Module 8 Portfolio Management Theory, Portfolio Development, and Asset Allocation Flashcards
Which of the following factors is NOT necessary for calculating the measure of risk that is used in Markowitz’s efficient frontier?
A)
Beta for each asset class
B)
The percentage of the portfolio invested in each asset class
C)
Standard deviation for each asset class
D)
Correlation between each asset class and every other asset class
a The efficient frontier consists of efficient portfolios. An efficient portfolio has the highest return for a given level of risk. The risk measure is standard deviation; specifically, the standard deviation of a multi-asset portfolio. The other choices represent inputs needed to determine the standard deviation of a multi-asset portfolio. Beta is not used in the calculation.
LO 8.1.1
Calculate the expected rate of return for Stock A based on the following information:
Risk-free rate of return: 3.85%
Factor Sensitivity Risk Premium
Inflation 1.2 4.00%
Industrial Production 0.9 5.75%
PopulationGrowth 0.5 2.60%
A)
15.13%
B)
11.28%
C)
12.35%
D)
7.97%
a The answer is 15.13%. The expected rate of return for Stock A based on the arbitrage pricing model (APT) is calculated as follows: ri = 0.0385 + (1.2 × 0.04) + (0.9 × 0.0575) + (0.5 × 0.0260) = 0.0385 + 0.048 + 0.0518 + 0.013 = 0.1513, or 15.13%.
LO 8.2.1
In analyzing the position of a portfolio in terms of risk/return on the capital market line (CML), superior performance exists if the fund’s position is ________ the CML, inferior performance exists if the fund’s position is ________ the CML, and equilibrium position exists if it is ________ the CML.
A)
below; on; above
B)
above; below; on
C)
above; on; below
D)
below; above; on
bn According to modern portfolio theory, the CML defines performance of a portfolio. All portfolios should plot on the CML in proportion to the risk of the portfolio. The Y axis is return and the X axis is the risk level. If a fund has superior performance, its return will be above the return level for the given risk level; if inferior, its return will be below the return level for the given risk level; and if it is in equilibrium, then it will plot exactly on the CML.
LO 8.2.1
In order to do an effective job of investment counseling, which of the following should be analyzed and reviewed?
Financial goals
Client tax situation
Client financial statements
Client preferences, investment understanding, and experience
A)
I, II, and III
B)
I and III
C)
I only
D)
I, II, III, and IV
d The answer is I, II, III, and IV. All of these are parts of a comprehensive client analysis. In addition, the planner should discuss the risk tolerance and risk exposure of the client and the liquidity needs and the investment time horizon of the client.
LO 8.5.1
A client has a portfolio of blue-chip stocks that were purchased many years ago by her spouse. The spouse is now deceased and the client is considering her needs for income and feels the dividend yield on the stocks is not sufficient. You have decided she should be in 60% fixed-income. Which of the following sets of factors related to the recommended changes in the portfolio is the most important for the portfolio advisor to review?
A)
Client goals, cash flows, and legal constraints
B)
Risk tolerance level, liquidity, and social investing
C)
Tax issues, risk tolerance level, and client goals
D)
Tax issues, liquidity, and legal constraints
c Investments purchased years ago will probably have a low tax basis, which could affect decisions to sell them, or they may have become worthless, in which case they can be used as a tax deduction. Likewise, the risk level of the investment is probably unknown and may not be compatible with the client’s risk tolerance level and goals.
LO 8.4.1
Stock Beta
A 2.16
B 1.54
C 0.96
D 1.28
Risk-free rate of return is 2.75%
Market rate of return = 6.75%
The investor’s required rate of return = 9.5%
Based on the information provided, choose the stock that would offer the best investment opportunity.
A)
Stock A
B)
Stock B
C)
Stock C
D)
Stock D
a The answer is Stock A. Calculate the expected rate of return of each stock using the capital asset pricing model (CAPM) and compare the result to the investor’s required rate of return.
