Portfolio Management Styles -Unit 20

When building an investment portfolio, it is generally recommended that an asset allocation process be used to increase the portfolio diversification and reduce risk. Which of the following is least likely to be considered an asset class? A) Mutual funds B) Stock C) Cash and cash equivalents D) Bonds

A) Mutual funds The 3 basic asset classes are equity (stock), debt (bonds), and cash/cash equivalents. Mutual funds are viewed as a tool for allocating to one or more specific asset classes; they, in themselves, are not an asset class. For example, a mutual fund investing in investment-grade bonds would be part of the portfolio's debt security allocation while a money market mutual fund would be part of the cash equivalents allocation. Many asset allocation models add tangibles, such as real estate or certain commodities. Unlike mutual funds, REITs are often used as a proxy for real estate so they might be considered an asset class on the exam.

Customer A and Customer B each have an open account in a mutual fund that charges a front-end load. Customer A has decided to receive all distributions in cash, while Customer B automatically reinvests all distributions. How do their decisions affect their investments? I. Receiving cash distributions may reduce Customer A's proportional interest in the fund. II. Customer A may use the cash distributions to purchase shares later at NAV. III. Customer B's reinvestments purchase additional shares at NAV rather than at the offering price. IV Due to compounding, Customer B's principal will be at greater risk. A) II and III B) I and IV C) I and III D) II and IV

B) I and IV If the customer elects to receive distributions in cash while other investors purchase shares through reinvestment, his proportional interest in the fund will decline. Automatic reinvestment is always at NAV.

Which of the following characteristics best exemplifies a value stock? A) Low earnings-per-share growth, high profitability B) Low price-to-book, low price-to-earnings ratio C) High earnings-per-share growth, high profitability D) Low price-to-book, high price-to-earnings ratio

B) Low price-to-book, low price-to-earnings ratio A value investor focuses on share price in anticipation of a market correction and improving company fundamentals. Therefore, such an investor tends to select a stock featuring lower price-to-earnings and price-to-book value ratios. A growth investor focuses on high earnings-per-share, growth, and high profitability.

The capital asset pricing model (CAPM) is used by many to assess the expected return of a security. If the current risk-free rate is 2%, the current return on the market is 10%, and a particular stock's beta is 1.5 with a standard deviation of 3.2, the expected return would be A) 12% B) 15% C) 14% D) 18.2%

C) 14% The formula for this computation is as follows: 10% (the return on the market is a beta of 1.0) minus the risk-free rate of 2%, or 8%. Then, multiply that by the beta of this stock (1.5) to arrive at 12%. That is, the stock should return 12% above the risk-free rate of 2%, or 14%. The standard deviation is not relevant to this computation.

Which two of the following would you expect of a growth stock? I. High price/earnings ratio II. Low price/earnings ratio III. High dividend payout ratio IV. Low dividend payout ratio A) II and IV B) I and III C) I and IV D) II and III

C) I and IV Growth stocks are stocks of companies that plow their earnings back into further product development. They sell at a high price-earnings ratio and pay out little or nothing as a percentage of their earnings in dividends.

If the current risk-free rate is 5%, and the expected return from the market is 10%, what return should we expect from a security that has a beta of 1.5? A) 15% B) 10% C) 11.5% D) 12.5%

D) 12.5% The expected return = 5% / (10% - 5%) × 1.5 5% / (5% x 1.5) = 5% / 7.5% = 12.5%.

Investment advisers who preach the benefits of strategic asset allocation do so because they believe A) over the long run, strategic management will eventually outperform the market B) the market is perfectly efficient because stock prices reflect all available information C) active management of a portfolio offers tactical benefits D) the market is basically inefficient and there is a strategy that can beat it

B) the market is perfectly efficient because stock prices reflect all available information The primary difference between strategic and tactical asset allocation comes down to the belief by those following the strategic style that it is not possible, over a long period of time, to beat the market. U20LO10

An investment adviser who believes that we are in the early recovery portion of the business cycle would most likely recommend A) long-term bonds. B) value stocks. C) cyclical stocks. D) defensive stocks.

C) cyclical stocks Cyclical stocks have a high correlation to the swings in the economy as reflected in the business cycle. The ideal time to purchase stocks that are affected by economic cycles is right as the recovery begins from a trough (or recession). Defensive stocks are good to hold when the economy is in the early contraction period of the cycle. During a recovery, interest rates usually rise and that is not good for holders of long-term bonds because as interest rates go up, bond prices fall. Value stocks might also perform well, but many studies have shown that they offer better relative performance in periods of contraction rather than expansion.

