Chapter 15: Introduction to the Portfolio Approach

Question 1

what is included in the returns on investment?

Answer 1

Capital gain or loss and cash flow (dividend)

Question 2

How to calculate expected return?

Answer 2

= (cash flow + capital gain or - captial loss)/beginning value.

Question 3

how to calculate the return rate (yeild) of an investment?

Answer 3

= (cash flow + ending value - begining value)/beginning value * 100%

Question 4

What is the different between annual rate of return and holding period return?

Answer 4

Annual rate of return: return rate of 1 year

Holding period return: return rate of the transaction period can be > or < 1y

Question 5

What is ex-ante return?

Answer 5

Expected returns

Question 6

What is ex-post return?

Answer 6

actual historical returns

Question 7

what is the problem of investing base on rate of return only?

Answer 7

does not take risk into account.

Question 8

Can you rank the risk level of different securities?

Answer 8

Treasury bills < bonds < debentures < preferred shares < common shares < derivatives

Question 9

What is considered risk-free rate of return?

Answer 9

T-bills (assume is zero risk associated with)

Question 10

what is risk?

Answer 10

the likelihood that the actual return will be different from the expected return

Question 11

What are the types of risk entails in the market?

Answer 11

1. Inflation rate risk
2. Business risk (uncertainty of the company’s future performance)
3. Political risk
4. Liquidity risk
5. Interest rate risk
6. Foreign investment risk (exchange rate risk,…)
7. Default risk

Question 12

What are the two categories of risk?

Answer 12

1. Systematic risk or market risk (can’t reduce by diversification like inflation, business cycle, interest rate,..)
2. Non-systematic risk or specific risk (price of specific security will change,.. can be reduced by diversification)

Question 13

what are the common measures to measure risk?

Answer 13

variance, standard deviation, and beta

Question 14

What is variance measures to measure risk?

Answer 14

• to which extend the possible realized returns differ from the expected return
• the greater the distance estimated between the expected return and the possible returns, the
  greater the variance

Question 15

What is standard deviation (expressed as a %) measures to measure risk?

Answer 15

• is the measure of risk commonly applied to portfolios and to individual securities within that portfolio.
• Standard deviation is the square root of the variance
• The greater the standard deviation, the greater the risk
• Based on past performance.

Question 16

What is beta measures to measure risk?

Answer 16

• links the risk (volatility) of individual equity securities or a portfolio of equities to the market as a whole.
• Measure the part of the fluctuation in price driven by changes in stock market.
• the higher the beta, the greater the risk

Question 17

How to calculate the expected return of a portfolio?

Answer 17

= R1.W1 + R2.W2+ …+ Rn.Wn
R: Return on a particular security
W: weight % of the security in the portfolio

Question 18

Will the risk reduce according to the number of stocks in a portfolio?

Answer 18

No. although total risk does fall significantly when the first few stocks are added, the rate of reduction declines as the number of stocks increases

Question 19

What is the effect of adding negatively correlated securities to a portfolio does?

Answer 19

reduce risk. However, each additional security reduces risk at a lower rate. An accepted view is that, after 32 equities are added to a portfolio, the effect of adding additional securities to reduce risk is minimal.

Question 20

What is correlation?

Answer 20

refers to the way securities relate to each other when they are added to portfolio and to how the resulting combination affects the portfolio’s total risk and return.

Question 21

What is perfect positive correlation?

Answer 21

If the stock prices of those companies always move in the same direction (correlation = +1) -> not reduce risk.

Question 22

What is perfect negative correlation (-1)?

Answer 22

the stock prices of two companies always move in opposite directions -> no risk.

Question 23

What does it mean when beta = 1, >1 and <1?

Answer 23

Beta = 1: equity or equity portfolio that moves up or down to the same degree as the stock market
Beta > 1: security or portfolio that moves up or down more than the market (typically cyclical industries)
Beta < 1: security that moves less than the market
(In reality, most portfolios have a beta between 0.75 and 1.40)

Question 24

What is alpha?

Answer 24

the excess return earned on the portfolio when the portfolios outperform the market.

Question 25

What are the portfolio manager styles?

Answer 25

Active and passive

Question 26

What is active investment strategy?

Answer 26

Target to outperform a benchmark portfolio on a risk-adjusted basis

Question 27

What are the strategies of active equity investment?

