Chapter 20: Portfolio Management (1)

Question 1

Value managers

Answer 1

value managers specialise in managing portfolios of value stocks - stocks that appear good value in terms of certain accounting ratios, such as the forward earnings to price ratio or book to price ratio.

Question 2

Growth managers

Answer 2

specialise in managing portfolios of growth stocks - broadly stocks that are expected to experience rapid growth of earnings and hence share price

Question 3

List 5 Investment Styles

Answer 3

1. Growth
2. Value
3. Momentum
4. Contrarian
5. Rotational

Question 4

Momentum - Investment style

Answer 4

purchasing those stocks which have recently risen significantly in price on the belief that they will continue to rise owing to an upward shift in their demand curves, or vice versa for selling.

Question 5

Contrarian - Investment style

Answer 5

doing just the opposite to what most other investors are doing in the market in the belief that investors tend to overreact to news.

Question 6

Rotational - Investment style

Answer 6

moving between value and growth depending on which style is believed to be attractive at any particular point in time

Question 7

Describe top-down approach: (3)

Answer 7

1. the top-down approach to constructing and managing a portfolio involves a structured decision-making process that starts by considering the asset allocation at the highest level, i.e. between asset classes
2. Within each asset class an analysis is then made of how to distribute the available fund between different sectors…
3. and finally, the selection of the individual assets to purchase is made.

Question 8

Describe bottom-up approach

Answer 8

a bottom-up approach seeks to identify the best value individual investments, irrespective of their geographical or sectoral spread

Question 9

Asset allocation and stock selection may be based on these 3 methods: (3)

Answer 9

1. Fundamental analysis
2. Quantitative techniques
3. Technical analysis

Question 10

Describe: Passive investment managers

Answer 10

passive investment managers are, typically, index-trackers. they manage assets without taking active investment decisions.

Question 11

Available approaches to index tracking (3)

Answer 11

1. full replication
2. sampling
3. synthesizing the index using derivatives

Question 12

Active investment managers

Answer 12

active investment managers apply various types of judgement to the selection of portfolios with the objective of out-performing a benchmark.

Question 13

Two groups of active investment managers

Answer 13

1. multi-asset (balanced) mandates

2. specialist mandates

Question 14

Two types of active bond trading

Answer 14

1. anomaly switches

2. policy switches

Question 15

Anomaly switching

Answer 15

involves moving between stocks with similar volatilities, thereby taking advantage of temporary price anomalies

Question 16

Techniques used to identify possible anomalies (4)

Answer 16

1. yield differences
2. price ratios
3. yield models
4. price models

Question 17

Policy switching

Answer 17

policy switching is a riskier approach that involves moving between stocks with different volatilities, to take advantage of predicted changes in the level and/or the shape of the yield curve

Question 18

Policy switching may be aided by the analysis of: (3)

Answer 18

1. volatility and duration
2. reinvestment rates
3. spot/forward rates

Question 19

(In matching specific liabilities) Techniques that may be used to control bond portfolio risk include: (4)

Answer 19

1. immunisation
2. stochastic asset-liability modelling
3. Value at Risk calculations
4. multifactor modelling

Question 20

Describe the MSCI - style indices

Answer 20

• From the universe of a standard index, securities are ranked according to price-to-book.
• the top half - stocks with low price-to-book values - is associated with value style
• the bottom half - stocks with high price-to-book values is associated with growth style

Question 21

Five growth factors: (5) (old syllabus)

Answer 21

1. sales growth
2. earnings growth
3. forecast earnings growth
4. return on equity (ROE)
5. upwards earnings revisions

Question 22

Five value factors

Answer 22

1. book-to-price
2. dividend yield
3. earnings yield
4. cashflow yield
5. sales to price

Question 23

Describe the Core-satellite approach

Answer 23

• An increasingly popular fund management structure whereby the majority of the fund consists of a passively managed “core”.
• In addition specialist satellite managers are then employed to provide increased performance via active management.

Question 24

Relative merits of top-down and bottom-up approach: (3)

Answer 24

1. The top-down approach lends itself better to controlling the risk of a portfolio by virtue of the fact that a balanced, diversified portfolio is held.
2. It can also be argued that the biggest differences in portfolio performance come from differences in asset allocation rather than in individual stock selection.
3. however stock pickers would argue that starting with allocation between sectors ignores the fact that all investment performance starts with the performance of the individual assets held and that is where the analysis should be concentrated.

