Portfolio Management【Reading 63】Sample Investment, allocation, 2012, individual

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Gemini Investment Management Company (GIMC) assumes markets will remain at equilibrium indefinitely. GIMC defines security analysis as the examination of factors affecting the value of individual securities. GIMC defines asset allocation as the examination of factors affecting the optimal allocation of assets to the market portfolio and to the risk-free asset. Given GIMC’s assumption that markets are at equilibrium indefinitely, indicate whether GIMC should place significant or insignificant emphasis on security selection and asset allocation.

A) Insignificant emphasis on asset allocation only.

B) Insignificant emphasis on both.

C) Insignificant emphasis on security selection only.

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When markets are at equilibrium, all asset prices will equal their fair values. Assets are neither undervalued nor overvalued. Therefore, if GIMC believes markets will remain at equilibrium indefinitely, then they should place very little, if any, emphasis on security selection. In contrast, active portfolio management is needed to determine the appropriate allocation of the client’s investment between the market portfolio and the risk free asset. Active portfolio management is needed to forecast the expected returns and risk for the market portfolio and to forecast the return on the risk-free asset. GIMC should allocate large percentages to the market portfolio for highly risk tolerant clients and high percentages to the risk-free asset for highly risk averse clients. Significant effort must be expended to determine the appropriate mix of assets for the client

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When markets are at equilibrium, all asset:

A) alphas will equal zero.

B) betas will equal zero.

C) alphas will be positive.

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When markets are at equilibrium, forecast returns equal equilibrium expected returns. The stock’s alpha is defined as the difference between the analyst’s forecast return for the stock and the stock’s equilibrium expected return. Therefore, when markets are at equilibrium, all alphas will equal zero.

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Intelligent Investors Inc. (III) manages $10 billion in assets using active portfolio management. III believes that security prices often stray from their equilibrium values. Elizabeth Adams and Rajendra Rao work as analysts at III. Adams states that III should overweight all positive alpha stocks. An overweight is defined as an allocation in excess of the asset’s relative market value weight. Rao states that III should allocate assets to maximize the portfolio Sharpe ratio.

Regarding these statements:

A) only Adams is correct.

B) both are correct.

C) only Rao is correct.

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Adams’ statement is correct. If markets are in disequilibrium, asset prices will deviate from their fair values. An asset’s alpha equals the difference between the analyst’s forecast return for an asset and its required return. Positive alpha assets should be overweighted. Note that a neutral weight for III equals the asset’s relative market value weight, which is how assets are allocated with the “market” portfolio. Rao’s statement is correct too. Allocations should provide investments with the maximum Sharpe ratio defined as the portfolio’s expected excess return, E(Rp) minus RF, divided by the portfolio’s standard deviation.

kasinkei

An asset’s alpha returns are returns earned in addition to the asset’s:

A) ex ante returns.

B) projected returns.

C) required returns.

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Alpha returns are returns beyond the required return expected on an asset given its level of risk.

kasinkei

Expected returns beyond required returns are referred to as an asset’s:

A) alpha.

B) beta.

C) ex ante returns.

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Alpha returns are returns beyond the required return expected on an asset given its level of risk.

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MPT Associates selects optimal portfolios using the Treynor-Black model. Randall Morgan and Charles Alverson, research associates at MPT, debate the assumptions of the model. Morgan states that the model assumes that large numbers of assets are mispriced. Alverson states that the model places high importance on diversification.

Regarding these statements:

A) only Alverson is incorrect.

B) both are incorrect.

C) only Morgan is incorrect.

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The Treynor-Black model combines modern portfolio theory and market inefficiency. The model is based on the premise that markets are nearly efficient, implying that the number of mispriced assets is small. Therefore, Morgan’s statement is not correct. In contrast, Alverson’s statement is correct. The Treynor-Black model incorporates active security selection within an optimally diversified portfolio context. Therefore, the model places large value on the importance of diversification.

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Amanda Keene, CFA, works for an investment firm that employs the Treynor-Black portfolio optimization model. Keene predicts that the market index return will move higher next year as markets move closer to equilibrium. Keene advises a client, whose risk aversion will remain unchanged next year. Using the Treynor-Black framework, Keene should make which of the following changes in her client’s allocations, with respect to the percentage of actively managed and passively managed portfolios, noting that the remaining percentage is allocated to cash?

A) Decrease both portfolios.

B) Decrease only passively managed portfolios.

C) Decrease only actively managed portfolios.

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The client’s risk aversion will remain unchanged next year, which suggests that the percentage allocated to cash will not change. A higher market return suggests greater weight should be placed on the passively managed portfolio, especially in light of Keene’s prediction that markets will move closer to equilibrium. Less emphasis is placed on active management as markets move toward equilibrium (alphas move closer to zero).

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Gary Zeller, an independent portfolio manager who manages money for high-net-worth individuals, is a proponent of the efficient market hypothesis. He uses the Treynor-Black model to determine asset allocations for his portfolios. At the moment, he is considering several investments for new portfolios. Here are their characteristics.

