LUBIN SCHOOL OF BUSINESS
Pace University
Fin 652 Investment Analysis
Fall 2011
Prof. P.V. Viswanath

Midterm

1. (20 points) Read the following article from the online magazine ETF Profits (http://etf-profits.thestreet.com/articles/10/07/2011/buying-single-stocks-foolhardy), written by Matt Hougan and posted on October 7, 2011, and answer the following questions. Keep in mind that this article is from a website that promotes ETFs. Its arguments are not, for that reason, necessarily wrong; however, you need to be critical. The article by Jonathan Heller that it refers to can be found on another commercial website called the New Real Money (http://realmoney.thestreet.com/articles/10/07/2011/screening-large-dividend-plays). You may not be able to see the entire article, but you don't need to for the purpose of answering the question. Use all that you have learnt from the chapters that we have covered upto now, including Chapter 6 and 7.

  1. Explain the author's critique of Heller's dividend-based picks and his recommendations for using ETFs. What is your viewpoint? Support it.
  2. Can you think of counter-arguments as to why ETFs would not be the way to go? What would you substitute as an investment strategy instead of ETFs? Keep to the theme of this article, where he agrees essentially with Heller's basic point of using dividend-paying stocks in one's portfolio.

I spend a lot of time reading RealMoney. It provides a unique and valuable service to investors: near-real-time, intelligent reaction to breaking news in the financial markets.

If it has a flaw, it’s an obsession with single stocks.

It struck me when I was reading Jonathan Heller’s article on “Screening the Large Dividend Plays.” In one sense, it’s a perfectly reasonable piece. Noting that dividend-paying companies can smooth the ride for investors during times of crisis, Heller develops a screen to find large-cap dividend companies with strong financials.

His criteria are reasonable. It produces a list of 32 names ranging from ExxonMobil (XOM) to Lowe’s (LOW) to AFLAC (AFL), with an average yield of 2.8%.

Heller doesn’t talk about how to choose between the various stocks. He only suggests that this will be a group worth monitoring.

I couldn’t agree more. In fact, I’d go a step further and say that taking this research and buying any one of these stocks would be foolhardy, for three reasons.

First, it defeats the purpose of the exercise. The premise of Heller’s argument is that high-yielding stocks should help you ride out market volatility. That’s a great argument for buying all the stocks Heller outlines, but a terrible reason to pick one or two. One or two would concentrate your risk and would (by any reasonable definition) be riskier than owning the market as a whole.

Second, there’s no reason to think you would do it well. This is the big one.  I’m sure that the readers of RealMoney are smarter than most people. I know they have more informational resources at their fingertips than most of their peers. But to select a firm like XOM or AFL out of the haystack and assume you’ll have an informational advantage over the rest of Wall Street? Well, that’s just crazy.

There are lots of very-well-paid analysts who spend their lives covering these firms and you’re unlikely to uncover a hidden gem or a mispriced large-cap.  You may be right that the trend of dividend-payers-as-a-whole outperforming is real, but finding an undiscovered U.S. large-cap? Good luck.

Third, you don’t have to. This is important. There are 27 ETFs designed specifically to provide exposure to high-yielding stocks. That includes 12 focused in the U.S. market, drawn from eight different providers, tracking 12 distinct indexes. Each of those indexes uses some version of the criteria that Jonathan lays out.

The granddaddy of dividend funds, for instance, the iShares Dow Jones Select Dividend ETF (DVY), selects the highest-yielding stocks screened for dividend-per-share growth, dividend payout percentage, and liquidity. It currently yields 3.91%, higher than the 2.8% average yield screened by Heller’s criteria. The best-performing high-yield U.S. equity ETF over the past year is the First Trust Morningstar Dividend Leaders Fund (NYSEArca: FDL), which selects the highest yielding stocks after screening them for the ability to sustain those dividends long-term.

It’s currently yielding 4.24%, and has outperformed the S&P 500 by more than 5% over the past year.

There are other good choices as well.

I know why single stocks are attractive. It’s nice to think you have better information that your peers. It feels like you can get to know a company and how it’s stock trends. It’s fun to hit home runs.

But, in essence, you’re just playing hunches and unless you have the ability to massively diversify you’re taking on untoward risk. In a scenario like this, where you’re looking to smooth out your returns, single stocks are a mistake. The concept -- high-yielding stocks -- is a good idea. But an ETF is the way to play it.

2.(15 points) Old Economy Traders opened an account to short sell 3,000 shares of Internet Dreams at $81 per share. The initial margin requirement was 50%. (The margin account pays no interest.) A year later, the price of Internet Dreams has risen from $81 to $90, and the stock has paid a dividend of $3.00 per share.

  1. What is the remaining margin in the account?
  2. If the maintenance margin requirement is 30%, will Old Economy receive a margin call?
  3. What is the rate of return on the investment?

3. (10 points) Assume that you manage a risky portfolio with an expected rate of return of 17% and a standard deviation of 37%. The T-bill rate is 5%. Your client's degree of risk aversion is A = 2.1

  1. What proportion, y, of the total investment should be invested in your fund?
  2. What is the expected value and standard deviation of the rate of return on your client's optimized portfolio?

4. (10 points) Suppose that you have $1 million and the following two opportunities from which to construct a portfolio:

  1. Risk-free asset earning 7% per year.
  2. Risky asset with expected return of 27% per year and standard deviation of 40%.

If you construct a portfolio with a standard deviation of 28%, what is its expected rate of return?

5. (15 points) A pension fund manager is considering three mutual funds. The first is a stock fund, the second is a long-term government and corporate bond fund, and the third is a T-bill money market fund that yields a rate of 5%. The probability distribution of the risky funds is as follows:

  Expected Return Standard Deviation
Stock Fund (S) 17% 13%
Bond Fund (B) 11 22

The correlation between the fund returns is 0.10. You require that your portfolio yield an expected return of 14%, and that it be efficient, on the best feasible CAL.

  1. What is the standard deviation of your portfolio?
  2. What is the proportion invested in the T-bill fund and each of the two risky funds?

6. (20 points) Answer any four of the following questions:

  1. Security A has expected return of 11% and standard deviation of 22%.  Security B has expected return of 16% and standard deviation of 29%.  If the two securities have a correlation coefficient of 0.6, what is their covariance?
  2. Suppose you have the following four investment possibilities:
    Investment Expected Return E(r) Standard Deviation
    A 0.12 0.29
    B 0.15 0.35
    C 0.24 0.38
    D 0.29 0.44

    Suppose further that your utility function is U = E(r) – (.5) (A) (σ2), where A = 3.0. Which of the four investments above would you select, if you could only pick one of them?
  3. You purchased shares of a mutual fund at a NAV of $18.00 per share at the beginning of the year and paid a front-end load of 5.75%. If the securities in which the fund invested increased in value by 12% during the year, and the fund’s expense ratio was 0.75%, what would your return be if you sold the fund at the end of the year?
  4. You purchased Research in Motion (RIMM) for $79.83 per share.  Its current price is $71.17.  If the price goes below $70.00 per share you think it could be headed even lower.  What kind of order would you call in to your broker to avoid bigger losses?
  5. A 6.25% 25-year municipal bond is currently priced to yield 8.7%. What is the equivalent taxable yield that this bond would offer for a taxpayer in the 25% marginal tax bracket?

7. (15 points) Answer any three of the following questions:

  1. Who are specialists?  What is their role?
  2. How is the DJIA constructed?
  3. The Sharpe Ratio implicitly assumes normality because it uses standard deviation as a measure of uncertainty.  What measure of return-to-risk can we use if return distributions are not normal?
  4. What are TIPs?