You have a client who wishes to manage his own portfolio of individual stocks. The simplest style for him to follow would be A) tactical B) buy and hold C) core D) indexing

B) buy and 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.

An investment strategy where a higher price is paid for a stock based on expected returns is A) dollar cost averaging B) growth investing C ) futures investing D) return on investment.

B) growth investing A growth investor purchases shares that have exhibited faster-than-average gains in earnings over the past few years that is likely to continue to show high levels of margin. Over the long run, growth stocks tend to outperform the market but are riskier than most other stocks and generally pay little or no dividend.

The concept of creating a model portfolio, through asset allocation principles, that both increases return and reduces risk is known as A) portfolio optimization B) rebalancing C) corrective adaptation D) risk reduction fundamentals

A) portfolio optimization One of the primary concepts of asset allocation is that the performance of a portfolio can be enhanced while also reducing the associated risk. This is accomplished through a proper allocation of assets, among many different asset categories, to establish a portfolio suitable for the investor's risk tolerance and desired performance. This model portfolio would lie on the efficient frontier, thus representing the optimal portfolio for the client-maximum return with the least risk.

As a rule, which of the following is NOT a characteristic of micro-cap stocks? A) Are typically subject to higher business risk than large-cap stocks B) Have lower liquidity because they are thinly traded C) Represent mature, well-established companies D) Sometimes have great potential for growth

C) Represent mature, well-established companies Micro-cap stocks generally represent younger, less-established companies than large-cap stocks. As a result, micro-cap stocks sometimes have a great potential for growth. At the same time, though, they may be subject to greater business risk than stocks in more mature companies. In addition, their shares are often thinly traded, so they can have fairly low liquidity.

All of the following statements concerning capital market theory are correct EXCEPT A) the security market line (SML) is the graphical depiction of the capital asset pricing model (CAPM). B) the market risk premium is the difference between the expected return for the equities market and the risk-free rate of return. C) beta is a measure of volatility, or relative unsystematic risk, for stock or portfolio returns. D) the security market line (SML) depicts the tradeoff between risk and expected return for all assets, whether individual securities, inefficient portfolios, or efficient portfolios.

C) beta is a measure of volatility, or relative unsystematic risk, for stock or portfolio returns. Beta is a measure of relative systematic risk for stock or portfolio returns. A stock or portfolio with a beta of 1.0 would have the same systematic risk as the overall market.

An investor has $50,000 to invest in bonds. Currently, 10-year bonds are offering very attractive yields, but the client is concerned that in a few years, rates will be even higher. What would you suggest? A) Bullet bonds B) Diversifying C) Barbell bonds D) Laddering

C) Barbell bonds With the barbell strategy, the investor would place $25,000 into bonds maturing in 10 years and the other half into bonds maturing in two years. This makes $25,000 available for reinvestment in two years enabling the investor to take advantage of the higher rates (if they materialize).

Professor William Sharpe stipulated that certain assumptions must be present for the capital asset pricing model (CAPM) to be useful. Which of the following is not one of these assumptions? A) Investment expenses, such as taxes and transaction costs, are relevant in investment decision making. B) All investors have the same expectations for a given investment. C) Investors can always borrow and lend money at the risk-free rate of return. D) At all times, capital markets are in equilibrium.

A) Investment expenses, such as taxes and transaction costs, are relevant in investment decision making. The CAPM does not consider taxes or transaction costs; they are irrelevant. The main assumptions of the capital market theory are as follows: All investors can borrow or lend money at the risk-free rate of return. All investors are rational and evaluate investments in terms of expected return and variability (standard deviation). Therefore, given a set of security prices and a risk-free rate, all investors use the same information to generate an efficient frontier. The time horizon is equal for all investors: when choosing investments, investors have equal time horizons for the chosen investments. There are no transaction costs or personal income taxes; investors are indifferent between capital gains and dividends. There is no inflation. All assets are infinitely divisible: this means that fractional shares can be purchased. There is no mispricing within the capital markets: it is assumed that the markets are efficient and that no mispricings within the markets exist. Another way to state this is that capital markets are in equilibrium. U20LO8

Emanuel owns 500 shares of IJKL common stock with a cost basis of $63 per share. IJKL is now priced at $82 and Emanuel is concerned that the stock may suffer a sharp decline in the near term. As his IAR, you would suggest his best move to protect his profit would be to A) buy 5 IJKL 80 put options. B) buy 5 IJKL 80 call options. C) sell 500 shares of IJKL short. D) sell 5 IJKL 80 put options.

