NISM Series XXI-B Portfolio Managers Cert. Mock Test -3

As the KYC of Mr. SUMIT has been done, the PMS cannot ask for any more documents

Fusion Investing integrates traditional and behavioral paradigms to create investment strategies. It attempts to combine fundamental analysis with behavioral finance. On one hand, the fundamental style of investing suggests that stock price is the discounted value of future cash flows.

Further, all the company-related information is fully reflected in the stock price. on the other hand, we observe volatile stock prices in the short-term, which shows that short-term price is influenced by the collective behavior of investors or traders.

Fusion investing, therefore, combines the value-growth phenomenon from fundamental investing and the momentum effect from behavioral finance. (Cognitive errors are statistical, information-processing or memory errors that cause a person to deviate from rational behavior.)

The securities market line (SML) is the graphical form of the Capital asset pricing model (CAPM). SML graphically depicts the relationship between risk and estimated rate of return. In equilibrium, all assets and all portfolios of assets should be ploted on the SML. The expected rate of return of the security too can be plotted, and undervalued/overvalued/fairly valued security can be identified. Any security with an estimated return that plots above the SML is undervalued. Any security with an estimated return that plots below the SML is over-valued.

In a Callable bond, the issuer ie. who has issued the secutities/bonds has the right to prepay the bond on specified dates before maturity. This generally happens when interest rates fall in the economy. The issuer will repay the money to investors and then can issue new bonds at a lower interest rate and thus save on interest costs.

Listed equity pose LESS complications in rebalancing as there is high liquidity of the same in secondary markets plus efficient price discovery

Stocks in the eligible universe must satisfy the following eligibility factors in order to be considered for index (BSE Sensex) inclusion

-The index is derived from the constituents of the S&P BSE 100.

-The stock must have traded on every trading day at BSE during the six month reference period

-The number of companies in the index remains fixed at 30

-Multiple Share Classes.

DVRs satisfying the above eligibility criteria are aggregated with the company’s common stock and index construction is done based on the aggregated company data. (This means only one of the various classes of shares of a company is selected)

SEBI (Portfolio Managers) Regulation 2020 requires that the disclosure document is to be given to the prospective client along with the account opening form prior to signing the agreement.

In the Random Walk Theory – Weak-form of efficiency assumes that current stock prices fully reflect all historical information such as historical sequence of prices, rates of return, trading volume data etc. This implies that the current prices are completely independent of the past prices. Hence under the weak form of efficiency the investors would gain little from technical analysis and studying the past prices to predict future prices.

Multi Factor Models are helpful not only in portfolio creation, but also helps in: • Attribution analysis of the portfolio , • Risk analysis of the portfolios, and • Decision making while launching new products. Multi-factor models perform granular risk and return attribution on actively managed portfolios.

As per SEBI rules and code of conduct for Portfolio Managers –

The portfolio manager shall not derive any direct or indirect benefit out of client’s funds or securities.

The money or securities accepted by the portfolio manager shall not be invested or managed by the portfolio manager except in terms of the agreement between the portfolio manager and the client.

The portfolio manager shall not deploy the clients’ funds in bill discounting, badla financing or for the purpose of lending or placement with corporate or non-corporate bodies.

The money received by a portfolio manager from a client for an investment purpose should be deployed by the portfolio manager as soon as possible for that purpose and money due and payable to a client should be paid forthwith.

A Group of individuals coming together with a common purpose is called the Association of Persons and it is eligible to invest in a PMS. No minimum contract period with respect to PMS has been stated in the SEBI guidelines.

There are two types of cost associated with rebalancing of a portfolio – transaction cost and tax cost. Transaction costs are  the time and money costs like research cost, brokerage etc., for buying and selling securities.

While rebalancing, the portfolio managers may sell the appreciated assets and buy the depreciated asset with a view to restoring  the desired asset mix. the Sale of an appreciated asset attracts tax liabilities and hence it is a cost of rebalancing the portfolio.

Loss due to misalignment of allocation is not a rebalancing cost.

The strong-form Efficient Market Hypothesis states that prices reflect not just historical and current publicly available information, but insider information, too. This is not always possible as in well regulated markets inside information is generally not available and used. Also strong laws prohibit trading based on inside information.

