LOS a: Justify the need for a theory of active portfolio management.

Q1. Gemini Investment Management Company (GIMC) assumes markets will remain at equilibrium indefinitely. GIMC defines security analysis as the examination of factors affecting the value of individual securities. GIMC defines asset allocation as the examination of factors affecting the optimal allocation of assets to the market portfolio and to the risk-free asset. Given GIMC’s assumption that markets are at equilibrium indefinitely, indicate whether GIMC should place significant or insignificant emphasis on security selection and asset allocation.

A)   Insignificant emphasis on security selection only.

B)   Insignificant emphasis on asset allocation only.

C)   Insignificant emphasis on both.

Q2. When markets are at equilibrium, all asset:

A)   betas will equal zero.

B)   alphas will equal zero.

C)   alphas will be positive.

Q3. Intelligent Investors Inc. (III) manages $10 billion in assets using active portfolio management. III believes that security prices often stray from their equilibrium values. Elizabeth Adams and Rajendra Rao work as analysts at III. Adams states that III should overweight all positive alpha stocks. An overweight is defined as an allocation in excess of the asset’s relative market value weight. Rao states that III should allocate assets to maximize the portfolio Sharpe ratio.
Regarding these statements:

A)   only Adams is correct.

B)   only Rao is correct.

C)   both are correct.

LOS a: Justify the need for a theory of active portfolio management. fficeffice" />

Q1. Gemini Investment Management Company (GIMC) assumes markets will remain at equilibrium indefinitely. GIMC defines security analysis as the examination of factors affecting the value of individual securities. GIMC defines asset allocation as the examination of factors affecting the optimal allocation of assets to the market portfolio and to the risk-free asset. Given GIMC’s assumption that markets are at equilibrium indefinitely, indicate whether GIMC should place significant or insignificant emphasis on security selection and asset allocation.

A)   Insignificant emphasis on security selection only.

B)   Insignificant emphasis on asset allocation only.

C)   Insignificant emphasis on both.

Correct answer is A)        

When markets are at equilibrium, all asset prices will equal their fair values. Assets are neither undervalued nor overvalued. Therefore, if GIMC believes markets will remain at equilibrium indefinitely, then they should place very little, if any, emphasis on security selection. In contrast, active portfolio management is needed to determine the appropriate allocation of the client’s investment between the market portfolio and the risk free asset. Active portfolio management is needed to forecast the expected returns and risk for the market portfolio and to forecast the return on the risk-free asset. GIMC should allocate large percentages to the market portfolio for highly risk tolerant clients and high percentages to the risk-free asset for highly risk averse clients. Significant effort must be expended to determine the appropriate mix of assets for the client.

Q2. When markets are at equilibrium, all asset:

A)   betas will equal zero.

B)   alphas will equal zero.

C)   alphas will be positive.

Correct answer is B)

When markets are at equilibrium, forecast returns equal equilibrium expected returns. The stock’s alpha is defined as the difference between the analyst’s forecast return for the stock and the stock’s equilibrium expected return. Therefore, when markets are at equilibrium, all alphas will equal zero.

Q3. Intelligent Investors Inc. (III) manages $10 billion in assets using active portfolio management. III believes that security prices often stray from their equilibrium values. Elizabeth Adams and Rajendra Rao work as analysts at III. ffice:smarttags" />Adams states that III should overweight all positive alpha stocks. An overweight is defined as an allocation in excess of the asset’s relative market value weight. Rao states that III should allocate assets to maximize the portfolio Sharpe ratio.
Regarding these statements:

A)   only Adams is correct.

B)   only Rao is correct.

C)   both are correct.

Correct answer is C)

Adams’ statement is correct. If markets are in disequilibrium, asset prices will deviate from their fair values. An asset’s alpha equals the difference between the analyst’s forecast return for an asset and its required return. Positive alpha assets should be overweighted. Note that a neutral weight for III equals the asset’s relative market value weight, which is how assets are allocated with the “market” portfolio. Rao’s statement is correct too. Allocations should provide investments with the maximum Sharpe ratio defined as the portfolio’s expected excess return, E(R_p) minus R_F, divided by the portfolio’s standard deviation.

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