CFA Investment Foundations | Portfolio Management Flashcards
Define the 4 stages of the business cycle
Expansion/ recovery: GDP is increasing
Boom: economy is growing at its fastest
Contraction: GDP has fallen from previous quarter
Recession: 2 consecutive quarters of declining GDP
What is the difference between disinflation and deflation?
Disinflation is a slowing in the rate of inflation, prices are still rising
Deflation is when the inflation rate is negative, and prices decline
What are the 3 money market instruments and who issues them?
Treasury Bills - Debt Management Office (DMO)
Commercial Bills - Companies
Certificate of Deposits - Banks
How do the 3 money market instruments pay returns?
Treasury Bills
No interest payments but issued at a discount to their maturity value
Commercial Bills
No interest payments but issued at a discount to their maturity value
Certificate of Deposit
The deposit carries a fixed rate and term
What is the purpose of a money market fund?
Minimum investments in money market instruments are high which makes it difficult for an individual to gain access to the market. However, a fund is a collective investment vehicle that pools together investors’ funds to invest in the money market.
What are the 2 classifications of money market funds with respect to time?
Standard Fund – 6 to 12 months
Short-term Fund – 2 to 4 months
Who can issue fixed interest securities and what is their purpose?
Issued by governments in the form of gilts, and companies in the form of corporate bonds.
A means of raising money in order to finance their long-term borrowing requirements.
What are the characteristics of fixed interest securities?
Pay a fixed rate of interest, known as the coupon. This is set at issue and is a percentage interest on the nominal value.
A fixed redemption value, known as the par/nominal value.
A fixed redemption date, known as the maturity date. This is set at issue.
What 3 things must a bond title include?
The issuer, the coupon and the maturity date.
e.g., Amazon 3.5% 29/05/2025
What is the difference between secured and unsecured bonds?
Secured – A charge is placed on certain assets of the issuing company. If bond defaults, the assets can be seized.
Unsecured – Only reimbursed once all secured bonds are settled, along with other creditors.
Bonds can be secured by a fixed charge or a floating charge. What is the difference?
Fixed charge – Bond secured against a specified asset(s) that can be readily identified.
Floating charge – Bonds secured against any assets of the company that are not already secured for other lenders. They are a lower priority for payment than fixed charge bonds.
What are the 2 types of Government issued gilts and their key features?
Conventional Gilts
Issued by DMO
Trade at a discount to par instead of offering an interest payment (zero coupon)
Classified according to their time to redemption
Shorts: 7 years, Mediums: 7-15 years, Longs: 15+ years
Index Linked Gilts
Coupon and capital payment adjusted in line with inflation
Measured by changes in RPI
What is a Floating Rate Note?
A type of bond often issued by banks, that pays a coupon biannually or quarterly linked to a money market rate such as LIBOR.
N.B. Cash products linked to LIBOR will end by Q3 2020 and the transition from LIBOR to SONIA will be completed by the end of 2021.
What is the difference between ‘clean’ and ‘dirty’ prices?
The difference between these prices is the inclusion of accrued interest
Prices quoted in the FT are ‘clean’ prices. This price does not include the value of accrued interest
Interest is accrued daily, so gets added to the price from the last interest payment date to the selling date, known as ‘dirty’ price
Bonds can be bought cum dividend or ex-divined, what is the difference?
Cum dividend: This is where the buyer receives the full 6 months’ interest – even though they didn’t own the stock for the whole period
Ex dividend: This is where the full 6 months’ interest is paid to the seller
The total amount paid by the buyer is called the ‘dirty price’, which is the clean price +/- any adjustments for interest payments
What is the difference between non-systematic risk and systematic risk?
Non-systematic risk is a specific risk that occurs as a result of the issuer, it can be eliminated by diversification
Systematic risk is a market risk (interest and inflation rates) that is unavoidable, it cannot be eliminated by diversification
What are the 2 main credit rating agencies and what is the minimum classification for an investment grade bond?
Standard & Poor’s: BBB-
Moody’s: Baa3
Name 5 factors that can affect bond prices
Interest rates
Inflation rates
Credit worthiness of issuer
Time to redemption
The coupon
How does a change in interest rates affect bond prices?
If interest rates increase, investors will demand a higher yield from their bonds. As bond coupons are fixed the prices of bonds must fall so that the yield increases.
What are the risks of holding fixed interest investments?
Inflation - Erodes the purchasing power of interest
Interest rates - Generally bond prices move in the opposite direction
Credit risk - Issuer may not be able to pay interest or capital at maturity
Currency - Movements in exchange rates affect the value of holding
Liquidity - May be difficult to sell at an acceptable price
How can investors expect to receive income from equities?
