Unit 20: Portfolio Management Styles, Strategies, and Techniques

Does a "buy-and-hold" strategy usually result in lower or higher transaction costs?

"buy and hold" strategy usually results in lower transaction costs.

What is the least active strategy of the three?

*The bullet strategy* is the least active strategy of the three. It involves investing in bonds all maturing at or about the same time (such as when a child is entering college). As such, once the portfolio is established, the investor basically sits and waits for the bonds to mature. Barbell and ladder strategies have bonds maturing at regular intervals requiring an active role in reinvesting the principal.

What are the two main asset allocation styles?

1. Tactical asset allocation 2. Strategic asset allocation.

What is the standard rule for determining what proportion of someone's portfolio should be in stocks vs. bonds

100 - investor's age = amount that should be in stocks E.g. if you're 27 years old, 73% should be in stocks

What are the three major types of asset classes?

3 major asset classes: 1) Stock 2) Bonds 3) Cash

What are the three strategies you can use to minimize interest rate risk?

3 strategies to minimize interest rate risk: 1. Barbell strategy 2. Bullet strategy 3. Laddering strategy

What is a growth manager's main goal?

A growth manager is looking for *earnings momentum*

According to EMH, if a financial market is weakly efficient, what type of analysis could still be used to seek out mispriced investments?

According to EMH, if a financial market is weakly efficient, you could still use *fundamental analysis* to seek out mispriced investments.

What does "active management" of a portfolio rely on the portfolio manager having?

Active management relies on portfolio manager's stock picking and market timing --> ability to outperform market indexes

What are the advantages of the Monte Carlo Simulation?

Advantages of Monte Carla Simulation: -Can clearly display tradeoffs of risk and return -Clearer understanding of short- and long-term risk -Can better model real probability -Can potentially answer questions like "do savings need to be increased?"

What is the goal of an efficient frontier re: the risk/return curve?

An efficient frontier should fall *on* the risk/return curve, not below it.

What two things does an efficient portfolio aim to offer?

An efficient portfolio aims to offer: 1. The most return for a given amount of risk 2. The least risk for a given amount of return

An investment plan that tries to maintain the determined ratio is called a _____ ______ _______

An investment plan that tries to maintain the determined ratio is called a *constant ratio plan*

An investor buys 100 shares of RST at 53 and writes 1 RST 55 call at 2. What is the maximum gain?

An investor buys 100 shares of RST at 53 and writes 1 RST 55 call at 2. --> if selling shares at strike price, $200 profit (55-53, original purchase price) --> $200 profit from premium *Max gain is $400*

What does asset allocation refer to?

Asset allocation is spreading a portfolio out among diversified risks and returns, based on the investment policy statement (IPS).

What is a barbell strategy?

Barbell strategy: -Purchase some bonds that mature in 1-2 years -Purchase some bonds that mature in 10+ years Nothing in between! --> short-term ones would yield sooner, and you can reinvest, while longer-term ones usually have higher interest rates

What does that mean?

Basically, SML helps you determine how much OVER the risk-free rate we should earn for taking the investment risk

What is the bullet strategy? (How you structure it, and the objective)

Bullet strategy: If you have 12 years until a goal (e.g. child's college education), purchase bonds that mature in 12 years; in two years, purchase 10 year bonds, in two years, buy 8 year bonds, etc. Allows you to capture current interest rates as they change.

In a buy and hold strategy, are gains usually taxed on short or long term basis?

Buy-and-hold strategy--> gains usually taxed on long-term capital gains basis

What is the basic premise of the Capital Asset Pricing Model (CAPM)?

CAPM = each investment carries both systematic and unsystematic risk. Only unsystematic can be diversified away.

What 5 factors does the CML use to determine expected return based on level of risk?

CML equation uses: 1. Expected return of portfolio 2. Risk-free rate 3. Return on the market 4. Standard deviation of the market 5. Standard deviation of the portfolio

What does the Capital Market Line (CML) equation provide?

CML provides expected return based on level of risk

What is a constant dollar plan?

