Portfolio Construction

Question 1

For normally distributed portfolios, what proportion will have returns within 2 standard deviations?

Answer 1

95%

Question 2

Why is the optimal risk portfolio usually considered to be around the middle of the efficient frontier?

Answer 2

Because you get proportionately less returns for increasing the risk at this point

Question 3

What are some drawbacks of MPT? (5)

Answer 3

• Assumes returns are normally distributed
• Doesn’t take into account charges/tax.
• ATR may not be only consideration for investor i.e. ESG.
• Past performance does not indicated future performance.
• Tricky to get good data to plot the graph.

Question 4

How does the CAPM measure risk?

Answer 4

Via beta, thus relative to the market.

Question 5

What is the expected return for a security if:
Beta = 1.3
xReturn on a Treasury Bill = 3%
xReturn on the security = 7%

Answer 5

3+(1.3x[7-3]) = 8.2%

Question 6

What are the main assumptions of CAPM? (5)

Answer 6

• Borrowing and lending all takes place at the risk-free rate.
• Investors have diversified away all non-systematic risk.
• No tax or transaction costs.
• Maximising return for a given level of risk is sole incentive for all investors.
• Investors retain identical expectations of returns and standard deviations of all assets.

Question 7

How did Fama & French expand upon CAPM?

Answer 7

Added in factors for:
-Company size
-Value

Question 8

What two conclusions did Fama & French make with regard to securities offering the best growth potential?

Answer 8

• Small cap stocks tend to outperform large cap stocks.
• Value stocks tend to outperform growth stocks.

Question 9

How is arbitrage pricing theory used to make a risk-free profit?

Answer 9

By highlighting mispriced securities which can then be bought at a discount to their ‘true value’.

Question 10

What is the main principle of the Efficient Markets Hypothesis?

Answer 10

That it should be impossible to achieve returns in excess of the average market consistently.

Question 11

Investors who believe in the efficient markets hypothesis will generally prefer what type of fund?

Answer 11

Passive

Question 12

True or false? With semi-strong EMH, both fundamental and technical analysis are useless.

Answer 12

True

Question 13

What does regret theory demonstrate?

Answer 13

People will be less willing to sell a losing investment due to it showing a loss.

Question 14

What type of risk cannot be diversified against?

Answer 14

Systematic risk

Question 15

What three client attributes should be considered when designing an asset allocation?

Answer 15

-Timescale
-Acceptable level of loss
-Need for income

Question 16

How does hedging help reduce downside risk?

Answer 16

By taking another position that will increase in value should the existing position fall.

Question 17

What is shown empirically as having the greatest impact on portfolio performance?

Answer 17

Asset allocation

Question 18

SAA is: 30% Intl equities, 30% UK equities, 40% Gilts.
Portfolio is currently £50k Intl equities, £35k UK equities & £25k Gilts. What action should be taken?

Answer 18

Rebalance as such:
Intl equities = £33k
UK Equities = £33k
Gilts = £44k

Question 19

What three benchmarks could a fund manager assess their fund against?

Answer 19

-Index
-Peer group
-Custom benchmark

Question 20

How are top down portfolios constructed?

Answer 20

Asset allocation –> sector allocation –> stock selection

Question 21

What are the benefits and drawbacks of active fund management?

Answer 21

Benefits:
- Informed investment decisions based on sound analysis.
- Possibility of higher returns against the index.
- Ability to take defensive measures to protect the fund’s value in the event of market downturns.
- Certain strategies (i.e. absolute return, hedge fund) not readily available as passive options.

Drawbacks:
- Higher fees and charges
- Empirically, unlikely to overperform once fees taken into account.
- Investment style adopted may underperform in certain market conditions.

Question 22

What are the benefits and drawbacks of passive fund management?

Answer 22

Benefits:
- Tend to be cheaper than active funds.
- No risk of significantly underperforming the index.
- Removes reliance on fund manager skill.

Drawbacks:
- Investors must be satisifed with the performance of the index.
- Won’t be able to go on the defensive in a market downturn.
- Index funds not able to take tactical decisions or use hedging.

Question 23

How does ‘riding the yield curve’ work?

Answer 23

The investor will buy a bond with a maturity of longer than their time horizon, then ceteris paribus, the yield will fall and the bond price will rise. Works in a normal yield curve environment.

Question 24

What is ‘anomaly switching’?

Answer 24

Involves switching two bonds with similar characteristics, choosing the one with the higher yield.

Question 25

What is ‘policy switching’?

Answer 25

Involves switching bonds that have different attributes to take advantage of an event that may change the bond’s price. I.e. interest rates

Question 26

What is cash flow matching?

Answer 26

A passive bond strategy whereby bonds are purchased with redemption proceeds or coupons that equal some future liability.

Question 27

What is duration matching generally used for?

Answer 27

Hedging interest rate risk

Question 28

What is horizon matching?

Answer 28

Combines cash flow and duration matching.
Cash flow for short term liabilities, duration for long term.

Question 29

What is the info ratio for the following fund:
Benchmark return - 6%
Fund return - 7.5%
Tracking error - 10%

Answer 29

(7.5-6)/10 = 0.15

Question 30

What is the sharpe ratio for the following fund:
90 Day Gilt interest rate - 4%
Fund return - 6%
Standard deviation - 8%

Answer 30

(6-4)/8 = 0.25