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J10 > Random J10 > Flashcards

Random J10 Flashcards

1
Q

Efficient Market Hypothesis (EMH) What is it? & the 3 forms

A

Weak form efficiency
Semi-strong efficiency
Strong form efficiency

Eugene Fama in 1960s.

In an open & efficient market, security prices fully reflect all available info & adjust to new info.
Therefore, market prices are always correct & reflect the best estimate of their value.
You cannot therefore outperform the market by picking undervalued stocks as EMH says none are undervalued.

Only way to get higher than average returns is by purchasing riskier investments. A game of chance not skill.

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2
Q

Weak form efficiency (EMH)

A

Weak
Reflects all past price & trading volume info. Future prices cannot be predicted by analysing this type of historic data.

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3
Q

Semi-strong efficiency (EMH)

A

Semi-strong
Prices adjust to all public information rapidly and unbiasedly. So excess returns can not be earned by trading on that info.

Public info includes past prices, companies’ financial statements & announcements & economic factors.

Indicates companies’ financial statements are of no help forecasting future prices & to securing excess returns.

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4
Q

Strong form efficiency (EMH)

A

Strong form

Prices reflect all info an investor can acquire - public & private.

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5
Q

Strong form efficiency (EMH)

A

Strong form

Prices reflect all info an investor can acquire - public & private.

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6
Q

Investment styles - 2 categories & 3 stages or styles in each

A

Top down
1. Asset allocation
2. Sector selection
3. Stock selection

Bottom up
1. Value - analysis to show businesses whose value is greater than their marker price.

  1. GAARP - Growth at a reasonable price - finding companies with long-term sustainable advantages in terms of their business franchise, quality of management, tech or other specific factors. Worth paying a premium for quality characteristics. Adopted by active fund managers.
  2. Momentum - capitalise on existing trends. Believes large price increases in a security will be followed by additional gains and vice versa for declining prices. Adopted by middle of the road managers.
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7
Q

Trustee Act 2000 imposed statutory duty to…

A

Trustees must obtain & consider proper advice.
Have regard for the need to diversify.
When reviewing, they should consider whether, having regars to the standard investment criteria, the investments should be varied.

They can not rely on a financial adviser they have not personally appointed as they should check the person is qualified and able.

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8
Q

Tier one capital ratio

A

Used to judge the adequacy of a banks capital position.

Expressed as a % - higher % = greater the strength.

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9
Q

Geometric & arithmetic mean - what are they used for?

A

Geometric mean most suitable for calculating average historic returns as it compounds the returns and represents what the investor would actually have achieved.

Arithmetic mean is often used for predicting future return as it better predicts the future portfolio value.

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10
Q

Multi factor models

A

Allow for different sensitivities to different factors & the identification of each factors contribution to the securities return.

All share 2 basic ideas
1. Investors require extra return for taking risk
2. They are concerned with risk that cannot be eliminated by diversification.

Arbitrage pricing theory is an example of a multi factor model.

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11
Q

Single factor models

A

Relationship between risk & return. Indicated the expected return = risk free return + a risk premium.

The risk premium is determined by the level of a securities systematic risk I.e. it’s sensitivity to the market as measured by its beta.

Capital asset pricing model is an example of a single factor model.

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12
Q

Arbitrage pricing theory

A

Multi factor model.

A securities price can be predicted using the relationship between the security and a number of common risk factors, where sensitivity to changes in the factors is represented by factor specific beta.

More flexible assumptions than CAPM.

The model doesn’t tell us which factors are relevant. The factors will also change over time.

Expected return is determined by adding the risk-free return to figures representing the risk premium for each factor.

Key factors =
1. Unanticipated inflation
2. Changes to anticipated production level
3. Changes to default risk premium on bonds
4. Unanticipated Changes in return of long-term government bonds over treasury bills.

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13
Q

What is the balance of payments?

A

A country’s record of the trade transactions with the rest of the world.

Measured in terms of receipts and payments.

Receipt = sterling flowing into the country or a transaction that requires the exchange of foreign currency for sterling.

Payments = Sterling flowing out or conversion of sterling to another currency.

Consists of two offsetting components:

  1. Current account - deals with imports and export of goods and services
  2. Capital and financial account - deals with foreign investments in the UK and UK investments abroad, as well as loans.
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14
Q

What does the current account consist of?

A

Transactions in goods (visible trade)
Such as…
oil, agricultural products, raw materials, machinery & transport equipment, computers, white goods and clothing.

Services (invisible trade)
Such as….
international transport, travel, tourism & financial and business services.

It is split into 4 parts
1. Trade in goods
2. Trade in services
3. Investment income - the earnings on investments
held by Brits overseas (credit the balance of payments)
4. Earnings on investments held by foreigners in Britain (debit the balance of payments).

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15
Q

What does the capital account consist of?

A

Records all movement of money into and out of the country for investment. Could be real assets (land or buildings) or financial assets (shares, bonds and loans).

Sale of assets earn foreign currency, while purchases use up foreign currency.

