RPA2 Module 5 Flashcards
What is the single most important risk affecting the price movements of common stocks?
market risk.
Describe what characterizes an investment decision.
(1) asset allocation
(2) security selection.
.
What is a passive investment management strategy, and what does it seek to
accomplish?
Passive strategies simply aim to do as well as the market.
What is the relationship between a passive investment strategy for common stocks and (a) the efficiency of markets, (b) the return objective and (c) transaction costs?
(a) If the market is totally efficient, no active strategy should be able to beat the market on a risk-adjusted basis. The greater the efficiency of the market, the greater the merit of passive investing.
(b) The investment objective of a passive strategy is to simply do as well as the market.
(c) With a passive strategy, the goal is to minimize transaction costs because the benefits of active trading are not likely to be worthwhile.
With a buy-and-hold strategy, does an investor have to perform any functions
after the stocks are selected?
The emphasis is on avoiding transaction costs, taxable transactions, additional search costs, the time commitment to portfolio management.
Even with a buy-and-hold strategy, an investor has to perform certain functions such as dealing with dividends (whether to reinvest them in other securities) and adjusting the portfolio for risk considerations.
What is an index fund?
An index fund is a pool of assets designed to duplicate as nearly as possible the performance of some market index.
A stock index fund may consist of all the stocks in a well-known market average such as Standard & Poor’s 500 Composite Stock Index (S&P 500).
Explain the tax efficiency of index funds.
A significant advantage of index funds is their tax efficiency. Index funds basically buy and hold, selling shares only when necessary. Actively managed funds, on the other hand, do more frequent trading and tend to generate larger tax bills, some of which may be short-term gains taxable at ordinary income tax rates.
What is an enhanced index fund?
index funds that are tweaked
For example, an enhanced fund tracking the Standard & Poor’s (S&P) 500 could have the same industry sector weightings as the S&P 500 but hold somewhat different stocks, perhaps with lower price/earnings (P/E) ratios.
Or an enhanced fund can use futures and options to hold the S&P 500 and invest the remainder of the funds in bonds or other securities. The theory is that the manager can, by tweaking the fund slightly, outperform the index
What is the rationale for adopting a passive management investment strategy that utilizes index funds?
According to reputable market observers, on average the typical actively managed fund underperforms the index by about 2% annually.
The rationale for this underperformance can be attributed to the following factors:
(a) Securities markets are extremely efficient in digesting information.
(b) Indexing is cost-efficient, with expenses much lower than actively managed funds.
(c) Actively managed funds incur heavy trading expenses. Trading costs can
amount to 0.5% to 1.0% per year in additional expenses.
(d) Indexing has a tax advantage, deferring the realization of capital gains
Discuss how equity index funds have performed over time relative to actively
managed equity mutual funds.
According to Morningstar, the mutual fund tracking company, for the five-year
period ending in 2010, passive equity index funds outperformed active funds within each asset class, except for one, when results were adjusted for survivorship bias.
Balanced funds showed the most pronounced level of outperformance while
international funds were the lone category where active funds outperformed passive funds.
According to S&P, over a recent five-year period, 75% of actively managed
mutual funds failed to outperform the market.
Describe the underlying assumption of an active investment management strategy and the most likely form that such a strategy takes.
An active management strategy assumes (implicitly or explicitly) that investors
possess some advantage relative to other market participants. The most traditional and popular form of active stock strategies is the selection of individual stocks.
What sources of information do analysts use in evaluating common stocks?
Presentations from the top management of the companies being considered
Annual reports
Form 10-K
What can be said about the quality of analysts’ earnings per share forecasting?
Analysts spend much of their time forecasting earnings. Regardless of the effort expended by analysts, investors should be cautious in accepting analysts’ forecasts of earnings per share (EPS). The forecasts for long-term EPS are typically overly optimistic. Errors can be large and occur often.
Describe the investment strategy that involves shifting among cyclicals, growth and value stocks..
Such a strategy is known as sector rotation. Investors can pursue the sector investing approach using what are called sector mutual funds, or sector exchange-traded funds (ETFs).
How successful is market timing? Explain.
Much of the empirical evidence on market timing comes from studies of mutual funds. Several studies found no evidence that funds were able to time market changes and change their risk levels in response. (Also, market timing often involves high brokerage commissions and taxes.)
The biggest risk of market timing is that investors will not be in the market at critical times. Investors who miss only a few key months may suffer significantly.
