indexes 5. Implement the plan fully and maintain the strategic asset allocation through occasional rebalancing to control portfolio risk and enhance return

Five conclusions related to persistence of performance

1. There was only short-term persistence (4 quarters) 2. Performance attracts new money 3. Manager's drive to perform diminishes with more assets under management 4. Salaries and fees rise with performance 5. Future performance is random

When was the first open-end stock fund introduced

1928

What is an IPS?

A Investment Policy Statement documents structure and helps ensure fair and equitable investment result over the long term. A guide for an investment plan

What is a fixed income fund?

A type of investing or budgeting style for which real return rates or periodic income is received at regular intervals at reasonably predictable levels.

A proper benchmark should be:

A viable alternative Not easily beaten Low in cost identifiable before the fact

Vanguard 500 Index Fund

Beat 85% of all actively managed funds in a 25 year period Low Turnover Low fees Top echelon of performance

What should the benchmark represent?

Before costs, is should represent the aggregation of all active managers who participate in the asset class

How can an investor achieve the highest probability for meeting an investors financial objectives?

Combining index funds from a number of asset classes

Types of International Equity index Funds

EAFE (Europe, Australasia, Pacific East - developed countries outside US and Canada) MSCI ACWI (Morgan Stanley Capital International All Country World Index Ex-U.S.)

Types of index funds

ETFs Mutual Fixed Income International REITs

Five big liabilities individual investors face over a lifetime

Education costs Home ownership Retirement funding Charitable Giving Bequest to loved ones

Benefits of index investing

Eliminate management fees and sales loads Minimizes operating costs and portfolio turnover costs

How often is the Sharpe Ratio re-calculated?

Every month

Consequences of an actively managed index fund

Higher fees- double and triple the fees of traditional index funds Often leveraged

What is an ETF?

In the simplest terms, Exchange Traded Funds (ETFs) are funds that track indexes like the NASDAQ-100 Index, S&P 500, Dow Jones, etc. When you buy shares of an ETF, you are buying shares of a portfolio that tracks the yield and return of its native index.

What is the Morningstar Tax Cost ratio

It measures how much a fund's annualized return is reduced by the taxes investors pay on distributions. Mutual funds regularly distribute stock dividends, bond dividends and capital gains to their shareholders. Investors then must pay taxes on those distributions during the year they were received.

What is the SPIVA Performance studies

It tracks one, three, and five year active mutual fund performance across several different asset classes and is derived from a survivorship-bias-free database. It includes: US equity US real estate US fixed income International equity Emerging markets equity International fixed income

Who designed the first index fund?

John Bogle, the founder of Vanguard, in 1976

Benefits of Passive Investing

Lower Costs Lower turnover

Qualitative factors as predictors

Manager education and experience: 1988 to 1994 MBAs performed better than non-MBAs (took more risk) Younger performed better Higher SAT scores improved performance Ivy league graduates performed better Management has skin in the game (small sample over short period) Less of an agent, more owner Managerial ownership > $1million outperformed others Lower turnover

What opportunities does rebalancing the Russell 2000 provide?

Manipulation

What passive investors should care about

Market and subsections of the market returns

Are all index funds passive?

No, there are active index funds that are costly and generally underperform the market

Popular methods for choosing actively managed funds

Past performance Ratings Personal investment by manager

The SEC requires all funds to disclose that...

Past performance is not an indication of future returns

How can an investor opt for investment with greater certainty?

Picking correct active fund manager Picking an indexed fund

What is Jensen's alpha?

Portfolio return that can't be explained by beta. Found that costs are often greater than risk-adjusted return

What is small cap?

Refers to stocks with a relatively small market capitalization. The definition of small cap can vary among brokerages, but generally it is a company with a market capitalization of between $300 million and $2 billion.

Ratings don't consider

Risk Persistence Category definitions

Cowles Commission Report

Studied 20 insurance companies and found that 6 outperformed and the rest outperformed. Showed that as an investor you are twice as likely to lose as you are to win. Results were more consistent with luck rather than skill

What index did the first index fund follow?

The S&P 500

What kind of indexes should you buy?

The benchmarks

Why should investors deal passively vs. Actively

The costs are lower, diversification broader, the transparency of fund holdings is superior, and the tax benefit from lower turnover helps investors whose accounts are subject to taxation

Successful Investment Experience depends on

The development of a prudent investment policy Full implementation of the policy Discipline to adhere to the plan

Intended to help investors determine the risk-reward profile of a mutual fund

The five technical risk ratios

Why has what qualifies as an index broadened over the past few years?

The introduction of more ETFS into the market that follow highly-customized nonstandard index methods

Fund Objective for Passive Investing

To beat the market

What can the Sharpe Ratio be used for?

To compare directly how much risk two funds each had to bear to earn excess return over the risk-free rate

What is the difference between the Sharpe Ratio and the Treynor ratio?

Treynor Ratio utilizes "market" risk (beta) instead of total risk (standard deviation)

T/F Actively managed funds underperform the market by close to their average costs

True

T/F There is no evidence that supports that actively managed index funds perform greater than passively managed index funds

True

Who developed the risk-adjusted measure?

William Sharpe

What is a REIT?

a company that owns and typically operates income-producing real estate or related assets. These may include office buildings, shopping malls, apartments, hotels, resorts, self-storage facilities, warehouses, and mortgages or loans.

What is the Treynor Ratio?

a measurement of efficiency utilizing the relationship between annualized risk-adjusted return and risk

What is alpha?

a risk-adjusted measure of the so-called active return on an investment. It is the return in excess of the compensation for the risk borne, and thus commonly used to assess active managers' performances.

The five technical risk ratios

alpha, beta, standard deviation, R-squared, and the Sharpe ratio

The higher the Sharpe ratio, the _____________ the fund's risk-adjusted performance

better

How is the Sharpe Ratio calculated?

by using standard deviation and excess return to determine reward per unit of risk.

The Treynor is used to

diversify non-market risk

While using the Treynor ratio, good performance is indicated by a ____ ratio

high

What is an index?

is a generic term that describes a list of securities that are selected and weighted according to a set of rules provided by an index originator

How is the tax cost ratio similar to an expense ratio?

is a measure of how one factor can negatively impact performance. Also like an expense ratio, it is usually concentrated in the range of 0-5%. 0% indicates that the fund had no taxable distributions and 5% indicates that the fund was less tax efficient. For example, if a fund had a 2% tax cost ratio for the three-year time period, it means that on average each year, investors in that fund lost 2% of their assets to taxes. If the fund had a three-year annualized pre-tax return of 10%, an investor in the fund took home about 8% on an after-tax basis. (Because the returns are compounded, the after-tax return is actually 7.8%.)

What is a benchmark?

is a plain vanilla index and beta seeking index