8. Security Market Indices / Equity Portfolio Management

Question 1

Why is it contended that bond-market indexes are more difficult to construct and maintain than stock-market indexes?

Answer 1

• Wide diversity of bonds available
• Bonds are hard to standardise because their MATURITIES AND MARKET YIELDS are constantly changing
• One solution is to segment the market into sub-indexes based on coupon, quality, industry etc

Question 2

Discuss three strategies active managers can use to add value to their portfolios.

Answer 2

1. Timing their investments in the various markets in light of market forecasts and estimated risk premiums
2. Shifting funds between various equity sectors, industries, or investment styles in order to catch the next hot concept
3. Stock-picking of individual issues (buy low, sell high)

Question 3

Describe the difference between price momentum strategy and earnings momentum strategy.

Answer 3

• PMS: based on the assumptions that a stock’s recent price behaviour will continue to hold (buy rising stock, sell falling stock)
• EMS: firm’s stock price will ultimately follow its earnings. The measurement of earnings momentum is usually based on a comparison to expected earnings.
• These two approaches may produce similar portfolios if the company’s P/E ratios remain stable as their earnings (or prices) exhibit momentum characteristics

Question 4

Price-weighted index vs. Value-weighted index

Answer 4

PWI: arithmetic mean of current stock prices, which means that movements are influenced by the differential prices of the components
VWI: generated by deriving the initial total market value of all stocks used in the index (#shares x market price)

Question 5

Arguments for active management: economic diversity

Answer 5

-Economic diversity across various sectors offer the opportunity for the active investor to employ “top down” sector rotation strategies

Question 6

Arguments for active management: Capital restriction

Answer 6

-Restrictions on capital flows may discourage foreign investor participation and serve to segment the market, creating exploitable market inefficiencies for the active investor

Question 7

Arguments for active management: High transaction costs

Answer 7

-May discourage trading activity by international investors and lead to inefficiencies that may be exploited

Question 8

Arguments for passive management: Settlement problems

Answer 8

Indexation would be favoured by the implied lower levels of trading activity and thus settlement activity

Question 9

Arguments for passive management: High transaction costs

Answer 9

Indexation would be favoured by the implied lower levels of trading activity and thus costs

Question 10

Arguments for passive management: Economic diversity

Answer 10

Across a broad sector of industries implies that indexing may provide a diverse representative portfolio that is not subject to the risks associated with concentrated sectors