Portfolio Management (Section II.B) (11%, 14 Questions)

Question 1

Asset Location - Taxable Account

Answer 1

-Index and other passive funds
-Growth funds with low turnover
-tax-managed funds
-REITS
-Muni’s

Question 2

Asset Location - Tax-Deferred Accounts

Answer 2

-Dividend Stocks
-Most taxable bonds
-Actively managed funds, high turnover funds
-Partnerhips “IF” they avoid UBTI.

Question 3

Pair-wise Trades

Answer 3

Sell asset at a loss (to harvest tax loss) and buy a comparable, but not identical, asset to maintain risk exposure while avoiding wash sale rules.

Question 4

Portfolio Turnover Rate

Answer 4

• A Simple measure of potential taxation, but not usually the best measure of tax efficiency.
• Measures how often assets or investments in a fund or portfolio are bought and/or sold within a specific time period.
• Calculated by dividing the net assets or invsts bought and sold by the portfolio value.

Question 5

Capital Gains Realization Rate

Answer 5

• The percentage of the fund’s net unrealized capital gains that the manager chose to realize.
• CGRR = CGDIST/GAINSTOCK

Question 6

Relative Wealth Measure

Answer 6

*The higher the better, zero indicates little tax impact

RWM = [(R(at)-R(bt))/(1+R(bt)) x 1,000

• RWM works in all kinds of markets
• RWM is usually negative but can be positive if realized losses and/or applicable deferred losses are included.

Question 7

Consultant Capture Ratio

Answer 7

• Captures the % of return that taxable investors retain.

CCR = after-tax return / before-tax return

• Works well in smooth, upward-trending markets.

Question 8

Accountants Ratio

Answer 8

• Equals the ratio of short-term capital gains realized to total capital gains realized.

Question 9

Alternative Investments - Benefits and Risks

Answer 9

• Potential Benefits = diversification, hedging, performance, innovation, leverage, etc.
• Risks/Disadvantages = Lock-up periods, high fees, taxes, lack of tranparency, reporting standards, less regulation, risk of total loss, leverage, volatility, illiquidity.

Question 10

Contango & Backwardation

Answer 10

*If asked about this on the test, the information below should be all we need to know.

• Backwardation is desirable for investors who are “net long”
• Backwardation occurs when futures prices are lower than spot prices.
• Backwardation indicates short supply
• Contango occurs when futures prices are higher than spot prices.
• Contango indicates immediate supply.

Question 11

The J-Curve Concept

Answer 11

The “j-curve” concept relates to the expectation that for some investments, such as priate equity, there are negatives cash flows for several years before leading to positive cash flows in later years.

Question 12

“Vintage Year” Concept

Answer 12

• Vintage year refers to the first (initial) year of investment.
• Analysis is common for venture capital projects and other private equity investments as well as real estate.

Question 13

Master Limited Partnerships “MLPs”

Answer 13

• Type of limited partnership that is traded on a public exchange. LPs typically provide the investments and general partners typically manage operations.
• Requirements that 90% of cash flow comes from the real estate, commodities, or natural resources.
• Many MLPs are not appropriate for tax-deferred accounts because of UBTI and other tax related issues.

Question 14

Hedge Fund Performance - Backfill bias

Answer 14

• Hedge funds report returns only if they choose to, and they may do so only when their prior performance is good.

Question 15

Hedge Fund Performance - Survivorship bias

Answer 15

• Failed funds drop out of the database
• Hedge fund attrition rates are more than double those for mutual funds.

Question 16

Hedge Fund Performance - High water mark

Answer 16

• The fee structure can give incentives to shut down a poorly performance fund
• If a fund experiences losses, it may not be able to charge an incentive unless it recovers to its previous higher value.

Question 17

UBTI - Unrelated Business Taxable Income

Answer 17

• Can create current tax liability for tax-deferred accounts due to gains realized from investments activities such as leveraged trading strategies and other gain producing activities not considered directly related to the main function of the entitiy. Subject to federal and state income tax.

Question 18

Mean-Variance Optimization (MVO)

Answer 18

• The process or method that measures the efficiency of various mixes of assets or invstments that seeks the optimal combination of choices through diversification that minimizes risk per unit of return gained.
• Advantage = Helps quantify risk and return to build optimal portfolios.
• Disadvantage = Assumes investors are rational; assumes history of risk and return characteristics are resonable predictors of future performance.

Question 19

Strategic Asset Allocation

Answer 19

• Involves crafting a portfolio of various asset classes with specific target mixes. The objective of strategic allocation is to maintain these mixes.

Question 20

Tatical Asset Allocation

Answer 20

• It is an active management strategy
• Allows the advisor to make changes to a portfolio allocation based on their convictions about various asset classes looking forward.

Question 21

Dynamic Asset Allocation

Answer 21

• A method of changing the allocation of the portolio based on market conditions.
• One approach to DAA is when the riskier part of a portfolio outperforms the safer part, the investor or the advisor would assume more risk by increasing the allocation to the riskier part of the portfolio.

Question 22

Options Strategies - Collar

Answer 22

• Options-based hedge that involves selling an out of the money call and buying an out of the money put.

