Portfolio Theory Flashcards

Question

Summarise stock selection (3)

Answer 1

- Involves seeking out mis-priced securities to buy undervalued and sell overvalued stock - Stock selection and market timing are important when an active strategy is adopted - Joint impact of timing and selection is called ‘interaction effect’

Answer 2

- Process of identifying stocks that are undervalued by looking at the underlying investment

Answer 3

- Focuses on the market rather than the features of the stock - Trends in price movement - Seeing trades as indicators of human behaviour - Predicting trends in hope they outperform the market

Answer 4

- Focuses on attractions of individual stocks e.g. Direct Equity models - Specific company factors such as M&A, pipeline, cash flow are important - In effects removes the asset allocation and sector selection as primary factors and focuses instead on stock selection - Event driven and tactical trading basis

Answer 5

- Hybrid of active/passive funds - Enhanced indexing - Higher risk adjusted return - Main problem with this strategy is knowing where the balance between active/passive should lie

Answer 6

- Describes the value of an individual security relative to the portfolio or benchmark as a whole E.g. GSK = £74bn of the FTSE worth £2tn. £74bn/£2tn * 100+ 3.7%

Answer 7

- Where the weighting of the portfolio differs from that of the benchmark, it is referred to as an active share - A tracker fund would aim for 0% active share - Funds that are marketed as being actively managed but have an active share close to zero - closet index funds - Active share of 100% shows a portfolio with no overlap with the benchmark e.g. Direct Equity model and MSCI World

Answer 8

- Growth stocks - Value stocks - SMID cap - ESG

Answer 9

- A specific attribute of a security that persistently drives returns e.g. interest rate sensitive, sensitivity to oil prices - Factor investing looks for companies that are sensitive to the factors we want exposure to and avoid companies that are sensitive to factors we do not want exposure to - Attributes such as market cap, price to earnings ratio

Answer 10

- Identify undervalued shares - Low price-earnings ratio including in defensive and cyclical sectors - High dividend yield - conservative approach looks for high yielding stocks expected to maintain or increase dividends - Low price-book ratio - contrarian investors look for low share prices in relation to book value. These companies are expected to experience cyclical rebound/company turnaround - Low price-sales ratio - Other factors: credit quality - debt ratio - capital discipline - cash floW - market cap

Answer 11

- Uses different methodologies to create weightings - Simplest is to give equal weightings to all components of the benchmark - Factors used to weight the portfolio could be many things; volatility, earnings, dividends etc

Answer 12

- Socially responsible investing introduces personal values and social issues into stock selection - Screening: including or excluding securities due to ESG criteria such as ignoring oil, gambling, pornography - Shareholder advocacy: active involvement by shareholders to encourage CSR

Answer 13

- Asset allocation - effect of tactical asset allocation - Currency - effect of currency movement if assets are invested overseas - Stock selection - manager’s ability to select undervalued/overvalued stocks correctly - Interaction - impact of trading the stocks actively - Return on asset allocation + return on currency + return on stock selection + return on interaction = total return on equity - YTM effect + interest rate effect + sector/quality effect + residual effect = total return on bonds - All factors may not work in the fund manager’s favour and may create negative values

Answer 14

- Perfect information - No need for research as security will be perfectly priced - No transaction costs - No earnings surprises because investors would know the information already - Real life markets are not perfectly efficient

Answer 15

- Weak form - current market price reflects historic share price information. If true, no point in looking at historic price/charts as current information is true. Contradicts technical analysis - looking at past prices for patterns will not work. Use of technical analysis in real life suggests inefficiencies exists - Semi strong form - current market price already reflects historic share price information and all other publicly available information - carrying out research of a company’s activities and products is useless as market participants already know this. Not the case in reality - proves inefficiencies - Strong form - current market price reflects historical, all publicly available information as well as privately held ‘insider’ information that the market is not yet aware about. Bold assumption that the market has already priced in private information when this is not yet available.

Answer 16

- Information is not perfectly available to all market participants - need for technical analysis, research - The larger and more liquid the market, the more efficient it is - larger markets have more analysts following larger companies - fewer surprises - Fewer analysts follow smaller, less well known companies - often less efficient and carry their own specific risks

Answer 17

- Investors do not process information correctly - Investors make sub-optimal decision even with correct information processing

Answer 18

- Memory bias - investors place weight on recent experience when forecasting - Overconfidence - market participants overestimate the precision of their forecasts - Confirmation bias - investors seek information that confirms their beliefs and ignore information that contradicts it - Conservatism bias - investors are to slow in updating their beliefs when confronted with new evidence - Sample size neglect - investors infer wider population behaviour from too small a sample data

