Reading 68: LOS a (Part 2) ～ Q20- 25

20.Andy Green, CFA and Sue Hutchinson, CFA are considering adding alternative investments to the portfolio they manage for a private client. They have found that it is recommended that a large, well-diversified portfolio like the one that they manage should include a 5 to 10 percent allocation in alternative investments such as commodities, distressed companies, emerging markets, etc.. After much discussion, Green and Hutchinson have decided that they will not choose individual assets themselves. Instead of choosing individual alternative investments, they will add a hedge fund to the portfolio. They decide to divide up their research by having each of them take a different focus. In their research of hedge funds, Green focuses on hedge funds that have the highest returns. Hutchinson focuses on finding hedge funds that can allow the client’s portfolio to lower risk while, with the use of leverage, maintain the same level of return.

After completing their research into finding appropriate hedge funds, Green proposes two hedge funds: the New Horizon Emerging Market Fund, which takes long-term positions in emerging markets, and the Hi Rise Real Estate Fund, which holds a highly leveraged real estate portfolio. Hutchinson proposes two hedge funds: the Quality Commodity Fund, which takes conservative long-term positions in commodities, and the Beta Naught Fund, which manages an equity long/short portfolio that has the goal of targeting the portfolio’s market risk to zero. The Beta Naught Fund engages in short-term pair trading to capture additional returns while keeping the beta of the fund equal to zero. The table below lists the statistics for the client’s portfolio without any alternative investments and for the four hedge funds based upon recent data. The expected return, standard deviation and beta of the client portfolio and the hedge funds are expected to have the same values in the near future. The historical data shows that estimating a covariance between two portfolios with their respective betas and market variance produces fairly reliable and accurate estimates. The variance of the market return is 324(%²).

Green and Hutchinson have decided to sell off 10 percent of the current client portfolio and replace it with one of the four hedge funds. They have agreed to select the hedge fund that will provide the highest Sharpe Ratio when 10 percent of the client’s portfolio is allocated to that hedge fund.

As an alternative to investing 10 percent in one hedge fund, Green and Hutchinson have discussed investing five percent in the Beta Naught Fund and five percent in one of the other three hedge funds. This new 50/50 hedge fund portfolio would then serve as the 10 percent allocation in alternative investments for the client’s portfolio.

Green and Hutchinson divided up their research into return enhancement and diversification benefits. Based upon the stated goals of their research, which of the two approaches is more likely to lead to an appropriate choice? The focus of:

A)   Green’s research.

B)   either manager will achieve the same goal.

C)   Hutchinson’s research.

D)   neither manager is appropriate and will not achieve a meaningful result.

The correct answer was C)

Simply increasing return may not be appropriate if the risk level increases more than the return increases. Focusing on assets that help diversify the existing portfolio is more appropriate because any reduction in return can be offset by an increase in leverage.

21.Of the proposed hedge funds, which is most likely to introduce active risk into the client’s portfolio?

A)   Hi Rise Real Estate Fund.

B)   Quality Commodity Fund.

C)   New Horizon Emerging Market Fund.

D)   The Beta Naught Fund.

The correct answer was D)

The Beta Naught Fund is the only one that takes short-term positions.

22.Which of the following is closest to the expected return of the client’s portfolio if 10 percent of the portfolio is invested in the New Horizon Emerging Market Fund?

A)   10.2%.

B)   11.0%.

C)   9.2%.

D)   11.8%.

The correct answer was B)

11% = 0.9*10% + 0.1*20%

23.Which of the following is closest to the expected standard deviation of the client’s portfolio if 10 percent of the portfolio is invested in the Quality Commodity Fund?

A)   9.6%.

B)   16.0%.

C)   14.2%.

D)   18.2%.

The correct answer was C)

The covariance is –51.84 = 0.8*(-0.2)*324 The variance is 200.59 = 0.9*0.9*16*16 + 0.1*0.1*16*16 + 2*0.9*0.1*(-51.84) The square root of the variance is approximately 14.2%.

24.Which of the following is closest to the expected return of a portfolio that consists of 90 percent of the original client’s portfolio, five percent of the Hi Rise Real Estate Fund and five percent in the Beta Naught Fund?

A)   9.0%.

B)   9.7%.

C)   8.0%.

D)   10.4%.

The correct answer was B)

9.7% = 0.9*10% + 0.05*10% + 0.05*4%

25.There was a discussion of allocating five percent each in Beta Naught and one of the other funds. When combined with Beta Naught in a 50/50 portfolio, which of the other three funds will produce a portfolio that has the lowest standard deviation?

A)   New Horizon only.

B)   Either Hi Rise or Quality Commodity.

C)   Quality Commodity only.

D)   Hi Rise only.

The correct answer was B)

Since the beta of Beta Naught is zero, its covariance with any of the other funds is zero. Thus, the lowest standard deviation will be achieved with the fund with the lowest standard deviation. Since Hi Rise and Quality Commodity have the same standard deviation, which is less than New Horizon, either of them would produce the same result.