Question 23

Option Strategies - Horizontal Spread

Answer 23

• A spread where the investor buy and sells two options on the same underlying asset that the same strike but different expiration dates.
• Also called “Calendar Spread”.

Question 24

Arithmetic Mean

Answer 24

• Mean calculation by adding together the different stock prices and then dividing by the number of stocks.
• Arithmetic Mean = ($10+$20)/2 = $15

Question 25

Geometric Mean

Answer 25

-Mean calculation by multiplying the differet stock and then taking the nth root, where n equals the number of stocks.
-The geometric mean tends to produce a downward bias (lower mean compared to arithmetic.)
-Geometric Mean = ($10*$20)(1/2) = $14.14.

Question 26

Dollar Weighted Return (DWR) & Internal Rate of Return (IRR) - Part 1

Answer 26

Dollar-weighted returns
=Investor’s return
=Considers cash flows
=IRR

Question 27

Dollar Weighted Return (DWR) & Internal Rate of Return (IRR) - Part 2

Answer 27

• The dollar weighted rate of return applies the concept of IRR to investment portfolios. The dollar-weighted rate of return is defined as the IRR of a portfolio, taking into account all cash inflows and outflows.

Question 28

Dollar Weighted Return (DWR) & Internal Rate of Return (IRR) - Part 3

Answer 28

-Example: Investor buys one share of stock for $50 at the beginning of the 1st year and buys another share for $55 at the end of the first year. The investor earns $1 in dividends in the 1st year and $2 in the 2nd year. What is the IRR if the shares are sold at the end of the second year for $65 each.
-Answer: Cash outflows ($50 at t=0 & $55 at t=1). Cash inflows ($1 at t=1 and $132 a t t=2). The next step is to group net cash flow by time (-$54 at t=0 & $132 at t=2. You can enter the cash flows into the calculator to find the IRR.

Question 29

Time-Weighted Return (TWR)

Answer 29

• Does not weigh the amount of all dollar flows during each time period. It computes the return for each period and takes the average of the results by finding the holding period and averaging the returns.
  Example (same as DWR example): First year = $55-$50+$1 = 12%
  Second year =
  ($130-$110+$2) - $110 = 20%
  TWR =
  ((1.12)(1.20))^1/2-1 = 15.9%

Question 30

Real Return (Inflation Adjusted)

Answer 30

• Real return is an inflation adjusted return. It has an inflation premium as an adjustment to the real risk-free rate to compensate investors for expected inflation and tightening or easing of monetary policy due to inflationary expectations.

Question 31

Systematic Risk (Market Risk)

Answer 31

• Systemic risk in a broad category or composite of risk that affects the entire market rather than unique to a particular security. In effect, all securities tend to move together in a systematic manner in response to these risks.
• Systematic risks are non-diversifiable . Examples: market risks, interest rate risk, purchasing power risk, foreign currency risk and reinvestment risk.

Question 32

Unsystematic Risk (Diversifiable)

Answer 32

• Unsystematic risk is unique to a single business or industry, such as operations and methods of financing.
• Unlike systematic risk, since this risk is not a risk of the entire market, unsystematic risk can be eliminated through diversification.

Question 33

Standard Deviation (SD)

Answer 33

• Measures volatility
• Measures the amount of variation or dispersion from an average
• SD is considered a measure of “Total Risk” (unsystematic & Systematic risk).

Question 34

Beta

Answer 34

• Measures systematic risk (market risk)
• Used in the Capital Asset Pricing Model (CAPM)
• A beta of 1 indicates an asset will move directly in proportion to the markets as a whole.
• A low beta (ex: .4) indicated that an asset has been less volatile than the market while a high beta (ex: 1.2) indicates that an asset has been more volatile than the market.

Question 35

Beta Coefficient

Answer 35

• Used for a diversified portfolio, where all unsystematic risk has been eliminated. The beta coefficient is a measure of volatility for a diversified portfolio.

Question 36

Sharpe Ratio

Answer 36

• A risk-adjusted performance metric measuring how much return is achieved per unit of risk taken.
• Measures total risk (using standard deviation)
• The higher the Sharpe Ration the better
• MPT serves as the foundation for the Sharpe Ratio - The higher the ratio, the closer the portfolio is to the mean variance portfolio.
• Sharpe Ratio = (Rp - Rf) / σp

Question 37

Sharpe Ratio (More)

Answer 37

• Measures the total risk of the portfolio by including standard deviation instead of only systematic risk (Beta).
• The foundation of the Sharpe ratio is MPT, and the idea is the higher the Sharpe ratio, the closer the portfolio is to the mean variance portfolio.

Question 38

Jensen’s Alpha(CAPM)

Answer 38

• Measurement of invesment manager’s risk-adjusted performancec based on security selection and market timing.
• Measures the value-add by manager.
  Alpha = Ra-[Rf+Beta(Rm-Rf)]

Question 39

Treynor Ratio

Answer 39

-Measure performance relative to risk taken as measured by beta.
- Same formula as sharpe ratio except that it uses beta, which measures systematic risk, instead of standard deviation which measure total risk.