hinsafdar

Which of the following assumptions is typically used to calculate the portfolio active risk from a group of equity managers? The correlation between equity managers’ active returns are:

A) zero.

B) positive, ranging from 0.3 to 0.8.

C) a function of the amount allocated to each manager.

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To calculate the portfolio active risk, it is typically assumed that the correlations between the equity managers’ active returns are zero. This is not an unreasonable assumption if the managers are following different styles.

hinsafdar

Which of the following is least accurate regarding the completeness fund approach?

A) It will increase the misfit return.

B) It can be managed passively or semiactively.

C) Combining a completeness fund with an active fund will result in risk exposure similar to the benchmark.

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A potential disadvantage of a completeness fund is that it may result in a reduction of active returns arising from misfit risk.

hinsafdar

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

A) generated using a completeness fund approach.

B) that is indexed to a broad market.

C) generated using a core-satellite approach.

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Whenever the manager’s portfolio diverges significantly from the investor’s portfolio, there will be misfit risk. An investor’s portfolio is one that the investor uses to evaluate the manager and may not be appropriate for their style. The investor’s 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 portfolio 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.

hinsafdar

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

A) Generate a positive “true” information ratio.

B) Eliminate misfit risk.

C) Maximize total active return.

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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.

hinsafdar

Which of the following is least likely to be a limitation of an alpha and beta separation approach?

A) The investor may be exposed to systematic risk.

B) It may be difficult to implement in markets.

C) Some long-short strategies may have a degree of systematic risk.

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One of the main reasons to undertake an alpha and beta separation approach is to gain an exposure to systematic risk (the beta) through a long position in an equity index. The alpha is picked up using a long-short approach.

hinsafdar

Which of the following would least likely be a component of an alpha and beta separation approach for an investor who is restricted from explicit long-short investing strategies?

A) A long position in a large-cap equity futures contract.

B) A short position in a small-cap equity futures contract.

C) A market neutral hedge fund.

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A market-neutral hedge fund strategy would be undertaking long-short positions so this would not be available to the investor. An investor restricted from long-short strategies could create a similar exposure as the alpha and beta separation approach by taking a long position in a large-cap index futures contract and invest with a small-cap manager to generate the alpha. To become market neutral in the small-cap market, the investor would then short a futures contract based on small-cap equities.

hinsafdar

Which of the following is least accurate regarding an alpha and beta separation approach?

A) The alpha position is more costly than the beta position.

B) A portable alpha strategy means that an investor can easily pick up systematic risk through a variety of positions.

C) This approach may obscure investment risks.

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One of the advantages of an alpha and beta separation approach is that the investor can better understand and manage the risks in an alpha and beta separation approach because they are more clearly defined. The investor also has a better idea of the costs of investing. The passive beta exposure is typically cheaper than the active alpha exposure. In a portable alpha strategy, the investor can easily pick up systematic risk through a variety of positions using equity index positions while maintaining the long-short alpha.

hinsafdar

Which of the following provisions in an equity manager’s compensation plan would create symmetry in the compensation?

A) A high water mark provision.

B) A fee cap.

C) Stock options.

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Symmetry refers to when the manager receives both rewards for good performance and punishment for bad performance. A high water mark provision states that a manager must compensate for past underperformance before receiving a performance-based fee. This is the only compensation provision mentioned in the responses that punishes for bad performance so it is the only one that provides symmetry.

hinsafdar

Which of the following equity manager compensation plans would create the greatest incentive for performance?

A) A base compensation plus bonus and stock options.

B) A base compensation plus stock options.

C) A symmetric compensation plan.

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Performance-based fees align the interests of the equity manager and the investor, especially if they are symmetric. A symmetric compensation plan has both rewards for good performance and punishment for bad performance. Both remaining responses do not punish the manager for bad performance.

hinsafdar

If an investor is concerned that his or her equity manager might undertake too much risk, which of the following provisions in the equity manager’s compensation plan should be included?

A) A fee cap.

B) Stock options.

C) A high water mark provision.

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A performance-based fee may include a fee cap where a maximum is placed on the performance fee. The intent is to prevent managers from undertaking too much risk to earn higher fees.