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 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 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

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 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

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 statements is least accurate? An investor’s utility of the active return:

A) increases as the investor’s risk aversion to active risk decreases.

B) increases as active risk decreases.

C) increases as the investor’s risk tolerance for active risk decreases.

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The utility function for active return is similar to the utility function for total return. The utility of the active return increases as active return increases, active risk decreases, and as the investor’s risk aversion to active risk decreases. Risk tolerance is the opposite of risk aversion. Lower risk tolerance would imply lower utility from a risky return.

hinsafdar

In which of the following situations would an investor be most risk averse?

A) When allocating assets to stocks, bonds, and other assets.

B) When allocating funds to active equity managers.

C) When allocating funds to a passive index.

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At the asset allocation level, the focus is on maximizing expected return for a given level of risk. Once an investor has made a decision to invest in equity, the tradeoff focuses on active risk and active return. As one moves from passive management to enhanced indexing to active management, the expected active return and active risk increase.
Investors are more risk averse when facing active risk. To believe that an active return is possible, the investor must believe that there are active managers who can produce it and that the investor will be able to pick those successful managers. Second, an active equity style will also be judged against a passive benchmark. It is difficult to earn alpha and those investors who don’t will face pressure from their superiors. Lastly, higher active returns mean more is invested with the high return active manager, and this results in less diversification.

hinsafdar

How is risk controlled in a stock-based enhanced indexing strategy?

A) Buying puts on equity indices.

B) Selling equity futures contracts.

C) Through monitoring factor risk and industry exposures.

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In a stock-based enhanced indexing strategy, risk is controlled by monitoring factor risk and industry exposures.

hinsafdar

Which of the following concerning investment strategies is least accurate?

A) Stock-based enhanced indexing strategy can produce higher information ratios because investors can apply their knowledge to a large number of securities.

B) In a long-short, market neutral strategy the benchmark should be the risk-free rate.

C) If a manager does not have an opinion about an index stock in stock-based enhanced indexing strategy, they will not hold the stock.

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If a manager does not have an opinion about an index stock in a stock-based enhanced indexing strategy, they will hold the stock at the same level as the benchmark. Stock-based enhanced indexing strategies can produce higher information ratios because the investor can systematically apply his knowledge to a large number of securities, each of which would require independent decisions. Because a long-short, market neutral strategy has no systematic risk, its benchmark should be the risk-free rate (the return on T-bills).