Stock A: E(r) = 2.75 + (6.75 – 2.75)2.16 = 11.39%
Stock B: E(r) = 2.75 + (6.75 – 2.75)1.54 = 8.91%
Stock C: E(r) = 2.75 + (6.75 – 2.75)0.96 = 6.59%
Stock D: E(r) = 2.75 + (6.75 – 2.75)1.28 = 7.87%
Based on a required rate of return of 9.5%, Stock A with an expected return of 11.39% is the best available investment opportunity.
LO 8.2.1
An investor selects an appropriate portfolio by choosing the portfolio
A)
at the point of tangency between the indifference curve and the efficient frontier.
B)
that lies below the efficient frontier.
C)
with the highest return.
D)
with the lowest risk.
a The answer is at the point of tangency between the indifference curve and the efficient frontier. The investor will choose a portfolio represented by the highest point attainable on the indifference curve.
LO 8.1.1
Which of the following are reasons why a client’s preferences, understanding, and experience may influence the management of his or her portfolio?
These factors affect investment strategies that might be used by the planner.
Consideration of these factors relieves the planner of any fiduciary duty.
Consideration of these factors eliminates the need for due diligence of securities.
Investment choices must be checked for suitability, with these factors kept in mind.
A)
I and IV
B)
II and III
C)
I, II, and III
D)
I and II
a The answer is I and IV. Investment strategies used by a planner should tie closely to the client’s goals, risk tolerance, investment preferences, and other intangible factors. Clients with little understanding may not tolerate complicated investment strategies and products. Unsuitability lawsuits are very common in the investment universe. By matching as closely as possible a client’s suitability factors with investment products, an advisor may be able to defeat claims of unsuitability.
LO 8.5.2
In the Markowitz framework, an investor should most appropriately evaluate a potential investment based on its
A)
effect on portfolio risk and return.
B)
required return.
C)
expected return.
D)
intrinsic value compared to market value.
a The answer is effect on portfolio risk and return. Modern portfolio theory concludes that an investor should evaluate potential investments from a portfolio perspective and consider how the investment will affect the risk and return characteristics of an investor’s entire portfolio.
LO 8.1.1
Which of these statements regarding the capital asset pricing model (CAPM) are CORRECT?
Standard deviation is used as the measure of risk on the security market line.
The capital asset pricing model formula defines the security market line.
Superior performance opportunity exists if a fund’s position is above the security market line.
Both portfolio risk and return increase when investors substitute risky securities for risk-free assets.
A)
I and IV
B)
II, III, and IV
C)
I, II, and IV
D)
II and III
d The answer is II and III. Beta is used as the measure of risk on the security market line. If risky securities are added to the portfolio, both risk and return will increase. The capital market line slopes upward indicating that as more risk is undertaken, more return should be achieved.
LO 8.2.1
Which of the following statements describes a limitation of Monte Carlo simulation?
A)
Variables are assumed to be normally distributed but may not be normally distributed.
B)
Outcomes of a simulation can only be as accurate as the inputs to the model.
C)
Simulations do not consider possible input values that lie outside of historical experience.
D)
A clearer understanding of short-term and long-term risk can be gained.
b The answer is outcomes of a simulation can only be as accurate as the inputs to the model. Monte Carlo simulations can be set up with inputs that have any distribution and any desired range of possible values. However, a limitation of the technique is that its output can only be as accurate as the assumptions an analyst makes about the range and distribution of the inputs.
LO 8.4.1
Assume that the economic forecast for the coming year is expected to be one of increasing inflation and interest rates. The GDP is expected to be strong. Which of the following types of investments would be advisable for the coming year and why?
Liquid investments, such as money market funds and short-term securities, to allow the investor flexibility to reinvest as rates increase
Long-term debt, such as 20-year government bonds, to lock in current interest rates
Stock in public utilities and durable goods firms, becausethey benefit from a rising interest rate environment
Tangible assets, such as gold, to keep pace with the rate of inflation
A)
I and IV
B)
I, III, and IV
C)
I, II, and III
D)
II and IV
a Long-term bonds decrease in value in a rising interest rate environment. Stock in public utilities and durable goods firms does not benefit from a rising interest rate environment.