Answer 19

- Framing - information is framed in a particular way to influence investors decision e.g. anchoring prices - Regret avoidance - investors resist realising losses in hope that this can be recovered and therefore avoided - Loss aversion - willingness to take more risk to avoid loss, in order to make profit - Endowment effect - investors place great value on assets they own - expectations of large gains/legacy positions

Answer 20

Boom - Overconfience and increased appetite for risk - Herd mentality - Lack of regulatory rigour e.g. control of debt - Price bubbles, over valuation of assets Bust - Inability for borrowers to pay debts - Unwillingness of depositors to hold their money in banks - Reduced circular flow of money available for investment in the economy

Answer 21

- Irrational behaviour where market participants forget the financial lesson/patterns of the past - Effects investors, institutions and regulators - Asset prices can become divorced from the fundamental drivers of their value e.g. property prices rising far beyond those which rental income can support or share prices rising beyond company earnings - Yields are so low that investors can only continue making money if prices continue to rise - ‘asset price bubble’

Answer 22

- Incentive structure - managers within financial services are incentivised to take risks which are detrimental to the wider financial system. Lack of accountability and policy myopia - Moral hazard - wider economy carries the cost of excessive risk taken by financial services industry - Behavioural finance biases - cognitive dissonance (ignoring information), herd mentality, overconfidence, framing

Answer 23

- Strong corporate governance - Strong regulation - Education and training - Appreciation of the history of markets

Answer 24

- Environmental; climate change, nuclear energy, hazardous waste - Social; human rights issues, animal welfare, consumer protection, supply chain - Governance; board diversity, employee relationship, executive pay

Answer 25

- Sets out the number of areas of good practice to which institutional investors and service providers should aspire

Answer 26

- Sullivan Principles - Rev Leon Sullivan against apartheid by applying economic pressure on South Africa - Milton Friedman suggested SRI would limit performance and returns

Answer 27

1. Firms will incorporate ESG issues into their investment analysis and decision making 2. Firms will actively incorporate ESG issues into their policies and practices 3. This includes seeking appropriate disclosures on ESG issues from entities in which they invest 4. Firms will support and promote the acceptance of these principles within the investment industry 5. Firms will work together to raise their effectiveness in implementing the principles 6. Each signatory will report on activities and profess toward implementing the principles

Answer 28

- Environmental issues - climate change, nuclear power - Societal concerns - human rights, animal welfare, consumer protection - Better information and education of investors - Empirical evidence that SRI does not compromise returns - Ease of access to responsible investing products - Moral obligations - Increasing evidence of better return from ESG investing

Answer 29

- Increasing and ready demand - Increased disclosure requirements for companies with respect to ESG - Widely accepted international standards for measuring ESG - Reputational risk - firms suffer if they are not ESG compliant/aware - Financial risk - mitigate financial risk and the impact on a company’s share price should ESG event occur - 6 principles of ESG investing offer high profile advocacy

Answer 30

- ESG information is resource intensive to acquire and assess than conventional audited financial information - Disclosure by companies often trails reality - Context is important as different regulatory regimes have different requirements - subjective - Traditional value tools are less useful given the longer time frames needed for ESG issues to impact companies - Corporate greenwashing

Answer 31

- Holding Period Return (HPR) - also known as ‘Total Return’ or ‘Holding Period Yield’ - Money Weighted Rate of Return - Time Weighted Rate of Return - These measures do not take into account the risks a fund is exposed to, therefore these measures are limited when comparing returns with different risk profiles

Answer 32

- Measures how much a portfolio has increasing in value over a particular time horizon - Identifies changes in value of the fund as a percentage of the start value - HPR = End value - start value / start value * 100 - Limitations: timing of cash flow, withdrawals and deposits. Not useful for calculating the returns of OEIC, pension funds where there are regular cash flows

Answer 33

- Used to measure returns of a fund that has experienced deposits and withdrawals during a period - (1+r)+(1+r)^0.5 - Only valid if portfolios receive/withdraw cash at the same time - timing/size of flow will impact return - Cash injection at unfavourable time = MWRR depressed. Cash favourable = MWRR boosted

Answer 34

- Accounts for injections/withdrawals but can still be affected by the timing and size of flows into and out of the fund - Overstates returns when it performs well and understates returns when fund performs badly - MWRR doesn’t account for timing - TWRR gives equal weighting to the timing of the cash flows

Answer 35

- Additional return over a risk free return needed to compensate an investor for taking on the risk of an investment E.g. equity risk premium compensates the investor for: potential variability of stock returns, income/dividends, giving up immediate access to the funds invested - Riskier the assets, the higher the risk premium e.g VC investing in start ups - higher risk of default