Question 25

The MSCI Growth indices consider five variables when categorising index members:

Answer 25

1. long-term forecast earnings growth
2. short-term forecast earnings growth
3. current internal growth rate
4. long-term historical earnings growth
5. long-term historical sales growth

Question 26

The MSCI Value indices consider three variables: (3)

Answer 26

1. book value to price
2. forward earnings to price
3. dividend yield

Question 27

What types of data will be especially important to consider within the strategic asset allocation: (8)

Answer 27

1. economic growth
2. short-term and long-term inflation
3. short-term and long-term interest rates
4. structural shifts within the economy
5. currency movements
6. bond and equity market yields
7. the investment objective, attitude to risk and/or liabilities of the investor
8. the investment strategies pursued by the investor’s peer group.

Question 28

Alternative approaches to passive management include: (3)

Answer 28

1. index tracking, whereby the investor selects investments to replicate the movements of a chosen index.
2. tracking competitors, which is sometimes referred to as commercial matching
3. immunisation, as a method of passively managing a bond fund.

Question 29

Advantages of index tracking (4)

Answer 29

1. Reduce risk of substantially under-performing the index in question.
2. Lower dealing and research costs.
3. A passive investment strategy is appropriate if the particular market is believed to be efficient.
4. Tracking a well-diversified index will ensure that the fund itself is well-diversified, so reducing specific risk and hence the volatility of portfolio returns.

Question 30

Disadvantages of index tracking (4)

Answer 30

1. The risk of (substantially) over-performing the index in question is greatly reduced.
2. A fully replicating index tracker is forced to buy new constituents of an index at inappropriate times.
3. The resulting investment strategy may pay insufficient regard to the investor’s objectives and hence result in unacceptable levels of actuarial risk.
4. It may prove difficult either to find an appropriate index to track, or to track the chosen index, e.g. in the property sector.

Question 31

Index tracking - a stratified sample approach carefully selects shares so as to broadly reflect the various characteristics of the shares in the index, e.g. with regard to factors such as: (3)

Answer 31

1. the market weightings in each of the main sectors,
2. the sizes of the companies
3. their exposures to overseas earnings etc.

Question 32

Important differences of bond indices compared to equity indices: (2)

Answer 32

1. Bond market trading is often less transparent ( for example, by being over-the-counter).
2. The concept of ‘market capitalisation’ is less well understood in the bond market.
   2a) issuers may have several similar, possibly overlapping bonds outstanding at any one time.
   2b) using the total value of outstanding bonds would mean the index overweights the most indebted issuers which may be undesirable.

Question 33

The limited circumstances in which an individual bond will outperform its peers and provide a higher return than its GRY at the point of purchase, include: (3)

Answer 33

1. The issuer’s perceived creditworthiness being upgraded or ‘corrected’ relative to other issuers
2. The issue’s terms, liquidity or other trading aspects improving relative to other bonds, resulting in excess demand for the security.
3. A current supply/ demand imbalance causing the bond to trade away from its fair value.

Question 34

The outperformance of a specific bond is bounded by the facts that: (2)

Answer 34

1. credit upgrades can only take the bond to the highest rating category.
2. yield curve movements are limited to ‘realistic’ interest rate levels. (e.g. negative interest rates - while in existence today - are uncommon.)

Question 35

Alternatives to government bonds: (10)

Answer 35

1. Agency bonds
2. Investment grade corporate bonds
3. High yield (“junk”) corporate bonds
4. Convertible bonds
5. Distressed debt
6. Event-linked bonds
7. Interest rate and inflation swaps
8. Credit default swaps
9. Mortgage-back securities (MBS)
10. Asset-backed securities (ABS)

Question 36

Partial replication: (2)

Answer 36

1. A representative selection or stratified sample of the index is held.
2. This might involve a lesser number of shares carefully chosen, so as to broadly reflect the various characteristics of the shares in the index, e.g.

• the market weightings in each of the main sectors,
• the sizes of the companies
• their exposures to overseas earnings, etc.