Investments Ch 13 Flashcards
ASSET ALLOCATION USING MUTUAL FUNDS
ASSET ALLOCATION USING MUTUAL FUNDS
- Asset allocation explains over 90 percent of the variation in portfolio
returns. - Mutual funds can and should be part of an investment strategy.
- The allocation decision identifies the proportional investments of
each fund.
STEPS IN INVESTMENT PROCESS
STEPS IN INVESTMENT PROCESS
- Collect relevant information, both qualitative and quantitative.
- Identify the investor constraints, including any liquidity needs, time
horizon issues, tax liabilities, etc. - Determine the return and risk objectives.
- Identify the appropriate funds to be included in the portfolio. Each
should be consistent with the risk and return objectives. - Identify the appropriate allocation for each fund.
- Monitor the portfolio for performance.
ASSET ALLOCATION: EXAMPLE
Rory and Paulina Gill have been married for ten years and are in their early 40s. The Gills have no children and a combined income of $90,000. They have $45,000 of investable assets.
The Gills have average risk tolerance and average return objectives.
They seek growth with moderate risk. The adviser suggests the following allocation:
ASSET ALLOCATION: EXAMPLE
Rory and Paulina Gill have been married for ten years and are in their
early 40s. The Gills have no children and a combined income of $90,000. They have $45,000 of investable assets.
The Gills have average risk tolerance and average return objectives.
They seek growth with moderate risk.
The adviser suggests the following allocation:
MEAN VARIANCE OPTIMIZATION
MEAN VARIANCE OPTIMIZATION
- The Markowitz model is used to find optimal allocations for portfolio management.
- To compute mean-variance optimal allocations, it is necessary to
collect data for each fund: - historical returns
- standard deviation
- correlations between and among all the funds
MUTUAL FUND SELECTION
MUTUAL FUND SELECTION
Appropriate selection begins with the investor’s risk and return
objectives.
- The investment adviser must match investor objectives with funds
that have similar goals. - The adviser should seek funds with:
- a low expense ratio
- relatively low turnover
- high quality historical performance
THE FUND PROSPECTUS
The SEC requires mutual funds to disclose important information to
investors in the fund’s prospectus:
THE FUND PROSPECTUS
The SEC requires mutual funds to disclose important information to
investors in the fund’s prospectus:
- the fund’s investment objectives or goals
- its strategies for reaching those goals
- the principal risks of investing in the fund
- the fund’s fees and expenses
- its past performance
MUTUAL FUND OBJECTIVES
MUTUAL FUND OBJECTIVES
- The primary objectives for most investors are capital appreciation
and/or income. - Capital appreciation and income can be further defined in the stated objectives.
- Stable income
- High total return
- Aggressive growth
- Specialty investments
MORNINGSTAR STYLE BOX
MORNINGSTAR STYLE BOX
Investors can use the style box for a specific fund to determine if it fits their general objectives. For example, investors who desire a blend of growth and value for medium sized firms will select funds that Morningstar® places in the center box of the grid.
INVESTMENT POLICY AND STRATEGY
INVESTMENT POLICY AND STRATEGY
- Once primary objectives are established, the principal strategies that are intended to achieve those objectives will be outlined.
- Includes the manner in which securities will be categorized as
appropriate for the fund and whether the selection is quantitative or
qualitative based. - The prospectus might provide ranges on allocations and whether
the securities of foreign based firms are allowed
MANAGER TENURE
MANAGER TENURE
- Details regarding the educational and professional background of
the fund managers can be found in the prospectus.
TOTAL ANNUAL RETURNS
TOTAL ANNUAL RETURNS
- Updated annually in the prospectus
- 1-, 5-, AND 10-year total returns are normally provided
- The return on the benchmark or relevant index is provided
PORTFOLIO TURNOVER
PORTFOLIO TURNOVER
- The process of buying and selling securities inside a mutual fund
has implications for both expenses and taxes. - Be aware of the turnover in each taxable fund (but can be less
concerned if the funds are held in tax-deferred accounts).
FEES AND EXPENSES
FEES AND EXPENSES
- The fee and expense section of the prospectus usually follows the
objectives section and provides a table as an outline. - There are two parts to the table:
- list of shareholder fees, including sales fees, purchase fees,
account fees, and redemption fees - annual operating expenses, including the management fee,
any 12 b-1 fees, and other relevant expenses
RISK OF INVESTING
- Each mutual fund identifies the types of risks to which the fund is
subject based on the fund’s stated strategy and types of investments
purchased by the manager.
