NASAA Series 66 — All Questions

A critic of active management relying on the efficient market hypothesis would argue that:

• a.Markets are so inefficient that any manager can reliably earn large excess returns
• b.After fees, most active managers struggle to consistently beat their benchmark✓
• c.Active managers are guaranteed by regulation to outperform index funds
• d.Index funds may not be sold to retail investors because they underperform active strategies

The efficient market hypothesis holds that prices reflect available information, so after costs active managers rarely beat the index consistently. This argument supports low-cost indexing.

A value investing style focuses on:

• a.Companies with rapidly rising earnings trading at high price-to-earnings multiples
• b.A fixed replica of a broad market index
• c.Stocks trading below their intrinsic worth, often with low P/E or P/B ratios✓
• d.Securities chosen by their recent price momentum

Value investing seeks securities priced below intrinsic value, typically with low price-to-earnings or price-to-book ratios. It contrasts with growth investing, which pays up for expansion.

A growth investing style is characterized by:

• a.Buying stocks that trade at low price-to-earnings and price-to-book ratios compared with intrinsic value
• b.Buying the stocks that have fallen most in the past year, expecting them to revert to prior prices
• c.Emphasis on companies with above-average earnings growth, often reinvesting profits rather than paying dividends✓
• d.Emphasis on mature companies that pay high, stable dividends and offer modest earnings growth

Growth investing targets companies with above-average earnings growth, which often reinvest profits instead of paying dividends and trade at higher valuations. Buying on low price-to-earnings and price-to-book ratios is value investing. Buying recent losers expecting a rebound is contrarian investing. Favoring mature, high-dividend companies is an income approach.

Tactical asset allocation differs from strategic asset allocation because it:

• a.Sets long-term target weights from the client's risk tolerance and rebalances to them periodically
• b.Matches asset maturities to the dates of the client's known future liabilities
• c.Chooses individual securities within each asset class rather than choosing the asset-class weights themselves
• d.Makes shorter-term shifts away from target weights to exploit perceived opportunities✓

Tactical allocation makes shorter-term shifts away from the strategic target weights to exploit perceived opportunities, then typically returns to the targets. Setting long-term weights from risk tolerance and rebalancing to them describes strategic allocation. Matching maturities to known liabilities is a dedication or liability-driven approach. Choosing individual securities within asset classes is security selection, not asset allocation.

A buy-and-hold strategy's main advantages include:

• a.Generating large short-term gains taxed at favorable long-term rates
• b.Lower transaction costs and deferral of taxable capital gains✓
• c.Eliminating market and interest-rate risk because securities are never sold
• d.Guaranteeing outperformance of an actively traded portfolio

Buy-and-hold minimizes trading costs and defers capital-gains taxation while reducing timing errors. It does not eliminate market risk or guarantee outperformance.

A 'core-satellite' portfolio construction typically combines:

• a.A low-cost index 'core' with smaller active 'satellite' positions✓
• b.A large actively managed 'core' with smaller index funds added as the 'satellite' positions
• c.A 'core' of the investor's taxable holdings and 'satellite' accounts held in tax-deferred retirement plans
• d.Equal-weighted holdings in a few index funds and a few active funds, with no designated core position

Core-satellite pairs a low-cost, passive index core that supplies broad market exposure with smaller active satellite positions that aim to add return. Reversing the roles, with an active core and index satellites, gets the structure backward. Core and satellite are portfolio roles, not account types, so splitting taxable and tax-deferred accounts is asset location. Equal weights with no designated core is just a mixed portfolio.

A contrarian investor tends to:

• a.Always follow the prevailing market consensus and crowd sentiment
• b.Trade only in the direction of the strongest recent twelve-month price momentum
• c.Buy assets that are out of favor and sell those that are widely popular✓
• d.Hold a static index fund and never deviate from the benchmark's exact composition

Contrarian investing goes against prevailing sentiment, buying unpopular assets and selling popular ones, betting on mean reversion. It is the opposite of momentum following.

Studies of portfolio returns commonly conclude that the largest driver of a diversified portfolio's variability over time is:

• a.The security-selection decisions made within each asset class
• b.The brokerage firm selected to custody the assets
• c.The precise day and time at which each order is entered into the market
• d.The overall asset allocation among stocks, bonds, and cash✓

Research generally finds that asset-allocation policy, the mix of stocks, bonds, and cash, explains most of the variability of portfolio returns over time, more than security selection or market timing.