LO 8.5.1
While managing his portfolio, James’s investment adviser attempts to take advantage of perceived market inefficiencies. His investment adviser is not concerned with James’s long-term goals; rather, the interest lies in continuously changing the investment mix to take advantage of overall investor sentiment. Based on this information, choose the type of portfolio management style that the investment adviser is using to manage James’s money.
A)
Strategic asset allocation
B)
Portfolio ratio analysis
C)
Tactical asset allocation
D)
Buy and hold
c The answer is tactical asset allocation. Tactical asset allocation continuously adjusts the asset allocation in an attempt to take advantage of changing market conditions.
LO 8.5.2
Which of the following statements regarding the efficient frontier is CORRECT?
A)
Combines all assets that can be held in a portfolio
B)
Represents the assets or asset combinations with the least return for the given level of risk
C)
Represents an inferior set of assets or asset combinations available to investors
D)
Shows all portfolios that offer the highest expected returns for each level of risk
d The answer is shows all portfolios that offer the highest expected returns for each level of risk. Efficient frontiers take all of the possible combinations of assets that can be held in a portfolio into account in order to represent the set of portfolios that offer the highest expected return for a given amount of risk.
LO 8.1.1
When working with anxious clients who are concerned about widely fluctuating stock market prices, what is the most important service you can provide to them?
A)
Referring them to a financial counselor
B)
Guaranteeing them a profit on their investments
C)
Managing their expectations
D)
Discussing their risk tolerance
c The answer is managing their expectations. Unrealistic expectations can be a function of a client’s ignorance about financial markets and securities. By using your knowledge, you can educate clients about markets and securities so that expectations are realistic. Doing so also strengthens the client/planner relationship and allows you to demonstrate your expertise.
LO 8.6.1
The answer is managing their expectations. Unrealistic expectations can be a function of a client’s ignorance about financial markets and securities. By using your knowledge, you can educate clients about markets and securities so that expectations are realistic. Doing so also strengthens the client/planner relationship and allows you to demonstrate your expertise.
LO 8.6.1
d The answer is the optimal portfolio will always lie above the efficient frontier. The optimal portfolio is found at the point of tangency of the investor’s indifference curve and the efficient frontier.
LO 8.1.1
Which of the following steps are involved in the investment planning process?
Establishment of a brokerage account
Selection of assets for investment
Implementation of investment plan
Determination of ability to invest
A)
I, II, and IV
B)
II, III, and IV
C)
I, II, and III
D)
I, III, and IV
b The answer is II, III, and IV. Establishing a brokerage account is not a necessary step in the investment process; however, it may be included in the implementation phase.
LO 8.4.1
JEM stock has a beta coefficient of 1.35 and the market has a rate of return of 8.50%. The 90-day U.S. Treasury bill rate of return is 1.75%. Based on the information provided, choose the CORRECT statements.
The stock risk premium is 6.75%.
The market risk premium is 9.11%.
The expected rate of return is 10.86%.
A)
III only
B)
I and II
C)
I and III
D)
I, II, and III
a The answer is III only. The expected rate of return based on the capital asset pricing model is 10.86%, calculated as follows:
ri = 0.0175 + (0.085 – 0.0175)1.35 = 10.86, or 10.86%
The stock risk premium is 9.11%, (0.085 – 0.0175)1.35.
The market risk premium is 6.75%, (0.085 – 0.0175).
LO 8.2.1
An active portfolio strategy is based on which of the following premises?
A)
The stock market is inefficient
B)
The stock market is efficient
C)
The investor’s ability to obtain public information
D)
The portfolio manager’s access to corporate management
a If the market is efficient, then a buy-and-hold strategy would be best. Only if the market is inefficient is it worth the costs involved in active management to attempt to generate superior returns.
