CISI IAD Advanced Investment Analysis — Questions and Answers
Question 1: What is the 'Sharpe ratio' and what does it measure?
- The ratio of a portfolio's gross return to its benchmark return
- A measure of risk-adjusted return calculated by dividing the portfolio's excess return (above the risk-free rate) by its standard deviation (Correct answer)
- The ratio of a fund's annual management charge to its alpha generation
- The ratio of a portfolio's equity allocation to its bond allocation
Correct answer: A measure of risk-adjusted return calculated by dividing the portfolio's excess return (above the risk-free rate) by its standard deviation
The Sharpe ratio measures how much excess return (above the risk-free rate) an investment generates per unit of total risk (standard deviation). A higher Sharpe ratio indicates better risk-adjusted performance — more return for each unit of risk taken.
Question 2: What is 'alpha' in the context of investment performance?
- The risk premium earned by holding equities over bonds
- The excess return of a portfolio above its benchmark, adjusted for risk, indicating the value added (or destroyed) by active management (Correct answer)
- The sensitivity of a portfolio to market movements
- The annual return on the risk-free rate
Correct answer: The excess return of a portfolio above its benchmark, adjusted for risk, indicating the value added (or destroyed) by active management
Alpha measures the excess return of a portfolio relative to its expected return given its level of market risk (beta). Positive alpha indicates the manager has added value beyond what market exposure alone would explain; negative alpha indicates underperformance.
Question 3: What is the 'information ratio' used to assess in investment management?
- The ratio of a manager's communication quality to their return
- The consistency and magnitude of a manager's outperformance relative to a benchmark, calculated as active return divided by tracking error (Correct answer)
- The ratio of a fund's information technology costs to its AUM
- The ratio of fundamental analysis to technical analysis in a manager's process
Correct answer: The consistency and magnitude of a manager's outperformance relative to a benchmark, calculated as active return divided by tracking error
The information ratio measures the active return (portfolio return minus benchmark return) divided by tracking error (standard deviation of active returns). A higher information ratio indicates more consistent outperformance relative to the risk taken in deviating from the benchmark.
Question 4: What is 'tracking error' in portfolio management?
- The number of administrative errors made in portfolio rebalancing
- The standard deviation of the difference between a portfolio's returns and its benchmark returns, measuring how closely the portfolio follows the benchmark (Correct answer)
- The percentage of orders that fail to execute at the intended price
- The cost of rebalancing a portfolio to its target weights
Correct answer: The standard deviation of the difference between a portfolio's returns and its benchmark returns, measuring how closely the portfolio follows the benchmark
Tracking error measures the volatility of the difference between the portfolio's returns and the benchmark's returns. Low tracking error (e.g., in index funds) means the portfolio closely mirrors the benchmark; high tracking error indicates significant deviation from the benchmark.
Question 5: What is 'fundamental analysis' in the context of equity valuation?
- The analysis of historical share price patterns to predict future prices
- The analysis of a company's financial statements, business model, competitive position, and economic factors to determine its intrinsic value (Correct answer)
- The analysis of trading volumes and momentum indicators
- The analysis of a company's technical infrastructure and systems
Correct answer: The analysis of a company's financial statements, business model, competitive position, and economic factors to determine its intrinsic value
Fundamental analysis examines a company's financial statements (income statement, balance sheet, cash flow), management quality, competitive advantages, and macroeconomic factors to estimate the intrinsic value of its shares and determine whether they are over- or undervalued.
Question 6: What is the 'dividend discount model' (DDM)?
- A model for calculating the fair value of a bond based on its coupon payments
- A model that values a share by discounting all expected future dividends back to their present value (Correct answer)
- A model that assesses dividend sustainability by comparing payout ratio to earnings
- A model that identifies which shares are likely to increase their dividend in the next year
Correct answer: A model that values a share by discounting all expected future dividends back to their present value
The DDM values a company's shares by summing the present value of all expected future dividend payments, discounted at the required rate of return. In its simplest form (Gordon Growth Model), value = D1 / (r - g), where D1 is next year's dividend, r is the required return, and g is the constant growth rate.
CISI IAD Advanced Investment Analysis
What is the 'Sharpe ratio' and what does it measure?