Tactical asset allocation (TAA)

Question 1

For tactical asset allocation, different proxies are

mainly used to predict returns

Answer 1

–Technical proxies: charts, trading volume, price volatility, etc.

–Fundamental proxies: interest rates, business cycle, comparable ratios, etc.

–Non-financial proxies: weather, major sports events, investor sentiment, etc.

These proxies can be used either based on quantitative procedures or the discretion of the portfolio managers.
–There is no rule of thumb or single normative approach

Question 2

Investment styles

Answer 2

Small vs. large cap
Value vs. growth
High vs. low risk
Foreign vs.domestic

Question 3

Value investing

Answer 3

Very popular stock picking method, where the aim is to find companies that appear to be undervalued by the market
–Cheap stocks can be cyclical stocks at the low end of their business cycle.

•How to recognize value stocks?
–They are stocks with low prices compared with underlying book, replacement, or liquidation values
–They tend to have low P/E ratios and/or higher dividend yields
–Remember, easier said than done…

•Most prominent value investors are Benjamin Graham and Warren Buffett

Question 4

Morningstar’s equity style box

Answer 4

–Small-cap and growth stocks have higher risks with higher potential return.

–Large-cap value stocks are likely low risk and are optimal for long-term investments.

–The blend is a mix of growth and value stocks.

There is a bond equivalent for the equity style box, along the dimensions of credit quality and maturity

Question 5

Growth investing

Answer 5

•Growth investing focuses on growth shares.
–They have good prospects for future returns, mainly because earnings are expected to grow. This will later also drive share prices up.
–Growth should be larger than that of the market.
–Growth potential can come from factors like sector, geography, asset class, regulation and the point in the business cycle for cyclical industries.

•Growth firms have
–High P/E ratios, high ROE, high profit margins and

Question 6

Value premium and its explanations

Answer 6

•Value stocks (high B/M, E/P or C/P) tend to outperform growth stocks (low B/M, E/P, C/P).

Question 7

Value trap

Answer 7

Value trap is a stock whose price does not go down because it is undervalued, but due to the future prospects of the firm that are deteriorating, which adversely affects the fundamental value

Question 8

Quality investing

Answer 8

•Indicators of quality:
–Market positioning – competitive advantages
–Business model – enterprise life cycle
–Corporate governance – good management

Question 9

Market cap investing

Answer 9

• Market capitalization is the number of shares of stock a company has outstanding, multiplied by the share price.
• Some investors prefer small cap firms due to their potential to deliver better returns:

–Greater opportunities for growth
–However, the return potential comes with greater risk due to fewer resources, less diversified business lines
–Also, share prices tend to be more volatile

•Risk averse investors might prefer large cap stocks

–E.g.: GE, Microsoft, and Exxon Mobil – S&P500 stocks
–Good track record, well-established firms with more stable cash flows

Question 10

Momentum

Answer 10

•Momentum indicators:
–Trend line, drawn between two points on a price graph. If the line is going up, the trend is up, and momentum investors take this as a buy signal. If the line is sloping down, the trend is down, and momentum investors see this as a sell signal.

–50-period moving average: when the price drops below the 50-period moving average, it is a confirmation that the

Question 11

Factor investing

Answer 11

Factor investing focuses on underlying risks, returns and correlations and aims to explain why certain asset classes move together to offer a better portfolio construction method

Question 12

Market frictions

Answer 12

Textbook arbitrage requires no capital and entails no risk.
•In reality, this is not the case due to market frictions, such as…
–Transaction costs
–Market and funding liquidity
–Benchmarking
–Short sales and leverage constraints
–Slow-moving capital
–etc.

Question 13

Liquidity

Answer 13

Liquidity is the ease and speed with which an asset can be sold at fair market value
•This is a versatile concept, it has many different aspects
–Trading cost: bid-ask spread, effective spread, etc.
–Search cost: opportunity cost of time until we find the counterparty to trade with
–Price impact: if I trade a large quantity, I am moving the price, price impact is this change