Investors expect to receive income in the form of dividends and also hope to achieve capital growth on disposal.
What is the primary and secondary market?
The primary market offers new securities on an exchange, once the initial sale is completed further trading is carried out on the secondary market.
When shares are first issued in the primary market, what must they be admitted to?
Official List, Main Market or Alternative Investment Market (AIM).
What are the benefits of being listed on AIM?
Less formalities
Lower cost
Can be described as ‘quoted’ but not listed
What is a participating preference share?
A share that receives a fixed income as well as a proportion of the ordinary dividend declared.
What are the 4 types of ordinary shares?
Ordinary shares
Non-voting ordinary Shares (A)
Deferred Shares
Redeemable ordinary Shares (B)
If a company has a dividend cover of less than 1, what does this mean?
The dividend in ‘uncovered’
A company does not have the required profits for dividend payments, but they can draw this from reserves.
What is an example of a hard commodity?
Oil, gold, gas
Anything that is a product of mining or another extraction process
What type of correlation is needed for maximum diversification?
Negative correlation
What is a financial bubble?
Bubbles occur when investors lose sight of fundamental values (prices are inconsistent with inherent value) and they continue to buy assets expecting the price to increase
The bubble ‘bursts’ when there is a sudden drop in price
How does quantitative easing work?
Bank of England (BoE) creates new money electronically which is used to buy gilts from large financial institutions. Large purchases of gilts push down interest rates, which promotes borrowing and spending.
How are equities impacted by economic expansion and contraction?
During expansion prices strengthen.
During contraction equites generally fall as interest rates remain higher.
Why is inflation important with regard to fixed interest securities?
With rising inflation capital values of fixed interest securities tend to fall. Purchasing power of fixed interest reduces.
When inflation falls, interest yields fall, and capital values tend to rise.
Why would equities benefit from low interest rates?
Lower interest rates mean cheaper borrowing and higher profits. This generally increases dividends and strengthens share prices.
What does standard deviation measure?
Measures how much the actual return on an investment varies around its average expected return. The higher this is, the greater the volatility.
What Greek letter is used to denote standard deviation?
Sigma
What type of risk does diversification reduce?
It reduces non-systematic/specific risk.
If two assets have a correlation of 0, what does this mean?
There is no degree of correlation.
Name 2 asset classes that have a negative correlation
Cash and Property. If interest rates are high the returns on cash deposits become attractive, but property investors will be hit by the increased cost of borrow.
Is the Capital Asset Pricing Model (CAPM) a single-factor or multi-factor model?
As it only considers beta, it is a single-factor model.
What does it mean if a security has a beta greater than 1?
If the beta is greater than 1, the security is more volatile than the market and is referred to as an aggressive security.
What are the assumptions of CAPM?
Investors are rational and risk averse
Investors only make decisions based on risk and return
Investors all have the same holding period
No individual can affect market price
No taxes
No transaction costs
No restrictions
Information is free and available to all
All investors can borrow and lend unlimited amounts at the risk-free rate
What is the underlying assumption of prospect theory/ loss aversion?
Investors do not act rationally in respect to risk tolerance. They may be much more distressed by a prospective loss than they would be made happy by an equivalent gain.
What is the basis of the Arbitrage Pricing Theory (APT)?
Based on the idea that a security’s return can be predicted using the relationship between the security and the number of common risk factors. Each factor is represented by a factor specific beta.
How can non-systematic risk be eliminated?
Through diversification.
Name 2 examples of systematic risk
Interest rates, inflation, terrorist attacks or war
Anything that that will affect the whole market
What is the name of the formula that explains the change in the price of a bond in response to a change in interest rates?
Modified duration
e.g. a bond with a duration of 5 years, will move approximately 5% in the opposite direction when interest rates move by 1%
When interest rates rise, what happens to the capital value of fixed interest securities?
They will fall.
Describe bail-in risk
Instead of governments or central banks bailing out financial institutions that are in trouble, it falls on the shareholders and depositors.
What percentage of a fund’s holdings must be in a particular sector for it to be a sector fund?
80%
What is bed and breakfasting?
Selling units and buying back the next day to avoid changing units, used to realise gains or losses.
What is the ex-dividend (xd) date?
The cut-off point for an investor to be entitled to the next distribution of income.
What is the difference between the buying and selling price referred to?
Bid-offer spread
What does it mean if a fund of funds is ‘fettered’?
‘Fettered’ fund can only invest in funds ran by the same management group.
What is a manager of manager’s fund?
