Portfolio Theory

Question 1

The risk-free rate of return is 1.5%, the expected market return is 6%, the BETA is 1.2. What is the expected return according to CAPM?

Actual return on asset = 8%

Answer 1

CAPM formula =

E(Ri) = Rf + Bi (E (Rm) - Rf)

Therefore:

1.5 + 1.2 (6 - 1.5) = 6.9

Alpha =

a = actual return - expected return

8 - 6.9 = 1.1

Question 2

investment process - four stages of the investment process:

Answer 2

• Client’s objective (risk and/ or return);
• Investment strategy (active/ passive/ both)
• Stock selection (asset options)
• Performance Analysis

Fund manager is responsible for managing the fund for the investors, taking into account their investment objectives.

Question 3

Strategic asset allocation - key summary:

Answer 3

• Studies suggest asset allocation is single most important factor on fund performance
• Deciding asset allocation before stock selection is a ‘top-down’ approach
• Choosing shares and bonds that meet investment needs first is known as ‘bottom-up’ approach.
• Tactical allocation is where ranges are specified around the strategic level to enable market timing adjustments to be made by the manager. (e.g. FI 50-50%)
• Stock selection may be based on fundamental or technical analysis.

Question 4

Fundamental vs technical analysis:

Answer 4

• Fundamental
  
  • Process of identifying stocks that are undervalued by looking at underlying investment.
  • May include use of discounted cashflow calcs, multiple analysis, strategic analysis and other stock measurments.
  • Looks for value in what look like under-valued stocks
• Technical
  
  • AKA ‘charting’
  • focuses on market rather than stock
  • seek to identify market trends and use prediction of trends to outperform the market

Question 5

Value investing - advantages and disadvantages:

Answer 5

Fund managers aim to identify undervalued shares. Selection criteria used can vary, but may involve looking at low P/E ratios, high div yields, price book rtio and price to sales ratios. Strategy based on works of Benjamin Graham and David Dodd.

• Advantages
  
  • usually wins in long run
  • optimal strategy for those with long horizons, i.e. pension funds
• Disadvantages
  
  • Key issue is strandard remit for fund manager to beat investment index return. index may have moved ahead and certain shares may makeup bigger weighting, for example due to momentum investors - not necessarily because of value (alpha).
  • Manager must keep up with market regardless of value.

Question 6

Growth investing - summary:

Answer 6

Manager is looking to companies with high growth prospects, generally reflectin by a high P/E ratio.

Fice mandatory points to consider for growth investors were outlines by Jim Slater, a UK growth manager. Mandatory points were:

• Growth in EPS for at least four out of the ast five years
• Low P/E relative to growth
• Good cashflow (low gearing, high liquidity)
• Optimistic annual statement from the company chairman
• Competitive advantage

Question 7

Momentum investing - summary:

Answer 7

• Momentum investing was established by US fund manager Richard Driehaus
• Momentum investing looks for quick results, spot movements quickly.
• Referred to as trend investing and uses technical analysis in order to try and beat the market.
• Advantages
  
  • Managers tend to be influenced by momentum because clients like to see investments which as showing good news and results, favoured by the pr