Reading 33: Equity Portfolio Management- LOS b～ Q1-9

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LOS b: Discuss the rationales for passive, active, and semiactive (enhanced index) equity investment approaches and distinguish among those approaches with respect to expected active return and tracking risk.

Q1. Which of the following equity strategies would provide the highest expected active return?

A) Enhanced indexing.

B) Active.

C) Risk-controlled active management.

Q2. Which of the following equity strategies would provide the highest information ratio?

A) Active.

B) Enhanced indexing.

C) Passive.

Q3. Mavis Borchard, principal of Borchard Investments, is discussing portfolio strategy with Wilford Tupper, a potential client who walked into her office in the hopes of finding a shrewd way to invest an $800,000 IRA roll-over. Tupper is an experienced investor with other stock holdings, but he does not have the time to manage his own account.

After listening to Tupper's investment goals, Borchard suggests a policy of active management, listing several of its benefits.

"The potential returns of this strategy are higher than those of passive-management strategies, yet the risk-reward trade-off is appealing. The information ratio for active management is higher than the ratio for passive management."
"My optimization approach limits risk by using a factor model that takes into account the covariance of different risk factors."
"To ensure that my portfolios deliver the best performance and that I don't deviate from my original investment style, I regress my returns against three indexes, a large-cap, a mid-cap, and small-cap."
"I use a bottom-up approach to select stocks, focusing most on industry conditions."

Tupper is not satisfied with Borchard's strategies and asks about other types of investments. Historically, Tupper has not been successful at beating the market with his large-cap stock choices, but he is a firm believer in reversion to the mean.

Borchard then recommends an enhanced indexing strategy. She suggests that Tupper start with 60 percent of his money in a market index fund, then divide the remainder between two portfolio managers, one who manages accounts in a large-cap blend style, and one who buys small-cap stocks with a value slant. Borchard expects the risk-free return to remain at 4.3 percent for the rest of the year and projects a market return of 12.7 percent and market risk of 18.6 percent for the year. The following is some data on expectations for both investment managers. Assume the correlation between the equity manager's active returns are zero.

Manager	Expected Return	Expected Risk
Large-cap blend manager	13.8%	27.5%
Small-cap value manager	17.5%	30.1%

This plan appeals to Tupper, but he is still not sure in what index he should invest. He is picky about his indexes and would like any selections to meet a number of criteria:

The index must be investable.
Transaction costs must be low.
The index value must be easy to track.
Index construction must allow investors to mimic the index with minimal tracking risk.
The index must reflect the broader market as closely as possible.

While Tupper likes the mix of index funds and active management proposed by Borchard, he is also concerned that the active managers stick to their knitting. Borchard generally uses a large-cap index like the Dow Jones Industrial Average as a benchmark, but Tupper wants a benchmark customized to each manager's investment style. Borchard reluctantly agrees to provide a customized benchmark. She generally uses returns-based analysis to track whether money managers stay on target, but Tupper prefers a holdings-based approach.

To best meet Tupper's index requirements, Borchard should select:

A) a price-weighted index.

B) a capitalization-weighted index.

C) an index reconstituted by committee, rather than by rule.

Q4. Which of Borchard's statements is likely to be most effective at convincing Tupper to let her actively manage his account?

A) "My optimization approach limits risk by using a factor model that takes into account the covariance of different risk factors."

B) "The potential returns of this strategy are higher than those of passive-management strategies, yet the risk-reward trade-off is appealing. The information ratio for active management is higher than the ratio for passive management."

C) "To ensure that my portfolios deliver the best performance and that I don't deviate from my original investment style, I regress my returns against three indexes, a large-cap, a mid-cap, and small-cap."

Q5. Assuming a 30 percent weighting in large-cap stocks, Borchard's enhanced indexing strategy for Tupper should generate an active return closest to:

A) 13.51%.

B) 0.81%.

C) 5.11%.

Q6. Based on his belief in mean reversion, Tupper should pursue a strategy of:

A) momentum investing.

B) optimization.

C) value investing.

Q7. Which of the following statements about holdings-based analysis is least accurate? It:

A) can pick up style drift faster than returns-based analysis.

B) requires the use of less data than returns-based analysis.

C) can yield different results depending on the method used.

Q8. Assuming a 25 percent weighting in small-cap stocks, Borchard's enhanced indexing strategy for Tupper should generate active risk closest to: