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LOS t: Explain alpha and beta separation as an approach to active management and demonstrate the use of portable alpha.

Q1. Which of the following is least accurate regarding an alpha and beta separation approach?

A)   This approach may obscure investment risks.

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

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

Correct answer is A)

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.

 

Q2. 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.

Correct answer is C)

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.

 

Q3. 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.

Correct answer is A)

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

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LOS m: Compare and contrast long-short versus long-only investment strategies, including their risks and potential alphas, and explain why greater pricing inefficiency may exist on the short side of the market. fficeffice" />

Q1. Which of the following are advantages of a long-short trade? A long-short trade focuses on:

A)   exploiting constraints and can generate a symmetric distribution of active returns.

B)   fundamental valuation and can generate an asymmetric distribution of active returns.

C)   exploiting constraints and can generate an asymmetric distribution of active returns.

Correct answer is A)

Long-only strategies are focused on using fundamental analysis to find undervalued stocks. In contrast, long-short strategies focus on exploiting the constraints many investors face. For example, institutions are unable to short a stock. If an investor would like to express a negative view of an index security in a long-only strategy, he is limited to avoidance of the stock. The distribution of potential active weights in a long-only portfolio is asymmetric.

 

Q2. Which of the following is characteristic of a long-short trade? A long-short trade has the potential to earn:

A)   two alphas and eliminate systematic risk.

B)   two alphas and eliminate unsystematic risk.

C)   one alpha and eliminate systematic risk.

Correct answer is A)

Long-short strategies can buy undervalued stocks and short overvalued stocks, earning two alphas. A long-only strategy can only earn the long alpha. Long-short strategies can eliminate expected systematic risk by buying one stock and shorting another in the same industry. The investor however still has unsystematic risk if the short position rises while the long falls.

 

Q3. Which of the following is least likely to be a reason pricing inefficiencies exist on the short-side?

A)   There are more potential buyers than sellers of stock.

B)   The securities exchanges in the developed world prohibit short sales.

C)   Management has options in firm’s stock.

Correct answer is B)         

Although there may be limitations on short sales, they are not prohibited by securities exchanges. There are more potential buyers than sellers of stock so analysts are reluctant to lose these potential customers with a sell recommendation. Also management may hold their firm’s stock and options and put pressure on analysts to not issue sell recommendations.

 

Q4. A recession is expected in an economy within the next year. Portfolio Manager A has shifted more of their stocks from the financial industry to the health care industry. Portfolio Manager B has shifted more of their stocks from the technology industry to the utility industry. Which of the following statements is most accurate regarding the performance of each manager?

A)   Portfolio Manager A is expected to underperform the broad market while Portfolio Manager B is expected to outperform the broad market.

B)   Portfolio Manager A is expected to outperform the broad market and Portfolio Manager B is expected to outperform the broad market.

C)   Portfolio Manager A is expected to outperform the broad market while Portfolio Manager B is expected to underperform the broad market.

Correct answer is C)

Both managers are exhibiting style drift. Manager A’s drift is actually beneficial to performance while B’s is not. Value managers tend to have greater representation in the utility and financial industries whereas growth managers tend to have higher weights in the technology and health care industries. Growth stocks are more likely to outperform during a recession as there are few other firms with growth prospects and a premium would be placed on growth stocks’ valuation.