LOS m, (Part 2): Explain factor portfolio and tracking portfolio.

Q1. The Real Value Fund is designed to have zero exposure to inflation. However its current inflation factor sensitivity is 0.30. To correct for this, the portfolio manager should take a:

A)   30% short position in the inflation factor portfolio.

B)   30% short position in the inflation tracking portfolio.

C)   30% long position in the inflation factor portfolio.

Q2. Sidney Peterson is starting a new fund that is designed to have the same factor exposures as the Dow Jones Industrial Average, but seeks to outperform the index by at least 2% annually thorough superior stock selection. To achieve this, the fund would most likely use a:

A)   bottom-up strategy.

B)   tracking portfolio.

C)   pure factor portfolio.

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Q1. The Real Value Fund is designed to have zero exposure to inflation. However its current inflation factor sensitivity is 0.30. To correct for this, the portfolio manager should take a:

A)   30% short position in the inflation factor portfolio.

B)   30% short position in the inflation tracking portfolio.

C)   30% long position in the inflation factor portfolio.

Correct answer is A)

To hedge inflation, the fund should take a 30% short position in the inflation factor portfolio. This short position will fully offset the fund’s positive exposure to inflation. Tracking portfolios are typically used for active asset selection and have multiple factor exposures which would prevent them from adequately hedging the inflation exposure of the fund.

Q2. Sidney Peterson is starting a new fund that is designed to have the same factor exposures as the Dow Jones Industrial Average, but seeks to outperform the index by at least 2% annually thorough superior stock selection. To achieve this, the fund would most likely use a:

A)   bottom-up strategy.

B)   tracking portfolio.

C)   pure factor portfolio.

Correct answer is B)

Tracking portfolios are typically used for active asset selection. A pure factor portfolio would be used to increase or decrease exposure to one specific factor, such as GNP. A bottom-up strategy is unsuitable because it solely focuses on a firm’s characteristics and fails to properly invest in the same industries as the index.

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