Exam 1 Study Guide
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This 16 page Study Guide was uploaded by Jamie Douglas on Thursday September 22, 2016. The Study Guide belongs to 4365-03 at Baylor University taught by Dr. William Reichenstein in Fall 2016. Since its upload, it has received 92 views. For similar materials see Investment Analysis in Finance at Baylor University.
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Quizlet for Exam 1: https://quizlet.com/_2jf0e1 Topics for Exam 1 Class Review: ● 13 true false (13 problems (one of them has 4 parts; all have multiple parts) total) ● HW for #11 for Taxes WILL BE ON THE EXAM (1 QUESTION with 4 PARTS) ○ State 3 investment implication s of the Markowitz efficient frontier ● Ex. if markets are semi strong efficient than ● Calculating efficient frontier ○ Expected return of each asset class ○ Standard deviation of each asset class ○ Correlation coefficient between each pair of asset classes ● Everyone should want to be on the efficient frontier ○ Be able to state 3 or 4 of Markowetz ● State 3 investment implications ● Return to U.S. investor …. ● Missing Large CAP / Mid CAP/ and Small CAP ● Active and Passive investor 1. Be able to calculate the arithmetic mean return and geometric mean return. AM = [(HPY) + (HPY) + (HPY)] / Years = ____% GM = [(HPR) + (HPR) + (HPR)] / ^ (1/Year) 1 ● The geometric mean is a better measure of longrun return because it indicates the ending wealth. ● Standard deviation is a measure of risk. ● Nominal riskfree rate (NRFR) approximately equals the real risk free rate (RRFR) + expected inflation: NRFR = RRFR + E[inflation]. ● Required return on security i, RR = NRi + B (K NRiR)m where B is the i security's beta, (K m NRFR) is the required rate of return on the market less NRFR and is also called the equity risk premium or market risk premium. ● A change in the asset’s systematic risk (i.e., beta) causes a move along Security Market Line (SML): ○ SML: shows the relationship between risk and return for all risky assets in the capital market at a given time. ● An increase in equity risk premium causes an increase in the slope of the SML. ● An increase in real RFR or expected inflation increases the NRFR and thus causes a parallel upward shift in the SML. 2. Ch 7: Markowitz Portfolio Theory. ● What do we mean by a dominated portfolio? ○ The efficient frontier is the set of dominant portfolio. ○ Assuming numerous assets and a multitude of combination curves, the efficient frontier is the envelope curve that encompasses all of the best combinations. It defines the set of portfolios that has the highest expected return for each given level of risk or the minimum risk for each given level of return. From this set of dominant portfolios, investors select the one that lies at the point of tangency between the efficient frontier and their highest utility curve. Because risk–return utility functions differ, the point of tangency and, therefore, the portfolio choice will differ among investors. ● Standard deviation (SD) of portfolio is seldom the weightedaverage of SD of individual assets. Covariance or correlation of returns between assets must also be considered. ● What does a correlation coefficient r of 1.0 mean? What does r = 1.0 mean? What does r = 0 mean? ( r=0 means you remove the risk ) ○ A value of +1 indicates a perfect positive linear relationship between Ri and Rj, meaning the returns for the two assets move together in a completely linear manner. A value of −1 indicates a perfect negative relationship between the two return indexes, so that when one asset’s rate of return is above its mean, the other asset’s rate of return will be below its mean by a comparable amount. ● A correlation coefficient of 0.5 means that 0.5 or 25% of the variance of one asset’s returns can be explained by the variance of the other asset’s returns. (.25 moving together, other .75 moving) ● Know Exhibit 7.13 p. 197, that is, given two assets and their correlation be able to approximately graph the feasible portfolios. ● What information is needed to calculate the efficient frontier of a set of asset classes? ○ Expected return of each asset class and standard deviation of each asset class and correlation coefficient between each pair of asset classes. ○ Chapter 1 homework #3 ● Capital markets prospects determine the efficient frontier, while the investor’s risk tolerance determines the best point on that frontier. You will not have to calculate a standard deviation of a portfolio. Markowitz says a good portfolio requires more than a collection of quality assets. (if returns are highly correlated they move up and down together) **You also want to combine assets whose returns are not highly correlated. ** ○ Be able to do HW questions and problems. 