Stock Expected	12-Month Return Five-Year Avg.	Standard Deviation	Beta
Hearthstone [td=1,1,120]15%	34%	1.6
Imperial Shipyards	9%	12%	0.7
Minster Mask and Costume	26%	44%	1.4
Kustom Auto	11%	14%	0.85

The risk-free rate is 5.7%. The expected return of the S&P 500 Index is 10%, and the index’s standard deviation is 14%.
Zeller plans to create a portfolio using a mix of the S&P 500 Index, the risk-free asset, and the four stocks discussed above. He uses the data above to select the appropriate asset allocations to maximize returns.
Recent market activity has Zeller concerned. For several weeks he has seen stocks with weak fundamentals stage a strong rally, while solid, steady-growth stocks have lagged. After extensive research into technical trends and an analysis of the market’s fundamentals, Zeller has come to believe the recent trend in the market is likely to continue, with speculative stocks continuing to rally.
Despite the gains in speculative stocks, Zeller sees continued weakness in larger, solid stocks causing a decline in the S&P 500 Index. To compensate for this risk, he purchases put options on the 50 largest stocks in the capitalization-weighted index instead of buying the index itself for the new portfolios.
Later that day, Zeller receives an e-mail from Florence Whitaker, a client whose portfolio has performed poorly in recent months. She is not happy with the results and questions Zeller’s allocation strategy.
In a response e-mail, Zeller defends the Treynor-Black model and makes the following points:

• The strategy is designed to beat the market, but not necessarily to generate gains when the market is down.
• In your portfolio, I overweight the stocks with the highest potential return to boost performance.
• A mix of individual stocks and index funds gives the portfolio better potential returns than the index, while offering less risk than the individual stocks.
• All of the stocks in your portfolio have betas below 1.

After sending the e-mail, Zeller opens up a spreadsheet to crunch some numbers. Several of his portfolios have underperformed over the last year, and he resolves to consider whether he should relax his assumptions about the accuracy of forecasts.From highest allocation to lowest, how should Zeller allocate the four stocks in his portfolio?

A) Hearthstone, Minster Mask and Costume, Kustom Auto, Imperial Shipyards.

B) Minster Mask and Costume, Kustom Auto, Imperial Shipyards, Hearthstone.

C) Minster Mask and Costume, Hearthstone, Kustom Auto, Imperial Shipyards.

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The Treynor-Black model calls for greater weights to stocks with high forecast alpha relative to unsystematic risk. The Sharpe ratio reflects that relationship. To calculate the Sharpe ratio, we subtract the risk free rate from the expected stock returns, and then divide by the stock’s standard deviation. Beta is not a measure of unsystematic risk, so it should not be used. Sharpe ratios for the four stocks are as follows:

Hearthstone = 27.35%.
Imperial = 27.50%.
Kustom Auto = 37.86%.
Minster = 46.14%.

The higher the Sharpe ratio, the higher the level of alpha relative to unsystematic risk. As such, the highest weighting should go to Minster Mask and Costume, the second-highest to Kustom Auto, the third-highest to Imperial Shipyards, and the fourth-highest to Hearthstone. (Study Session 18, LOS 63.b, c)

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Which of Zeller’s actions is least compatible with the use of the Treynor-Black model? His:

A) support of the efficient market hypothesis.

B) use of index funds.

C) purchase of put options.

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Index funds appeal to efficient market theorists in part because they offer a low-cost way of investing in the market without trying to exploit infrequent mispricing. While active management of any sort may seem incongruous against the efficient market backdrop, it is active management, or the search for alpha, that clears up mispricings and theoretically leads to market equilibrium. The Treynor-Black model is an optimization framework that assumes markets are nearly efficient but does allow for some active management. The Treynor-Black model assumes a portfolio consisting of index funds, stocks, and the risk-free return. Put options have no place in that model. (Study Session 18, LOS 63.b)

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Which of Zeller’s points is his weakest defense of the Treynor-Black model?

A) In your portfolio, I overweight the stocks with the highest potential return to boost performance.

B) All of the stocks in your portfolio have betas below 1.

C) The strategy is designed to beat the market, but not necessarily to generate gains when the market is down.

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Strategies based on a mix of index funds and individual investments are not likely to generate gains during periods when the index falls, but they are still able to beat the market if the individual stocks are selected wisely. Zeller’s comment about diversification is true, and at the heart of the argument in favor of the Treynor-Black model. The statement about overweighting high-return stocks is not a particularly good argument, because the model also calls for underweighting stocks with high unsystematic risk. But the worst argument involves beta, because the Treynor-Black model doesn’t take beta into account directly. (Study Session 18, LOS 63.b)

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In light of his observations about market movements, Zeller should:

A) increase his cash allocation.

B) increase his index-fund allocation.

C) increase his allocation of actively managed stocks.

