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.
Using the Treynor ratio, which of the following funds provides the highest risk-adjusted return if the risk-free rate of interest is 3%.
Average Return Standard Deviation Beta
Index 1 10 12 1.0
Index 2 18 20 1.0
Fund 1 22 28 1.7
Fund 2 16 17 1.2
index 2.
Rationale
The fund with the highest Treynor ratio provides the highest risk-adjusted return. The Treynor ratio is an appropriate measure for diversified portfolios (R2 = 0.70 or higher).
Index 1 10-3 / 1.0 = 7
Index 2 18 - 3 / 1.0 = 15 «< BEST
Fund 1 22 -3 / 1.7 = 11.17
Fund 2 16-3 / 1.3 = 10.82
Jeremiah is a portfolio manager who consistently earns a high Sharpe ratio. His forecasting ability is which of the following?
Above average.
Rationale
A manager with the highest Sharpe ratio presumably has better forecasting abilities.
Which of the following statements regarding exchange-traded funds (ETFs) is least likely to be accurate?
ETFs cannot be purchased with margin accounts.
Rationale
The advantages of owning ETFs include tax efficiency, the possibility of short selling, trading at current market values even during the day, and the opportunity to use margins to leverage returns.
Mutual fund management fees may include:
Investment advisor fees.
Rationale
Management fees are fees that are paid out of fund assets to the fund’s investment adviser (or its affiliates) for managing the fund’s investment portfolio, and administrative fees payable to the investment adviser.
The beta of Portfolio A is 1.5.
The standard deviation of the returns on the market index is 20%.
Changes in the market account for 64% of the changes in Portfolio A.
The standard deviation of the returns on the active portfolio is:???
37.50%.
Rationale
cORAVUIRANCE
Which one of the following is accurate for a purely passive investment strategy using mutual funds?
It uses only index funds.
It allocates assets in fixed proportions that do not vary with market conditions.
It incorporates only funds with a beta of 2.0 or higher.
Both a and b.
Both a and b.
Rationale
A purely passive investment strategy is one that uses index funds with fixed proportions.
The determination of the success of an active portfolio is:
Positive alpha/high R2.
Rationale
A positive alpha implies above average performance – beating the market. However, r-squared must be high for beta and thus, alpha to be reliable. A high r-squared also implies that the fund is highly diversified relative to the market.
Mutual fund fees that cover advertising and promotional literature are typically referred to as:
Back-end loads.
Front-end loads.
Advertising fees.
12 b-1 charges.
12 b-1 charges.
Rationale
Front-end loads and back-end loads are sales commissions paid to advisors to sell the fund. The 12 b-1 fee structure allows for up to 1% allowance for advertising and promotion. There are no specific and separate advertising fees required for inclusion in the prospectus.
Active managers in contrast with passive portfolios attempt to construct risky portfolios with securities that have:
A higher Sharpe ratio than an index fund.
Rationale
A higher Sharpe measure than an index fund is indicative of the benefits of active management.
An investor considers adding the Eagle High Income Fund to her portfolio. Eagle has returned 18% over the previous year while the risk-free rate is 4%. Measures of risk for Eagle include a beta of 1.9 and a standard deviation of 30%. The return on the relevant benchmark over the previous year is 12% with a standard deviation of 17%. The investor’s estimate of the Jensen’s alpha for the Eagle Fund is closest to:
-0.012.
Rationale
Rp - [ Rf + B ( Rm - Rf ) ] = jensen
.18 - [ .04 + 1.9 ( .12 - .04 ) ] = - .012
An analyst collects the following data for two mutual funds, given a risk-free rate of 5%.
Fund Return Standard Deviation Beta
1 12% 16% 1.160
2 13% 18% 1.326
Which of the following is most accurate?
Fund 1 has the lower Sharpe ratio.
Rationale
Both funds have a Treynor ratio of 6.034, but Fund 1 has a Sharpe ratio of 0.438 and Fund 2 has a Sharpe ratio of 0.444.
In comparison to their relevant index, most actively managed mutual funds:
Underperform the majority of the time.
Rationale
Most actively managed funds fail to equal or surpass the return earned by their relevant index or benchmark for a variety of reasons. At the top of the list is the simple fact that actively managed funds have much higher expenses, but also because of turnover, hubris, and asset allocation decisions.
In January of this year, Selena invested in the Alpha Aggressive Growth & Accumulation Fund (Alpha). The fund had NAV per share of $21.60 in January of this year. On December 31 of the same year, the fund’s NAV was $26.98. Income distributions were $0.90 and the fund had capital distributions of $1.20. What rate of return did Selena receive on the fund last year (disregard taxes and transaction costs)?
34.63%.
Rationale
use the holding period return formula:
Capital gain Income yield
[Sale Price – Purchase Price +/- cash flows ] HPR = ------------------------------------------------------------------------------
Purchase Price
[$26.98 - 21.60 + 0.90 + 1.20] ------------------------------------------------------ = 34.63%.
21.60
Two portfolios have identical expected returns and standard deviations. Portfolio 1 has a higher beta than Portfolio 2. An investor using the Sharpe ratio to compare these two portfolios would most likely conclude the performance of Portfolio 1 is:
Less than Portfolio 2.
Identical to Portfolio 2.
Greater than Portfolio 2.
Not enough information provided.
Identical to Portfolio 2.
Rationale
Since the Sharpe ratio uses standard deviation as the relevant measure of risk, the ratios for the two portfolios will be identical. Beta is not relevant to this analysis.
Rp - Rf sharpe = ------------------ = so equal the same
SD
sing the Sharpe ratio, which of the following funds provides the highest risk-adjusted return if the risk-free rate of interest is 3%.
Average Return Standard Deviation Beta
Index 1 10 12 1.0
Index 2 18 20 1.0
Fund 1 22 28 1.7
Fund 2 16 17 1.2
Index 1.
Index 2.
Fund 1.
Fund 2.
Fund 2.
The fund with highest Sharpe provides the highest risk adjusted return.
Rp - Rf sharpe = ------------------
SD
Index 1 10 -3 / 12 = .5835
Index 2 18-3 / 20 = .75
Fund 1 22-3 / 28 = .6785
Funds 2 16- 3 / 17 = .7647
What is the range of the coefficients of correlation?
-1 to +1.
Rationale
-1 to +1 is the range of the coefficient of correlation.
Mutual fund management fees may include:
Front-end loads.
Investment advisor fees.
12b-1 charges.
All of the above.
Investment advisor fees.
Rationale
Management fees are fees that are paid out of fund assets to the fund’s investment adviser (or its affiliates) for managing the fund’s investment portfolio, and administrative fees payable to the investment adviser.