3. Ch 6, pp. 150152, 171176: Why should financial markets be efficient? ● Security prices adjust rapidly to the infusion of new information…. Security prices fully reflect all available information ● A large number of profitmaximizing participants analyze and value securities ● New information regarding securities comes to the market in a random fashion ● The buy and sell decisions of those profitmaximizing investors cause security prices to adjust rapidly to reflect the effect of new information What information is considered in tests of weak, semistrong and strongform efficient markets hypothesis (EMH)? ● Weakform tests examine the usefulness of ○ a) technical analysis (a.k.a., chartists including 65 day moving averages in WSJ) ○ b) price momentum strategies ( don’t need to explain this for test purposes). ● Semistrong ○ Security prices adjust rapidly to the release of all public information; that is, current security prices fully reflect all public information. ● Strong ○ The strongform EMH contends that stock prices fully reflect all information from public and private sources. This means that no group of investors has monopolistic access to information relevant to the formation of prices. Is technical analysis consistent with weakform EMH? ● No, weakform EHM assumes that current stock prices fully reflect all past security market information, including the historical sequence of prices, rates of return, trading volume data, and other marketgenerated information …. Also implying that past rates of return and other historical market data should have no relationship with future rates of return (pattern of the past shouldn’t be able to determine the future) ● Technical analysis believes that stocks prices move in trends that persist ○ Technicians believe that when new information comes to the market, it is not immediately available to everyone but it typically disseminated from the informed professional to the aggressive investing public and then to the bulk of investors ( can’t use public information to beat the market) ( should be very hard to find under valued securities) ○ EMH indicates that Technical Analysis should be of no value What does EMH say about efficiency of fundamental analysis (172174)? Fundamental analysts believe that, at any time, there is a basic intrinsic value for the aggregate stock market, various industries, or individual securities and that these values depend on underlying economic factors. An investor who can do a superior job of estimating intrinsic value can consistently make superior market timing decisions or acquire undervalued securities and generate aboveaverage returns. Fundamental analysis involves aggregate market analysis, industry analysis, company analysis, and portfolio management. How should you manage a client’s portfolio if you do not have access to superior analysts (or if markets are perfectly efficient), p. 175 hw question on this page ( they give 5 reasons)? 1. Determine and quantify your risk preference 2. Construct the appropriate risk portfolio by dividing the total portfolio between riskfree assets and a risky asset portfolio ( welldiversified portfolio) 3. Maintain the specified risk level by rebalancing when necessary 4. Minimize total transaction costs What is the rationale of index funds and Exchange Traded Funds (ETFs) if investment markets are efficient, p.175176? ● If you lack superior analysts to manage your portfolio than your investments should be measured passively to match the performance of the market ○ This response has increased a demand.. Leading institutions to introduce an Index fund ; which is a security portfolio designed to duplicate the composition, and performance of a selected market index series. Attempt to emulate the bondmarket indexes (Chapter 5) ○ Index and ETFs are less costly in terms of research and commissions, and, they generally provide the same or better performance than the majority of active portfolio managers 4. Ch. 3: Global diversification and other topics. ● Return for a U.S. investor in Japanese stocks is approximately equal to return to Japanese investor+ re urn (appreciation) on the Japanese yen. . ○ (if you are living in japan and you invest you’ll get a negative return. If you are living in the united states and invest in japan stock, you’ll have a positive return. (international stocks are riskier because of the currency volatility) ● Based on Exhibit 3.5 (p. 69), some global (i.e., U.S. and foreign) bond portfolios produced a lower risk than a U.S. bond portfolio despite the larger volatility of foreign bonds. ● Explain how a global bond portfolio can be less risky than a U.S bond portfolio. ○ Investors should create diversified global bond portfolios to reduce the variability of the returns over time. Proper diversifications reduces the variability ( our measure of risk) of the portfolio because alternative investments have different patterns of returns over time. Specifically, when the rates of return on some investments are negative or below average, potentially other investments in the portfolio will be experiencing aboveaverage rates of return. Therefore, if a portfolio is properly diversified, it should provide a more stable rate of return for the total portfolio. ● What is the economic lesson of Exhibit 3.7, p.71? **Global ● To have successful diversification, an investor should combine investments with low positive or negative correlations between rates of return. An analysis of the correlation between rates of return on U.S. and foreign bonds and stocks indicated a consistent pattern of relatively low positive correlations. Therefore, the existence of similar rates of return on foreign securities combined with low correlation coefficients indicates that adding foreign stocks and bonds to a U.S. portfolio will almost certainly reduce the risk of the portfolio and can possibly increase its average return. ● In