Reading 61: portfolio management- an overview Flashcards
Compared to investing in a single security, diversification provides investors a way to:
increase the expected rate of return.
decrease the volatility of returns.
increase the probability of high returns.
Diversification provides an investor reduced risk. However, the expected return is generally similar or less than that expected from investing in a single risky security. Very high or very low returns become less likely. (LOS 61.a)
Which of the following is least likely to be considered an appropriate schedule for reviewing and updating an investment policy statement?
At regular intervals (e.g., every year).
When there is a major change in the client’s constraints.
Frequently, based on the recent performance of the portfolio.
An IPS should be updated at regular intervals and whenever there is a major change in the client’s objectives or constraints. Updating an IPS based on portfolio performance is not recommended. (LOS 61.b)
A top-down security analysis begins by:
analyzing a firm’s business prospects and quality of management.
identifying the most attractive companies within each industry.
examining economic conditions.
A top-down analysis begins with an analysis of broad economic trends. After an industry that is expected to perform well is chosen, the most attractive companies within that industry are identified. A bottom-up analysis begins with criteria such as firms’ business prospects and quality of management. (LOS 61.b)
Portfolio diversification is least likely to protect against losses:
during severe market turmoil.
when markets are operating normally.
when the portfolio securities have low return correlation
Portfolio diversification has been shown to be relatively ineffective during severe market turmoil. Portfolio diversification is most effective when the securities have low correlation and the markets are operating normally. (LOS 61.a)
Low risk tolerance and high liquidity requirements best describe the typical investment needs of:
a defined-benefit pension plan.
a foundation.
an insurance company.
Insurance companies need to be able to pay claims as they arise, which leads to insurance firms having low risk tolerance and high liquidity needs. Defined benefit pension plans and foundations both typically have high risk tolerance and low liquidity needs. (LOS 61.c)
A long time horizon and low liquidity requirements best describe the investment needs of:
an endowment.
an insurance company.
a bank.
An endowment has a long time horizon and low liquidity needs, as an endowment generally intends to fund its causes perpetually. Both insurance companies and banks require high liquidity. (LOS 61.c)
In a defined contribution pension plan:
the employee accepts the investment risk.
the plan sponsor promises a predetermined retirement income to participants.
the plan manager attempts to match the fund’s assets to its liabilities.
In a defined contribution pension plan, the employee accepts the investment risk. The plan sponsor and manager neither promise a specific level of retirement income to participants nor make investment decisions. These are features of a defined benefit plan. (LOS 61.d)
In a defined benefit pension plan:
the employee assumes the investment risk.
the employer contributes to the employee’s retirement account each period.
the plan sponsor promises a predetermined retirement income to participants.
In a defined benefit plan, the employer promises a specific level of benefits to employees when they retire. Thus, the employer bears the investment risk. (LOS 61.d)
Compared to exchange-traded funds (ETFs), open-end mutual funds are typically associated with lower:
brokerage costs.
minimum investment amounts.
management fees.
Open-end mutual funds do not have brokerage costs, as the shares are purchased from and redeemed with the fund company. Minimum investment amounts and management fees are typically higher for mutual funds. (LOS 61.f)
Private equity and venture capital funds:
expect that only a small percentage of investments will pay off.
play an active role in the management of companies.
restructure companies to increase cash flow.
Private equity and venture capital funds play an active role in the management of companies. Private equity funds other than venture capital expect that the majority of investments will pay off. Venture capital funds do not typically restructure companies. (LOS 61.f)
Hedge funds most likely:
have stricter reporting requirements than a typical investment firm because of their use of leverage and derivatives.
hold equal values of long and short securities.
are not offered for sale to the general public.
Hedge funds may not be offered for sale to the general public; they can be sold only to qualified investors who meet certain criteria. Hedge funds that hold equal values of long and short securities today make up only a small percentage of funds; many other kinds of hedge funds exist that make no attempt to be market neutral. Hedge funds have reporting requirements that are less strict than those of a typical investment firm. (LOS 61.f)
