1. Appeal of Hong Kong as a Fund Management Centre

The influx of investment fund managers over the years highlights the appeal of Hong Kong as a fund management centre, including:

  • Central location in the Asia region
  • Clear regulations covering local market authorisation
  • Just and equitable legal system
  • Widespread use of English
  • Experienced administrators
  • Simple and low-rate tax system
  • Proximity to China
  • World class communication systems
  • Stock market liquidity
  • Accountants, lawyers and stockbrokers supporting the fund management industry

[To access practice questions for this topic, go to – Paper 12]


2. Asset Management Industry Categories

The Hong Kong asset management industry is divided into three categories:

  • Institutional Investors
    • Active fund management companies
    • Passive fund management companies (eg ETFs)
    • Insurance companies
    • Banks
    • Sovereign wealth funds
    • Endowment funds
    • Corporate treasury management
    • Retirement schemes (MPF & ORSO)
  • Retail Investors
    • Individuals with less sophisticated needs
    • Less complex objectives without investment mandates
    • Attracted to unit trusts and mutual funds
  • Private Clients
    • Wealthy individuals with needs between retail and institutional investors
    • May set up family offices
    • Family offices aim to preserve and grow family wealth for future generations

[To access practice questions for this topic, go to – Paper 12]


3. Unit Trusts vs Mutual Funds
Unit TrustsMutual Funds
Form of establishmentTrustLimited liability company
Governing lawTrustee lawCompanies law
Legal document in which the rules are detailedTrust deedCompany’s articles/bye laws and custodian agreement
Who protects investor interestsTrusteeCustodian
Who owns or holds the fund assetsTrustee for the benefit of the investorsMutual fund company
Who is liableTrusteeCompany has limited liability; directors can be liable

Source: Hong Kong Investment Funds Association

[To access practice questions for this topic, go to – Paper 12]


4. Mandatory Provident Funds

Introduced in December 2000 to provide a retirement scheme for employees in Hong Kong.  Supplemented Hong Kong’s long-running ORSO schemes, established for large employers.  An employer may choose from three types of MPF scheme:

  • Master trust scheme: open to company employees, self-employed and those transferring benefits from other schemes. Fee structure appeals to small- and medium-sized employers.  Employer selects the master trust; employees select from a set of constituent funds, one of which must be an MPF conservative fund
  • Employer sponsored scheme: only employees of a single company are eligible. Cost of establishing such a scheme means they are usually restricted to large employers
  • Industry scheme: designed for itinerant workers such as those in catering and construction industries – allows workers to continue contributing to same fund as they move employers within the same industry

All MPF schemes must include a standardised, low-fee default strategy, known as a default investment strategy (DIS)

[To access practice questions for this topic, go to – Paper 12]


5. Potential for Future Growth of HK Asset Management Industry
  • Rapid expansion of the Mainland economy has led to significant growth in foreign currency reserves leading to further opportunities for Hong Kong asset managers
  • The Qualified Domestic Institutional Investors (QDII) scheme opens up channels for Mainland entities to invest abroad
  • The Qualified Foreign Institutional Investors (QFII) scheme allows foreign access to domestic China securities
  • Continued growth of:
    • Shanghai-Hong Kong Stock Connect (launched 2014)
    • Shenzhen-Hong Kong Stock Connect (launched 2016)
    • Bond Connect (launched 2017)
  • Continued growth of Mainland-Hong Kong Mutual Recognition of Funds (launched 2015)
  • Hong Kong is ranked among the leaders for hedge fund management in the Asia Pacific region
  • Institutional investors are the major investors in hedge funds, such as fund of hedge funds, banks, insurance companies, pension funds, endowment funds and sovereign wealth funds
  • Efficiencies emerging from the development of the financial technology (Fintech) sector will further enable future growth

[To access practice questions for this topic, go to – Paper 12]


 6. Benefits and Costs of Managed Funds
  • The benefits of managed funds include:
    • Access to professional investment management services
    • Diversification
    • Access to greater investment opportunities
    • Cost benefits from asset managers having access to volume discounts
    • Access to the use of technology
    • Liquidity – many funds can handle redemptions on a daily basis
    • Convenience of support from service providers
    • Taxation benefits
  • The disadvantages of managed funds include:
    • Monetary costs: front-end fees; annual management fees; redemption charges; and performance fees
    • Foregoing control – investment manager determines what is bought and what is sold…and when
    • Higher risk than bank savings
    • Forward pricing – NAV is determined at the end of each day