Exhibit 3.10 on p. 86, what are the approximate correlation coefficients between S&P 500 (apparently mislabeled “Wilshire 5000 S&P Cap Weighted”) and, respectively, most international stock indices, U.S. highgrade bonds, REITs, commodities, and cash? ○ S&P 500, international stock indices: not highly correlated ( know the correlation value) ( for international it’s about .6) ○ S&P 500, U.S. highgrade bonds: highly correlated( know the correlation value) (it’s about .2) ○ S&P 500, REIT, commodities, cash: not highly correlated( know the correlation value) (REITs is about .255, cash is about zero) ● What is an American Depository Receipt (see p. 77)? ○ Two ways to acquire an international equity exposure: ■ 1) are to buy ADRs or invest in an international ■ 2) or global stock fund U.S and international together) stock funds. (He said) ○ These are certificates of ownership issued by a U.S. bank that represent indirect ownership of a certain number of shares of a specific foreign firm on deposit in a bank in the firm’s home country. ADRs are a convenient way to own foreign shares because the investor buys and sells them in U.S. dollars and receives all dividends in U.S. dollars. Therefore, the price and returns reflect both the domestic returns for the stock and the exchange rate effect. ● Global Investment Choices, selective comments: What is the key difference between taxexempt municipal bonds and corporate bonds? ○ Taxexempt status affects the valuation of taxable versus nontaxable bonds. Although you could adjust each present value equation for the tax effects, it is not necessary for our purposes. ● The interest on the muni bonds is tax free at the federal level vs. Corporate bonds interest is taxed at federal level ● What type of assets does each of the following mutual funds invest in: money market, bond, equity, balanced? ○ MM: treasury bills and commercial paper (veryshort term debt) ○ Bond: bonds, ○ Equity: Stocks ○ Balanced: stock and bonds mixed 50/50 (both) ● What is a real estate investment trust or REIT (pronounced reet)? ○ A real estate investment trust (REIT) is an investment fund designed to invest in various real estate properties. It is similar to a stock or bond mutual fund, except that the money provided by the investors is invested in property and buildings rather than in stocks and bonds.(mainly shopping centers and office building, buying investment properties) ( income producing properties) ○ Historically, the correlation coefficient between REIT returns and U.S. stock returns has been about 0.55. ( along the line of correlation coefficient of international stocks) Some investors consider REITs as stocks, while other view REITs as a separate asset class. ○ Be able to do HW questions and problems.?? Which homework 5. Ch 16, p. 580582. Distinguish between strategic asset allocation (SAA) and tactical asset allocation (TAA). ● SAA is the longrun normal portfolio. ● TAA deviate from the asset allocation, ○ Used to determine the longterm policy asset weights in a portfolio ○ Constantmix asset allocation with periodic rebalancing to adjust the portfolio to the specified asset weights ● Someone who believes relative returns cannot be predicted (that is, TAA cannot add value) and has a stable risk tolerance should follow a fixedweight strategy with periodic rebalancing. ● A fixedweight strategy is a contrarian strategy by its nature in that you must sell the better performing asset class(es) and move funds to the poorer performing asset class(es). Already contrarian… selling the better performing asset and moving into the poorer performing asset. ( if bonds are doing well, sell the bonds and move into the worst performing asset, stocks) ( if stocks are moving well and bonds are doing poorly, move into bonds) T/F Question ● TAA; adjusts the asset class mix in the portfolio to take advantage of changing market conditions ○ These adjustments are driven solely by perceived changes in the relative values of the various asset classes; the investor’s risk tolerance and investment constraints are summed to be constant over time ○ TAA is an inherently contrarian method of investing ● In practice, someone following a tactical asset allocation strategy is usually even more contrarian than someone following a fixedweight strategy. ○ For example, TAA usually advocates a higherthannormal stock allocation after a severe bear market like 2008, and lowerthannormal stock allocations after almost six years of strong returns as in December 2014. 6. Book KISS: Ch 1. List four factors that people can control that influence their level of retirement wealth. Savings decisions: 1. The amount you save each year 2. The timing of your savings Investment decisions: 3. The asset allocation decision 4. Investment costs, including taxes on investment returns (expenses including taxes) What are the five steps in the investment management process? 