The fund manager appoints external specialist managers who each have their own management style and have a segment of the portfolio to manage.
What is a reporting fund?
One in which dividends and interest are treated the same as a UK-based fund and normal rules apply for CGT. They do not have to distribute all the income, but it must be reported to HMRC.
What is a non-reporting fund?
Gains on disposal are calculated using CGT principals but the gain is taxed as income therefore the CGT allowance cannot be used.
The fund is not completely tax free, dividends received on equity investment will often be subject to a non-reclaimable withholding tax.
How do you calculate the Net Asset Value per Share (NAV)?
Divide the shareholders fund by the number of shares in issue
The shareholders fund is the total of the fund’s assets less any liabilities
What is a warrant and how can they be used to attract investors to a new investment trust?
A warrant is the right to buy shares at a fixed price at a predetermined date, the warrant price may only be a fraction of the share price
Investors in a new investment trust have to pay the NAV and launch costs; however, shortly after the shares often trade at a discount, so the trust may offer 1 warrant for every 5 shares purchased to encourage new investment
What is the concept of pound cost averaging?
This only applies to regular premium contracts. When prices are low, the premium paid can buy extra units
The saver will receive a better return if prices are low for a long period then rise before the policy is encashed
If an exchange traded fund (ETF) uses derivatives, what is this known as?
Synthetic replication
What is the tax treatment on an ETF?
Dividend payments are subject to income tax as normal and CGT applies on any gains
What is an exchange traded note (ETN)?
Unsecured bonds issued by banks, the performance tracks an index using derivatives
What is the income tax relief given on a VCT, EIS and SEIS?
VCT: 30% on first £200,000
EIS: 30% up to £1,000,000 (£2,000,000 for knowledge intensive companies)
SEIS: 50% on first £100,000
How long must an EIS or SEIS be held to qualify for 100% business relief inheritance tax?
2 years
Income tax relief will be withdrawn from an EIS if the shares are not held for how long?
3 years
What is a financial future?
A legally binding contract to buy or sell an asset at a specified future date at a price that is agreed when the contract is made.
What is meant when buyers of futures are said to have the ‘long position’?
They expect prices to rise
They have an obligation to buy the asset at the agreed price
What is the variation margin?
An initial trade of a purchase or sale opens a client’s position and the contract is made. An initial margin is deposited with an independent 3rd party, this acts as collateral.
Open positions are revalued daily, this takes into account any movement in the price of the contract. Any profits or losses are paid and received daily within the depository account. These profits and losses are referred to as the variation margin.
What is a financial option?
Contracts that give the buyer the right but not the obligation to buy or sell the underlying asset at some future time at an agreed price.
The option fixes the price.
What’s the difference between a call option and put option?
Call options give the owner the right to buy the underlying share at a predetermined price, known as the exercise/strike price (this will not change no matter how high the shares subsequently go)
When will a call option and a put option be ‘in the money’?
Call options will have an intrinsic value if the value of the underlying asset is above the strike price.
Put options will have intrinsic value in the value of the underlying asset is below the strike price.
When the strike price is equal to the asset price, what is this referred to?
‘At the money’
How can a fund manager who expects the market is about to drop offset any losses?
They could sell FTSE 100 futures and any profit can offset the losses on the fund.
What is the tax treatment of derivatives?
Profits of both future and options are chargeable to CGT unless the investor is classed as a trade, then their profits will be classed as income.
There is no CGT to pay if the underlying asset is a gilt or a qualifying corporate bond.
What are the 4 categories of hedge funds?
Long/short funds
Relative value funds
Event driven funds
Tactical trading funds
What is the objective of an absolute return fund?
To make a positive return in all market conditions by using derivatives.
What 2 components might a structured product typically contain?
Zero coupon bond: capital guarantee element
An OTC call option: provides a potential return on an index
What are the benefits of using a structured product?
Wide range of underlying asset combinations available.
No exposure to a fund manager’s style or ability.
The amount an investor can lose, or gain will be explicitly stated.
What is strategic asset allocation?
Strategic asset allocation is creating an asset mix that will provide the optimal balance between risk and return for a long-term investment horizon and will only be adjusted in extreme conditions or if the client’s circumstances change.
What is tactical asset allocation?
Tactical asset allocation works on the basis of having asset allocation models that give a range for the amount of capital in each asset class. If the range given for equities is 40-50%, then any deviation from the central 45% is seen as a tactical move by the adviser to take advantage of short-term movement in the market.
What is positive screening?
Involves investing in companies that have a responsible approach to business practices, products or services, e.g. companies that only use renewable energy.