Answer 27

1. Bottom-up analysis (focus on individual stocks and build the portfolios of the best stocks) 2. Top-down analysis (start with macroeconomic factors then narrowing to individual stocks) (2 strategies are not mutually exclusive)

Question 28

What is passive investment strategy?

Answer 28

tend to replicate the performance of a specific market index without trying to beat it.

Question 29

What are the strategies of passive investment?

Answer 29

1. Indexing (buying and holding a portfolio that matches a index) 2. Buy and hold (believe that securities markets are efficient which means price reflects all information on expected return and risk)

Question 30

What are the equity manager styles?

Answer 30

growth, value, or sector rotation

Question 31

What is growth managers?

Answer 31

- focus on stocks with above average potential for price increase. - Bottom - up focus on EPS and pay more for company with potential of high price -> usually low dividend yeild. - Not concerned with quaterly portfolio fluctuations.

Question 32

What is the risk of Growth portfolios?

Answer 32

* If EPS falters, it can cause large percentage price declines. * Reported EPS, above or below analysts’ expectations, produces high portfolio volatility. * These types of securities are highly vulnerable to market cycles.

Question 33

What is the characteristics of growth portfolios in term of valuation ratios?

Answer 33

* High price-to-earnings * High price-to-book value * High price-to-cash flow

Question 34

What are the characteristics of growth portfolios?

Answer 34

- Long-term returns mostly from capital gain. - Perform best in rising market - investors in taxable accounts may be liable for increased amounts of capital gains tax every year

Question 35

What are value managers?

Answer 35

- Focus on specific stock selection. - Bottom-up picker with intensive research. - Security turnover is typically low because they wait for a stock’s intrinsic value to be realized (buy discounted stocks that should eventually rise in price). - seek stocks that are overlooked, disliked, or out of favour with individual investors, institutional investors, and equity analysts

Question 36

What is the characteristics of Value portfolios in term of valuation ratios?

Answer 36

* Lower annualized standard deviation * Lower historical beta * Stock price is already low and could remain low for a long time

Question 37

What are the characteristics of Value portfolios?

Answer 37

* Low price-to-earnings ratio * Low price-to-book value ratio * Low price-to-cash flow ratio * High dividend yield

Question 38

What are the characteristics of Value portfolios?

Answer 38

- Long-term returns are similar to Growth portfolio but with higher current dividend and less volatility - Perform best in down or inefficient markets - Suitable for low-to-medium tolerance for market risk and long-term investment horizons. - Incur fewer capital gains and ignore short-term market fluctuations.

Question 39

What is Sector rotation manager?

Answer 39

- Top-down approach (identify trend and industry selection) - Typically buy large-cap stocks to mazimize their liquidity and not as concerned with individual stock characteristic. - Focus on current phase of the economic cycle, direction headed and various sectors affected.

Question 40

What are the characteristics of Sector rotation portfolios

Answer 40

- High volatility caused by industry concentration and rotation between industries. - worse when choosing wrong economic scenario and industries do not perform as expected. - Can be underperform the market benchmark in short-term but turnover tends to be high (which can have tax problem) - trying to outperform the market averages. - Variations in the economic cycle can have a dramatic bearing on the timing of sector rotation

Question 41

What is the basic industry rotation strategy?

Answer 41

- shifting back and forth between cyclical industries (paper, mine,..) and defensive industries (banks or utilities,..)

Question 42

What are the fixed-income managers styles?

Answer 42

1. term to maturity 2. Credit quality 3. Interest rate anticipators.

Question 43

What is term-to-maturity managers style?

Answer 43

- Short-term managers hold T-bills, short-term bonds -> portfolios are less volatile - Medium-term managers hold 5-10 years securities such as mortgage fund. - Long-term managers hold >10 years securities.

Question 44

What is Creadit quality managers style?

Answer 44

- Balance between return potential and risk of default. - To mitigate this risk, managers often invest in high-yield bonds that mature in less than three years - Also consider liquidity (Lower-rated bonds have less liquidity than government issues so difficult to sell in a declining market)

Question 45

What are junk bonds?

Answer 45

High-yield bonds that are non-investment grade products.

Question 46

What are interest rate anticipators managers?

Answer 46

- Anticipating the direction of interest rate to structuring the portfolio (ex: i increase then shorten the average term on bond investment) - Also called duration switching - Works best when the yield curve is normal (wide gap between short and long term rate) - If the yield curve is flat, it is not advantageous to extend the term to maturity of the portfolio