[To access practice questions for this topic, go to – Paper 12]


7. Fund Offer Document
  • The offer document for managed funds catering to the retail and private client markets is known as a prospectus
  • Prospectuses must have prior SFC approval before being released to the public
  • Professional investors, including institutional investors, are exempt from the prospectus requirements, however a less detailed document must be sent to them, known as an information (or explanatory) memorandum
  • As well as a prospectus or information memorandum, the management company should also provide:
    • Last audited annual report
    • Last unaudited semi-annual report
    • Key facts statement
    • Application form
    • Other pertinent information

 [To access practice questions for this topic, go to – Paper 12]


8. Fees and Charges

Initial Subscription Charge or Front-end Fee

  • Applied to the initial investment in a managed fund
  • Fund houses pay a large part of this fee as commission to distributors who help promote the fund units to investors
  • Distributor may choose to rebate some of the fee to the investor
  • Institutional and most private client funds do not have front-end fees
  • The bid offer spread is the price difference between the purchase and redemption prices

Redemption Fee

  • Applies to funds that do not charge a front-end fee (referred to as no-load funds)
  • Applied to withdrawals made from a fund, usually within a certain time period after purchase
  • Also referred to as contingent deferred sales charges
  • Do not normally apply to private clients/institutional investments
  • Investors switching between investment options within an umbrella fund pay a switching fee, not a redemption fee

Annual Management Fee

  • Comprises fees payable to fund manager as well as operating expenses
  • May include a trailer fee paid to distributors
  • Bond funds tend to have lower management fees than equity funds
  • Institutional fund management fees are lower than for retail funds; private client funds are priced somewhere between the two levels
  • An annual trustee fee is paid separately

Performance Fee

  • Tends to apply to alternative investment strategy funds, including hedge funds and private equity funds
  • Fee is charged when fund NAV exceeds previous highest water-mark and can be referred to as “high on high” or “water-mark”

[To access practice questions for this topic, go to – Paper 12]


9. Fund Distributors
  • Distributors market managed funds to their clients on behalf of the promoters
  • Two types of distributors:
  1. Direct – promoter or subsidiary of promoter
  2. Indirect – through an intermediary
  • Intermediaries include:
    • Independent financial advisers (IFAs)
    • Life insurance agents
    • Banks
    • Discount brokers
    • Accountants and solicitors
    • Asset consultants

[To access practice questions for this topic, go to – Paper 12]




10. Investment Policy Statement
  • Reasons why an asset manager should construct an investment policy statement for clients (both high net-with and institutional):
    • Helps state goals and objectives of the investment plan
    • Provides an evaluation system for benchmarking performance
    • Sets boundaries for strategies and product purchases
    • Helps communicate the investment policy, especially when there is a dispute or change in fund manager
  • The Statements should include the following:
    • Statement of purpose
    • Investment objectives
    • Roles and responsibilities of investment managers
    • Investment guidelines and boundaries
  • Objectives should indicate medium- and long-term performance targets, the benchmark and return performance and asset allocation strategies for each asset class
  • Guidelines and boundaries should indicate the investment choices that are prohibited and any investment vehicles/tactics that should be avoided
  • Estimated maximum permitted loss should also be included

[To access practice questions for this topic, go to – Paper 12]


11. Risk Tolerance
  • Risk tolerance levels range from conservative to aggressive, depending upon:
    • Client’s attitude to risk
    • Personal background
    • Investment experience and knowledge
    • Stage in investment life cycle
  • In establishing a client’s level of risk tolerance, consideration should be taken of the client’s views regarding:
    • Losing some or all of the capital
    • Earning a negative return
    • Earning less than inflation
    • Substantial price swings in an investment’s value
  • A client’s personal background, investment experience and knowledge should also be considered, including:
    • Diversification of current investments
    • Interpretation of investments’ past performance
    • Ability to set and adhere to a budget, or other investment goals

[To access practice questions for this topic, go to – Paper 12]