Combining two assets with a correlation coefficient of -1.0 would:

• a.Give no diversification benefit, because risk is just the weighted average of the two assets' risks
• b.Raise portfolio volatility above the weighted average of the two assets' standard deviations
• c.Allow risk to be reduced to zero in the right proportion, since the two assets move perfectly oppositely✓
• d.Cut risk by exactly half, since each asset's movements partly cancel the other's

A correlation of -1.0 means the assets move in exactly opposite directions, so some combination of weights can reduce portfolio standard deviation to zero. A weighted-average risk with no benefit describes a correlation of +1.0. No correlation can push portfolio volatility above the weighted average. The reduction is not fixed at half; it depends on the weights and can reach the full amount.

Two assets have a correlation coefficient of +1.0. Combining them in a portfolio will:

• a.Eliminate the unsystematic risk of the two individual securities
• b.Create a portfolio whose expected return far exceeds that of either asset on its own
• c.Reduce the portfolio's standard deviation below the weighted average of the two assets' deviations
• d.Provide no diversification benefit, since the assets move in perfect lockstep✓

Perfectly positively correlated (+1.0) assets move together, so combining them yields portfolio risk equal to the weighted average, producing no diversification benefit.

As more securities are added to a diversified stock portfolio, unsystematic risk:

• a.Declines with diminishing benefit, approaching the market's systematic risk✓
• b.Is unchanged, because diversification reduces only systematic risk and leaves company-specific risk alone
• c.Falls steadily until it reaches zero at about 30 securities
• d.Rises with each new security, since each adds its own business risk

Adding securities reduces unsystematic (diversifiable) risk with diminishing benefit, approaching the floor of systematic market risk, which cannot be diversified away. Diversification works on company-specific risk, not the reverse. Unsystematic risk does not hit zero at any fixed number of securities. It also does not rise as securities are added, because individual risks offset one another.

Adding international equities to a U.S.-only portfolio is primarily intended to:

• a.Convert the portfolio's dividends into completely tax-free income under current U.S. federal income-tax rules
• b.Improve diversification through exposure to markets that may not move in step with the U.S.✓
• c.Guarantee higher returns every single year because foreign markets always outperform the U.S. market over time
• d.Eliminate currency risk entirely and remove all exposure to foreign political and economic developments

International diversification adds assets with imperfect correlation to domestic markets, potentially improving the risk-return tradeoff. It also introduces currency and political risk.

Systematic rebalancing back to target weights tends to:

• a.Shift the entire portfolio into whichever asset class rose most last year
• b.Enforce selling relatively high and buying relatively low✓
• c.Guarantee no loss in any calendar quarter
• d.Increase portfolio risk by letting the best-performing asset class grow without limit

Rebalancing trims outperforming asset classes and adds to underperformers, imposing a buy-low/sell-high discipline and controlling the drift of portfolio risk away from targets.

Holding 15 different large-cap U.S. equity mutual funds that own broadly similar stocks is an example of:

• a.True diversification, since each fund has a different management company
• b.A hedge, because large-cap funds offset one another when the market falls
• c.Redundant overlap that adds cost without meaningfully improving diversification✓
• d.A core-satellite structure, with some funds serving as active satellites

Owning many funds that hold broadly similar large-cap stocks is redundant overlap: it adds cost and complexity without meaningfully improving diversification, because the holdings are highly correlated. Different managers do not make the holdings different. Large-cap funds fall together, so they do not hedge one another. A core-satellite structure needs a distinct index core and a small number of differentiated satellites, not 15 look-alike funds.

Portfolio X returns 8% with a standard deviation of 12%. Portfolio Y returns 8% with a standard deviation of 16%. A rational, risk-averse investor would say portfolio X:

• a.Is inferior to Y, because more standard deviation means better long-run outcomes
• b.Cannot be compared without their expense ratios
• c.Is identical to Y in every respect that matters to a risk-averse investor
• d.Dominates Y, since it offers the same return with less risk✓

With equal expected return, the lower-standard-deviation portfolio (X) dominates and lies closer to the efficient frontier. Risk-averse investors prefer less risk per unit of return.

A portfolio holds 60% in Stock A (expected return 12%) and 40% in Bond B (expected return 5%). The portfolio's expected return is:

• a.9.2%✓
• b.17%
• c.11.2%
• d.8.5%

Portfolio expected return is a weighted average: 0.60 x 12% + 0.40 x 5% = 7.2% + 2.0% = 9.2%. Multiply each weight by its return and sum.

A portfolio is 70% in a fund with a beta of 1.4 and 30% in a fund with a beta of 0.6. The portfolio's beta is:

• a.2.00
• b.1.00
• c.0.98
• d.1.16✓

Portfolio beta is a weighted average of the component betas: 0.70 x 1.4 + 0.30 x 0.6 = 0.98 + 0.18 = 1.16.