1. Decide what asset classes you with to invest in 2. Select your longrun normal or strategic asset allocation 3. Determine your target asset allocation, which may deviate from the strategic allocation due to current market prospects 4. Select mutual funds. Within each asset class, pick one or more mutual funds 5. Rebalance periodically (page 175 of text shows hw question on this) 7. Book KISS: Ch 2. Lessons in Modern Investment Management. There are two major parts to this chapter, Modern Portfolio Theory and Efficient Markets Theory. MPT (a.k.a., Markowitz’s efficient frontier) presents the riskreturn tradeoff between stocks and bonds for 19872002. The chapter presents eight lessons from this period. State four of them. ● A good portfolio combines assets with returns that do not vary closely together ● Investors should be concerned with overall portfolio risk, and not the risk of specific asset classes when held alone ● There are tremendous diversification benefits to mixing asset classes within a portfolio, especially if their returns do not vary closely together ● A small exposure to a volatile asset class may not increase the risk of the portfolio, especially if its returns do not vary closely with the returns of the other assets Be able to define the efficient frontier in exact terms. ● Efficient Frontier: The set of portfolios that has the maximum rate of return for every given level of risk or the minimum risk for every potential rate of return. Lowest expected return to the highest expected portfolio ** Efficient Markets Theory: Be able to discuss four major investment implications of semistrong form of market efficiency. 1. Securities should be fairly valued 2. It is difficult to add value through security selection 3. No mutual fund should be able to consistently beat its benchmark portfolio 4. In a perfectly efficient market, the ideal U.S. stock portfolio should be a market value weighted index of the entire U.S. stock market 5. If markets were perfectly efficient then investors should follow the fivestep investment management process but, when it comes to security or mutual fund selection, they should buy and hold lowcost index funds. This would allows them to cut out middlemen retail brokers, financial planners, etc. and minimize investment costs. 8. Book KISS: Ch 4 Asset Classes, Investment Styles, and Benchmark Portfolios. What is meant by a mutual fund’s investment style? ● Indicates the types of securities it invests in ● Two ways to determine the investment style 1. Look at the fund’s Morningstar Report 2. Look at the fund’s benchmark portfolio 3. Reread the prospectus What is meant by a fund’s benchmark portfolio? ● Benchmark portfolio: the portfolio whose return it is trying to meet or beat, the benchmark portfolio usually provides a good indication of the fund’s investment style Know what factors are on the two dimensions of Morningstar’s 3x3 equity style box. ● Duration and Quality Know what factors are on the two dimensions of the fixedincome style box. ● Duration is either shortterm, intermediateterm, or longterm ○ It measures the bond fund’s price sensitivity to changes in interest rates ● Quality is based on average bond rating and reflects default or credit risk as assessed by Moody’s: Highgrade (Aaa) Mediumgrade ( A or Baa) Lowgrade (below Bbb) … also called junk bonds or highyield bonds, have higher yields to reflect their higher credit risk Know the breadth of holdings and styles of the major US stock indexes including S&P 500, Dow Jones Wilshire 4500 and 5000, and Russell 1000, Russell 2000, and Russell 3000 indexes (e.g., Figs 4.3 through 4.5). be able to explain these. He could ask: Give me a measure of the total U.S stock market: Russell 3000 and Dow Jones wilshire 5000 *Wilshire 4500 is everything but the S&P 500* S&P 500 large cap and some midcap Russell 1000 large cap and midcap Russell 3000 large, mid and smallcap Russell 2000 small cap According to the author, what are the four major broad asset classes? 1. Stocks or equities (U.S and International) 2. Fixed Income or bonds (U.S and International) 3. Money market or cash equivalents 4. Real estate or other tangible assets Does the chapter recommend international stock diversification for all investors from students through their grandmothers? ● Yes, Incorporating international stocks can be beneficial in someone’s portfolio however the percentage of international stocks you own will decrease as you get older (decrease risk because you won’t have enough time or money to recover any potential losses) ● For someone our age, should have about 3040% in international stocks ● For someone near retirement age, should have about 3040% even though their stock allocation is roughly 55% ● For someone around age 80, stock allocation is 2530%, should have about 3040% in international ( that would be around 10 international and 10 U.S) 9. Book KISS: Ch 6 Risk Tolerance. When we ask if someone is ready for retirement we consider her financial assets and others sources of retirement income that may include Social Security, company definedbenefit pensions, immediate annuities, and rental income among other things. That is, we consider the person’s extended portfolio. Someone’s appropriate asset allocation can depend upon these nonfinancial sources of cash flow in her extended portfolio. According to the author, would each of the following increase or decrease the recommended stock allocation of an individual’s financial portfolio? ● Job security Affects risk capacity since it means that the investment horizon may be shorter than planned (decrease) ● Availability of retirement income from company definedbenefit plans or immediate fixed Annuity (a.k.a., payout annuity) fixed payout annuity is like a bod in the investor’s extended