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Questions on Investment Funds - Post #08 - FPSC Level 1 Examination - December 2017

Posted by John Gobeil on

The FPSC Level 1 Examination is the first of two exams that must be passed to obtain CFP® certification. We have posted this entry to assist you in your preparation for the FPSC Level 1 Examination (FPE1) on Friday December 1, 2017. 

In our last Post, we provided the solutions to the two questions on RESPs and our summary of the knowledge requirements for investment funds.

In this Post, we will provide the solutions to the two questions on investment funds.

Questions on Investment Funds

You can expect 15% to 20% of the questions to involve investment products.  The investment products of which you need knowledge include CSBs, GICs, T-bills, bonds and debentures, common and preferred shares, investment funds, trusts and derivatives.

The following question is a number cruncher and we hope that you remember the formula.

Oprah would like to earn a minimum return of 10% on her RRSP investments.  She has narrowed her choice to units of the Ecstasy, an equity mutual fund and shares of iShares S&P/TSX 60 Index Fund, another equity mutual fund.  Over the last ten years, Ecstasy posted a mean return of 18% with a standard deviation of 9 and iShares posted a mean return of 20% with a standard deviation of 5.  

Oprah would:

(A) likely achieve her minimum return by investing in iShares.
(B) likely achieve her minimum return by investing in Ecstasy.
(C) likely achieve her minimum return by investing equal amounts in the 2 funds.
(D) not likely achieve her minimum return with either investment.

(Concepts) When applied to investment returns, standard deviation is used to measure the spread of actual returns around the average or mean return.  If the historical returns follow a normal distribution pattern, such that 50% of the actual returns are above the mean and 50% of the actual returns are below the mean, then 95% of all investment returns should fall within two standard deviations of the mean return.  Standard deviation is sometimes used to determine the likelihood that an investment would provide an acceptable return, based on its historical returns.

In any one year, there is a 95% chance that an investment would post a return of between:

  • (mean return + (2 × standard deviation)) and (mean return - (2 × standard deviation)).

(Choice A is true.)  In any one year, there is a 95% chance that the iShares would post a return of between:

  • 30%, calculated as (mean return + (2 × standard deviation)) or (20% + (2 × 5%)); and
  • 10%, calculated as (mean return - (2 × standard deviation)) or (20% - (2 × 5%)).

So, Oprah would likely achieve her minimum return by investing in iShares. 

(Choice B) In any one year, there is a 95% chance that the fund would post a return between:

  • 36%, calculated as (mean return + (2 × standard deviation)) or (18% + (2 × 9%)); and
  • 0%, calculated as (mean return - (2 × standard deviation)) or (18% - (2 × 9%)).

So, Oprah would not likely achieve her minimum return by investing in Ecstasy.

(Choice C)  If Oprah invests in equal amounts of each fund, her return would have a 95% chance of providing a return between:

  • 33%, calculated as ((high end return on iShares + high end return on Ecstasy) ÷ 2) or ((30% + 36%) ÷ 2), and
  • 5%, calculated as ((low end return on fund 1 + low end return on fund 2) ÷ 2) or ((10% + 0%) ÷ 2).

So, by investing equal amounts in two funds, Oprah would not likely achieve her minimum return.

(Choice D) As per Choice A, in any one year, there is a 95% chance that the iShares would post a return of between 30% and 10%.  The iShares has a 95% chance of satisfying her minimum return.  

So, Oprah should not avoid both investments because she would likely achieve her minimum return by investing in iShares.

The following question is probably as challenging as you can get with a multiple-choice question.

Jerry is a growth-oriented investor. His strategic asset allocation is 0% to 20% fixed income and 80% to 100% equities. He has implemented his strategy by purchasing units of the iShares S&P/TSX 60 Index Fund, which have a fair market value of $78,000 and units of the iShares Canadian Universe Bond Index ETF, which have a fair market value of $22,000.

Jerry is very concerned that the financial institutions, which make up over 30% of the iShares S&P/TSX 60 Index Fund, are overvalued by at least 25%. He will not change his strategic asset allocation.

Which of the following tactics would be the most appropriate?