A) buy 5 IJKL 80 put options. When one is long a security, the best hedge is to buy a put. Should Emanuel's fears be realized, regardless of how low the stock declines, he will be able to exercise and deliver his 500 shares at the strike price of $80 per share. An alternative would be to sell call options, but that is generally not going to be the correct choice when the question asks about protecting a profit. Writing an option is more appropriate when the question deals with the investor generating income. U20LO12

Two portfolios have the same expected return of 10%. Portfolio A has a standard deviation of 5% and Portfolio B has a standard deviation of 18%. Under modern portfolio theory (MPT), A) neither portfolio would be acceptable because the risk is too high for the expected return B) Portfolio B would be preferred by investors because its standard deviation is more than 3 times that of Portfolio A C) Portfolio A would be preferred by investors because the portfolio has the same return as Portfolio B but bears less risk D) neither portfolio would be preferred because both portfolios have the same 10% expected return

C) Portfolio A would be preferred by investors because the portfolio has the same return as Portfolio B but bears less risk Portfolio A would be preferred by investors because it has the same return (10%) as Portfolio B but bears less risk. One of the assumptions of MPT is that investors prefer less risk rather than more risk per unit of return. Because Portfolio A has a smaller standard deviation than that of Portfolio B, it has less risk. Standard deviation measures the volatility of a security. The larger the standard deviation, the larger the security's returns are expected to deviate from its average return and, hence, the greater the risk.

Ian is a technical analyst who believes the market, as represented by the S&P 500 Index, is overbought. Over the next several months, there is a 12% correction. Which of the following strategies would have been successful for Ian? A) Buy call options on the S&P 500 Index B) Buy futures contracts on the S&P 500 Index C) Sell put options on the S&P 500 Index D) Sell futures contracts on the S&P 500 Index

D) Sell futures contracts on the S&P 500 Index Ian was obviously bearish on the market. When something is overbought, it means it is overvalued due to excessive buying at unreasonably high prices. In this case, it is likely the market is primed for a correction (a reversal). The 12% correction proves him to have been correct. Selling a futures contract is taking a short position. Just as with selling stock short, the investor profits when the price of the underlying asset declines. Ian could have also profited by going long (buying) put options on the index. Selling puts and buying calls generate profit in a bullish market, not a bearish one.

A high-risk investment strategy is the short sale of stock. Each of the following is a method of offering some degree of protection EXCEPT A) entering a buy stop order for the short stock. B) selling a put on the short stock. C) buying a call on the short stock. D) buying a put on the short stock.

D) buying a put on the short stock. The risk in selling a stock short is that the price of the stock will rise rather than fall. Those who purchase put options have the same market view as those who sell short—they will profit if the price of the security declines. Buying a put would be the equivalent of "doubling down" on your bet. The best way to hedge (protect) a short stock position is to purchase a call option on the security because that gives you a guaranteed "buy-back" price regardless of how high the stock's price rises. If you sell a put on the stock and the price rises, the put will expire and the seller will have the premium to partially offset any loss. If the short seller enters a buy stop order, once the price rises (or goes through) the stop price, a market order to buy the stock will be entered and the position will be closed out preventing any further loss.

In a financial market that is efficient, A) investors who do not believe in the efficient market hypothesis (EMH) will stop seeking undervalued securities. B) the prices of securities will not differ from their justified economic values for any length of time. C) new information will be slowly reflected in securities prices. D) investors will take an active investment strategy if they are strong believers in the efficient market hypothesis (EMH).

B) the prices of securities will not differ from their justified economic values for any length of time. An efficient market is a market that quickly reflects all new information. Accordingly, securities prices will not depart from their justified economic value for any extended period of time. Investors who are strong subscribers to the efficient market hypothesis (EMH) will be passive investors because they believe you just can't beat the market. On the other hand, investors who do not believe in the EMH will become active investors and will seek to identify undervalued securities.

If a portfolio manager wished to reduce inflation risk, which of the following would be most appropriate to add to the portfolio? A) Tangible assets B) AAA bonds C) Preferred stock D) Fixed annuities issued by an insurance company with Best's highest rating

A) Tangible assets Tangible assets, such as real estate, precious metals, and other commodities, tend to keep pace with inflation. Fixed dollar investments do not.