Answer 36

- Effect the financial system as a whole. Also known as market risk - Difficult to predict - Interest rate risk, inflation risk, liquidity risk and currency risk

Answer 37

- Changes in interest rates an have a negative impact on assets - Cost for borrowing, reward for saving - Bonds rise in price from interest rate falls, yields fall - Coupons from bonds can be reinvested at higher rates when interest rates rise and at lower rates when IR falls - Company debt rises when IR rise, puts pressure on operating profits and slows R+D - Mortgage rates increase with IR rise

Answer 38

- General rise in price level - value of money is worth less - Damaging to bonds - index linked gilts protects against inflation - Damaging to equities - companies seeing rising costs, puts pressure on margins and profits - Commodities benefit from inflation e.g. gold and oil prices rise, returns rise too

Answer 39

- Not being able to buy/sell at a fair market price and at the time at which the investor wants - Some positions may have zero liquidity at all - VCT/EIS

Answer 40

- When foreign currency depreciates against the home currency - Buying goods aboard and sterling depreciates - imports are more expensive. WPIDEC. SPICED

Answer 41

- Risks specific to businesses; business risk, industry risk, management risk - Business risk; business becomes unprofitable and uncompetitive leading to reduced profits - lack of good products/services, education and training of staff, location, manageable costs, balance sheet, strong demand - Industry risk; each industry has its own risks e.g. airline industry health and safety issues are paramount and quite different to H&S in finance - Management risks; when a company performs well, growing its profits, increasing market share, creating happy customers - this reflects good management

Answer 42

International Organisation of Securities Commission (IOSCO)

Answer 43

- Fraud risk - deception deliberately practices in order to secure unfair or unlawful gain. FCA attempts to clamp down on fraud; share fraud and boiler room, land banking schemes, unauthorised firms, commodity schemes - focus on where market transparency is poor - Counterparty risk - risk that a person you have agreed to trade with defaults on their obligations - derivatives. This risk is greater for OTC as most exchanges have strict systems to ensure settlement occurs

Answer 44

- Standard deviation - measures the total risks of an individual security - A security with a low risk - returns do not fluctuate significantly around its mean average return - smaller standard deviation - A security with high risk - returns fluctuate significantly around its mean average return - larger standard deviation

Answer 45

Advantages - Based on every item of the distribution - Measures the spread of data from the MEAN - The unit of measurement is the same as the data source - When the variability is great, the standard deviation will be larger Disadvantages - Past patterns may not be representative of future patterns - Measures both upside and downside risk - Assumes that upside is equally as likely as downside - Volatility generally is not a complete measure of risk

Answer 46

- Based on historical returns which may not be representative of future patterns - Measures upside movements as well as downside movements - investors likely to be only concerned with downside - Assumes that upside is equally as likely as downside - Volatility generally is not a complete measure of risk - Autocorrelation can result in quoted standard deviation being lower than the true risk - future returns being significantly related to current returns - prevalent in property assets

Answer 47

- Semi variance; only considers returns that fall below the mean over the period. A downside measure of risk - Probability of shortfall; change of a return over a period falling below a specific level - Expected shortfall; expected loss at a given probability level. E.g. expected loss in worst 5% of cases

Answer 48

Total risk = systematic risk + specific risk

Answer 49

- Adding stocks that are not perfectly correlated with one another to offset risk e.g. tech and utilities - Impact of specific risk of each investment is reduce by increasing the number of holdings - During times of crisis, correlations tend to become more strongly positive, reducing the impact of offsetting - Diversification reduces specific risk, idiosyncratic, unsystematic, unique risk but cannot reduce systematic risk, market, business and non-specific risk (measured by Beta)

Answer 50

- Portfolio managers assess systematic risk by measuring the Beta of a security - Beta = sensitivity of a stock’s return to the return on the market portfolio - Beta measures the systematic risk of a security relative to the systematic risk of the market as a whole - Determined by constructing a scatter gram of returns achieved by the stock against the returns achieved by the market - Gradient of the line of best fit = value of Beta - B = Change in return to stock/Change in return to the market

Answer 51

- A line of best fit is drawn between the points on the scatter gram - this is the stocks Beta - If the gradient/Beta is greater than 1, the stock is more volatile than the market e.g. Beta of 1.2 reflects volatility of 20% more than the market - If the gradient/beta is less that 1, the stock is less volatile than the market e.g. Beta of 0.7 reflect 30% less volatility than the market - If the gradient/Beta is equal to 1, the stock has the same volatility as the market - Variance of portfolio return = Beta2 x variance of return on the market + variance of unsystematic risk

