How to construct a portfolio Flashcards
What are the 3 main areas of investment theory?
1) Modern portfolio theory - supports active management
2) efficient market hypothesis - supports passive management
3) behavioural finance - decisions based on emotion not logic
What is Model portfolio theory
General premise is that risk and reward cannot be considered in isolation. There is a correlation between it. Only when you consider them together can you achieve diversification of risk
What is the purpose of the efficient frontier?
aims to visually show the portfolios that provide the ultimate trade off of risk/reward within any sector. Risk is along the bottom line and value/growth is on the left vertical
What is the top down construction method?
Asset Allocation
Geographical split
Choose sectors (ie oil, retail, banks, pharmaceutical)
Choose stocks
What is the bottom up construction approach?
No structure, stocks are simply selected first based on the opinion of the fund manager. This can lead to significant weightings in certain sectors and geography. This is a riskier approach as diversification is not as pronounced and you are accepting the fund managers bias.
What are the 3 different investment styles adopted by fund managers?
1) Value - most traditional approach, choosing stocks based on rigorous analysis and holding them, often for a long time. Also known as buy and hold strategy
2) Growth at a reasonable price (GAARP) - paying a premium for quality stock
3) Momentum - Investing to capitalize on market trends and fashions
What is Efficient Market Hypothesis (EMH)
It advocates the use of tracker/passive managed investments particularly in developed markets. Argues that growth through fund manages is more by luck than judgement
What are the 3 forms of EMH?
Weak form - current price reflects all past price and trading volume info
Semi-strong form - Prices adapt to all new info rapidly so new info cant be sed to provide excess returns
Strong form - prices reflect all info that an investor can acquire
What are the Pro’s and Cons of passive/tracker investments?
Pros - Cheap and easy to follow
No fund manager underperformance
Cons- No Alpha
Lack of diversity
No fund manager expertise
What is a tracking error?
A tracking error is a distortion that will happen from an index performance. A low tracking error is where a fund stays close to the performance of the index its tracking and a high error is when there is a significant difference between index and fund performance
What are the 3 types of physical replication?
Full replication - actual assets are bought to ‘replicate’ the index. Lowest tracking error and highest costs
Stratified sampling - Actual assets are bought but not all of the shares in the index will be purchased, instead a ‘sample’ is bought. Higher tracking error but lower costs
Optimisation - similar to Stratified but uses a computer to select stocks. Highest tracking errors but lowest costs
What is Synthetic replication?
Derivative based - Artificially attempts to replicate index, most popular with passive managed funds. Samples of stocks purchased but favours derivatives. Swaps most commonly used. Lower cost than physical replication, passes tracking error and rebalancing costs onto third part, the counter party takes on the risk
What are Hybrid schemes?
Core-satellite - Part passive, part active
Passive are at the core tracking developed market indices, Satellites are actively managed in developed markets
Behavioural finance - what are the 3 main areas?
Prospect theory/loss aversion - Investors get protective of gains but take more risks when faced with potential losses. Much more distressed by losses than they are happy with gains. Don’t behave rationally
Regret - Less willing to sell an investment thats fallen in value even though they should cut their losses
Overconfidence - overestimate their own kills and underestimate likelihood of bad outcomes
What 3 factors does the Fama-French 3 factor model go on?
Beta
Size
Value
