Reading 14: Alpha Hunters and Beta Grazers －LOS b impact, efficiency, market

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 3: Behavioral Finance
Reading 14: Alpha Hunters and Beta Grazers
LOS b: Explain the portfolio rebalancing behavior of holders, rebalancers, valuators, and shifters and evaluate the impact these rebalancing behaviors have on market efficiency.

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Which of the following market actors trades would be most likely to dampen movements in the overall stock market?

A) Momentum valuators.

B) Shifters.

C) Rebalancers.

D) Holders.

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Answer and Explanation

Rebalancers tend to dampen overall market movements because they buy stock as the market falls and sell stock as the market rises. Momentum valuators and shifters tend to buy stock as the market rises and sell stock as the market falls so they accentuate market movements. Holders invest for the long term and their trades are not related to overall market movements. So their trades do not affect the overall market.

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Which of the following market actors trades would be most likely to have no affect on movements in the overall stock market?

A) Contrarian valuators.

B) Shifters.

C) Holders.

D) Rebalancers.

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Answer and Explanation

Holders invest for the long term and their trades are not related to overall market movements. So their trades do not affect the overall market. Shifters tend to buy stock as the market rises and sell stock as the market falls so they accentuate market movements. Contrarian valuators and rebalancers tend to dampen overall market movements because they buy stock as the market falls and sell stock as the market rises.

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Tom Dunn was just laid off from his job because his employer, Falcon Manufacturing, is downsizing. If Dunn and the other employees at his firm are shifters, what is the most likely direction of the stock market and what is the most likely impact of the Falcon employees on the aggregate stock market? The stock market is:

A) declining and the actions of the Falcon employees will dampen the decline.

B) rising and the actions of the Falcon employees will accelerate the increase.

C) declining and the actions of the Falcon employees will exacerbate the decline.

D) rising and the actions of the Falcon employees will dampen the increase.

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Answer and Explanation

If Falcon Manufacturing is downsizing, then it is likely that the economy is in a recession and that the stock market is declining. If Falcon employees are shifters, they respond to the loss of their job by shifting assets away from equities. This would exacerbate the decline of the stock market.

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The users of formulaic rebalancing argue that their strategy increases the portfolios performance when the overall stock market declines. The opposing argument would be that when the market temporarily declines, the users of formulaic rebalancing should actually:

A) buy more stock than their original allocation.

B) buy equities so that they are rebalanced back to their original allocation.

C) sell stock so that the equities are reduced below their original allocation.

D) follow a buy and hold strategy to minimize transactions costs.

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Answer and Explanation

In formulaic rebalancing, the investor buys stock when the market falls so equities are rebalanced back to their original allocation. The argument is that they are buying stock when equities are cheap and this helps improve the portfolios performance. However, if equities really are so cheap, the formulaic rebalancers should actually buy more stock than their original allocation to equities.

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Jack Munyon monitors his portfolio and uses formulaic rebalancing. If the stock market increases, which of the following actions will Munyon most likely take?

A) Munyon will sell stock so that the equities are rebalanced back to its original allocation.

B) Munyon will sell stock so that the equities are reduced below their original allocation.

C) Munyon will buy stock so that the equities are increased above their original allocation.

D) Munyon will utilize a formula based on market fundamentals to decide if any rebalancing should take place.

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Answer and Explanation

In formulaic rebalancing, the investor sells stock when the market rises so equities are rebalanced back to their original allocation. Equities are bought when the market falls.

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The users of formulaic rebalancing argue that their strategy is consistent with efficient markets. In regards to being consistent with efficient markets, the opposing argument would be that the users of formulaic rebalancing should actually:

A) sell stock when the market declines.

B) buy stock when the market declines.

C) follow a buy and hold strategy to minimize transactions costs.

D) follow a CPPI rebalancing strategy.

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Answer and Explanation

In formulaic rebalancing, the investor buys stock when the market falls so equities are rebalanced back to their original allocation. If they were actually consistent with efficient market theory however, they would reduce the allocation to equities in their portfolio because the allocation to equities in the market portfolio has also fallen.

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Frank Mercer invests on the behalf of institutional clients and tracks the MSCI World index. Which of the following is the best characterization of Mercer as an investor? Mercer is a(n):

A) alpha hunter.

B) gamma hedger.

C) beta grazer.

D) delta hedger.

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Answer and Explanation

A beta grazer uses a passive strategy to track an index. Mercer is therefore a beta grazer. These investors believe that markets are efficient. Alpha hunters search for undervalued stocks using an active strategy. Delta and gamma hedging typically refers to using options to hedge the value of a portfolio.