portfolio. Everything else the same, someone who has a fixed annuity “bond” which is held outside the financial portfolio, has a larger risk capacity in the financial portfolio ● Liabilities including financing parents’ retirement and children’s education decrease, planned investment horizon is shortened What is human capital? ● Human capital is a measure of the economic value of an employee's skill set. This measure builds on the basic production input of labor measure where all labor is thought to be equal. ● Human capital is future wages Explain why the human capital literature suggests that a recent college graduate with bondlike human capital should invest 100% of her financial portfolio in stocks. ○ The safer the human capital , the more the financial portfolio should be invested in stocks ○ The more flexible the individual’s labor supply, the more the financial portfolio should be invested in stocks ○ Managing both human capital and financial capital; Financial capital all in stock, Human capital is all in bonds, as future wages Know the key implications of human capital literature. ● When humancapital is bondlike, young investors should invest more in stocks than older investors ● Everything else the same, at every age the safer the human capital, the more of the financial portfolio that should be invested in stocks; and ● The more flexible the individual’s labor supply (i.e. the more the individual is willing and able to substitute labor for leisure) the larger should be the allocation to stocks Distinguish between risk attitude and risk capacity. ● Risk attitude: willingness to bear risk ● Risk capacity: ability to bear With an immediate fixed annuity, a 70yearold retiree may exchange $100,000 for $800 a month for the rest of her life with payments stopping at her death. It is designed to reduce longevity risk, that is, the risk of outliving her resources. Know the difference between a definedbenefit plan and a definedcontribution plan, and who bears the investment risk in each plan. ● Definedbenefit plan ○ provides a specific payment amount by employer ○ Employer bear risk? ● Definedcontribution plan ○ funded by employee to invest in a retirement plan, employer contribute certain amount ○ Employee bear risk? 10. Target Date (a.k.a., Life Cycle) Funds material and HW: This material presents the recommended asset allocations by age at three families of mutual funds. State four investment implications that are imbedded in these model portfolios. That is, state four areas of broad agreement about the appropriate asset allocations at various ages, how the asset allocation should vary through time, etc. ● 90 percent socks, 3040 international, 50/55 stocks, internatinal 3040, ● Possible test questions: what’s wrong with this couple's investment portfolio ● Four investment implications ○ As age increases, stock allocation decreases ○ Consist of four broad asset classes ■ U.S. Stocks/ bonds ■ International stocks/bonds ○ Investors practices fixedweight strategy with periodic rebalancing ○ U.S. stock well deversified ■ value/ growth ■ small/ large ● Explain why target date funds are a better default option than a money market fund for individuals entering a company definedcontribution pension plan such as a 401(k). ○ Target date funds automatically reset the asset mix of stocks, bonds and cash equivalents in its portfolio according to a selected time frame that is appropriate for a particular investor ■ This is set to address key dates in the future (ie. retirement) ■ Allows investors to select a single fund to help them reach their retirement goals ■ Fund managers then rebalance the fund’s assets each year and keep its investments on track ○ Money market funds are generally short term (less than one year securities) investments that create a low risklow return ○ Used by investors as a “safe place” to easily invest accessible, cashequivalent assets” ● What is the approximate stockbond asset allocation for, respectively, a 23 yearold student, a new mid60s retiree, and an 80yearold grandmother? ○ 23 year: 90% stock (30 international) /10 bond ○ 60 year: 60% stock 40 bond ○ 80 year (most conservative): 30% stock(510%international stocks) 70 bond 11. Book KISS: Ch 12. Basics of Taxes and Investments. Savings Vehicles 1. First amount of savings should go to the 401(k) with matching contributions 2. The 2nd and 3rd choice between contributions to the nonmatched portion of the 401(k) or the Roth IRA depends upon the relationship between her tax rate before retirement, t, and the expected tax rate during retirement a. ** if the tax rate during retirement is expected to be below the tax rate before retirement, the nonmatched 401(k) should be her second choice of savings vehicle and the Roth IRA should be her third choice b. **if the tax rate in retirement is expected to be equal to or higher than the tax rate before retirement, the Roth IRA should be the second choice and the 401(k) should be the third 3. The fourth choice is between a taxable account and nonqualified taxdeferred annuity Know and be able to apply the ending wealth models for investments in taxable account, nonqualified taxdeferred annuity, Roth IRA, and 401(k) or any other tax deferred retirement account. ● Nonqualified taxdeferred annuity: investment of after tax funds, the returns grow tax deferred until