Using CAPM, if the risk-free rate is 3%, the expected market return is 10%, and a stock's beta is 1.2, the stock's required return is:

• a.8.4%
• b.13.0%
• c.15.0%
• d.11.4%✓

CAPM: required return = Rf + beta x (Rm - Rf) = 3% + 1.2 x (10% - 3%) = 3% + 1.2 x 7% = 3% + 8.4% = 11.4%.

A portfolio's CAPM-expected return is 11%, but it actually returned 13%. Its alpha is:

• a.+2%✓
• b.0%
• c.-2%
• d.+24%

Alpha = actual return - CAPM-expected return = 13% - 11% = +2%. A positive alpha indicates outperformance versus the risk-adjusted expectation.

A portfolio returns 12%, the risk-free rate is 2%, and the portfolio's standard deviation is 8%. Its Sharpe ratio is:

• a.10.0
• b.1.25✓
• c.0.17
• d.1.50

Sharpe ratio = (Rp - Rf) / standard deviation = (12% - 2%) / 8% = 10 / 8 = 1.25. It measures excess return per unit of total risk.

Fund A has a Sharpe ratio of 0.9; Fund B has a Sharpe ratio of 0.6. This indicates that:

• a.Fund A necessarily carries a higher standard deviation than Fund B
• b.The two funds are equally attractive on a risk-adjusted basis
• c.Fund B produced a higher total return
• d.Fund A delivered more return per unit of total risk✓

A higher Sharpe ratio means more excess return per unit of total risk (standard deviation). Fund A is more efficient on a risk-adjusted basis than Fund B.

A portfolio has an expected return of 8% and a standard deviation of 10%. Assuming returns are normally distributed, about 68% of annual outcomes should fall between:

• a.0% and 16%
• b.-2% and 18%✓
• c.-12% and 28%
• d.6% and 10%

About 68% of outcomes lie within plus or minus one standard deviation: 8% +/- 10% = -2% to 18%. Roughly 95% lie within two standard deviations.

A U.S. Treasury bill used as the risk-free asset has a beta of:

• a.-1
• b.0✓
• c.1
• d.Greater than 1

The risk-free asset has zero systematic risk, so its beta is 0: its return does not move with the market. A beta of 1 belongs to the market portfolio, a beta above 1 means more volatile than the market, and a negative beta means moving opposite the market, which a Treasury bill does not do.

Under CAPM, an investor is compensated with a higher expected return for bearing:

• a.Unsystematic risk, which diversification eliminates
• b.Liquidity risk from securities that are hard to sell quickly
• c.Systematic (market) risk, as measured by beta✓
• d.Total risk

CAPM holds that only systematic (non-diversifiable) risk, measured by beta, is rewarded. Unsystematic risk can be diversified away and therefore earns no risk premium.

Adding a risk-free asset to the risky portfolios on the efficient frontier creates:

• a.A security market line that plots each security's required return against its beta
• b.A straight line from the risk-free rate to the minimum-variance portfolio on the efficient frontier
• c.The capital market line, a straight line from the risk-free rate through the market portfolio✓
• d.A downward-curving line showing that more of the risk-free asset lowers expected return and raises risk

Combining the risk-free asset with the market portfolio produces the capital market line, a straight line from the risk-free rate through the market portfolio that dominates the efficient frontier alone. The security market line plots required return against beta for individual securities. The line touches the frontier at the market (tangency) portfolio, not at the minimum-variance portfolio. The risk-free asset lowers risk, so the combinations do not bend downward.

The correlation coefficient between two assets can range:

• a.From 0 to 100
• b.From -1.0 to +1.0✓
• c.From 0 to +1.0 only, since assets can never move in opposite directions
• d.From negative infinity to positive infinity

Correlation ranges from -1.0 (perfectly opposite) to +1.0 (perfectly together), with 0 meaning no linear relationship. Lower correlation improves diversification.

Two investors both choose portfolios on the efficient frontier but pick different points on it. The best explanation is that they:

• a.Are measured against different benchmarks
• b.Must have different time horizons
• c.Have different risk tolerances✓
• d.Hold different amounts of wealth

Every portfolio on the efficient frontier is efficient, and where an investor sits depends on personal risk tolerance and utility. More risk-averse investors choose lower-risk points and less risk-averse investors choose higher-risk points. Benchmarks are used to measure results, not to choose a point on the frontier. Time horizon may influence risk tolerance but does not by itself fix the point. Wealth does not restrict which frontier portfolio an investor can hold.