Constant dollar plan = one that tries to maintain a constant dollar amount in stocks --> moves money in and out of a money market fund when necessary

What is a "contrarian" investment manager?

Contrarian investment manager = one who takes positions opposite to general beliefs/other investment managers (they buy when everyone else is selling)

What are disadvantages of Monte Carlo Simulation?

Disadvantages of MCS: -Simplistic use of historical data for inputs -Models use asset classes but not actual assets held

What is *dollar cost averaging*?

Dollar cost averaging = Investing consistent amounts of money on a regular interval E.g. putting $50 in a mutual fund every month

What does dollar cost averaging allow you to do?

Dollar cost averaging allows you to purchase more when prices are down and less when prices are up.

What risk does dollar cost averaging reduce? (this isn't a systematic/nonsystematic risk)

Dollar cost averaging reduces *timing risk*, aka the risk that all money will be invested at market top.

What does the Efficient Market Hypothsis posit?

EMH says that securities prices adjust rapidly to new info --> securities prices fully reflect all available information ---> AKA, markets are priced efficiently

What are the three versions/theories of the Efficient Market Hypothesis?

EMH theories: a. Weak-form market efficiency b. Semi-strong-form market efficiency c. Strong-form market efficiency

What is an "efficient frontier"?

Efficient frontier = a collection of efficient portfolios. Also called an efficient set.

Every portfolio residing ON the efficient frontier has a _______ risk for equal rate of return than a portfolio residing below the efficient frontier

Every portfolio residing ON the efficient frontier has a *lower risk for equal rate of return* than a portfolio residing below the efficient frontier

Every portfolio residing on the efficient frontier has a _______ rate of return for equal risk than another portfolio below the efficient frontier

Every portfolio residing on the efficient frontier has a *higher rate of return for equal risk* than another portfolio below the efficient frontier

Fixed-income assets are a hedge against __________

Fixed income assets are a hedge against *deflation* (and equity assets are a hedge against inflation)

Which type of analysis (fundamental vs technical) is then useful/not of use for weak-form market efficiency?

For weak-form market efficiency, fundamental analysis or insider info may provide higher than expected return, but NOT technical analysis.

What does it mean if a portfolio manager uses a *growth style* of portfolio management?

Growth style focuses on stocks of companies whose earnings are a) growing faster than that of most other stocks, and b) are expected to keep doing so

Do investment managers tend to buy growth stocks at the high end or low end of their 52-week price range?

Investment managers tend to buy growth stocks at the high end of their 52-week range (some think they are buying overvalued stocks)

Does a ladder portfolio provide higher or lower yields that a short-term bond portfolio?

Ladder portfolio typically provides *higher* yields that a short-term portfolio

What is the ladder strategy?

Ladder strategy: -Bonds are purchased at the same time but mature at different times -When shorter ones mature, reinvest them and become the long-term ones

Large cap companies

Large cap companies = $10 billion +

Name a few assumptions in Modern Portfolio Theory

MPT assumes that: -Investors can borrow/lend money at risk free rate of return -Investors are rational and evaluate investments re: expected return and risk -There is no inflation -Fractional shares can be purchased -No mispricing; market pricing is efficient

What two factors make up market capitalization?

Market capitalization is the product of: 1. Number of outstanding shares 2. Current market price per share.

How much market cap does a *micro-cap* company have?

Micro cap = typically <$300 million

Mid-cap companies

Mid cap companies = $2 billion - $10 billion

What does Modern Portfolio Theory try to do?

Modern Portfolio Theory focuses on the relationship between all securities in a portfolio, vs. the performance of particular securities. --> seeks to decrease risk while increasing returns

The Monte Carlo Simulation is.....

Monte Carla Simulation = A computer programming tool that generates hundreds or thousands of probable performance outcomes. Used widely in the field of finance.

Is it possible for a portfolio to fall above the efficient frontier?

No, a portfolio cannot be above the efficient frontier.

What is an "optimal portfolio"?

Optimal portfolio = one that returns the highest rate of return in relation to the amount of risk that an investor is willing to take.

What kind of risk does portfolio diversification reduce?

Portfolio diversification reduces unsystematic risk.