withdrawn, and the deferred returns are taxed at withdrawal at the ordinary income tax rate ○ Nonqualified means the investment amount does not qualify as a deduction from that year’s taxable income ● Roth IRA: invests aftertax funds and the returns grow taxexempt (as long as the withdrawal occurs after she is at least 59 ½ and the Roth IRA has been in existence for at least five years ● Qualified retirement accounts: the original investment is made pre tax funds (that is, the original investment reduces taxable income), the funds grow taxdeferred, and withdrawals are taxable at ordinary income tax rates ● ** aftertax ending wealth values are the same as for the tax exempt Roth IRA Know the ending wealth models for four stock management styles when stocks are held in a taxable account. ● The stock management styles are those of a day trader, active investor, passive investor, and exempt investor. The article discusses two ways that the exempt investor can avoid ever paying capital gain taxes on an appreciated asset held in a taxable account. Step up in basis (market value) Book Kiss Chapter (Saving Vehicle Cpt 12 pg 19) State one of them. Be able to explain why, for someone in the 25% tax bracket, the appropriate comparison is between an initial investment of $4,000 in a 401(k) or $3,000 in any other savings vehicle. Be able to explain why the effective tax rate is zero for savings in a 401(k) when the tax rates in the contribution year and withdrawal year are the same. The 401(k) and Roth accounts are the two best savings vehicles when saving for retirement. You do not need to know contribution limits or anything about income tests. Given a marginal tax rate, select between a taxexempt municipal bond and a taxable bond, where the bonds are similar in all respects except taxation of interest. 12. “Two Key Concepts for Risk Management and Beyond” by Reichenstein, Horan, and Jennings. ● One key concept: A taxdeferred account (e.g., 401(k)) is like a partnership where the government owns t of tn partnership, where t is thn expected tax rate during retirement. Thus $1 of pretax funds in a 401(k) is like (1t n dollar of aftertax funds in a taxexempt Roth account because they both buy the same amount of goods and services in retirement. ● Given information as in Slide 8, be able to calculate an aftertax asset allocation. In particular, the aftertax value of each $1 in a 401(k) is (1tn . cording to the aftertax approach of calculating an asset allocation, the traditional approach tends to exaggerate the portfolio’s allocation to the dominant asset class in 401(k) and similar taxdeferred accounts. ● Given marginal tax rates this year and in retirement, be able to state whether you should save in a 401(k) or Roth 401(k). Ppt 15 ○ Roth pay tax, after tax. 401 save ○ This year tax rate and next year ○ If you expect a lower marginal tax rate in retirement then save in the TDA (401K), and vice versa ○ If you expect a lower marginal tax rate today and in retirement then there may be a slight preference for the Roth ■ Why? ● Tax diversification ● 17,500 saving in a roth is larger than 17,500 saving in a TDA(401K) ● Roth distributions do not affect taxation of Social Security or Medicare Part B premiums ● Given marginal tax rates this year and in retirement, be able to state whether a Roth conversion makes sense. Know what is meant by the term asset location? Ppt 16. ● Where do you locate assets? Most people have a 401K and a taxable account, asset location decision is the amount you decide to hold in each. ○ Roth conversion makes sense when the investor has a lower marginal tax rate today than in retirement. ○ Know calculations? 13. Hedge funds: pp 910914, and Reichenstein article. ( 36 points on hedge funds) What are some of the biases in reported average returns on hedge funds? State one of the biases and give a brief description of it: ● Survivorship bias a poor performing hedge fund is not reported making the returns earned by investors inaccurate … reports are exaggerated to only include those that performed well ( drops historic returns of the poor performing ones so you are only looking at returns on the high performing ones) we aren’t giving a right average, we are getting a biased sample. ● Nonreporting bias ● Questionablenumber bias ● Instanthistory bias A manager may begin several hedge funds, each one based on a different strategy with a small amount of the seed money in each. After a couple of years, the successful strategies will go public and their historical records are made public. The records of the unsuccessful strategies are not made public… the historical returns earned by the successful strategies are not returns earned by typical investors Know why Reichenstein thinks hedge funds tend to mess up the asset allocation decision? (2 reasons listed below) ● Cause investors to lose control of their asset allocation ( 3 examples: longshort market neutral) ● A typical hedge fund has a 2% annual expense ratio and takes 20% of profits as part of its expense arrangement. For each of the following, should an investment in the hedgefund strategy be considered cash, bonds, or stocks? a) Longshort market neutral Cash ( expected return is the riskfree rate; basically left with cash) b) longshort with futures overlay Stock
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