Reading 31: Equity Portfolio Management－LOS s active, return, measures

tycoon

CFA Institute Area 8-11, 13: Asset Valuation
Session 10: Equity Portfolio Management
Reading 31: Equity Portfolio Management
LOS s: Distinguish among the components of total active return ("true" active return and "misfit" active return) and their associated risk measures and explain their relevance for evaluating a portfolio of managers.

tycoon

Which of the following is least likely to be an objective of optimization after decomposing total active return into true and misfit components?

A) Maximize total active return.

B) Eliminate misfit risk.

C) Minimize total active risk.

D) Generate a positive true information ratio.

---

Answer and Explanation

The decomposition of the total active performance into true and misfit components is useful for optimization. The objective is maximize the total active return for a given level of total active risk, while still allowing for an optimal amount of misfit risk. Note that misfit risk is not optimized at zero because a manager may be able to generate a level of true active return for some level of misfit risk. In other words, if you let the manager specialize in the style they are familiar with, the manager is more likely to generate excess returns relative to their normal portfolio.

tycoon

In which of the following portfolios would misfit risk be largest? A portfolio:

A) generated using a core-satellite approach.

B) generated using a completeness fund approach.

C) that is indexed to a broad market.

D) that is an enhanced index portfolio.

---

Answer and Explanation

Whenever the managers portfolio diverges significantly from the investors portfolio, there will be misfit risk. An investors portfolio is one that the investor uses to evaluate the manager and may not be appropriate for their style. The investors portfolio is usually a broad market benchmark for that asset class. By design, the completeness fund results in a reduction of misfit risk. The indexed and enhanced indexed portfolios will have small misfit risk. The portfolio generated using a core-satellite approach will have the highest misfit risk because the satellite portfolios allow for specialized manager styles.