Portfolio Theory

Question 1

What are top-down approach and bottom up approaches?

Answer 1

Top Down:
Asset Allocation is decided before stock selection and market timing.

Asset Allocation -> Sector Selection->Stock Selection

Bottom up:
Stock selection -> Economic factors

Question 2

What are fundamental and technical analysis?

Answer 2

Fundamental:
process of identifying stocks that are undervalued by looking at the underlying investment. looks at the historical financial performance of a company

Technical:
focuses on the market rather than the stock, identify trends etc. charts historical trading .data

Question 3

What are the main management styles?

Answer 3

Value:
Aim to identify undervalued shares which will produce higher value in the long run.
Usually wins in the long run.
Fund managers have to beat an index and value shares unlikely to keep up with these.

GAARP:
Looking for companies with high growth prospects, such as those with high PE ratios. Companies will have a long-term sustainable advantage over competitors.

Momentum:
Hold stocks which capitalise on existing trends in the market.
Demands a much higher level of trading.

Contrarianism
Betting against the herd, hedge funds.

Question 4

Explain the EMH and what is the crux of it?

Answer 4

In an open and efficient market, security prices fully reflect all available information and rapidly adjust to any new information.

Market prices are always the correct price for any given security and reflect the best estimate of their true intrinsic value.

It is therefore not possible to outperform the market by picking undervalued securities, since the EMH indicates that there are no undervalued or overvalued securities.

The crux of the EMH is that it should be impossible to achieve returns in excess of average market returns consistently through stock selection

Question 5

What are the 3 forms of the EMH, explain them.

Answer 5

Weak form:
- Current security prices fully reflect all past price and trading volume information.
- Future prices cannot be predicted by analysing this type of historical data.
- Technical analysis is of no use in determining future prices, and will not be able to consistently produce marketbeating returns.

Semi-strong form:
- Security prices adjust to all publicly available information very rapidly and in an unbiased way.
- Public information includes information reported in a company’s financial statements, company announcements and economic factors.
- A company’s financial statements are of no help in forecasting future price movements and securing excess returns.
- Implies that neither fundamental analysis nor technical analysis will be able to help identify whether a security is over- or undervalued.

Strong form:
Current market price reflects all historic share price AND all publicly available information AND all privately held information.

If an investor is not able to beat the market even if he had insider information, then the market would be strongly efficient, i.e. very efficient.

Question 6

What makes a market more efficient?

Answer 6

The larger and more liquid the market, e.g. the FTSE 100.

Thus, markets that are less efficient, more knowledgeable investors may be able to outperform the market.

If the EMH is correct then there is not point in choosing active funds.

Question 7

What is one key source of market inefficeny?

Answer 7

Human Behaviour - humans are irrational

Question 8

What are the principle theories of behavioural finance?

Answer 8

Loss Aversion:
People are more effected by prospective losses then they are to equivalent gains and react differently depending on the outcome is a gain or a loss. People will take higher risk to not lose money, then they would to get an equivalent gain, such as not wanting to realise losses, so hold on to a failing investment.

Regret:
Don’t want to sell an investment because it is showing a loss. People feel regret after making an error of judgement and don’t want to crystallise it.

Overconfidence:
People have a tendency to overestimate their own skills and predictions for success, and underestimate the likelihood of bad outcomes over which they have no control.

Question 9

What are the ways to replicate an index?

Answer 9

Full Replication:
Each constituent of the index to be tracked to be held in accordance with its index weighting. Although full replication is accurate, it is also the most expensive of the three methods and so is only really suitable for large portfolios.

Stratified Sampling:
A representative sample of securities from each sector of the index to be held. Although this method is less expensive, the lack of statistical analysis renders it subjective and potentially encourages biases towards those stocks with the best perceived prospects.

Optimisation:
Costs less than fully replicating the index tracked, but is statistically more complex. Optimisation uses a sophisticated computer modelling technique to find a representative sample of those securities that mimic the broad characteristics of the index tracked.

Question 10

What is tracking error?

