Chapter 3 Flashcards
The relative performance of different asset classes is dependent on the holding period selected.
Based on historical performance data, which class of assets would be likely to provide the greatest pretax total return over the long term?
a. small company stocks
b. long-term (L-T) corporate bonds
c. large company stocks
d. long-term (L-T) government bonds
a. small company stocks
Investment professional Bill Winters received the latest long-term total return data for different asset classes. He sees that the compounded annual rate of return for common stocks was 10%, and for t-bills was 4%. What is the expected return of a portfolio of 60% stocks and 40% T-bills?
a. 6.4%
b. 7.0%
c. 7.6%
d. 9.4%
c. 7.6%
(.6 x 10%) + (.4 x 4%) = 7.6%
Hector has been investing for years, and has approximately three-quarters of his portfolio invested in stock index and bond index funds, which he rebalances periodically. He has the remainder of his portfolio invested in oil and health care stocks, which he believes provide above average price appreciation potential over the next few years.
His style of asset allocation would be best described as
a. strategic
b. tactical
c. random
d. core-satellite
d. core-satellite
Josh is considering a corporate bond paying 7.5% and a muni bond paying 5.5%. He has an average tax rate of 22% and a marginal tax rate of 24%. Which bond should Josh choose and why?
a. muni bond, because the taxable equivalent yield for the muni is 7.05
b. corp bond, because the taxable equivalent yield for the muni is 7.24%
c. muni bond, because the taxable equivalent yield for the muni is 7.24%
d. corp bond, because the taxable equivalent yield for the muni is 7.05%
b. corp bond, because the taxable equivalent yield for the muni is 7.24%
Tax Exempt Yield (TEY)
tax-exempt yield / 1 - marginal tax bracket)
5.5 / (1-.24) = 5.5/.76 = 7.24%
What three categories of investment practices did the Brinson study evaluate?
Security selection
market timing
asset allocation policy
What conclusion did the Brinson study reach?
On average, 93.6% of the variability of total returns of large pension funds was attributable to how assets were allocated. Securities selection and market timing counted for very little. Therefore, more attention should be given to the part of the investment process that produces the greatest payoff for the client (the asset allocation decision) and less attention given to those parts whose contribution to total return are less (securities selection and market timing).
What is one implication of recognizing the importance of asset allocation in a client’s investment strategy?
Clients must be active in determining their asset allocation and be explicit about personal investment objectives and risk and liquidity concerns over a longer horizon.
Average rate of returns since 1926:
T-bills
3.3%
Average rate of returns since 1926:
long-term U.S. gov bonds
5.7%
Average rate of returns since 1926:
long-term corp bonds
6.2%
Average rate of returns since 1926:
intermediate-term U.S. gov bonds
5.1%
Average rate of returns since 1926:
large-company stocks
10.3%
Average rate of returns since 1926:
small-company stocks
11.9%
Average rate of returns since 1926:
inflation
2.9%
Calculate the expected returns of the following portfolios using historic data.
T-bills (3.3%) 50%, long-term gov bonds (5.7%) 50%
.5(.033) + .5(.057)
.0165 + .0285 = .045 (4.5%)
Calculate the expected returns of the following portfolios using historic data.
T-bills (3.3) 20%, Corp bonds (6.2%) 20%, small-company stocks (11.9%) 60%
9.04%
.2(3.3) + .2(6.2) + .6(11.9) = 9.04%
Calculate the expected returns of the following portfolios using historic data.
longterm gov bonds (5.7) 20%, small company stocks (11.9) 20%, large company stock (10.3) 60%
9.7%
.2(5.7) + .2(11.9) + .6(10.3) =
1.14 + 2.38 + 6.18 = 9.7%
three types of asset allocation:
strategic
tactical
core/satellite
Strategic asset allocation:
the identification of the asset mix that will provide the optimal balance between expected risk and return for a long term investment horizon. that mix is maintained with periodic rebalancing by repositioning higher-performing assets into lower-performing assets.
Tactical asset allocation:
this is the use of securities selection, sector rotation, and market timing into periodically revise the asset mix of a portfolio.
Core/satellite asset allocation:
This approach involves a combination of strategic and tactical asset allocation enabled by dividing a portfolio into a core holding of stocks and bonds, often in broad-based, low-cost index mutual funds or exchange-traded funds, and a satellite portion.
The core may represent 70-80% of the total portfolio. It might be divided into, say, 60% stocks and 40% bonds, and maintained at those proportions through periodic rebalancing.
The remaining part of the portfolio, the satellite portion, is used to take advantage of particular opportunities that add return, diversification, and/or reduce risk to the porfolio.
For example, the satellite might include investments in actively managed small-cap funds, real estate investment trusts, commodity funds, sector funds, junk bond funds, or other specialized investments that complement the portfolio.