Answer 52

Advantages - Easy to calculate - Easy to understand Disadvantage - Longer time series tend to have greater drawdown - Has a large and uncertain error distribution

Answer 53

- Alternative measure to quantify market risk - VaR is the maximum potential change in value of a portfolio with a given probability over a certain horizon - Can be applied in many circumstances to measure performance e.g. risk managers and for regulatory requirements - VaR does not give any information about the severity of loss by which it is exceeded

Answer 54

- Historical approach - using historic returns to identify probability and base predictions on these. This method assumes history will repeat itself - Variance-covariant method - assumes normal distribution of data and uses standard deviation to assess probabilities. Skewness of the distribution needs to be considered - Monte Carlo approach - uses computer models to run multiple simulations based on random variations in historical data, also referred to at stochastic modelling

Answer 55

- A single factor pricing model - Useful for its simplicity of predictions - Popular tool for quantifying and measuring risk

Answer 56

- All market participants may borrow and lend at the same risk-free rate - All market participants agree on the same investment period - All market participants are well diversified investors e.g. specific risk has been diversified away - There are no tax or transaction costs to consider - All investors want a maximum return for the minimum risk - Market participants have the same expectations about the returns and standard deviations of all assets

Answer 57

- CAPM is used to predict the expected/required returns to a security using its systematic risk e.g its Beta - Rj = Rf +Bj (Rm - Rf) - Rj - expected return to stock J - Bj - the Beta for stock J - Rm - the expected return to the market portfolio - Rf - the risk free rate of return

Answer 58

- If the actual return of a stock is greater than the CAPM prediction, the stock has a positive Alpha - Stocks with positive Alphas are under priced - investors looking for undervalued stocks should look for positive Alpha - as demand increases, price increases, yield/return falls until it is bought back in line with the SML (straight line) - If the return is lower than the CAPM predicts, there is a negative Alpha and therefore overpriced. Stock pickers should sell stocks with negative Alphas. As supply increases, price falls, yield/return increases until bought back in line with SML

Answer 59

- Uses market risk to predict and judge the performance of an asset - Market risk can be broken down into serparate factors - inflation, investor confidence, GDP, or the yield curve - For any company, the sensitivity to each of these factor will be different - Each investor will hold a portfolio with its own particular set of betas - Goal of APT is to derive a rate of return which will be used to price the asset correctly - If price diverges for the assessed fair value, arbitrage should bring it back into line

Answer 60

- Information ratio - Sharpe ratio - Treynor ratio - Jensen measure - All of these calculate the return to the portfolio and compare it with the level of risk taken on

Answer 61

- Compares the excess return achieved by the fund over a benchmark portfolio to the funds tracking error - Calculated as the standard deviation of excess returns from the benchmark - Information ratio = ER/OER - ER - arithmetic mean of excess returns over benchmark - OER - standard deviation of excess returns from the benchmark / tracking error - If the fund outperforms the benchmark, the ratio will be positive - If the fund underperforms the benchmark, the ratio will be negative - A high information ratio is indicative of a successful fund manager

Answer 62

- Uses standard deviation of portfolio returns as an estimate of risk in order to calculate the excess return to volatility - Sharpe measure is best suited to measure the performance of non-diversified funds - exposed to total risk (specific and systematic risk) - NB: standard deviation is a measure of total risk - Sharpe measure calculates the excess return achieved by a fund (over an above risk free rate) for each unit of total risk taken on - Sharpe = Rp - Rf / Op Rp - return to the portfolio Rf - risk free return Op - standard deviation of the portfolio - Dominance - where one fund achieves better return than another for the same risk or less risk

Answer 63

- Similar to Sharpe except it is used to measure the performance of a well diversified fund e.g. specific risk has been diversified away - Based on the CAPM Beta coefficient of the portfolio and is a measure of the portfolio excess return - Measures the excess return achieved by a fund (return over and above the risk free rate) for each unit of systematic risk (Beta) taken on - Treynor = Rp - Rf/Bp Rp - return to portfolio Rf - risk free return Bp - beta of the portfolio - Higher the Treynor, better the fund has performed on a risk adjusted basis

Answer 64

- Measures the fund’s return in excess of its CAPM predicted return - Jensen measure = Rp - RCAPM Rp - return to portfolio RCAPM - return predicted by CAPM - To calculate return predicted by CAPM a beta is necessary - benchmark portfolio Beta compared to the return the manager actually achieved - If the difference is positive, fund manager has performed well (dominant/above SML/positive Alpha/underpriced). If Jensen measure is negative, performed poorly (below SML/negative Alpha/overpriced)

Answer 65

- Most risk adjusted performance figures use ex post measure of risk - Based on a historic measure of risk and performance and create a measure based on this - Treynor and Sharpe use ex post measure of risk. Advantage is risk measures are clear and already crystallised. Disadvantage is looking at performance after the event is seen as giving information too late - act has already occurred - Jensen uses ex ante. Predicts the expected risk and return of an investment based on assumptions which is a disadvantage. Advantage is that it sets visible targets before the event.