What is the ultimate purpose/advantage of dollar cost averaging?

Purpose of dollar cost averaging is to *reduce investor's average cost to acquire a security over the buying period relative to its average price.*

What is the ultimate conclusion of Random Walk Theory?

Random Walk Theory = passive investment is the best form of investing, because you'll never beat the market

What is the Random Walk Theory?

Random walk theory = you could throw darts at stock listings and that's as good a method as any for selecting stocks for investment

what does the security market line (SML) allow you to evaluate?

SML allows you to evaluate *individual securities* for use in a diversified portfolio

SML determines the expected return for its security on the basis of: a. Its ________ b. Expectations of the market c. Risk free rate

SML determines the expected return for its security on the basis of: a. Its *beta* b. Expectations of the market c. Risk free rate

What 4 things go into an SML calculation?

SML uses: -Expected return for the asset -Risk-free rate -Return on the market -Beta coefficient

What is the formula for SML (aka the expected rate of return for a particular stock) *This is also in your notebook, in color!

SML: [Expected market rate - risk-free return rate] x [Stock's beta] + [Risk-free return rate] = Expected rate of stock's return

A client is 30 years old, and initially invests $100,000 (split 70K in stocks and 30K in bonds). The market has risen and the account value is now $120,000, and equities are $90K and debt $30K. How should the portfolio be rebalanced to attain the original 70/30 split.

Sell $6K stocks, buy $6K bonds --> $84K stock, $36K bonds

What is semi-strong form market efficiency?

Semi-strong-form market efficiency = Current stock prices reflect all historical price data AND analysis of financial statements/industry/current economic outlook.

What is the only thing that would provide above-market returns, according to semi-strong-form market efficiency?

Semi-strong-form market efficiency says that only insider information would provide above-market returns.

What is a semi-weak EMH?

Semi-weak EMH *doesn't exist*. There is only semi-strong EMH.

Small-cap companies =

Small cap companies >$300 million, <$2 billion

What is *Stochastic modeling*?

Stochastic modeling = method of financial analysis that uses thousands of lil simulations to try to forecast how returns of different investment returns on different asset classes vary over time

Is strategic asset allocation active or passively managed?

Strategic asset allocation = PASSIVE

What is strategic asset allocation?

Strategic asset allocation = setting portfolio priorities/allocations and rebalancing periodically (e.g. moving into more conservative investments as someone gets closer to retirement)

What is strong-form market efficiency?

Strong-form market efficiency says that security prices *fully reflect all information from both public and private sources*. E.g. public market, insider information

According to strong-form market efficiency, what would provide above-market returns?

Strong-form market efficiency: -All the information is wrapped up in the price, nothing intentional will provide above market returns --> random walk theory is your best bet

What is *tactical asset allocation*?

Tactical asset allocation = *short term* portfolio adjustments in response to current market conditions and investor sentiment e.g. if the stock market is expected to do well over the near term, a portfolio manager may allocate more of the portfolio to stocks.

Is tactical asset allocation passive or active?

Tactical asset allocation = ACTIVE *tACTical*

Are these strategies active or passive?

These strategies are active.

What is time-based investing?

Time-based investing tries to average your cost.

What are two popular time-based investment programs?

Two popular time-based investment programs: 1. Dollar-cost averaging 2. Income reinvestment

What is the ultimate goal of capital market theories?

Ultimate goal of capital market theories = to maximize return while minimizing risk.

What kind of P/E ratio does a value manager expect to see?

Value manager expects to see a *low* P/E ratio (company might even be operating at a loss)

What does it mean if a portfolio manager uses a *value style* of portfolio management?

Value style = concentrating on undervalued or out-of-favor securities (because they're going for cheap and might earn more later)

Which strategy is the purchasing of very long-term and very short-term bonds?

Very long-term + short-term bonds = barbell

What does *Weak-form market efficiency* say?

Weak-form market efficiency: -Current stock prices have already incorporated all historical market data --> historical price trends have no value in predicting future price changes

What would a strategic asset allocation supporter believe about beating the market?

When you use strategic asset allocation, you don't think you can beat the market.