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CISI - Portfolio Construction Theory in Wealth Management > Chapter 7 > Flashcards

Chapter 7 Flashcards

1
Q

What are the three main assumptions in EMH?

A
  • a large number of profit-maximising participants
  • new information comes in randomly
  • participants no cognitive bias and price securities simply on new information
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2
Q

Why do efficient asset markets matter?

A

you can’t tell if a security is undervalued or overvalued without it

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3
Q

What is weak form efficient

A

current asset prices reflect all historical market information

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4
Q

What does the weak form EMH test?

A

whether publicly available information contained in historical prices is fully reflected in current prices

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5
Q

What is semi-strong form efficiency?

A

current prices reflect the same information in weak form

also, all public information

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6
Q

What does the semi-strong form efficiency test?

A

whether public information is fully reflected in current prices

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7
Q

What is strong form efficiency

A

current prices reflect all relevant information, including historical prices

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8
Q

What does the strong form efficiency test? (2)

A

whether all information (public and private) is fully compounded in market prices

and whether any type of investor can make excess profits

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9
Q

What kind of analysis may generate abnormal returns under weak EMH?

A

fundamental analysis

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10
Q

Why does fundamental analysis work in weak form EMH?

A

current prices may not reflect information about a public company

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11
Q

What kind of tests are used for weak form EMH?

A

random walk

zero correlation between past return and current return

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12
Q

Who have a knowledge advantage in semi-strong form EMH?

A

directors and other insiders that hold private information

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13
Q

What kind of studies are used to test semi-strong form efficiency? (3)

A

event studies

sample of firms that have an important announcement or event

then calculate abnormal return

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14
Q

What is the debate regarding strong form efficiency? (2)

A

markets efficient no room for active management

markets are inefficient and active management can generate alpha

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15
Q

Is there cyclicality between active and passive management? (2)

A

active strategies tend to outperform during market corrections

able to capture more upside during a recovery

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16
Q

Following a review of the EMH, what are the two main categories of tests of the EMH?

A
  • price studies
  • manager studies
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17
Q

What are the prices studies of EMH?

A

searching for trade rules that generate positive risk-adjusted returns when back-tested on historical data

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18
Q

What are the manager studies of EMH?

A

test the ability of active managers to generate risk-adjusted outperformance

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19
Q

What are the three anomalies in EMH?

A
  • small firms outperform large firms
  • evidence on mean reversion
  • higher daily returns before a public holiday
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20
Q

What is the key belief in EMH?

A

markets are quick to process new information, so investors are
unable to gain an advantage over other investors.

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21
Q

Which is more market efficient large developed markets or small less developed markets? (3)

A

lage markets

more efficient

more analysts and news more available

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22
Q

What are the challengers to market efficiency? (3)

A

markets driven by human (irrational)

markets are structurally inefficient

many investors have consistently beaten the market i.e. warren buffett

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23
Q

What are the two ways of constructing a portfolio actively? ^ v

A
  • top down
  • bottom up
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24
Q

What is top down portfolio construction?

A

assessing macroeconomic factors that lead to a particular asset allocation

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25
Q

What is bottom-up portfolio construction?

A

focuses solely on the unique attractions of individual stocks

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26
Q

What is fundamental analysis?

A

examination of macro and micro economic metrics

estimating intrinsic value of companies

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27
Q

What is the aim of fundamental analysis? (3)

A

forecasting future profits

determining fair value

and potential for mispricing

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28
Q

What is technical analysis?

A

look at the pattern of price and volumes of market behaviour with a view to anticipating the overall direction of a market or individual securities

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29
Q

What is the intellectual justification for technical analysis? (2)

A

it’s based on behaviour of crowds

markets filled with people who behave the same way when faced with similar market conditions

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30
Q

What is quantitative analysis? (2)

A

using mathematical models to price products

then use that price to gauge whether share is expensive or cheap

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31
Q

How does quantitative analysis aim to exploit market inefficiency?

A

use computer technology to swiftly execute trades

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32
Q

What is the return like with quantitative analysis?

A

small

needs leverage to boost returns

33
Q

What is the concept behind factor investing?

A

security returns are explained by multiple ‘factors’ that could be used to predict returns

34
Q

Give examples of factors used in factor investing (6)

A
  • company size
  • growth
  • valuation
  • profitability
  • leverage
  • momentum
35
Q

What is value investing? (3)

A
  • companies in distress
  • companies set for recovery
  • hope price return to reflect their intrinsic value
36
Q

How do you do value investing? (2)

A
  • screen for shares that are super cheap
  • compared to chosen yardsticks
37
Q

What are the three key ratios in value investing?

A
  • share price to assets
  • earnings
  • dividends
38
Q

What is growth investing? (3)

A
  • focus on companies with rising share price
  • hope momentum keeps going
  • and other investors join the bandwagon
39
Q

What are true growth stocks? (2)

A
  • able to differentiate their product or service
  • have a competitive advantage
40
Q

What is a growth stock?

A

one that has yet to gain market prominence but has potential to do so

41
Q

What is the key to growth investing?

A

rigorously forecast future earnings growth and avoid companies susceptible to issuing profits warnings

42
Q

What is Growth at a reasonable price (GARP) investing?

A

any P/E is reasonable if it is equal or less than the company’s annual rate of earnings growth

43
Q

Give an example of GARP

A

accept a P/E multiple of 15 if company’s earnings are growing at annual rate of at least 15%

44
Q

What does GARP do for managers?