Answer 10

The standard deviation of the difference between the portfolio and benchmark index return.

Question 11

Explain briefly the potential causes of an ETF tracking error.

Answer 11

• Inaccuracy of tracking/method used (i.e. sampling).
• Management fee.
• Other expenses/costs.
• Currency hedging.
• Cash drag/uninvested cash.
• Dividend reinvestment lag.
• Tax/withholding tax.
• Securities lending.

Question 12

What is a risk premium?

Answer 12

The additional return over a risk-free return needed to compensate for an investor taking on the risk of an investment.

Question 13

Systematic / non-systematic risk?

Answer 13

Systematic = risk within the general economy, i.e. war in Ukraine (market risk).

Non-systematic = risk of a particular business.

Question 14

What does the Capital Asset Pricing model (CAPM) posit and what is the formula?

Answer 14

Because non-systematic risk can be eliminated by diversification, it is not rewarded. It is the sensitivity of the security to the market that is the appropriate measure of risk.

The objective is to calculate the EXPECTED RETURN for any given amount of RISK.

Er = Rrf + Beta (Emr – Rrf)

Er = expected return on the risky investment;
Rrf = rate of return on a risk-free asset;
Beta = Beta
Emr = Expected market return

Question 15

What is Beta?

Answer 15

Beta measures the systematic risk of a security relative to the systematic risk of the market as a whole.

Beta = 1 = moves exactly in line with the market - market has a beta of 1

Beta < 1 = More stable than the market.

Beta > 1 = more volatile than the market.

Question 16

What are the limitations of the CAPM

Answer 16

What to use as the risk-free rate?
Finding a totally risk-free return is difficult.

What is the market portfolio?
Depending on which index is used, the betas are significantly different. This has brought into question whether these indices represent the true market portfolio, since if the true market portfolio is not used, the correct beta for a security cannot be determined.

The suitability of beta
Betas are calculated from past experience and do not seem to be stable over time, which brings into question their reliability as a guide to estimating future risk.

Question 17

Assumptions for the CAPM?

Answer 17

• Investors are rational and risk averse
• All investors have an identical holding period.
• The market comprises many buyers and many sellers
• There are no taxes, no transaction costs and no restrictions on short-selling.
• Information is free and is simultaneously available to all investors.
• All investors can borrow and lend unlimited amounts of money at the risk-free rate.
• The quantity of risky securities in the market is fixed

Question 18

What is Arbitrage pricing theory (APT)?

Answer 18

Measures the expected return on a security like the CAPM but takes account of all risk specific to the security.

CAPM assumes price is solely determined by market risk.

APT takes into account a series of risk premiums that can be specific to the security. It takes into account non-systematic risk as well as systematic risk.

Question 19

State and explain briefly the two central principles of the CAPM.

Answer 19

• Non-systematic/specific risk can be eliminated/diversified;
• is not rewarded.
• Sensitivity to systematic/market risk;
• dictates expected return.

Question 20

What are the limitations of APT?

Answer 20

One difficulty with the APT is its generality, as the model does not tell us which factors are
relevant.

In addition, the number and nature of those factors is likely to change over time and between economies.

Question 21

What four important factors influence security returns?

Answer 21

1. unanticipated inflation
2. changes in the expected level of industrial production
3. changes in the default risk premium on bonds
4. unanticipated changes in the return of long-term government bonds over Treasury bills (shifts in the yield curve).

Question 22

What is the basic premise of MPT

Answer 22

we cannot simply consider the potential risks and returns of an individual investment; it is important to consider how each investment changes in price relative to the other investments in the portfolio

Question 23

What happens to correlation in bad times?

Answer 23

Correlation also tends to get higher in bad times, so in major downturns, more asset classes move together. The global markets that ‘fell across the board’ in 2008 and in early 2020 are good examples of this.

Question 24

What is an optimisation model?

Answer 24

Optimisation models can generate optimal portfolios on a risk/return basis that make up the efficient frontier. The efficient frontier is the set of portfolios that offers the maximum rate of return for any given level of risk.

