L1 SH: Equity Funds

Question 1

What are equity funds?

Answer 1

A portfolio of shares

Question 2

What is a PLC?

Answer 2

A company that has been created to invest money in other shares

Question 3

Describe a specialist portfolio

Answer 3

Specialist: a portfolio that is deliberately constructed to cover firms of a particular type, e.g.: geographic, small cap firms, sector of the industry

They usually have a clue in their name, not fully diversified

Question 4

Describe a diversified portfolio

Answer 4

sometimes called ‘tracker’ funds –> they track a particular index e.g. FTSE-100, Dows Jones, S&P-500

They are very well diversified (apart from sometimes the index gives a small sample)

Question 5

What is a group rotation portfolio?

Answer 5

Equities are grouped on the basis of different characteristics e.g. risk, industry, growth rates

The fund manager moves their money from one group of shares to another to get a better risk-return combination

Question 6

What is an income fund?

Answer 6

Specialises in creating a stream of income for their investors

E.g. might be invested in company’s that regularly dividend

Question 7

Describe B-values

Answer 7

B value = 1 - portfolio moves the same as the market

B value < 1 - portfolio moves slower/less aggressively than the market

B value > 1 - portfolio moves faster/more aggressively than the market

Question 8

On a graph of Return of the investments (y) x Return of the Market (x), what would:

a) dots scattered around both sides of the B-value line?
b) dots scattered around one sides of the B-value line?

Answer 8

a) no timing

b) timing

Question 9

How would managers mould their B-values?

Answer 9

Each share tends to have a fixed B-value. However since portfolios are many shares, manager can change the B-value of their portfolio by adding or removing shares with high or low B-values

Question 10

Why would managers mould their B-values?

Answer 10

1. if a manager has insight into where the market is going e.g. i its rising then get a higher B-value
2. to maximise gains and minimise loses

Question 11

If the dots (share returns) are scattered around the B-value line, and the line is straight, what does this mean?

Answer 11

NO MARKET POWER (the portfolio cannot predict where the market is going)

Question 12

What does curvature of the line mean?

Answer 12

Can be treated like a quadratic:

Simple: Ri = y1 + y2Rm

Curved: Ri = y1 + y2Rm + y3(Rm)^2

Curved lines indicates market timing ability - and should result in statistically significant, positive, estimates of y3

Question 13

If y3 is:

a) positive and statistically significant
b) small or not significant

Answer 13

a) t-value is greater than or equal to 2, line is curved and market timing ability

b) straight line because in this equation
Ri = y1 + y2Rm + y3(Rm)^2
we can ignore the y3 section

Question 14

What are the 2 most important models for risk?

Answer 14

1. Capital market line (CML) - measures risk as the SD of returns
2. Capital asset pricing model (CAPM) - measures risk as the B

Question 15

What is meant by CAPM and CML being expectational models?

Answer 15

• hold risky assets in the expectation of better returns

- this expectation rises in a linear way

Question 16

What is the equation for the Sharpe ratio?

Answer 16

rp - rf / total risk

rp = return on portfolio
rf = rish free rate (e.g. government bonds)

rp - rf = ‘risk premium’

this equation gives a single number, so therefore very risky portfolios and very stable ones can be compared

Question 17

Describe the Sharpe Ratio

Answer 17

the SR is an investment measurement that is used the calculate the average return beyond the risk-free rate of volatility per unit

AKA: measures the actual return from an investment, adjusted for by the riskiness of the investment

Question 18

For the Sharpe ratio what does each mean?

a) <1
b) 1-1.99
c) 2-2.99
d) 3+

Answer 18

a) <1 = not good
b) 1-1.99 = okay
c) 2-2.99 = good
d) 3+ = exceptional

These are only useful when comparing to another Sharpe measure

Question 19

Describe the Treynor Ratio

Answer 19

This is the ‘reward to volatility’ ratio

Measures the volatility in the market, to calculate the risk of certain investments

E.g. many investment rise in value purely because the market is unstable - this doesn’t mean the investment is good or the company is good

The treynor ratio tries to un-bias this

Question 20

How is the Treynor ratio the same or different to the Sharpe ratio?

Answer 20

It is similar to the Sharpe Ratio BUT it uses the portfolios B-value as the risk measurement

By comparing B-value to volatility of entire stock market, investors can asses risk of the entire investment

Question 21

What is the formula for the Treynor?

Answer 21

average portfolio return - average risk free rate / B of the portfolio

Question 22

Give a drawback of the Treynor ratio

Answer 22

the B-value can be negative

Question 23

Define the Jensen Index/Alpha

Answer 23

the measure of portfolio performance, under the condition that the portfolio is well diversified to leverage unsystematic risk

Question 24

When do financial analysts use the alpha?

Answer 24

When they want to find the highest return with the lowest risk

Question 25

How is alpha evaluated?

Answer 25

In comparison to the benchmark (assuming the return on investment isn’t related to the market like B)

If alpha = 0, the portfolio is perfectly correlated to the benchmark

Question 26

What is the equation for alpha?

Answer 26

rp - (rf + B(rm - rf))

= portfolio return - risk free rate - portfolios B( market return - risk free rate)