RISK OF INVESTING
- Each mutual fund identifies the types of risks to which the fund is
subject based on the fund’s stated strategy and types of investments
purchased by the manager.
OTHER INFORMATION
- In prospectus: ?
- Not in prospectus: ?
OTHER INFORMATION
- In prospectus:___________________
- Options/methods for buying and selling shares
- Minimum investment requirement
- Not in prospectus:______________
- Statement of Additional Information (SAI)
– Must be provided to investor upon request - Description of Investor Services
MODERN PORTFOLIO THEORY STATISTICS
MODERN PORTFOLIO THEORY STATISTICS
- The correlation coefficient (r) between two variables indicates the
strength and direction of the relationship. - The coefficient of determination is r-squared and measures how
much of the variation in a mutual fund’s returns can be explained by
the variation of the benchmark portfolio returns. - Beta: The systematic risk of a portfolio is measured by its beta. A mutual fund beta is a weighted average of the betas of the assets in
the portfolio
PERFORMANCE MEASURES
PERFORMANCE MEASURES
Risk-adjusted return measures are useful in evaluating mutual fund
performance.
Three such measures include :
Jensen’s alpha,
Sharpe Ratio,
Treynor Ratio
PERFORMANCE MEASURES – INFORMATION RATIO
PERFORMANCE MEASURES – INFORMATION RATIO
Incorporates a risk adjustment to the performance of an active manager in comparison to the performance of the benchmark.
- Provides investors with a way to evaluate the excess return
earned by a fund manager given the risk associated with the
excess return. - Formula:
Rp - Rb IR = ----------------------- σA
Where:
* R = Return of the portfoliop
* RB = Return of the benchmark
* σA = Standard deviation of the active return (this standard
deviation is also referred to as a “tracking error”)
ISSUES FOR MANAGEMENT OF MUTUAL FUNDS
ISSUES FOR MANAGEMENT OF MUTUAL FUNDS
- Monitoring the Portfolio: The final step in the investment process
- Changing Asset Size: Change in size due to inflow/outflow, prices
- Style Shift: Problems can arise if there is a shift by the fund
manager from one style to another. - Manager Changes: It is important to monitor managerial changes.
- Built-In Capital Gains: All investors should be aware of the capital
gains that are built into a fund.
Monica purchased 100 shares of NOLA mutual fund at a price of $25 per share at the beginning of the year and paid a front-end load of 4.5%. The securities in the fund increased in value by 11% during the year and the fund’s expense ratio was 1.2%. What was Monica’s annual return for this year assuming she were to sell at year end? a. 4.50%. b. 4.85%. c. 5.30%. d. 9.80%.
Reduction upfront sales charge = NAV= $25 x ( 1.045) = $23.875
Expense ratio reduce return of 11% by 1.2% = 9.80% of NAV
Gain on NAV is 9.80% x $23.875 = $ 2.339 = $26.214 NAV
Gain net of sales load and expenses is $26.214 - $25 = $1.214.
$1.214 gain / $25 invested = 4.85 %
( $25 x .955 ) x ( 1.111 - .012 )
——————————————- - 1 = 4.85 %
$25
Active managers in contrast with passive portfolios attempt to construct risky portfolios with securities that have:
a. A higher Sharpe ratio than an index fund.
b. A lower Sharpe ratio than an index fund.
c. The same Sharpe ratio as an index fund.
d. A Sharpe ratio greater than 1.0.
a. A higher Sharpe ratio than an index fund.
What is the Sharpe measure of performance for the Panda Fund? The risk-free rate for the period was 4%.
Panda Fund Market Portfolio
Average Returns 18% 12%
Standard Deviation 30% 17%
Beta 1.9% 1.0%
47%.
Rationale
( 18% - 4%)
———————- = 0.4667 = 47%
30%
What is the Jensen measure of performance for the Koala Fund? The risk-free rate for the period was 4%.
Koala Fund Market Portfolio
Average Returns 14% 11%
Standard Deviation 23% 17%
Beta 1.10% 1.0%
2.3.
14 - ( 4 + 1.10 ( 11 - 4 ) ) = 2.30
A well-informed institutional investor would most likely use standard deviation to measure:
Total risk.
Rationale
Standard deviation measures the total variability in asset returns and as such is a great measure of total risk. It can be decomposed into its two components, systematic and unsystematic risk.
