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Question 1

What is the Small-Firm Effect?

Answer 1

Small companies historically tend to generate larger returns over time compared to large companies. This is known as the small-firm effect. However, small firms may be riskier, and their higher returns might be compensation for this added risk.

Question 2

What is the Investment Policy Statement (IPS)?

Answer 2

Investment Policy Statement (IPS) for individual investors, is like a strategic guide for managing investments.

It helps address various factors like the client’s financial plan, goals, risk tolerance, and preferences.

The IPS covers things like governance, asset allocation, risk management, and reporting.

Question 3

What are the parts of IPS? Elaborate on two of these.

Answer 3

1. Scope and Purpose:
   This section provides context to the investment strategy. It’s like setting the stage for the entire investment plan.
2. Governance:
   This part is about the structure and responsibilities of managing the investments. It outlines who has the authority to make decisions, who is responsible for reviewing and updating the plan, and how often this should happen.
3. Investment, Return, and Risk Objectives:
   This section gets into the nitty-gritty of why the investments are being made. It clarifies the goals of the investments. It also defines how performance will be measured. For instance, it might set specific benchmarks to compare the investment returns against. This ensures that there are clear targets for evaluating how well the investments are doing.
4. Risk Management:
   This section focuses on how risks associated with the investments will be identified, measured, and managed. It’s crucial because all investments carry some level of risk, and understanding and managing these risks is essential for making informed decisions.

Remember, an IPS is not a one-size-fits-all document. It’s highly customized to fit the individual investor’s unique circumstances, preferences, and goals. It serves as a guide that helps both the investor and their financial advisor make decisions that align with the investor’s overall financial plan and objectives. It also provides a framework for evaluating performance and making adjustments as needed over time.

Question 4

What are the versions of the efficient market hypothesis?

Answer 4

The weak-form:
Stock prices already reflect all information
that can be derived by examining market data such as the history of past prices, trading volume etcetera. Trend analysis is pointless.

Semistrong-form:
All publicly available information regarding the prospects of a firm must be reflected in the stock price. If investors have access to such information from publicly available sources, one would expect it to be reflected in stock prices.

Strong-form:
Stock prices reflect all information (public and private) relevant to the firm, even including information available only to company insiders.

One thing they all have in common: prices should reflect
available information

Question 5

! Inflows in passive investing funds have increased relative to those for funds based on an active investment philosophy. Please explain this trend and include in your answer the performance of both types of funds.

Answer 5

The increase in passive investing could be driven by market efficiency since Passive investing provides the market return.

Furthermore, there is less risk, cost and effort in passive investing.

Question 6

! The term ‘Active share’ was introduced by Cremers and Petajisto. Please explain (in words) the concept of active sharing. In addition, answer the following two questions:

• Did funds with a high active share outperform or underperform the market?
• Which type of mutual funds contributed to the average underperformance of mutual funds as a group, according to Cremers and Petajisto?

Answer 6

Active share is the difference between the weight of a stock in a portfolio and the weight of a stock in the benchmark.

Funds with HIGHT Active Shares outperform the market BOTH before and after expenses,

Funds with LOW Active Share underperform AFTER expenses.

According to Cremers and Petajisto the largest funds are most often tracking a benchmark index, and thus underperform.

Question 7

What repercussions does EMH yield for the type of management you should employ for your stock
portfolio: active vs passive management ?

Answer 7

If all information is absorbed into prices, it is not possible to find bargains so you should manage passively.

If you think against the EHM and you think there are bargains, you should manage actively.