Operational risk is the risk of potential losses due to inadequate or failed policies, processes, systems and people. Employee errors, criminal activity such as fraud, and physical events are among the factors that can trigger operational risk in companies. This risk can be reduced by diversifying across numerous companies and industries.

As per SEBI rules – The portfolio manager shall furnish periodically a report to the client, and such report shall contain the following details, namely :

– Details of risk foreseen by the portfolio manager and the risk relating to the securities recommended by the portfolio manager for investment or disinvestment; (f) default in payment of coupons or any other default in payments in the underlying debt security and downgrading to default rating by the rating agencies, if any

– Details of commission paid to distributor(s) for the particular client

– Beneficial interest received during that period in the form of interest, dividend, bonus shares, rights shares, etc

Any macro-economic forecast should include estimates of all of the important economic numbers, including gross domestic product, inflation rates, interest rates, unemployment etc.

Framing Bias is an information-processing bias in which a person answers a question differently based on the way in which it is asked (framed).

An investor’s choices will be influenced by how information or facts are presented. Different types of framing approaches have been identified, including risky choice framing (e.g. the risk of losing 10 out of 100 lives vs the opportunity to save 90 out of 100 lives), and attribute framing (e.g. product that is 0% fat vs 100% fat free). As can be seen, the outcomes of both the choices in both the scenarios are the same, however people mostly opted for second options in both the scenarios.

Most investors have limited (i) time and/or (ii) information and/or (iii) ability to comprehend complex information at the time of decision making. Similarly, when selecting one of the many options that requirs meticulous analysis incorporating all the available information, people get confused. They settle with an option (possibly sub-optimal), which seems to be satisfactory and sufficient based on quick analysis governed by ‘thumb rules’. In other words, instead of optimizing as suggested by theories in finance, investors “satisfice” (seemingly satisfactory and sufficient).

Depending on ‘thumb rules’ instead of doing exact calculations, is an example of cognitive bias. People are less likely to make cognitive errors if they remain vigilant. Unlike emotional bias, cognitive biases can be considered as a short-cut approach to decision making where one avoids going through the pains of analyzing and evaluating options. And at times, can be factually incorrect.

If regular income is the investment objective, funds will be invested in asset classes generating periodical income like dividend paying stocks, interest paying bond or/and rent paying realty. (Commercial paper is a short-term debt instrument issued by companies to raise funds generally for a time period of up to one year)

Overconfidence Bias is a bias in which people demonstrate unwarranted larger faith in their own intuitive reasoning, judgments and cognitive abilities. People confuse their brains with bull markets and believe that they have superior investment knowledge. Even the feedback loop in such cases further fuel the overconfidence bias and investor easily gets swayed from risk-return trade off principles. Some of the observed behaviour of overconfidence bias are visible in portfolio concentration, sector or country bias, excessive trading, sticking with loss making stocks in sectors which investor believes to know more etc.

Schedule C of the SEBI (Prohibition of Insider Trading) Regulations specifies the minimum standards for the code of conduct for intermediaries and fiduciaries to regulate, monitor and report trading by Designated Persons. It mentions that – All designated persons shall be required to disclose their name and Permanent Account Number or any other identifier authorized by law of the following to the intermediary or fiduciary on an annual basis and as and when the information changes:

a) immediate relatives

b) persons with whom such designated person(s) shares a material financial relationship

c) Phone, mobile, and cell numbers which are used by them In addition, names of educational institutions from which designated persons have graduated and names of their past employers shall also be disclosed on a one time basis. (Saving Bank account number is not mentioned to be disclosed.)

Bond management strategy can be active or passive. In Passive strategies like Buy and Hold, the investor buys and holds the investment till maturity. In an Active Bond Management strategy, a portfolio manager takes a view on future possibilities in terms of either interest rate movement (depending on monetary policies of RBI)  yield spreads or credit quality (depends on the profitability of the company for corporate bonds) and accordingly adjusts the portfolio whenever it is appropriate. Here, the portfolio manager does not accept the status quo as given and proactively takes steps to maximize returns based on her assessment of future direction.