A criticism of standard deviation as a risk measure is that it:

• a.Measures only market risk, so it ignores a security's company-specific risk
• b.Counts only whether returns were positive or negative, not how far they were from the average
• c.Is calculated only for individual securities, so it cannot describe the total variability of a whole portfolio
• d.Treats upside and downside volatility the same, though investors mainly fear the downside✓

Standard deviation penalizes upside and downside movements equally, while investors chiefly fear downside. Measures such as the Sortino ratio use downside deviation instead. It measures total risk, not just market risk, which is what beta captures. It is based on how far returns deviate from their average, not simply on their sign. It can be computed for a portfolio as readily as for a single security.

Which bond has the GREATEST interest-rate (price) risk, all else equal?

• a.A 5-year floating-rate bond that resets quarterly
• b.A 1-year Treasury bill
• c.A 2-year note with a high coupon
• d.A 30-year zero-coupon bond✓

Interest-rate risk rises with duration. A long-maturity zero-coupon bond has the highest duration (no interim cash flows) and therefore the greatest price sensitivity to rate changes.

Purchasing-power (inflation) risk is MOST damaging to which holding?

• a.A diversified portfolio of common stocks
• b.A long-term fixed-rate bond✓
• c.A commodity fund
• d.A Treasury Inflation-Protected Security whose principal adjusts with the CPI

Inflation (purchasing-power) risk most harms long-term fixed-rate bonds, whose fixed payments lose real value. Stocks, TIPS, and commodities offer some inflation protection.

Reinvestment risk is the danger that:

• a.Inflation will steadily erode the real purchasing power of the fixed coupon payments
• b.Rising interest rates will cause the price of a long-term bond to fall before maturity
• c.A bond issuer will default and fail to return the investor's principal
• d.Coupon or principal proceeds must be reinvested at lower rates than the original✓

Reinvestment risk is that cash flows (coupons or maturing principal) must be reinvested at lower prevailing rates, reducing total return. Zero-coupon bonds avoid coupon reinvestment risk.

Credit (default) risk is BEST described as the risk that:

• a.Broad stock-market declines reduce the whole portfolio's value
• b.The issuer fails to make timely interest or principal payments✓
• c.The investor cannot sell the security quickly without a price concession
• d.Market interest rates will rise and push the bond's price below par

Credit/default risk is the chance an issuer cannot meet its interest or principal obligations. It is highest for low-rated (junk) issuers, and rating agencies assess it.

An investor in a thinly traded, non-listed limited partnership faces significant:

• a.Market risk
• b.Interest-rate risk requiring daily marking to market
• c.Reinvestment risk
• d.Liquidity risk✓

Liquidity (marketability) risk is the difficulty of selling an asset quickly at a fair price. Non-listed partnerships and private placements are illiquid and hard to exit.

Which of the following is a form of SYSTEMATIC risk?

• a.The risk that one firm's management makes a strategic error
• b.The risk that a single issuer is downgraded
• c.Market risk affecting nearly all securities at once✓
• d.The risk that a specific company's new product launch fails and its shares fall

Systematic risk (market, interest-rate, inflation, currency) affects broad markets and is non-diversifiable. The other choices describe unsystematic, company-specific risks.

A U.S. investor holding unhedged European stocks faces currency risk, meaning returns can fall if:

• a.The euro gains in value relative to the dollar
• b.Dividends are paid in euros
• c.Trading hours differ from U.S. hours
• d.The euro weakens against the U.S. dollar✓

Currency (exchange-rate) risk: when the euro weakens against the dollar, each euro of stock value and dividend converts into fewer dollars, which reduces the U.S. investor's return. A stronger euro raises dollar returns. The currency a dividend is paid in only matters through how the exchange rate moves. Differences in trading hours do not change the dollar value of the holding.

The risk that a change in tax law removes the federal tax exemption on certain municipal bonds is an example of:

• a.Default risk, from the municipality's deteriorating finances
• b.Interest-rate risk, from a broad rise in market yields
• c.Legislative (political) risk✓
• d.Reinvestment risk

Legislative/political risk is the danger that new laws or regulations adversely affect an investment, such as altering the favorable tax treatment of municipal bond interest.

Using the Rule of 72, approximately how long will it take money to double at an 8% annual compound return?

• a.About 9 years✓
• b.About 12 years
• c.About 6 years
• d.About 15 years

Rule of 72: years to double is approximately 72 / rate = 72 / 8 = 9 years. The rule estimates doubling time at a given compound rate of return.

Using the Rule of 72, what approximate annual return is needed to double an investment in 6 years?

• a.About 12%✓
• b.About 18%
• c.About 8%
• d.About 6%

Rule of 72: rate is approximately 72 / years = 72 / 6 = 12%. Rearranging the rule solves for the compound return required to double in a given time.