What is negative screening?
Involves not investing in companies that do not meet certain ethical criteria, e.g. companies that carry out animal testing or are involved in arms manufacturing.
What are the 2 main approaches to asset allocation?
Theoretical
MPT uses mathematic analysis to obtain the desired risk/return trade-off, creating the optimal portfolio based on historical returns and using negatively correlated assets to reduce volatility. It is backwards looking
Pragmatic
Uses subjective forward-looking judgements about what is likely to happen in the future to determine how the portfolio should be weighted. This may be subject to bias
What is stochastic modelling?
Modelling that uses probabilistic methods to establish the ranges within which returns may fall over a future period
It takes an initial set of assets and assumes that their behaviour will be affected in a specific way by a change in one variable (e.g. interest rates)
What is the top-down approach to portfolio construction?
Involves looking at the ‘big picture’ first. Start by determining asset allocation, then allocate geographical distribution and chose sector weighting. Finally select the appropriate funds or stocks considering ethical considerations.
What is the bottom-up approach to portfolio construction?
Involves searching for individual investments based on their own characteristics (e.g. a company is a good takeover target), with less consideration given to the economy and market.
Outline each of the 4 main fund management styles?
Value: fund manager buys shares when their value is greater than the price placed on them by the market.
GAARP: fund manager finds companies that have a longer-term sustainable advantage, and is worth paying a reasonable price for quality characteristics.
Momentum: fund manager uses the theory that, in equity markets, there is a tendency for good and bad performance.
Contrarianism: fund manager believes that the common opinion is usually wrong and higher returns can be achieved by going against trends.
What is holding period return?
The total return you achieve from the change in the value of the asset and the income you receive.
What is the difference between Money Weighted Return (MWR) and Time Weighted return (TWR)?
MWR is strongly influenced by the timing of cashflows (when you put money in and when you take money out)
TWR ignores the timing of cashflows and thus eliminates the distortions around the timing of new money; it just considers the performance of the portfolio over time. This can be used to compare fund managers with each other
What are risk-adjusted returns and what is the purpose of using such calculations?
Risk-adjusted return is a performance measure, a calculated number that tells you how well the investment has performed but it also considers how much risk you took to achieve that return.
What are the 3 ways to measure risk-adjusted returns?
Sharpe ratio
Alpha
Information ratio
What is the sharpe ratio used for?
This ratio measures excess returns for every unit of risk and therefore it can be used to compare investments to see which gave the best return for a given amount of risk.
The higher the Sharpe ratio, the better the risk-adjusted performance has been, i.e., the investor has received a higher return for the level of risk.
How is the sharpe ratio affected if the standard deviation increases?
If the level of risk (i.e. standard deviation) increases, that means your risk adjusted return will decrease.
It means an investor has taken more risk to achieve the same return.
What does alpha look at?
It looks at the difference between the return you would have expected from a security, given its beta, and the return it actually achieved.
What is the information ratio?
It shows the consistency with which the manager beats the benchmark.
What 4 factors does performance evaluation asses?
Asset allocation
Stock selection
Market timing
Risk
What are ‘Securities’?
‘Securities’ is the general term used to refer to tradable financial assets such as equites and bonds.
What are Investment Companies?
Companies that exist solely to hold investments on behalf of their shareholders, partners, or unitholders, including mutual funds, hedge funds, venture capital funds, and investment trusts.
What is a Futures Contract?
An agreement that obligates the seller, at a specified future date, to deliver the buyer a specified underlying in exchange for the specified futures price.
What are Accrued Liabilities?
Liabilities related to expenses that have been incurred but not yet paid as of the end of an accounting period.
What is Marginal Cost?
The cost of producing an additional unit of a product or service.
What are Brokerage Services?
Trading services provided to clients who want to buy and sell securities; they include not only executions services (that is, processing orders on behalf of clients) but also investment advice and research.
What is Tracking Error?
The standard deviation of the differences between the deviation over time of the returns on a portfolio and the returns on its benchmark; a synonym of active risk.
What are Cash Flow Rights?
The rights of shareholders to distributions, such as dividends, made by the company.
What is Risk Management?
An iterative process that helps organizations reduce the chances and effects of adverse events while embracing the realization of opportunities.
What is a Cartel?
A special case of oligopoly in which a group of producers jointly control the production and pricing of products or services produced by the group.
What is Capitalism?
An economic system that promotes private ownership as the means of production and markers as the means of allocating scarce resources.
What is the Multiplier Effect?
An initial increase (decrease) in spending produces an increase (decrease) in GDP and consumption greater than the initial change in spending.