A portfolio manager shall disclose to SEBI as and when required the following information namely:

(i) particulars regarding the management of a portfolio;

(ii) any change in the information or particulars previously furnished, which have a bearing on the certificate granted to him;

(iii) the names of the clients whose portfolio he has managed; (iv) particulars relating to the net worth requirement.

Constant mix strategy is basically a rebalancing process. It is a “do something” strategy. Once the strategic asset allocation is decided, periodic trading will take place to reset the asset mix to avoid any drift. The benefit of a constant mix strategy is that it helps in maintaining market risk exposures.

Lets assume the probability of Recession as ‘x’. The probability of a Boom is 2 times of a Recession, so it will be 2x.

The total probability is always 100%. Out of this, the probability of a Normal scenario is 70%

Therefore 70 + x + 2x = 100

x + 2x = 100 – 70

3x = 30 x = 30/3 = 10

Therefore the probability of Recession is 10

Probability of Boom is 2x = 10 x 2 = 20

Thus the probability of a Boom is 20% and a Recession is 10%

Beta of Security P = Covariance of Market Return and Security Return/Variance of Market Return = 12 / 7 = 1.71

Therefore Beta of P = 1.71

Beta of Q is given as 0.6

Now since, both securities in the portfolio have an equal weight: Beta of Portfolio = (1.71 + 0.65) / 2 = 1.18

Index Divisor is an arbitrary number chosen at inception. It is initially chosen in such a way that the index has a convenient initial value, such as 100 or 1,000. The index provider adjusts the value of the divisor as and when necessary to avoid changes in the index value that are unrelated to changes in the prices of its constituent securities.

If the objective is Inflation Risk Mitigation, the Floating Interest Rate Benchmark is the relevant benchmark.

The Securities market line (SML) is the graphical form of the Capital asset pricing model (CAPM). SML graphically depicts the relationship between risk and estimated rate of return. In equilibrium, all assets and all portfolios of assets should be ploted on the SML. The expected rate of return of the security too can be plotted, and undervalued/overvalued/fairly valued security can be identified. Any security with an estimated return that plots above the SML is undervalued. Any security with an estimated return that plots below the SML is over-valued.

The agreement between the portfolio manager and the client includes the ‘investment approach’. An investment approach is a broad outlay of the type of securities and permissible instruments to be invested in by the portfolio manager for the customer.

The agreement also includes the areas of investment and restrictions, if any, imposed by the client with regard to the investment in a particular company or industry. Thus, the universe of securities for the purpose of investments is well defined in the agreement.

Investing in floaters provides protection from large movement of interest rates. A floater bond’s coupon is reset on periodic intervals as and when the underlying index is reset (for example the floater bond’s coupon is linked to the quarterly GDP growth rate or quarterly wholesale inflation index etc.) Therefore, the maximum duration of a floater bond at any given point in time is only the remaining time when the underlying index is reset, even though the maturity of the floater bond may be much longer.

Buy and hold is a passive strategy of deciding the strategic asset allocation mix and then going with the flow i.e. doing nothing about it subsequently. With this do nothing strategy the asset mix drifts significantly over a period of time from what was originally decided. In this kind of strategy, some investment is made in safe assets to provide a floor value as the investments made in safe assets do not fluctuate much. The amount invested in the risky assets is to provide the appreciation. The portfolio value becomes a function of the performance of risky assets and there would be no limit on the upside potential of the portfolio.

Stocks in the eligible universe must satisfy the following eligibility factors in order to be considered for index (BSE Sensex) inclusion

-The index is derived from the constituents of the S&P BSE 100.

-The stock must have traded on every trading day at BSE during the six month reference period

-The number of companies in the index remains fixed at 30

-Multiple Share Classes. DVRs satisfying the above eligibility criteria are aggregated with the company’s common stock and index construction is done based on the aggregated company data.

(This means only one of the various classes of a shares of a company is selected)

In India, the Central Government issues both, treasury bills and bonds or dated securities. Certificate of deposits are issued by Banks and Financial institutions.

Relative valuation is conducted by identifying comparable firms and then obtaining market values of equity of these firms. These values are then converted into standardized values which are in the form of multiples, with respect to any chosen metric of the company’s financials, such as earnings, cash flow, book values or sales. These multiples are then applied to the respective financials of the target company for valuation. Based on the value arrived and the market price of the equity shares of the company it is decided whether it is over-valued or under-valued.