An investor deposits $10,000 at a 10% annual compound return for 3 years. The approximate future value is:

• a.$13,310✓
• b.$11,000
• c.$30,000
• d.$13,000

Future value = PV x (1 + r)^n = 10,000 x (1.10)^3 = 10,000 x 1.331 = $13,310. Compounding applies the return to the accumulated balance each year.

What is the approximate present value of $20,000 to be received in 2 years, discounted at 5% annually?

• a.$18,000
• b.$22,050
• c.$19,048
• d.$18,141✓

Present value = FV / (1 + r)^n = 20,000 / (1.05)^2 = 20,000 / 1.1025 = $18,141. A higher discount rate or a longer horizon lowers the present value.

For a given stated annual rate, increasing the compounding frequency from annual to monthly will:

• a.Reduce the future value of a deposit
• b.Increase the effective annual yield✓
• c.Leave the effective annual yield unchanged
• d.Decrease the effective annual yield

More frequent compounding raises the effective annual yield (and the future value) because interest starts earning interest sooner. Effective yield exceeds the nominal rate as frequency rises.

An investor contributes $5,000 at the end of each year for 30 years. Compared with contributing the same total amount all at once at year 30, the annual-contribution plan will:

• a.Accumulate more, because earlier contributions compound for longer✓
• b.Accumulate the same amount, since the total dollars contributed are identical
• c.Accumulate less, because spreading contributions out reduces total interest
• d.Produce a guaranteed loss

By the time value of money, earlier contributions compound longer, so a stream of annual contributions accumulates more than a single lump sum deposited at the end of the period.

If inflation averages 3% per year, approximately how long until the purchasing power of a dollar is cut in half?

• a.About 33 years
• b.About 12 years
• c.About 24 years✓
• d.About 48 years

The Rule of 72 applies to inflation: 72 / 3 = 24 years for purchasing power to halve (equivalently, for prices to double). About 12 years is what a 6% rate would give, 48 years corresponds to 1.5%, and 33 years comes from dividing a different constant (100) by 3.

An investment's internal rate of return (IRR) is the discount rate at which:

• a.The net present value of all cash flows equals zero✓
• b.The coupon rate equals the risk-free rate
• c.The undiscounted cash inflows equal twice the initial outflow
• d.The investment's future value equals its par value at maturity

IRR is the discount rate that makes the net present value of an investment's cash flows equal zero. It is compared with the required return to judge whether to accept the investment.

A portfolio earns a nominal 7% while inflation is 3%. The approximate real rate of return is:

• a.About 2%
• b.About 21%
• c.About 10%
• d.About 4%✓

Real return is approximately nominal return minus inflation = 7% - 3% = 4% (the exact Fisher calculation gives about 3.9%). It reflects the true gain in purchasing power.

$1,000 invested at 7% compounded annually grows to about $1,967 after 10 years. After 20 years it will be worth approximately:

• a.$3,934
• b.$3,870✓
• c.$2,400
• d.$1,967

Future value = 1,000 x (1.07)^20 = about 1,000 x 3.87 = $3,870. Doubling the horizon more than doubles the value because compounding accelerates over time.

Two zero-coupon bonds both pay $1,000 at maturity in 10 years. Bond X is discounted at 4% and Bond Y at 8%. Which has the higher present value (price) today?

• a.Bond Y
• b.Bond X✓
• c.Neither can be valued without a coupon rate
• d.They have identical present values

A lower discount rate produces a higher present value, so Bond X (4%) is worth more today than Bond Y (8%). Present value and the discount rate move inversely.

A client wants a quick estimate of how many years it takes to double at a 9% annual return. The best estimate is:

• a.About 12 years
• b.About 8 years✓
• c.About 4 years
• d.About 6 years

Rule of 72: 72 / 9 = 8 years to double. The rule provides a fast mental estimate of the compound doubling time at a given return.

A bond has a modified duration of 6. If interest rates rise by 1%, the bond's price will approximately:

• a.Remain unchanged
• b.Rise by about 6%
• c.Fall by about 6%✓
• d.Fall by about 1%

Approximate price change is roughly minus modified duration times the change in yield = -6 x 1% = -6%. Prices fall as rates rise, scaled by duration.

A bond portfolio has a duration of 8. If interest rates fall by 0.5%, the portfolio's value will approximately:

• a.Rise by about 4%✓
• b.Remain flat
• c.Rise by about 0.5%
• d.Fall by about 4%

Price change is roughly minus duration times the change in yield = -8 x (-0.5%) = +4%. Falling rates raise bond prices, magnified by the portfolio's duration.