LO 8.3.2
Henry is constructing an asset allocation portfolio for his financial planning client, Gretchen, based on information obtained from completing a risk-profile questionnaire. Which of the following are considerations for Henry to keep in mind when developing portfolio alternatives for Gretchen?
A)
Construct portfolios that match Gretchen’s risk tolerance.
B)
Choose the appropriate benchmark(s) for investment performance comparison.
C)
Develop portfolios that take her tax situation into consideration.
D)
All of these are considerations.
d e answer is all of these are considerations. A financial planner should be aware of all of these considerations when constructing and monitoring an investment portfolio for a client.
LO 8.4.1
A well-crafted investment policy statement will take all of the following into account except
A)
investments the client is especially interested in considering for her portfolio.
B)
the client’s time horizon.
C)
anticipated liquidity needs.
D)
hobbies the client intends to pursue in retirement.
d Explanation
A properly crafted IPS will keep both the client and the advisor on track, and minimize any disagreements or confusion.
LO 8.4.1
The weak form of the efficient market hypothesis:
reinforces the value of technical analysis.
implies that technical analysis is not worthwhile.
implies that fundamental analysis is not worthwhile.
implies that inside traders cannot earn superior risk-adjusted returns.
A)
II and III
B)
II only
C)
I, III, and IV
D)
I and IV
b The weak form implies that information contained in historical stock prices is fully incorporated into current stock prices; therefore, technical analysis (the study of historical prices and volume) is not worthwhile in predicting future prices. This form neither refutes fundamental analysis nor implies that traders using insider information cannot earn superior profits.
LO 8.3.1
Which of the following statements regarding an efficient portfolio is CORRECT?
Provides the highest return for a given level of risk
Has the greatest risk for a given level of expected return
Shows an investor’s willingness to bear risk
Can be created with minimum transaction costs
A)
I, II, and III
B)
II and III
C)
III and IV
D)
I only
d The answer is I only. An investor should try to assemble an investment portfolio containing the optimum combination of risk and return. An efficient portfolio offers maximum return for a given level of risk. An investor’s willingness to bear risk is reflected in indifference curves.
LO 8.1.1
Which statement concerning an active portfolio management strategy is CORRECT?
A)
An actively managed portfolio has low total transaction costs.
B)
The key to success for an actively managed portfolio is to minimize trading activity.
C)
The goal of active portfolio management is to earn a return that exceeds the risk-adjusted return of a passive benchmark portfolio.
D)
An actively managed portfolio has lower risk than a passive benchmark portfolio in most cases.
c Explanation
The answer is the goal of active portfolio management is to earn a return that exceeds the risk-adjusted return of a passive benchmark portfolio. This is net of transaction costs. Such a strategy also involves higher transaction costs and, usually, risk.
LO 8.3.2
Which of the following are implications of the weak form of the efficient market hypothesis (EMH)?
Stock prices fully reflect all historical price behavior.
Consistently superior performance is common.
Fundamental analysis may produce superior investment performance.
Fundamental and technical analysis can produce superior investment performance.
A)
I and III
B)
I and IV
C)
I only
D)
II and IV
a Explanation
Technical analysis is not considered valuable under any of the forms of the EMH; fundamental analysis is considered valuable under the weak form only.
LO 8.3.1
The random walk hypothesis is supported when
future price changes are not correlated with past price changes.
stock price changes are random but predictable.
stock prices respond rapidly to new information.
past information is not useful in predicting future price changes.
A)
I, III, and IV
B)
II, III, and IV
C)
I, II, and IV
D)
III only
d The answer is I, III, and IV. The random walk hypothesis assumes that stock price changes are essentially random, and therefore unpredictable; or that successive stock returns are independent of past returns. Stock prices react quickly to new information. Past information is not relevant when predicting future price changes, hence, future price changes are not correlated with past price changes.
LO 8.1.1