There is a surplus if overseas investors invest more in the UK than UK investors invest overseas.

Any deficit on the current account is made up by the capital account.

If there is a deficit on both, the official reserves of foreign currencies owned by the BoE are used.

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16
Q

Growth investing

A

Identifying companies that exhibit the potential for above average growth, even if the share price seems expensive.

Key data such as price earnings ratios, price book ratios, or high dividend yields are ignored (things that are important to those following a value investment strategy).

Greater risk than value fund as dependent on judgements about the business, its markets & management.

Jim Slater - book Zulu Principle 1992. 11 criteria that a growth stock should be judged against & categorised as mandatory, important, or desirable.

Mandatory…
1. positive growth rate in earnings per share in at least 4 out of 5 of the past years.

  1. Low price earnings ratio relative to growth rate
  2. Optimistic chairperson statement in report & accounts
  3. Strong liquidity, low borrowings, and high cash flow
  4. Competitive advantage

It originally meant investing in companies that could grow into big, successful businesses, the strategy has moved on.

Now tends to seek out stocks with high growth rates that are trading at reasonable valuations.

Now means an investment style aimed to produce capital growth, rather than income. Could invest in recovery shares or special situations.

17
Q

Blend funds investment approach

A

Combines the value & growth approaches.

Seek growth stocks, value stocks and those that exhibit characteristics of both.

Warren Buffet advocate of value strategy believes not much difference between value & growth. “growth and value investing are joined at the hip”
Indicates a combination of the two is probably better.

Growth perform best when economy is strong.
Value perform better when economy recovering from a downturn.

18
Q

Income investing

A

Identify companies that can provide a steady stream of income.

Sustainable high dividend yields.
Steady, predictable income over the long term.

19
Q

Momentum investing

A

Aims to capitalise on the continuance of existing trends in the market.

Involves buying shares that have had high returns over last 3-12 months & selling those that had poor returns over the same period.

Essentially believes it it possible to ride the trends and make profits.

Ignores asset allocation & diversification as instead focuses on most popular and faster growing investments.

Risk managed by quickly moving out of assets or industries that start showing deterioration.

Belief that stock more likely to continue in that direction than move against the trend.

Demanding strategy & highly volatile.

20
Q

Contrarian investing

A

Goes against the conventional wisdom.

Opposite to momentum investing.

Whatever the majority is doing is likely to be wrong.

Use fund analysis in same way as value investors to determine whether a stock is undervalued or over priced but tend to be more aggressive in backing judgements.

21
Q

Top down investing

A

Top down
1. Asset allocation
2. Sector selection
3. Stock selection

22
Q

Bottom up investing

A

Focuses on unique attraction of individual stock.

  1. Value
  2. Growth
  3. Blend
  4. Income
  5. Momentum
  6. Contrarian
  7. Sustainable and responsible
23
Q

Sustainable and responsible investing

A

ESG

Sliding scale from negative to positive screening

Negative screening
Religious
Socially responsible investing
(SRI)
ESG
Impact investing
Positive screening

Greenwashing - where companies exaggerate their green credentials.

SDR - Sustainability Disclosure Requirements - includes anti-greenwashing rules & investment labels (4).

24
Q

Value investing

A

Seeks to identify stocks trading at less than their intrinsic value.

Belief that markets overreact to good and bad news, which leads to the share price movements, does not correspond with the long-term fundamentals of a company.

Based on the work of Benjamin Graham & David Dodd.
Graham identified 7 tests to identify stocks to be included in a defensive portfolio:

  1. Adequate size - recommended setting minimum size parameters such as annual sales.
  2. Strong financial condition - at least 2:1 (cash & near cash should be twice as much as near term liabilities) & long term debt should not exceed working capital.
  3. Earnings stability - no losses in last 10 yrs.
  4. Dividend record - history of paying dividends for at least 20 yrs.
  5. Earnings growth - Net income should have increased by at least a third on a per share basis over last 10yrs, using 3 year averages at beginning and end.
  6. Moderate price to earnings ratio - price of shares should not exceed 15 times average earnings for past 3 yrs.
  7. Moderate ratio of price to assets - should not be more than 1.5 times the book value of assets.
25
Q

Sharp ratio

A

William Sharpe US Economist

Measure the return of an investment whilst adjusting for its risk.

Measures excess return for every unit of risk taken.

Return on investment- risk free return
÷
standard deviation of the return

Normally measured in months but can annualise by x the average monthly return by 12 and square rooting by 12 the standard deviation.

The higher the Sharpe, the better the return compensates the investor for the risk taken.

Negative indicates a risk free asset would have performed better than the one being analysed.

Can be useful to see whether the returns are due to skilful investment management or result of excessive risk.

26
Q

Alpha (a)

A

Jensen’s alpha.

The difference between the return you would expect from a security, given its beta, and the actual return produced.

It is seen as a measure of the value added by the investment manager.