12. Human Capital
  • When determining the investment strategy for a client, the wealth manager should consider the human capital – that is, the ability to earn income in the future
  • Can be measured as the present value of future labour income
  • Two concepts related to human capital:
    • The Hedging Effect: the more stable a person’s future regular income, the more risk can be taken with financial investments, as there is an element of diversification
    • Labour Supply Flexibility: The ability to work overtime for extra pay. The stronger the cushion effect of labour supply flexibility, the riskier a client’s portfolio can be

[To access practice questions for this topic, go to – Paper 12]


13. Investment Constraints


  • The ease with which an asset can be converted to cash
  • Affected by:
    • Type of asset (eg listed shares are more liquid than unlisted shares)
    • Market supply and demand
    • Size of asset
    • Divisibility of asset

Investment Horizon

  • The time an investor is willing to retain an investment
  • Critical when assessing a client’s risk tolerance
  • Long-term investors (at least 10 years) can ride out short-term price movements
  • Short-term investors (1 to 3 years) are less tolerant of short-term price

Tax Considerations

  • Focus should be on returns after tax
  • Tax can arise from:
    • Capital gains
    • Dividends
    • Interest
    • Rental income
    • Sale of an estate

Legal Restrictions

  • Certain types or amounts of investments can be restricted for statutory/operational reasons

Unique Preferences and Needs

  • Examples could be:
    • Religious beliefs
    • Family and/or business relationships
    • Environmental concerns

Life-stage Considerations

  • A person’s stage in life will influence investment requirements and decisions
  • Each person’s experience at a particular stage of life is unique
  • See following table for a summary of life cycle stages

[To access practice questions for this topic, go to – Paper 12]


14. Investment Life Cycle Stages
No.Life-cycle StagesUsual AgeLifestyle Issues
1Single employed15 – 25First job and income, rent, first credit card
2Family nest25 – 45Marriage, birth of children, demanding career, need for life insurance, preparation of a will, living on one income
3Shrinking family45 – 65Children leaving home, two incomes, liabilities paid off, caring for aged parents, serious retirement planning
4Retirement65+Commence pension, establish retirement income and expenditure, travel plans, health requirements

[To access practice questions for this topic, go to – Paper 12]


15. Strategic Asset Allocation
  • An allocation strategy based on a longer term investment philosophy (5 years+)
  • Asset mix should be driven by policies assuming efficient markets
  • Usually a relatively constant mix of weightings for various asset classes
  • A 5% deviation from the benchmark weighting may trigger portfolio rebalancing
  • A very early step to advanced asset allocation strategies that exploit market timing and pricing inefficiencies
  • Requires selection of appropriate investment management styles

[To access practice questions for this topic, go to – Paper 12]


16. Tactical Asset Allocation
  • A dynamic strategy aiming to enhance returns, lower risk or both
  • Allows fund manager to trade aggressively and make frequent shifts in asset allocation

[To access practice questions for this topic, go to – Paper 12]


 17. Know Your Client (KYC) Requirement
  • KYC requirements are outlined in the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission
  • An asset manager or a fund distributor should establish a client’s:
    • True and full identity
    • Financial situation or strength
    • Investment experience
    • Investment objectives
  • Before executing any transaction for a client, the intermediary must establish the identity of the ultimately responsible for origination the transaction – exception is a CIS
  • Recommendations made to clients should be suitable, given their circumstances
  • When a client without knowledge of derivatives wishes to invest in a derivative product, the risks should be explained
  • Face-to-face account opening best way to verify identity
  • If not possible, the documents should be certified by appropriate person (licensed person, JP, bank manager, accountant, lawyer, notary)
  • Proper records must be kept of procedures followed

[To access practice questions for this topic, go to – Paper 12]


18. Evaluating Equities

Fund managers analyse stocks quantitatively (known as fundamental analysis) using the following models:

Dividend Yield

  • Shows the level of income an investor can expect to receive from a share

Dividend yield = Dividend per Share/Share price

Earnings per Share (EPS)

  • The most quoted reference in the financial markets

Earnings per share = (Profit after tax – preference dividends)/Weighted average number of shares

Price Earnings Ratio (PE ratio)

  • Represents the multiple of current year’s earnings that must be paid to buy a share
  • A relatively high PE stock implies strong future earnings growth and is referred to as a growth stock
  • A relatively low PE stock implies that the stock is cheap and is referred to as a value stock
  • The historical PE ratio is based on current earnings, the prospective PE ratio is based on expected future earnings

