13. Fads and Fashions

Question 1

True diversification comes from combining

Answer 1

lightly or negatively correlated risky assets, adding investment grade bonds to a stock portfolio does not provide true diversification

Question 2

Why would you add an investment grade bond to your portfolio?

Answer 2

to adjust for the level of risk aversion

Question 3

Is it possible to make bonds risky?

Answer 3

Yes –> if you borrow money and invest you can increase your beta and make investing in bonds risky (e.g. borrow 100% of money invested = beta 2)

Question 4

Risk-parity funds

Answer 4

leverage up the bond position of a portfolio until the stocks and bonds have equal risk in the portfolio (e.g. by borrowing the money and overinvesting in bonds)

Question 5

If the interest rate goes down what happens to bond prices?

Answer 5

Increase

Question 6

Trend in interest rates between 1981-2011?

Answer 6

Decreasing –> bond prices increasing

Question 7

Size of global bond market

Answer 7

$175 trillion

Question 8

Why is there more financial news headlines about stocks and crypto than bonds?

Answer 8

Bonds are not risky –> focus is on risky assets

Question 9

What are the benefits of the risk-parity funds?

Answer 9

Creates true diversification by making bonds risky

Question 10

On average, do you expect bonds to earn a higher or lower returns than stocks over an investment horizon?

Answer 10

From 1981-2011 bonds generated a higher return than stocks as interest rates kept declining

Question 11

US T-bonds with maturities of over 20 years or more _______ the broad stocks market (S&P500) over an investment horizon of 30 years?

Answer 11

Overperformed (11.5% p.a. vs. 10.8% for stocks)

Question 12

What is the coupon rate for a bond with a 20 year maturity?

Answer 12

High - compensating for more risk

Question 13

How were US T-bonds able to outperform S&P500?

Answer 13

Secular (persisting over many years) decline in long-term interest rates

Question 14

Rank the riskiest to least risky bond types (1 riskiest to 4 least risky)

Answer 14

1. Long Maturity, Low Coupon
2. Short Maturity, Low Coupon
3. Long Maturity, High Coupon
4. Short Maturity, High Coupon

Question 15

Types of bonds that are more sensitive to interest rate changes

Answer 15

Long maturity and low coupon rate

Question 16

When there is a trend of declining interest rates how long does it take for the interest rate to return to its original rate?

Answer 16

18-58 YEARS

Question 17

If interest rates are going up and you invest in a risk parity fund you can expect to make a…

Answer 17

loss

Question 18

If interest rates are going down and you are invested in risk parity fund you can expect to make a…

Answer 18

gain

Question 19

Five Categories of Smart Beta Strategies: 1. Funds with “____”

Answer 19

alternative weighting schemes - fundamental indexation strategies that use rules-based criteria on earnings, P/E, low beta, etc.

Question 20

Five Categories of Smart Beta Strategies: 2. Alternative asset classes

Answer 20

i.e. other than equity and fixed income, including commodity, infrastructure, etc

Question 21

Five Categories of Smart Beta Strategies: 3. Alternative payoff ____

Answer 21

structures - (e.g. leveraged or inverse strategies, downside protection strategies, etc.)

Question 22

Downside protection strategies

Answer 22

aim to reduce risk resulting from significant market declines, involving adjusting a portfolio’s market exposure to limit the impact of potential losses from market downturns. also known as smart beta

Question 23

Five Categories of Smart Beta Strategies: 4. Alternative fund types

Answer 23

e.g. hedge funds

Question 24

Five Categories of Smart Beta Strategies: 5. alternative risk factor tilts

Answer 24

also called risk premium investing or factor based investing e.g. size, value, momentum, volatility, quality, etc.