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As markets become more efficient, alphas shrink, and portfolio managers using the Treynor-Black model will reduce their allocation of actively managed stocks. However, Zeller expects mispricings to increase in the coming months, so he should step up the active management of his portfolios to take advantage of the higher alphas. (Study Session 18, LOS 63.c)

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If Zeller stops assuming forecasts are accurate, he will most likely:

A) increase the number of stocks in the portfolio.

B) reduce both risk and potential return of the portfolio.

C) shift subtly toward CAPM.

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The Treynor-Black model assumes forecasts are accurate. Relaxing that assumption requires analysts to place less weight on forecasts. If we discount the value of forecasted alpha, the weighting of the actively managed portion of the portfolio will decrease relative to the index. A higher index weighting is likely to reduce both risk and potential return. The less trust we have in forecasts, the more forecasted alpha is required to justify making a bet on an individual stock. Stocks with marginal alpha will become less appealing, so the number of stocks suitable for investment will decline. The number of stocks in the portfolio is more likely to decline than to increase. CAPM is very different from the Treynor-Black model, and accounting for inaccurate forecasts does not change that. Portfolio rebalancing is not relevant here. (Study Session 18, LOS 63.c)

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Assuming Zeller intends to take positions in all four of the stocks discussed above, how many should he sell short?

A) 2.

B) 1.

C) 0.

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While one of the stocks is expected to underperform, and two of the stocks have lower Sharpe ratios than the index, all have a positive expected alpha. As such, none should be shorted. (Study Session 18, LOS 63.b)

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Collette Gallant, CFA, employs the capital asset pricing model (CAPM) to determine the required returns for stocks. Gallant works for Trey-Black Inc. (TBI) which uses the Treynor-Black model for portfolio optimization. Gallant is deciding whether to include stock ABZ in the TBI’s actively managed portfolio. She forecasts that the ABZ stock return will be 15% next year. TBI provides Gallant with the following information.

• Expected return on the S&P500 stock market index = 15%.
• 1-year Treasury bill rate = 5%.
• ABZ stock beta = 1.25.

TBI determines that Gallant’s forecast ability has been very poor. TBI also finds that the average alpha across stocks in their actively managed portfolio equals 1%. Determine if Trey-Black’s allocation to ABZ in its actively managed portfolio should be an above or below average, long or short position.

Magnitude

Position

A) Below average Long

B) Below average Short

C) Above average Short

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According to the Treynor-Black model, the actively-managed portfolio takes long positions in positive alpha stocks and short positions in negative alpha stocks. The alpha is defined as the difference between the analyst’s forecast return for the stock and its required return. As stated in the question, the required return for stock ABZ is calculated using the CAPM:

E(R) = RF + βm) – RF] = 0.05 + 1.25[0.15 – 0.05] = 0.175 = 17.5%.

Gallant’s forecast return (15%) is less than the required return (17.5%):

alpha = 0.15 – 0.175 = −0.025 = −2.5%.

Therefore, Gallant’s predicted alpha is much higher in absolute magnitude than the average alpha (1%), which would suggest an above-average short position if Gallant’s forecasting ability is reliable. However, TBI has determined that Gallant’s forecast ability is poor. Therefore, her forecast alpha will be adjusted severely toward zero to account for her poor forecast ability. The end result is that only a small short position will be taken in ABZ.

kasinkei

Collette Gallant, CFA, employs the capital asset pricing model (CAPM) to determine the required returns for stocks. Gallant works for Trey-Black Inc. (TBI) which uses the Treynor-Black model for portfolio optimization. Gallant is deciding whether to include stock ABZ in the TBI’s actively managed portfolio. She forecasts that the ABZ stock return will be 15% next year. TBI provides Gallant with the following information.

• Expected return on the S&P500 stock market index = 15%.
• 1-year Treasury bill rate = 5%.
• ABZ stock beta = 1.25.

TBI determines that Gallant’s forecast ability has been very poor. TBI also finds that the average alpha across stocks in their actively managed portfolio equals 1%. Determine if Trey-Black’s allocation to ABZ in its actively managed portfolio should be an above or below average, long or short position.

Magnitude

Position

A) Below average Long

B) Below average Short

C) Above average Short

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According to the Treynor-Black model, the actively-managed portfolio takes long positions in positive alpha stocks and short positions in negative alpha stocks. The alpha is defined as the difference between the analyst’s forecast return for the stock and its required return. As stated in the question, the required return for stock ABZ is calculated using the CAPM:

E(R) = RF + βm) – RF] = 0.05 + 1.25[0.15 – 0.05] = 0.175 = 17.5%.

Gallant’s forecast return (15%) is less than the required return (17.5%):

alpha = 0.15 – 0.175 = −0.025 = −2.5%.

Therefore, Gallant’s predicted alpha is much higher in absolute magnitude than the average alpha (1%), which would suggest an above-average short position if Gallant’s forecasting ability is reliable. However, TBI has determined that Gallant’s forecast ability is poor. Therefore, her forecast alpha will be adjusted severely toward zero to account for her poor forecast ability. The end result is that only a small short position will be taken in ABZ.