PE ratio = Market price per share/Earnings per share

Price to Net Book Value Ratio (P/B ratio)

  • Shows market premium above a stock’s net book value
  • A high P/B ratio indicates a high growth opportunity, leading to a higher price premium

P/B ratio = Current stock price/NBV of equity per share

[To access practice questions for this topic, go to – Paper 12]


19. Fixed Income Securities
  • Interest bearing loans where the investor lends money to the company/organisation at a certain interest rate (coupon rate) for the life of the loan
  • Coupon rate can be either fixed or floating
  • A preference share is commonly considered to be a fixed income security in substance as shareholders receive a fixed preferred dividend, regardless of operating performance
  • Debt securities with terms of one year or less are known as bills or paper
  • In the US, treasury bills have a maturity of one year or less, treasury notes between two and ten years and treasury bonds of more than ten years
  • In Hong Kong:
    • Exchange Fund Bills have a maturity of one year or less
    • Exchange Fund Notes have a maturity of two years
  • Governments/government agencies/supranational organisations (World Bank & Asian Development Bank) can issue bonds

[To access practice questions for this topic, go to – Paper 12]


20. Bond Duration
  • A measure of duration approximates to the percentage change in a bond price for a 1% change in interest rates
  • Can also be thought of as the average number of years it takes for the discounted cash flow to be returned to the investor
  • The longer the time to maturity, the higher the duration
  • The lower the yield, the higher the duration
  • The lower the coupon rate, the higher the duration
  • A bond portfolio can be immunised by matching the duration of assets and liabilities, thus enabling a target rate of return, regardless of bond prices or interest rate variations

[To access practice questions for this topic, go to – Paper 12]


21. Closed-end and Open-end Funds

Closed-end Funds

  • Offered with a specific start and end date
  • Funds growth is limited to earnings generated from the initial invested sum
  • The number of shares issued is constant
  • Shares are listed and can be traded on a stock exchange, however they are not redeemable by the investment company
  • Shares can be traded at a premium or a discount
  • Majority of closed-end funds trade at discounts because of low liquidity
  • Closed-end funds offered in Hong Kong must register a prospectus with the Registrar of Companies and they must be SFC authorised
  • Although less popular than open-ended funds in Hong Kong, their benefits include:
    • They do not suffer from large swings in subscriptions and redemptions
    • Fund managers are not forced to liquidate investments to meet investor redemptions
    • Fund managers can concentrate on managing the portfiolio rather than being distracted by cash injections and withdrawals
    • Fund managers can consider long-term investments with relatively low liquidity

Open-end Funds

  • Remain open to receive money from new investors, expanding the portfolio
  • Represent the majority of managed fund products offered to the Hong Kong public
  • Can suffer from large swings in subscriptions and redemptions
  • Fund managers may be forced to liquidate investments to meet investor redemptions

[To access practice questions for this topic, go to – Paper 12]


22. Fixed Income Funds
  • They invest in long-term interest-bearing securities, with maturities of at least 12 months, and cash
  • The longer the securities’ term to maturity, the higher the yield
  • Fixed income investors tend to receive higher returns than those in money market funds
  • Fixed income fund returns come from:
    • Interest income
    • Capital gains from the secondary market
    • Currency movements, when unhedged funds are held in a foreign currency
  • To eliminate currency risk, managers hedge portfolios by effectively fixing the exchange rate through the buying/selling of forward contracts
  • Fixed income securities are subject to interest rate risk as well as credit risk
  • Credit risk, as perceived by the market, increases in the following order of securities:
  1. Government securities
  2. Government agency securities
  3. Bank-backed securities
  4. Corporate securities with collateral
  5. Corporate debentures and commercial paper without collateral

[To access practice questions for this topic, go to – Paper 12]


23. Balanced Funds
  • Also known as asset allocation, diversified or total return funds
  • Fund manager decides on asset allocation and allocation of funds
  • Fund manager can also change short-term composition of portfolio, known as tactical asset allocation
  • Most asset allocation fund managers offer a variety of diversified funds, including the three most common:
    • Capital preservation: aim is to maintain capital and produce income over the medium to long term. About 70% of funds are invested in fixed income securities and cash
    • Balanced: aim is to grow capital, avoid risk of capital loss and produce income over the medium to long term. About 70% of funds are invested in equities
    • Growth: aim is to provide capital growth and income over the medium to long term. Majority of funds are invested in growth assets

