Portfolio Management and Wealth Planning【Session17 - Reading 41】 2012, investment, including, increase

optiix

June Spraker, CFA, manages a portfolio for a private family. In the recent update of the investment policy statement (IPS), the family has asked Spraker to increase the sophistication of her portfolio performance evaluation to give an exhaustive assessment of the risks to which the portfolio is exposed. The family insists on including the details of the evaluation process in the IPS. Their request is:

A) not justified because portfolio performance evaluation should not be addressed in the IPS.

B) justified because there are a wide variety of ways investment returns can be earned with many types of risk exposures, and the details of the process should be in the IPS.

C) justified because this is what the law requires, but the usefulness of the request is not clear.

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Understanding how a return was earned is very important so that the manager can know if the fund had the correct exposures as specified in the IPS.

ikoreaii

Suppose that all of a firm’s managers are outperforming the benchmark, some by a little, some by a lot. If the confidence intervals for a quality control charts in portfolio management were widened, what would the most likely effect be?

A) Type I error would become more likely and Type II error would become more likely.

B) Type I error would become more likely and Type II error would become less likely.

C) Type I error would become less likely and Type II error would become more likely.

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Type I error is retaining a poorly performing manager. If the confidence intervals are widened and a poor manager is barely outperforming the benchmark, it is less likely that they will have statistically significant excess returns. We are thus more likely to fire them and hence less likely to commit Type I error. At the same time, we may be firing good managers who are outperforming the benchmark but yet do not have statistically significant excess returns. We are thus more likely to commit Type II error as Type II error is firing a superior manager.

ikoreaii

Jack Jensen is the president of Jensen Management. Jensen prides himself on the care of his employees. He states that in 30 years of portfolio management, he has only had to fire two employees. Tom Mercer is president of Analytical Investors. His policy has been to replace poorly performing managers, where poor performance equals underperforming their benchmark for two successive quarters. Which of the following best describes these managers’ continuation decisions?

A) Jensen is likely committing Type I error and Mercer is likely committing Type II error.

B) Jensen is likely committing Type II error and Mercer is likely committing Type I error.

C) Jensen is not likely to be committing any error and Mercer is likely committing Type II error.

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Type I error is retaining (or hiring) a poorly performing manager. Jensen is likely committing Type I error because he rarely fires anyone. Type II error is firing (or not hiring) a superior manager. Jensen is likely committing Type II error because he fires managers after only two quarters of underperformance. Two quarters is not enough time to properly evaluate a manager.

ikoreaii

Which of the following is NOT a conclusion regarding quality control charts and how they are typically used to evaluate manager performance?

A) This is a two-tailed test.

B) H0 will be that the manager adds no value; Ha is that the manager adds positive value.

C) Keeping a manager who generates no value added would be a Type I error.

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The test is set up as null, the manager generates no added value and the alternative is that the manager adds value. So we are looking for positive added value which is a one-tailed test. Therefore, the alternative will be that the manager generates positive value added.

ikoreaii

Suppose that a portfolio management firm has abnormally high turnover in their staff. Which of the following is the most likely scenario?

A) The firm’s Type I error rate is low and their Type II error rate is high.

B) The firm’s Type I error rate is high and their Type II error rate is low.

C) The firm’s Type I error rate is high and their Type II error rate is high.

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Type I error is retaining a poor manager and Type II error is firing a superior manager. If a firm has high turnover in staff, it is unlikely they are retaining poor managers but more likely that they are firing good managers.

ikoreaii

Suppose that a portfolio management firm has decided that the costs of hiring and firing managers are excessive. Which of the following would be their most appropriate course of action? The firm should:

A) tolerate more Type I error to reduce Type II error.

B) reduce both Type I and Type II errors.

C) tolerate more Type II error to reduce Type I error.

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Type I error is retaining a poor manager and Type II error is firing a superior manager. If a firm wishes to reduce the costs of hiring and firing managers, then they should reduce staff turnover. So they should err on the side of retaining poor managers (Type I error) to reduce the chance of firing superior managers (Type II error). They might do this by relaxing the performance criteria managers must meet.

ikoreaii

Which of the following would NOT be a feature of a well formulated manager continuation policy?

A) Decisions to replace managers should always be taken on a clear cost benefit analysis basis.

B) Underperformance, in any circumstances, will lead to automatic replacement of the manager.

C) A formalized, written manager continuation policy including goals and guidelines.

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Short periods of underperformance should not necessarily lead to automatic replacement of the manager. Underperformance for consecutive review periods should put the plan sponsor on notice of a potential problem.

ikoreaii

Which of the following is NOT a conclusion that could be derived from plotting a manager's value-added returns relative to the benchmark on a quality control chart?

A) The chart can be used to determine whether or not the potential superior performance is statistically significant.

B) If returns are consistently above the horizontal axis this would indicate superior performance on the part of the manager under review.

C) If value added returns are distributed randomly around the horizontal axis then manager’s added value returns are more or less random.

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In order to determine statistical significance or otherwise, confidence intervals need to be constructed using the standard deviation of the returns. Simply looking at the manager's value added returns above horizontal line alone does not tell you if the returns are significant or random.

ikoreaii

When constructing a quality control chart which of the following is an important assumption that is made about the distribution of the manager’s value added returns?

A) The investment process is consistent thus ensuring that a high degree of the error term in one period can be explained by the error term in the previous period.

B) The null hypothesis states that the expected value-added return is the risk free rate of return.

C) Value-added returns are independent and normally distributed.

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The null hypothesis states that the expected value-added return is zero. We are testing the manager’s ability to generate positive expected value added returns. We want a consistent process to ensure that the distribution of value added returns about their mean is constant. We do indeed assume that value-added returns are independent and normally distributed.

ikoreaii

Which of the following best describes the use of quality control charts in portfolio management? Quality control charts are used to determine if a manager has:

A) strayed from their stated style.

B) statistically significant excess returns.

C) substantial excess returns.

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In portfolio management, quality control charts are used to determine if a manager has statistically significant excess returns. The manager’s returns versus a benchmark are plotted on a graph where time is on the x-axis and value-added (excess) return is plotted on the y-axis. A confidence interval is formed around the x-axis of zero. If the manager’s returns plot outside the confidence interval, we conclude that the manager has generated statistically significant excess returns.