Gypsy

Which of the following is least likely to be an advantage of returns-based style analysis?

A) The use of different models provides similar results.

B) Low cost.

C) It will detect style changes quickly.

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Returns-based style analysis may detect style changes slowly because the regression requires historical data that may not reflect the current focus of the fund. Holdings-based style analysis will detect style changes more quickly than returns-based analysis.

Gypsy

Which of the following is a justification of a value investing strategy?

A) Current depressed earnings will rise in the future as they revert to the mean.

B) The value of stock is volatile so a cheaply priced stock will see an increase in value in the future.

C) The investor can add value using proper analysis of the risky firm.

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There are two justifications for a value investing strategy. The first is that although a firm’s earnings are depressed now, the earnings will rise in the future as they revert to the mean. One of the risks of this strategy however is that there is a good reason why the stock is priced so cheaply. Some stocks will take a long time to increase in value. The investor needs to consider this before investing. The second justification for value investors is that growth investors expose themselves to the risk that earnings and price multiples will contract for high-priced growth stocks.

Gypsy

The risk for growth investors is that the expected earnings growth does not occur. How will this low growth affect the price-multiple and stock prices, respectively?

A) Decrease; decrease.

B) Increase; decrease.

C) Decrease; increase.

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Growth investors search for firms or industries where high expected earnings growth will drive the stock price up. If the actual earnings are lower than expected, the stock price will decrease due to a lower growth rate and the price multiple will decrease and as a result.

Gypsy

Which of the following statements about value and growth investors is least accurate?

A) Value investors focus on the numerator of the P/E ratio while growth investors focus on the denominator.

B) Growth investors seek industries where low expected earnings growth will drive the stock price down.

C) Growth investors may do better during an economic contraction than during an expansion.

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Growth investors search for firms and industries where high expected earnings growth will drive the stock price up even higher.

Gypsy

Which of the following is most accurate regarding growth stocks? Growth stocks are likely to:

A) outperform during an economic contraction and outperform during an economic expansion.

B) outperform during an economic contraction and underperform during an economic expansion.

C) underperform during an economic contraction and outperform during an economic expansion.

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Growth stocks are more likely to outperform during a recession as there are few other firms with growth and a premium would be priced into growth stock valuation. During an expansion, many firms are doing well and the valuation premiums for growth stocks may decline.

Gypsy

Which of the following is least likely to be a rationale for investing in small cap stocks?

A) The higher betas for small cap stocks indicate that their future returns should be higher.

B) Smaller firms are more likely to be underpriced than larger cap stocks with greater coverage.

C) Higher returns are more likely when starting from a smaller stock price base.

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Although small-cap stocks may have a higher beta, this is not given as a rationale for investing in them. Both remaining responses indicate the most common rationales for investing in these stocks.

Gypsy

Which of the following is the primary risk of a market-oriented equity investing approach?

A) The tilt to growth is too strong.

B) The tilt to value is too strong.

C) The portfolio must outperform broad market averages or investors will switch to low cost indexing strategies.

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Market-oriented investors have portfolios that resemble a broad market average over time. The risk for a market-oriented manager is that he or she must outperform a broad market index or investors will use lower cost indexing strategies. Although a poor growth at a reasonable price (GARP) model would be a concern for this subset of market-oriented equity investing, it is not the primary risk of market-oriented equity investing.

Gypsy

An investor would like to track an index. Comparing optimization, stratified sampling, and replication; in which of the following indexes would the investor be least likely to use replication?

A) A value-weighted index.

B) An equal-weighted index.

C) A free float-adjusted market capitalization index.

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An equal-weighted index usually has a large representation in small-cap stocks. Replication would involve purchasing all the stocks in the index and this would be less feasible when there are small-cap stocks involved. The reason is that small-cap stocks tend to have lower liquidity and higher trading costs.

Gypsy

An investor would like to track an index. Compared to optimization, stratified sampling:

A) assumes the covariances are zero and leads to higher tracking risk.

B) models the covariances and leads to lower tracking risk.

C) models the covariances and leads to higher tracking risk.

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In a stratified sampling procedure, it is implicitly assumed that the risk factors have a covariance of zero. An optimization approach accounts for the covariances between the risk factors. An optimization approach leads to lower tracking risk than a stratified sampling approach.

Gypsy

An investor would like to track an index. Compared to stratified sampling and optimization, when would replication be favored? When the index has:

A) more than 1,000 stocks and liquid stocks.

B) less than 1,000 stocks and illiquid stocks.

C) less than 1,000 stocks and liquid stocks.

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Full replication is more likely to be used when the number of stocks in the index is less than 1,000 and when the stocks in the index are liquid.