A

sets bounds on how much higher a P/E is justifiable

45
Q

What other protective valuation measures can be used apart from GARP? (2)

A
  • dividend cover
  • borrowings and liquidity
46
Q

What is commingling? (2)

A

portfolio made of multiple unit trusts, OEICs and/or investment trusts

rather than forming an index fund

47
Q

Who is suitable for commingling? (3)

A
  • investors with relatively small portfolios
  • accept compromise between transaction costs of complete indexation
  • and tracking error of stratified sampling
48
Q

What does tracking error measure?

A

how closely returns have tracked the targeted benchmark index

49
Q

What is a good annualised TE when tracking a benchmark?

A

less than 1%

50
Q

What is duration swtiching?

A

changing duration of portfolio depending on expected interest rates

51
Q

For duration switching, what happens to duration of portfolio in bear market?

A

shorten duration

52
Q

For duration switching, what happens to duration of portfolio in bull market?

A

increase duration

53
Q

What is riding the yield curve?

A

buying long-term bond but selling it before maturity

to profit from a declining yield over the bond’s life

54
Q

What are the two main classes of bond switches?

A
  • anomaly switches
  • policy switches
55
Q

What is an anomaly switch?

A

switch between two bonds with very similar characteristics, but whose prices or yields are out of line with each other

56
Q

What is a pure yield switch?

A

sale of a bond that has a given GRY and the purchase of a similar bond with a g greater GRY

57
Q

What is a policy switch?

A

switch between two dissimilar bonds

58
Q

What does a policy switch aim to take advantage of? (3)

A
  • change in interest rates
  • term structure of interest rates,
  • change in credit ratings
59
Q

For a policy switch, how do they take advantage of change in interest rates?

A

low duration interest rates go up

high duration if interest rates expected to go down

60
Q

For policy switching, how to take advantage of changes in the structure of the yield curve?

A
  • yield curve normally smooth line
  • bonds on a hump, price will go up
  • bonds on a dip, price will go down
61
Q

For policy switching, how to take advantage of changes in bond quality ratings?

A

expected rating to go down, price down

expected rating to go up, price up

62
Q

What is intermarket spread switching?

A
  • different sections of simlar market
  • different terms
  • to obtain a more positive yield spread
63
Q

Example of intermarket spread switching

A
  • spread between government and corporate bonds to narrow
  • swap government bonds for corporate bond
64
Q

Bonds

What is a laddered portfolio?

A

buying securities with various maturities

65
Q

What is benefit of laddered portfolio?

A

reduce portfolio’s sensitivity to interest rate risk

66
Q

What is a bullet or focused portfolio?

A

constructed from bonds with maturities or durations close to that of liabilities

67
Q

What is a barbell portfolio?

A

only short dated and long dated bonds

68
Q

What are the roles of the bonds in a barbell portfolio?

A
  • long-dated for attractive yield
  • short-dated to invest money somewhere else during a downturn
69
Q

What is the advantage of a barbell strategy?

A

wider range of portfolios with different duration can be constructed

compared with a focused strategy

70
Q

What is the disadvantage of a barbell strategy?

A

further immunisation risks than the focused strategy

71
Q

What is cash flow matching?

A

purchase bonds whose redemption proceeds will meet a liabilityof the fund as they fall due

72
Q

What are the benefits of active management? (6)

A
  • tailor an active strategy to meet a specific investment goals
  • potential for better reutns
  • flexibility to choose assets they believe will provide a strong return
  • flexibility can reduce risk
  • teams of analysts support active managers in finding attractive investment opportunities
  • can be challenging which some might enjoy
73
Q

What are the three limitations of active management? (Commodities)

A
  • commodities trades high levered (magnifies gains and losses
  • commodities prices extremely volatile compared to other major asset classes
  • volatility is influenced by macroeconomic factors
74
Q

What are the benefits of passive management? (7)

A
  • reduced marketing, distribution and accoutning costs
  • liquid
  • transparent
  • minimal market trading
  • long term investors can benefit from higher returns
  • wide variety of indices are available
  • ETFs more tax efficient than mutual funds (better for tax-sensitive investors)
75
Q

What are the limitations of passive management? (5)

A
  • when adjusting when constituents change, may end up buying at elevated, or selling at depressed prices
  • costs affect performance relative to the index
  • unlikely to employ risk management, so can never outperform the index
  • can be overly concentrated, vulnerable to major political and regulatory events
  • still exposed to market risk, will follow the index down in bear markets

-

76
Q

What are the limitations of passive management?

A
  • when adjusting when constituents change, may end up buying at elevated, or selling at depressed prices
  • costs affect performance relative to the index
  • unlikely to employ risk management, so can never outperform the index
  • can be overly concentrated, vulnerable to major political and regulatory events
  • still exposed to market risk, will follow the index down in bear markets
  • buy and sell decisions based on index constituents, not research
  • with full replication, securities are considered to be sub-optimal are still included
77
Q

what is a core and satellite portfolio?

A

hold passively managed funds (about 70%+)

include specialist actively mange funds for outperformance

78
Q

What is smart beta? (3)

A

create custom benchmark consisting of stocks that exhibit certain behaviours

low val, value, momentum

passive strategy as the fund tracks that benchmark

CISI - Portfolio Construction Theory in Wealth Management (15 decks)

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