Answer 66

- Shift measures the degree to which a yield curve has moved upwards or downwars, parallel or across all maturities - Twist measures the degree to which the yield curve has steepened or flattened - Spread or premium is usually quoted as basis point and is related to the bond’s issues yield over the government risk free rate

Answer 67

- Measure of the interest rate risk of the portfolio e.g. how sensitive the fund is to changes in IR - Relative duration - duration of the portfolio relative to the duration of the market - Relative duration = Dp/Dm Dp - weighted average duration of portfolio Dm - weighted average duration of the market - Relative duration is applied as risk adjusted return measure for bond portfolios - Measure calculates the return from the portfolio in excess of the risk free return divided by the portfolio relative duration - Performance of bond portfolio = Rp - Rf / Dp / Dm Rp - return to the portfolio Rf - risk free rate of return

Answer 68

- Relative duration is used to measure duration instead of Betas - Relative duration is equal to the duration of the portfolio / the duration of the market - ERb = Rf + DB/DM (ER - Rf) ERb - expected return of the bon Db/Dm - relative duration of the bond ERm - expected market return Rf - risk free rate of return - Treynor measure used for bonds - Treynor = (Rp-Rf)/Dp/Dm

Answer 69

- Manager seeks to outperform the benchmark such as an index - Policy switch - switching between two different types of bonds to take advance of the different features e.g. selling short term bonds and buying long term bonds to take advantage of decreasing IR - Anomaly switch - switching between two similar bonds to take advantage of what appears to be mis pricing - Riding the yield curve - to meet liabilities - only works if the yield curve is upward sloping and remains this way. E.g. buying high yield/low priced 6 month gilt and sell it as low yielding/higher priced 3 month gilt - Advantage of riding the yield curve - yield higher return compared to buying and holding to redemption

Answer 70

- Manager looking to track an index or benchmark - Problems of interest rate risk and re investment rate risk for liability driven investments such as defined benefit schemes - Risk can be reduced by cash matching or immunisation strategies

Answer 71

- Fund manager chooses bonds that generate cash flows of the same size and timing as the funds liabilities e.g. meeting tax liabilities Jan 2025 gilts

Answer 72

- Designed to protect the fund from changing interest rates - Immunised portfolios are created by matching the duration of its bonds with the duration of its liabilities - Matching duration rather than cash flow - more practical and provides a greater range of bonds to implement the strategy - Disadvantage: assumes a flat term structure of interest e.g. a flat yield curve, that any shifts in yield curve are parallel and shifts occur before the first cash flow - Bullet portfolio (focused): duration of bonds is the same or similar to the duration of liabilities - 5 yr liabilities - 5 year durations. Disadvantage; portfolio will require rebalancing - Barbell portfolio (weighted): contains short and long duration for liabilities but are weighted so that the average duration matches liability e.g. liabilities of 10 years - some bonds with 5 year and 15 yrs duration until ‘point of balance’ is equal to 10 yrs. Greater range but disadvantage is portfolio requires greater deal of rebalancing than bullet strategy

Answer 73

- Technique that protects in case managers fail to achieve the required return through active management - If fund performs poorly, they will switch to a passively managed immunised portfolio

Answer 74

- Liability driven investment strategy - based on cash flows needed to fund future liabilities e.g. defined benefit scheme, insurance - Dedicated portfolio strategy/benchmark driven strategy - based on achieving returns relative to index e.g. FTSE All Share - Where future liabilities can be predicted with some degree of accuracy - Often involves derivatives such a s swaps to reduce the negative effects of external factors e.g. inflation linked gilts. Disadvantage is that this may cause reduction in return overall

Answer 75

Requires 4 main areas to be considered - Cash flow forecast of the funding needs into the future - Degree of acceptable risk must be specified by the trustees - Assessment of ability of active management to outperform market - Implementation of the LDI strategy and consideration of additional investment vehicles

Answer 76

- Duration is the difference between the target return and actual return (tracking error) - Volatiltiy of surplus measures the probability of a shortfall - similarly to VaR - more sophisticated measure of risk