It is a return that is not explained by CAPM.

a = actual portfolio return -
(risk-free return + beta (market return - risk-free))

a = Rp - (Rf +Bi (Rm - Rf))

I made Rp up it’s actually written out in full ‘as actual portfolio return in the book!

27
Q

Information ratio

A

Used to assess the risk-adjust3d performance of active portfolio managers. Guage their skill.

Measures the relative return, which is the difference between the return on the activity managed portfolio and its benchmark.

= Rp - Rb
÷
tracking error

Rp = Portfolio return
Rb = Benchmark return

The higher the information ratio, the more value added by the manager.

A negative information ratio would mean an investor would probably have achieved better returns using a tracker or index fund.

28
Q

Beta

A

The market has a beta of 1.

The beta of a security reflects the extent to which the security’s return moves up and down with the market.

More than 1 = exaggerated movement. More volatile.

Leas than 1 = less movement, more stable.

CAPM provides the relationship between a security’s systematic risk and it’s expected return. So those with a high beta can be expected to produce high returns in a rising market.

29
Q

CAPM
What is it?
What assumptions does it use? (7)

A

CAPM provides the relationship between a security’s systematic risk and its expected return. So, those with a high beta can be expected to produce high returns in a rising market.

Based on assumptions:
1. Investors are rational and
risk-averse.

  1. All investors have an identical holding period.
  2. The market has many buyers and sellers, and no one individual can affect the market price.
  3. There are no taxes, transaction costs & no restorations on short-selling.
  4. Information is free and available to investors.
  5. All investors can borrow and lend unlimited amounts of money at the risk-free rate.
  6. The quantity of risky securities in the market is fixed & all are fully marketable (I.e. the liquidity of an asset is ignored).
30
Q

CAPM - What are the limitations? (3)

A
  1. What to use as the risk-free free rate?
    Common practise is UK Gov treasury bills.
  2. What is the market portfolio?
    In theory, it should be all risky securities worldwide, but in reality, an index of national shares is normally used, e.g., FTSE all share or FTSE 100.

Different indices have significantly different betas. So if the true market portfolio is not used m, can the correct beta be determined?

  1. The suitability of beta
    For CAPM to be useful, beta must be stable and predictable, but past experience shows this not to be true. So, if unstable, how can it be reliable in predicting future risk?

Also, CAPM suggests a direct relationship between excess returns over risk-free returns and its beta. However, studies in the US have not found this relationship.

31
Q

What are UK Gov Treasury bills?

A

91 day money market instruments issues by the Gov.

Virtually no default risk.

Their short life also means interest rate risk and inflation risk are minimised.

No coupon.

32
Q

Typical charges for different types of investments

Hedge funds
Unit linked funds
Passive funds
Active funds
Bond funds

A

Hedge funds - Up front 1% - 2%
AMC - 2% & 20% performance fees.

Unit linked funds - 5% bid offer spread. AMC 0.75% - 1%

Passive funds- 0.1% - 0.75%
Active funds - 0.75% - 1.75%

Bond funds - 1% AMC

33
Q

Bond pricing

A

Traded at their nominal/par/face value.

Price is quoted for a standard £100 nominal value.

Prices quoted in FT & other major newspapers but not the price the investor would pay because….

  1. They are mid market prices between the bid and offer prices quoted.
  2. They are clean prices. Price of the stock, not including the interest that accrues daily.
    Once interest taken into account = dirty price.
34
Q

Bonds dividends (cum, ex, dirty!)

A

Usually paid 6 monthly but accrued daily.

The interest is paid to whoever is the registered holder of the bond 7 days before the payment date.

Cum dividend - the purchase receives the full 6 months interest even though they are not entitled to it and so will pay more (clean price + accrued interest).

Ex dividend - If sold in the 7 day window. Dividends will go to the seller and so buyer loses out on the interest on the days from when they bought to the payment date so price is adjusted to reflect (clean price - loss interest).

The adjusted price, whether more or less than the clean price, is called the dirty price.

35
Q

Modern portfolio theory (MPT)

A

Professor Harry Markowitz 1952.

Reflects the way portfolios can be constructed to maximise returns and minimise risks.

Assumes, like CAPM, that investors are risk averse & would choose less risk for the same return.

Harry demonstrated that portfolio diversification could reduce risk and increase returns.

Conclusion - a diversified portfolio of imperfectly correlated asset classes can provide high returns with least amount of volatility.

36
Q

Standard deviation

A

Most commonly used measure of risk.

Measures how widely the actual return varies to its average or expected return.

As a rule of thumb, return can be expected to fall within one standard deviation of the average return roughly 68% of the time.

Within 2 standard deviations 95% of the time.

If SD is 5% and the average return is 10%…
68% of the time it will fall between 5% - 15%
95% of the time it will fall between 0% & 20%.

37
Q

Dividend cover

A

Ability of a company to continue to pay its dividend.

Dividend cover looks at how many times a company could have paid its dividend based on the profit for the year.

= EPS
÷
Dividend per share

J10 (2 decks)

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