The Development of an Investment Policy Statement (IPS) is the key step in the process of portfolio management. IPS is the road map that guides the investment process. All investment decisions are based on IPS considering investors’ goals and objectives, risk appetite, etc.

When a Portfolio manager’s investment strategy is based on the continuation of an ongoing market trend, it is referred to as Momentum Investing. Portfolio managers aim at taking a long position in a rising trend, and a short position in a declining trend.

The agreement between the portfolio manager and the client includes the investment approach. An investment approach is a broad outlay of the type of securities and permissible instruments to be invested in by the portfolio manager for the customer, taking into account factors specific to clients and securities. The agreement also includes the areas of investment and restrictions, if any, imposed by the client with regard to the investment in a particular company or industry. Thus, the universe of securities for the purpose of investments is well defined in the agreement.

A Government Security (G-Sec) is a tradeable instrument issued by the Central Government or the State Governments. G-Secs carry practically no risk of default as they are backed by the Government of the land and hence, are called risk-free gilt-edged instruments.

Equity Shares represent ownership in a company that entitles its holders to a share in profits and the right to vote on the company’s affairs. Equity shareholders are residual owners of the firm’s profit after other contractual claims on the firm are satisfied and have the ultimate control over how the firm is operated.

A value-weighted index is generated by taking into consideration the market capitalization of the securities in the index. In a value-weighted index, a specified percentage change in the value of a large company has a greater impact than a comparable percentage change for a small company as the weight of individual stocks in the index is determined by the market value of the stocks.

The Prevention of Money Laundering Act, 2002 (PMLA) forms the core of the legal framework put in place in India to combat money laundering. Under this, record has to be maintained for all cash transactions of the value of more than Rs. 10 lakh or its equivalent in foreign currency etc.

Steps in Portfolio Management Process: 1. The first step in the process of portfolio management is the development of a policy statement for the portfolio. 2. The second step involves the study of current financial conditions and forecasting future trends 3. The third step is the construction of a portfolio after taking into consideration policy statements and financial markets forecast. 4. The fourth step in the portfolio management process is performance measurement & evaluation.

With a low (less than 1 correlation) or negative correlation it is possible to derive portfolios that have lower risk than either of the assets. This is the essence of diversification. As long as the correlation is less than perfect 1, benefits of diversification occur. the Lower the correlation, the higher the benefits of diversification. Therefore, in the above example, the highest negative correlation of – 0.85 will give the highest benefits of diversification.

Counterparty risk is the risk of an economic loss from the failure of a counterparty to fulfil its contractual obligation. The Exchange becomes a counterparty to both the buyer and seller of a futures contract through a clearing house. The clearing corporation associated with the exchange guarantees the settlement of these trades. The trades executed on the exchange are settled through a clearing corporation, which acts as a counterparty and guarantees the settlement of the trades to both buyers and sellers.

In the historical simulation method, the portfolio’s return is simulated assuming the same composition is in existence for a long period, say 5 years. The daily return (or weekly or monthly return) is calculated. Such returns are now arranged in descending or ascending order. And then finally 1%, 5%, 10% or any other value, for which VaR is needed, is calculated using the percentile approach. The main limitation of this method is that the past may not repeat itself leading to unreliable simulation.

An individual is treated as a resident in India if he stays in India for: (a) 182 days or more during the relevant previous year; or (b) 60 days or more (but less than 182 days) during the relevant previous year and for 365 days or more in the last 4 years. Therefore, if an individual stays outside India for more than 182 days, the person will be qualified as an NRI.

When a stock splits, the divisor is so adjusted to keep the level of the index as same. The adjusted divisor ensures that the value of the index is not fluctuate by these actions and new value for the index is the same as it would have been without the split.

The weak-form EMH assumes that current stock prices fully reflect all security market information. Technical analysts use technical indicators using past price/rerun/volume data to predict future price movement. If the market is in a weak form of efficiency, then analyzing past information will not lead to the identification of future price movements as past returns are not congruent with future returns.

Therefore, one should gain little from using any trading rule that indicates that one should buy or sell a security based on past rates of return or any other past security market data. EMH renders technical analysis completely irrelevant for superior returns.