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Second Question on Investment Funds

Posted by David Gobeil on

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.

So, an appropriate tactic would be to purchase units of the iShares S&P/TSX 60 Index Fund.

(Choice B is correct.) 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, appropriate tactics would be to sell $2,000 of units of the iShares Canadian Universe Bond Index ETF and purchase $2,000 of units of the iShares S&P/TSX 60 Index Fund.

However, this would only maintain his strategic asset allocation of 0% to 20% fixed income and 80% to 100% equities.  It would not address his concern about the financials.  A short sale of units of the iShares S&P/TSX Capped Financials Index ETF would reduce his exposure to the financials.

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


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