Question 25

Problems with optimisation models?

Answer 25

• Forecasts for risk, return and correlation, if used, may be incorrect.
• Historical data for risk, return and correlation, if used, may be a poor indicator of the future.
• Correlation in extreme market conditions is often quite different to those in ‘normal’ conditions.
• The appropriate measure of risk is assumed to be standard deviation based on normal distributions.
• Transaction costs are often not incorporated into the model.
• Individual portfolio managers construct portfolios in the individual markets that have different profiles to the indices that are used for inputs into the model (e.g. they purchase portfolios with a beta not equal to one).

Question 26

What is Stochastic modelling and what is a problem with it?

Answer 26

applies a mathematical technique to generate a probabilistic assessment of returns and volatility. It does this by specifying a number of factors, each of which may vary within a determined range.

Stochastic techniques are even more dependent on assumptions than optimisation models. Stochastic models need to be used with caution, like all models involving multiple uncertainties. Often, a very small change in one assumption will result in a large change in the output.

Question 27

For benchmarks to be useful, what factors need to be specified?

Answer 27

• specified in advance;
• appropriate to the manager’s investment approach and style;
• measurable so that its value can be calculated on a frequent basis;
• unambiguous in its construction;
• reflective of the manager’s current investment opinions
• accepted by the investment manager who will be accountable for deviations
• investable so that it is possible to replicate the benchmark.

Question 28

Purpose of the benchmark?

Answer 28

• Sets asset allocation/starting point/neutral basis.
• To manage risk/return.
• To measure relative performance to benchmark and value added/performance by the fund manager, to enable the analysis (attribution analysis).

Question 29

What does diversification do?

Answer 29

• reduces the risk of any one particular investment;
• spreads the opportunity for potential return across asset classes;
• minimises the risk of the overall portfolio suffering a significant downturn; and
• increases the possibility of stable returns through all economic cycles.

Question 30

How could a manager diversify?

Answer 30

Across asset classes: bonds, equities, property etc.
Selection of assets within asset class: type of equity, company etc.
Across industries
Across countries
Across bond issuer
Across Alternative investments
Across collective investments

Question 31

What is the difference between strategic and tactical asset allocation?

Answer 31

Strategic asset allocation and tactical asset allocation are different methods to maintain a multi-asset portfolio. Strategic asset allocation involves setting target allocations across various asset classes and rebalancing the multi-asset portfolio regularly to stay close to the assigned allocation through all market conditions.

tactical asset allocation encourages adjustments to a portfolio’s asset mix based on short-term market forecasts. This approach aims to systematically exploit perceived inefficiencies or temporary imbalances in values among different asset or sub-asset classes. It seeks to take advantage of market trends or economic conditions by actively shifting a portfolio’s allocations across or within asset classes.

Question 32

What are core satellite portfolios?

Answer 32

An investor indexing, say, 70% to 80% of the portfolio’s value minimises the risk of underperformance. They then invest the remainder in a number of specialist actively managed funds or individual securities. These are known as the satellites.

Question 33

Explain how multi-factor models work and how they differ from CAPM:

Answer 33

CAPM is a single factor model. It links expected returns to the single factor which is the return of the market above the risk-free rate and the sensitivity or the beta of the stock to that factor.

The CAPM formula can be extended to any number of factors.

There are three steps in multi-factor analysis: Specify a number of factors affecting historic data, measure the beta of the investments against each factor and measure the risk premium for each factor.

Question 34

List three examples of factors that are used in multi-factor models for forecasting share returns:

Answer 34

• Economic factors such as the oil price or inflation
• Fundamental factors such as price-earnings ratio, earnings growth or return on equity.
• FAMA and French factors of company size.

Question 35

Research suggests that there are four important factors that influence security returns:

Answer 35

1. unanticipated inflation;
2. changes in the expected level of industrial production;
3. changes in the default risk premium on bonds; and
4. unanticipated changes in the return of long-term government bonds over Treasury bills (shifts in the yield curve).