Portfolio Management Flashcards

According to Modern Portfolio Theory (MPT), what is the primary benefit of diversification?

Answer: It reduces unsystematic (specific) risk without necessarily reducing expected return

MPT demonstrates that by combining assets with less than perfect positive correlation, investors can reduce unsystematic (company-specific) risk. Systematic (market) risk cannot be diversified away. The efficient frontier shows optimal risk-return combinations achievable through diversification.

The Capital Asset Pricing Model (CAPM) is expressed as E(Ri) = Rf + βi(E(Rm) - Rf). What does the term βi represent?

Answer: The sensitivity of the asset's return to movements in the overall market

Beta (β) measures the systematic risk of an asset relative to the market. A beta of 1 means the asset moves in line with the market; greater than 1 indicates higher sensitivity to market movements; less than 1 indicates lower sensitivity. Beta only captures systematic risk.

An investor with a 'balanced' risk profile would most likely hold which of the following asset allocations?

Answer: A mix of equities, bonds, property and some cash

A balanced investor typically accepts moderate risk for moderate return potential. The appropriate allocation includes a diversified mix across asset classes — equities for growth, bonds for income and stability, property for diversification, and cash for liquidity. The exact proportions depend on individual circumstances.

What is 'rebalancing' in the context of portfolio management?

Answer: Adjusting portfolio holdings to restore the original target asset allocation

Rebalancing involves buying and selling assets to bring the portfolio back to its target allocation after market movements have caused drift. For example, if equities have outperformed and now represent 70% of a portfolio with a 60% target, the manager would sell equities and buy other assets to restore the 60/40 split.

Which performance measure adjusts returns for total risk using standard deviation?

Answer: The Sharpe ratio

The Sharpe ratio = (Portfolio Return - Risk-Free Rate) / Standard Deviation of Portfolio. It measures risk-adjusted return using total risk (standard deviation) rather than just systematic risk. A higher Sharpe ratio indicates better return per unit of total risk taken.

What is the key advantage of a passive (index-tracking) investment strategy compared to active management?

Answer: It typically has lower management fees and transaction costs

Passive strategies aim to replicate the performance of a benchmark index rather than beat it. Because they require less research and less frequent trading, they typically charge lower management fees and incur fewer transaction costs. However, they will also capture the full downside of market falls.