A registered representative is reviewing the following portfolio:
- 30% ABC Energy Company
- 30% XYZ Health Care Company
- 30% ETF (tracks the SP500)
- 10% Money Market funds
Which of the following risk is inherent in this portfolio?
a. Credit
b. Liquidity
c. Political
d. Nonsystematic
What I am confused about is the word of the question being asked: “which risk is inherent”. How do I dissect this question so that I can select an answer?
I was confused by ETF that tracks the SP500 is pretty much diversified or is that only an exception for a mutual funds?
The answer is D but just confused about how to read this.
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Good question, @FoxMcCloud. I believe this question comes from FINRA’s SIE Practice Exam. The word inherent means ‘built-in.’ In other words, they’re asking what risk is most present in the portfolio.
Let’s go through the wrong answers, then discuss the right answer.
Answer choice A is incorrect because there are no debt securities in the portfolio. Credit (default) risk occurs when an issuer is unable to make required interest and/or principal payments to investors. While the money market fund technically holds debt securities (1 year or less to maturity), funds are not themselves considered debt securities. When an investor buys shares of a mutual fund, they’re buying into a portfolio of securities. They aren’t necessarily promised any interest and/or principal from the fund company, although it could be argued the securities in the portfolio could be subject to this risk. Regardless, money markets (high quality short term debt securities) are typically low risk and unlikely to be subject to high levels of credit risk.
Answer choice B is incorrect because there’s no clear indicator liquidity risk exists. Mutual funds do not have liquidity risk because the issuer is required to legally redeem shares within 7 days of request, no matter the circumstance. Exchange traded funds (ETFs) are exchange traded, and therefore can be assumed to have very low levels of liquidity risk. Assume anything that trades on an exchange (NYSE or NASDAQ) can be bought and sold easily. Could the ABC and XYZ stocks be subject to liquidity risk? Yes, especially if it were clear they don’t trade on exchanges. Securities that trade solely in the OTC markets can sometimes have high levels of liquidity risk. Because this isn’t clear, we can’t make that assumption.
Answer choice C is incorrect because political risk only applies to foreign investments, and we don’t have any in this portfolio.
Nonsystematic risk is a category of risk that applies to a specific company or small portion of the market. The less diversified a portfolio, the more one must worry about nonsystematic risks. We don’t have to worry about nonsystematic risks with the ETF or the money market fund, as both are assumed to be diversified. However, the other 60% of the portfolio is invested in two companies. If a nonsystematic risk applies to either holding, it will have a major influence on the overall value of the portfolio. For example, the entire portfolio could lose value if ABC Energy Company was faced with business risk, as it comprises 30% of the portfolio.
Bottom line - the answer is D because 60% of the portfolio is invested in two individual companies, so 60% of the portfolio is not diversified.
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yes, it does come from the FINRA SIE practice exam.
I was confused by the layout of this portfolio and wasn’t sure how to analyze it.
But I like your approach. I will use this tactic.
Thanks!
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