(A) Write a put on units of the iShares S&P/TSX Capped Financials Index ETF
(B) Short sell units of the iShares S&P/TSX Capped Financials Index ETF
(C) Sell units of the iShares Canadian Universe Bond Index ETF
(D) Purchase units of the iShares S&P/TSX 60 Index Fund

(Concepts)   Asset allocation is a process that involves setting the desired mix of different asset classes that you would own.

In chess, a tactic is a short sequence of moves which limits the opponent's options and may result in tangible gain.

In military science, a tactic is a maneuver to achieve an objective set by strategy.

In general, a tactic is a maneuver or action calculated to achieve some end.

A tactical asset allocation (TAA) is an asset allocation that has changed in anticipation of changes in the market, rather than changes in the investor's risk profile.  Tactical asset allocation involves market timing.

The iShares S&P/TSX 60 Index ETF is an exchange-traded fund that seeks to provide long-term capital growth by replicating, to the extent possible, the performance of the S&P®/TSX® 60 Index, net of expenses. The index is comprised of 60 of the largest by market capitalization and most liquid constituents of the S&P/TSX Composite Index.

The iShares Canadian Universe Bond Index ETF is an exchange-traded fund that seeks to provide income by replicating, to the extent possible, the performance of the FTSE TMX Canada Universe Bond Index™, net of expenses. The index consists of a broadly diversified selection of investment-grade Government of Canada, provincial, corporate and municipal bonds issued domestically in Canada and denominated in Canadian dollars.

The iShares S&P/TSX Capped Financials Index ETF is an exchange-traded fund that seeks to provide long-term capital growth by replicating, to the extent possible, the performance of the S&P/TSX Capped Financials Index, net of expenses. Constituents are capped at 25% weight.

A put option is an agreement between two parties, which gives the buyer the option to sell shares and the writer the obligation to purchase the shares.  The writer of a put has the obligation to purchase 100 shares of the underlying security at a fixed price before a specified date, if the buyer chooses to exercise her right.

A short sale is a transaction in which an investor sells borrowed securities in anticipation of a price decline and is required to return an equal number of shares at some point in the future.

(Choice A) Jerry is very concerned that the financial institutions, which make up over 30% of the iShares S&P/TSX 60 Index Fund, are overvalued by at least 25%.

The writer of a put has the obligation to purchase shares of the underlying security.

So, an inappropriate tactic would be to write a put on units of the iShares S&P/TSX Capped Financials Index ETF.

(Choice B) Jerry is very concerned that the financial institutions, which make up over 30% of the iShares S&P/TSX 60 Index Fund, are overvalued by at least 25%.

A short sale is a transaction in which an investor sells borrowed securities in anticipation of a price decline and is required to return an equal number of shares at some point in the future.

So, an appropriate tactic would be to short sell units of the iShares S&P/TSX Capped Financials Index ETF.

(Choice C) His strategic asset allocation is 0% to 20% fixed income and 80% to 100% equities.  His equity position has a fair market value of $78,000 and his fixed income position has a fair market value of $22,000.

He will not change his strategic asset allocation.  To maintain his strategic asset allocation, he should sell at least $2,000 of fixed income and purchase at least $2,000 of equities.

So, an appropriate tactic would be to sell units of the iShares Canadian Universe Bond Index ETF.

(Choice D) His strategic asset allocation is 0% to 20% fixed income and 80% to 100% equities.  His equity position has a fair market value of $78,000 and his fixed income position has a fair market value of $22,000.

He will not change his strategic asset allocation.  To maintain his strategic asset allocation, he should sell at least $2,000 of fixed income and purchase at least $2,000 of equities.

Next Post

In our next Post, we will look at the Competency Profile: distinguishing between Collection, Analysis and Recommendation

John Gobeil, BSc, CFP®
David Gobeil, CPA, CA, CFP® 

Certified Financial Planner® and CFP® are certification marks owned outside the U.S. by the Financial Planning Standards Board Ltd. The Financial Planners Standards Council is the marks licensing authority for the CFP marks in Canada, through agreement with FPSB.


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