Typical Asset Allocations for Different Types of Funds

Types of funds
Asset classesCapital PreservationBalancedGrowth
Cash/fixed income70%30%10%

[To access practice questions for this topic, go to – Paper 12]


24. Mutual Recognition of Funds
  • The Mainland-Hong Kong Mutual Recognition of Funds (MRF) scheme was launched by the China Securities Regulatory Commission (CSRC) and the SFC on 1 July 2015
  • Eligible funds in China and Hong Kong can be distributed in each other’s market through a streamlined vetting process
  • The underlying principle is that a fund authorised by the authority in one jurisdiction (home jurisdiction) is generally deemed to have complied in substance with the requirements of the other jurisdiction (host jurisdiction)
  • The following requirements must be met by Mainland funds that are to be distributed in Hong Kong:
    • The fund is established, managed and operated in accordance with PRC laws
    • A publicly offered investment fund, registered with the CSRC under PRC laws
    • Fund must have been established for more than one year
    • Fund must have a minimum size of not less than RMB200 million or foreign currency equivalent
    • Fund must not primarily invest in the Hong Kong market
    • Value of shares/units sold to Hong Kong investors should not exceed 50% of the value of the fund’s total assets

[To access practice questions for this topic, go to – Paper 12]



25. Combining Returns

Two ways of combining returns: arithmetic average and geometric average

  • Arithmetic average is used to combine a number of returns over the same period to arrive at an average

Average return  =  (R1 + R2 + R3 + … + Rn)/n

  • Geometric average is used to combine a number of returns from the same source over a number of periods to arrive at an average return

Average return  =  [(1 + R1) x (1 + R2) x (1 + R3) x …(1 + Rn)]1/n – 1

Combining Returns Example

Calculate the arithmetic and geometric average returns for the following three returns

  • 50%
  • 75%
  • 00%


Arithmetic average  =  (5.5 + 5.75 + 6.0)/3  =  5.75%

Geometric average  =  [(1.055) x (1.0575) x (1.06)]1/3 – 1

=  (1.1826) 1/3 – 1

=  0.05749  =  5.479%

The geometric average can never be greater than the arithmetic average.

The two combined returns will be equal if all the individual returns are equal

[To access practice questions for this topic, go to – Paper 12]


26. How to Calculate the Expected Return
  • To measure expected return and risk of an investment, the probabilities of different possible investment returns will be required. The expected return is the weighted mean return
  • Although the actual return for an investment almost always differs from the expected return, there is generally a close relationship between actual and expected returns in the long run

Calculation of Expected Return

ER  =  Ʃ piri


ER   =  expected return

pi      =  probability of return i

ri      =  % return i

[To access practice questions for this topic, go to – Paper 12]


27. Measurement of Risk
  • There is a risk when an investment’s actual return is different from its expected return
  • Risk can be measured by variance and standard deviation
  • Standard deviation is the square root of the variance
  • The greater the variance/standard deviation, the greater the level of risk for the security

Calculation of Risk

Var  =  Ʃ pi(ri – ER)2

SD  =   ( Ʃ pi(ri – ER)2)1/2


SD   =  standard deviation

Var   =  variance

ER   =  expected return

pi      =  probability of return i

ri      =  % return i

[To access practice questions for this topic, go to – Paper 12]


28. The Normal Distribution Curve
  • The normal distribution illustrates the dispersion of a security’s return around the expected return
  • The lower the standard deviation of a security’s possible returns the more tightly clustered the returns are around the expected return
  • Statistically, there is a 68% probability of a security yielding a return within one standard deviation either side of the mean, assuming possible returns are normally distributed
  • Statistically, there is a 95% probability of a security yielding a return within two standard deviations either side of the mean, assuming possible returns are normally distributed (the actual measure is 1.96)

[To access practice questions for this topic, go to – Paper 12]


29. Correlation
  • Correlation is the relationship between the expected returns of two assets
  • Assets whose returns move in the same direction are known to be positively correlated (umbrella company and raincoat company)
  • Assets whose returns move in the opposite direction are known to be negatively correlated (umbrella company and sunglasses company)
  • The correlation coefficient measures the relationship between the returns of two assets and lies anywhere between -1 and +1
  • Perfect positive correlation has a correlation coefficient of +1
  • Perfect negative correlation has a correlation coefficient of -1
  • Zero correlation applies to two assets with no relationship
  • Combining assets in a portfolio with less than perfect positive correlation will reduce overall portfolio risk

