FP2 Chapter 5

Modern Portfolio Theory

 assess the market as a whole rather than analyzing individual investments

Modern Portfolio Theory Assumptions

Risk Aversion	Investors prefer the less risky of two investments with the same returns, or prefer the investment with the greater return with the same level of risk
Time Horizon	Investors will hold investments for the same period
Expected Returns	Investors have the same expectations of fluctuations in returns
Borrowing Rate	Investors are able to invest and borrow at the risk-free rate
Perfect Market	Information is freely available and insider information is already priced into the market

Capital Asset Pricing Model (CAPM)

used to estimate risk and determine the optimal price of an asset based on its risk

Risk-Return Relationship

inversely related

Components of Risk

Systematic Risk

Unsystematic Risk

systematic risk

Risk explained by market and economic conditions and is uncontrollable

unsystematic risk

Risk that is unique to each asset and is not explained by market conditions

examples of systematic risk

• Interest rates

• Inflation

• Market cycles

examples of unsystematic risk

• Bankruptcy

• Employee strikes

• Corporate issues

Portfolio creation attempts to eliminate….

unsystematic risk

Alpha

a measure of unsystematic risk that indicates excess return/loss

Alpha formula

Alpha = Actual Rate of Return - Expected Rate of Return

Beta

a measure of systematic risk

Beta for the optimal risky portfolio

1.00

Security Market Line

shows the linear relationship between risk and return

Expected rate of return formula

Expected Rate of Return = E(RP) = Rf + Beta(Rm - Rf)

Rf = Risk-Free Rate

Rm = Market Rate of Return

Limitations of Risk-Adjusted Performance

Beta may have changed over a measurement period	The measurement period may be too short
All securities may not be invested in the market or free to invest	A particular index may not be suitable as a benchmark
The source of the beta formula may be disputable

Modern Portfolio Theory Criticisms

The S&P/TSX does not represent the entire stock market and is not a perfect tool to measure performance	Different measurement techniques result in different beta values
Betas fluctuate over time	Betas are only available to large-cap stocks

How to reduce systematic risk

Creating a portfolio by assessing betas

How to reduce unsystematic risk

diversify

Portfolio beta formula

The sum for each stock: (Stock Beta * Portfolio Stock Share)

Risk-Adjustment Decisions

1. Add holdings with expected positive alphas

2. Reduce beta

When should you increase beta in a portfolio?

If the market is expected to rise

When should you reduce beta in a portfolio?

If the market is expected to fall

Asset Allocation

he principle that a mix of assets will produce the best solution to meet long-term financial planning goals

Investment Policy Statement (IPS)

describes the strategies the advisor will take to accomplish the client’s objectives

IPS answers the following 5 questions:

Does the IPS meet the needs and objectives of the client?	Does the IPS use simple language and can be understood?
Would the client have remained committed during historical market conditions?	Would the IPS have met the client’s objectives under past market conditions?
Would the advisor have remained committed during historical market conditions?	(Must answer yes to each)

Sources of Investment Returns

Asset Allocation	Market Timing
Securities Selection	Chance

How much does asset allocation account for in return?

80-90%

Asset Allocation Strategies

• Short-term assets should be liquid and have low volatility

• Allocation of assets other than short-term should be based on long-term risk/return

• Real estate can be used to hedge against inflation and should only be added to an investment portfolio on lifestyle considerations

Strategic Asset Allocation

establishing the long-term benchmark asset mix of various asset classes

Strategic asset allocation goal

to design an optimal portfolio in which the expected return is maximized given a level of risk or minimizing risk given an expected return

Tactical Asset Allocation

an active management strategy used to add value by temporarily departing from the portfolio’s long-term asset mix

tactical asset allocation goal

to respond to changing patterns in the market to take advantage of inefficiencies in the prices of securities/sectors

Which asset allocation strategy assumes risk is constant?

tactical

Which asset allocation strategy assumes risk changes?

startegic

Efficient Market Hypothesis

all available information is incorporated into a stock’s price and as the market digests new information, prices change accordingly

Forms of the Efficient Market Hypothesis

Weak

Semi-Strong

Strong

Weak Efficient Market Hypothesis

The stock’s past prices have no relation to its current price - stock prices are random

Semi-strong efficient market hypothesis

All publicly available information is already incorporated into a stock’s price. Only private information is useful

strong efficient market hypothesis

Stock prices reflect all public and private information

Fundamental Analysis

measures the value of a stock by examining conditions (interest rates, industry conditions, etc.)  that may affect it

technical analysis

analyzes historical market activity and investor behaviour to determine future price trends

Active Investment Strategy

uses expectations around securities and the environment to take advantage of the inefficiencies resulting from the expectations

goal of the active investment strategy

to outperform the benchmark

Passive Investment Strategy

no portfolio changes when market expectations change

Diversification Strategies

By industry	By geography
By management style (active vs passive)	By security (equity vs fixed income)

Advantages of Owning Real Estate

Forced to save for mortgage payments

Owning property

Hedges against inflation

Sale of principal residence means no tax on the capital gain

Disadvantages of Owning Real Estate

Mortgage payments, insurance, property tax, maintenance

Illiquid investment, not easily accessible

Vulnerable to rising interest rates

Little diversification if property takes up a large share of the portfolio

Disadvantages of Collectibles as Investments

Estate planning complications

Storage, upkeep and insurance costs

Difficult to convert to cash

Jensen Index

compares the actual return to the expected return using the Security Market Line formula (Quantifies the amount of amount of added value (alpha))

Jensen index formula

Jp = Rp-( Rf + Beta(Rm - Rf))

Treynor index

the slope of the security market line is used to measure performance

treynor index formula

Tp=(Rp - Rf)/Beta

Sharpe Index

performance is measured using standard deviation rather than beta

sharpe index formula

Sp=(Rp - Rf)/Standard deviation

Holding Period Rate of Return formula

(Price at time 1 - Price at time 0 + Dividends)/Price at time 0

Dollar-Weighted Return

measures performance taking into account the timing of cash flows

How to calculate Dollar-Weighted Return:

• Calculate the present values of all cash flows

• Set the PV of cash inflows to the PV of cash outflows and solve for the rate of return

Time-Weighted Return

measures performance without the regard of timing

How to calculate the time-weighted return:

• calculate the holding period rate of return for each period then calculate the average

Arithmetic mean ROR

Calculate the rate of return for each year and calculate the average (normal average formula)

Geometric Mean Rate of Return

1. Add the return for each year by 1

2. Multiply the results (1.11 * 1.05 * 1.054 for example)

3. Take the nth root (If there are two years, square root for example)

4. Subtract 1