Chapter 7 Portfolio Theory Flashcards
Efficient Market Hypothesis
What are the properties of a perfectly efficient market (5)
- all investors and market participants will have perfect information about each company
- Rational investors
- No point in carrying out research as everybody else will already know the information and will be priced into market
- perfect efficient market - no transaction costs
- No earnings surprises because investors would know info already
Three forms of Efficient Market Hypothesis (EMH)
- Weak from of EMH
- Semi-strong from of EMH
- Strong from of EMH
- Weak form : current market price already reflects all historic share price info. If things is true, there is no benefit in looking at historic stock price charts and graphs as everyone else will know the information - Charting. Technical analysis doesn’t work. Fundemental analysis does work
- Semi strong: Current market price not only reflects historic share price information, but also has all other publicly available information. Again, thanks means that carrying out research about a company’s activities and its products will also be of no use as others participants know the information. Fundemental analysis no use either
- Strong form: current market price already reflects not only all historic share price information, all additional public information and also private information
Property Investment - Rental Yields
Property £150k
Rental Income £600pm
What is rental yield
What’s rent compared to cost of property:
- £600 x 12
———————- x 100 = 4.8%
£150,000
More accurate would be to add in purchase costs (assume £4,500)
£600 x 12
————— x 100 = 4.66%
£154,500
Any costs would also reduce rental. For example any annual service charges by letting agent of £1,000
£600 x 12 (-£1,000)
—————————— (x 100) = 4.01%
£154,500
Fundamental v’s Technical
- Fundemental (Growth)- hard fact analysis. growth fundamentals. PE ratio, Dividend yield etc
- Technical (Momentum/Chartists): Believe in trends and that they can predict market movement and that trends persist.Value to be delivered. Analysis
On a spectrum - not exactly one or other
What is Beta
- What type is measured
- How measured
- When used? Rising markets / falling market
- Criticism of Beta
Numbers represent risk as measured against market in general eg S&P 500
Glaxo 0.5 , Apple 1, Rio Tinto 2 - How sensitive? Systematic risk
Non Systematic risk
————————-
Systematic risk
1- Volatility in line with market- tracks market
2 - approx twice (will grow twice as much and fall twice as much) When market rises 10%, stock will rise 20% and vice versa
I.e more beta number, the more risk
- Use Beta to predict returns in market
- When market rising, could choose beta stock
- Diversification. Not all high beta stock eg
Criticism
- Historic 36 or 60 months
- Only looks at stocks risk relative to market - what about what other stocks in sector are doing
- Beta doesn’t tell you anything about outcome
GH: beta is used to measure the volatility of an investment compared to the market average
- If investment moves in line with market, has beta of 1
- Beta of 0.8 means that investments rise and fall at a slower rate than market , hence less volatile
- If investment has beta of 1.2 , then higher risk and you would expect higher reward in return
- Higher the beta higher the risk
What are the CAPM assumptions (7)
- Risk. Free return = UK Treasury Bills(91 days)
- All investors are rational and risk averse
- All investors have same holding period
- No individual can move the market price
- No taxes,costs or restrictions
- information available to all
- Unlimited funds can be borrowed at risk free rate
- investors make decisions on risk and return alone
- Manu buyers and sellers
Describe CAPM
Formula
CAPM is the expected return for any given level of risk
Single factor
Assumes investor well diversified
Capital Asset Pricing Model
Formula: Expected return = Risk Free return + (Beta(expected market return - risk free return)
Er = Rrf + (Beta(Emr - Rrf)
Eg
Rrf - 1% Beta = 0.75, Expected Market return = 5%
Er = 1%+ (0.75((5-1) = 1% + (3%) = 4%
NB Could ask for Emr instead: Er - Rrf = Beta (Emr -Rrf) Er-Rrf = Emr - Rrf ——— Beta
Er - Rrf + Rf. = Rm
———-
Beta
Limitations of CAPM (3)
Benefits of CAPM (4)
- SIngle price one year model - one or more of the rates used in model will probably change over the course of a year. Single factor model (beta)
- Only applicable to Diversified portfolios as reflects market as a whole (small undiversified portfolios wouldn’t work)
- CAPM assumes prices are determined solely by market risk - difficult to establish what market risk is
- What is risk free rate of return? What do you use? Is it truly risk free
- Beta is unreliable (inconsistent) based on past performance
- Can’t eliminate all non- systematic risk
Benefits CAPM:
- Easy to calculate
- Takes into account systematic risk/ market risk
- Reflects fact that most portfolios are diversified to remove unsystematic risk
- Robust
- Gives an expected benchmark return
Decomposition of the total return of the fund /portfolio can be summarised as (4)
Return of portfolio- Risk free return + return due to client’s risk+return due to manager risk(market timing) + return due to stock selection
Risk free return»_space;>client risk»>manager risk»>stock
Types of Tracker fund and description (4)
Advantages (3)
Disadvantages (4)
- Full Replication: Holds each constituent part of index in accordance with weightin
- Stratified Sampling: Hold representative sample of shares from each sector in index
- Optimiastion: Uses computer modelling /algorithms
- Synthetic: Use Derivatives such as swaps with a market counterparts (ie investment bank)
Advantages: 1 Many active fund managers fail to beat benchmark 2) lower charges than active 3) SImple to understand, easy to follow
Disadvantages: 1) No opportunity to create specific portfolio according to clients requirements 2) No opportunity to outperform index 3)Benchmark can be dominated by small number of stocks/sectors 4) Tracking error - underperform because of costs and charges
Exchange Traded Funds
- Often selected to track performance of underlying index
- Open ended
- Low TERs
- Hundreds of varieties - track nearly every index, commodity, currency or exchange
Growth Investor (5) points
- Growth in EPS for 4/5 years
- low PEG
- Optimistic Chairman’s statement
- Strong liquidity
- Competitive advantage
Investment advice process (9)
- Establish & define relationship
- Gather client goals
- Ethical considerations
- Analyse & evaluate
- create risk profile
- Formulate investment strategy for asset allocation
- select investment funds using appropriate tax wrappers
- Present and I’m pole net recommendations
- monitor
Passive
2 main types
3 ways
- Not attempting to outperform the market.
- Should not require active intervention, self maintaining
- 2 main techniques: 1. Buy and hold 2. Indexation
Indexation: - Full replication - arithmatically weighted. Tracking error trying to replicate
- Stratified sampling - not buying all. Might look at sector. Human input
- Optimisation -computer modelling. Buying movement in stock
Active Management Strategies
2 main approaches
- Analysis used to attempt to beat market- above average risk adjusted returns
- 2 main approaches: 1. Top Down 2. Bottom up
Top Down : AGSS - Asset allocation Strategic & tactical (short term) - Geographical - Sector - Stock Fundamental Technical - Chartists , mechanical trading rules (if stock rises 15%, we’ll sell etc)
Bottom Up
- Securities selected on own merits
- Often applies when objectives of fund make asset allocation irrelevant
- Stock Picking
Value. GAARP - Growth at a reasonable price (Game changer)