Calculation of Correlation Coefficient for a Two Asset Portfolio

σp =     (wa2σa2 + wb2σb2 + 2wawbρa,bσaσb)1/2


σ=  portfolio standard deviation

w=  portfolio weight of asset a

w=  portfolio weight of asset b

σ=  standard deviation of asset a

σ=  standard deviation of asset b

ρa,b  =  correlation coefficient

[To access practice questions for this topic, go to – Paper 12]


30. Indifference Curves
  • Indifference curves are a set of utility curves showing different levels of satisfaction or utility for each investor
  • An investor is indifferent to choosing one portfolio rather than another lying along the same indifference curve
  • As an indifference curve moves upwards, an investor enjoys higher utility
  • Investors prefer portfolios with higher expected returns for the same level of risk
  • The slope of an indifference curve reflects the degree to which an individual is risk averse
  • The flatter the curve, the more risk tolerant the investor is
  • The steeper the curve, the more risk averse the individual is
  • The aggressive investor is more risk tolerant than the conservative investor

[To access practice questions for this topic, go to – Paper 12]


31. Capital Asset Pricing Model (CAPM)
  • CAPM provides the expected return on an equity, given the risk-free return and the risk-weighted market premium of the stock in question
  • Beta (β) is a measure of the sensitivity of company’s return on equity to a change in the overall market return

E(ri)  =  rf + βi(rm – rf)


  • E(ri)  =  expected return of security i
  • rf      =  risk-free rate of return
  • βi      =  beta (systematic risk) of security i
  • rm     =  return of market portfolio

Capital Asset Pricing Model Example

What is the expected return on shares of Growco Limited if:

Expected market return                  5%

Risk-free rate of return                   1%

Company beta of Growco              1.5


Expected return      = 1%  +  1.5(5% – 1%)

= 7%

[To access practice questions for this topic, go to – Paper 12]


32. Arbitrage Pricing Theory (APT)
  • CAPM prices expected returns for a security on a single factor – market risk measured by beta
  • APT, developed by the academic community, takes a more complex view of risk and return by assuming a security’s return is based on several independent economy-wide factors
  • The challenge faced when using APT, is to identify the factors relevant to the security in question. Chen, Roll and Ross identified the following four factors that did a reasonable job:
    • Surprises in inflation
    • Surprises in industrial production
    • Surprises in the default premium of corporate bonds
    • Shifts in the yield curve

[To access practice questions for this topic, go to – Paper 12]




33. Value vs Growth Investing
Value InvestingGrowth Investing
Based on stocks that are ‘cheap’ or undervalued relative to earnings potential

Low P/E stocks preferred

Based on concept that markets overreact to bad news

Risks are that stock is cheap because price reflects a poor future earnings stream and/or market may take longer than expected to return to fair value

Based on stocks that have solid future growth in earnings relative to stock price

Return comes from growth in earnings, leading to an increase in stock price

Risks are that forecast earnings may be unrealistic and share price may not rise as P/E ratio declines

  • Choice of style may be dependent upon stage of business cycle
    • Value investor will begin buying if a recession occurs
    • Growth investor will begin buying as a recession ends when earnings growth is expected

Portfolio characteristics have following attributes:

P/E ratioLowerHigher
Dividend yieldHigherLower
SectorsEnergy, finance and capital equipmentConsumer goods, technology, services, internet, pharmaceutical and healthcare

[To access practice questions for this topic, go to – Paper 12]


34. Behavioural Finance
  • This investment management style uses analytical and empirical results of cognitive and social psychological studies to set investment strategies
  • Investors are known to use mental rules of thumb, known as heuristics, to make investment decisions
  • Two investment strategies arising from behavioural financial studies are:
    • Momentum strategy: assumes that past price trends will continue in the future. Best results tend to be over the short-term
    • Contrarian strategy: assumes market involves a herd mentality with collective crowd action being wrong in the long-term. An investment manager would make investment decisions contrary to those of the general public. Asset managers should sell winner stocks and buy loser stocks

[To access practice questions for this topic, go to – Paper 12]


 35. Sharpe Ratio
  • The Sharpe ratio is derived directly from the Capital Market Line (CML), which shows the relationship between portfolio risk and portfolio return
  • A portfolio lying on the CML will have an expected return equal to the risk-free rate plus the risk of the portfolio multiplied by the slope
  • The Sharpe ratio measures the excess returns of a portfolio divided by the portfolio standard deviation, as shown below:

SRp  =  (Rp – Rf)/σp


  • SRp  =  Sharpe ratio for a portfolio
  • Rp  =  portfolio return
  • Rf  =  risk-free return
  • σp  =  portfolio standard deviation

A portfolio with a Sharpe ratio greater than the Sharpe ratio of the market portfolio is said to have beaten the market and will lie above the CML
A portfolio with a Sharpe ratio less than the Sharpe ratio of the market portfolio is said to have underperformed the market and will lie below the CML

[To access practice questions for this topic, go to – Paper 12]

 36. Treynor Index
  • The Treynor index is derived directly from the Security Market Line (SML), which shows the relationship between expected return of an investment and its systematic risk
  • The Treynor index for the market portfolio is the market risk premium (Rp – Rf)
  • A portfolio with a Treynor index greater than the market will lie above the SML
  • A portfolio with a Treynor index less than the market will lie below the SML
  • The portfolio with the highest Treynor index will be preferred as it will provide the best risk-adjusted performance
  • The Treynor index measures the excess returns of a portfolio divided by the portfolio systematic risk, as measured by beta and shown below:

TIp  =  (Rp – Rf)/βp


  • TIp  =  Treynor index for a portfolio
  • Rp  =  portfolio return
  • Rf  =  risk-free return
  • βp  =  portfolio beta

[To access practice questions for this topic, go to – Paper 12]


 37. Jensen’s Alpha
  • Jensen’s alpha is the average return of a portfolio over and above that predicted by CAPM
  • Jensen’s alpha for the market portfolio is zero
  • A portfolio with a positive Jensen’s alpha will have outperformed the market
  • A portfolio with a negative Jensen’s alpha will have underperformed the market

αp  =  Rp – [Rf + βp x (Rm – Rf)]


  • αp  =  Jensen’s alpha for a portfolio
  • Rp  =  portfolio return
  • Rf  =  risk-free return
  • βp  =  portfolio beta
  • Rm  =  market portfolio return

[To access practice questions for this topic, go to – Paper 12]


 38. Other Performance Ratios

Tracking Error

  • Performance of asset allocation managers can be measured by the consistency of outperformance in each period
  • Tracking error measures such consistency by computing the volatility or dispersion of alphas
  • Tracking error is a popular performance indicator among asset managers

Information Ratio

  • Information ratio reflects an asset manager’s ability in making profitable bets – the higher the better
  • Defined as the ratio of alpha to tracking error, which is a measure of unsystematic risk

Annualised Information Ratio

=  12½ x (Average Monthly Alpha/Monthly Tracking Error)

Information Ratio – Example

For a particular portfolio, the average monthly alpha is 0.052 and the monthly tracking error is 0.163.  What is the annualised information ratio?


Annualised information ratio    = 12½ x (0.052/0.163)

= 0.105

[To access practice questions for this topic, go to – Paper 12]


 39. Attribution Analysis
  • To monitor portfolio performance, attribution analysis identifies performance attributable to each set of active decisions
  • Performance is broken down into three components:
    • Tactical asset allocation decisions
    • Sector (industry) selection decisions within each asset class
    • Security selection decisions within each sector
  • While attribution analysis helps measure the effect of an active manager’s decisions, SAA is generally the greatest influence on a portfolio’s risk and return characteristics

[To access practice questions for this topic, go to – Paper 12]


 40. Role of Fund Research House or Rating Agency
  • Fund research houses/rating agencies produce reports on funds and investment managers to help investors select or monitor fund managers
  • Most advising firms do not rely entirely on recommendations made by fund research houses/rating agencies – they will also consider their own research
  • It is in their best interest for fund managers to work closely with fund research houses/rating agencies to ensure that they are portrayed accurately
  • Successful reviews will help maximise fund managers’ branding opportunities

[To access practice questions for this topic, go to – Paper 12]

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