Equity Investments 【 Reading 27】 习题精选 2012, regarding, following, statements

Gypsy

Which of the following statements regarding using equities as an inflation hedge is most accurate? They have been a good inflation hedge:

A) in many countries over a short time span.

B) but only in the U.S for a short time span.

C) in many countries over a long time span.

---

Using data for 17 countries for 106 years, equities have had consistently positive real returns (i.e., their nominal return has been higher than that of inflation).

Gypsy

Which of the following is least accurate regarding using equities as an inflation hedge?

A) Their ability to hedge is unaffected by taxes.

B) The effectiveness of an individual stock as a hedge depends on its product market.

C) The historical record is impressive as to their effectiveness.

---

Because corporate income and capital gains tax rates are not indexed to inflation, inflation can reduce the stock investor’s return, unless this effect was priced into the stock when the investor bought it. Equities have had consistently positive real returns in 17 countries from 1900-2005. The more competition in a firm’s product market, the less effective their stock will be as a hedge.

Gypsy

Which of the following is least accurate regarding equities in a portfolio?

A) U.S. equity typically constitutes about half of world equity.

B) Equities have been shown to be an inflation hedge worldwide.

C) European institutions hold more equity than U.S. institutions in their portfolio.

---

In the U.S., institutional investors hold about 60% of their portfolio in equity. In Europe, the percentage is closer to 20%. The historical evidence in the U.S. and in other countries indicates that equities have been a good inflation hedge.

Gypsy

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 capitalization-weighted index.

B) a price-weighted index.

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

---

Borchard seeks an index that reflects the broader market as closely as possible. This suggests a price-weighted index is out, as nominal stock prices are somewhat arbitrary and quite changeable, so the index's complexion can change simply because of a stock split. Low transaction costs favor capitalization-weighted indexes rather than equal-weighted indexes that must be rebalanced more often. The investability requirement also weighs on equal-weighted indexes, which tend to favor smaller stocks, which in turn may offer less liquidity. That leaves a capitalization-weighted index. Most indexes are easy to track. Index reconstitution policies can affect tracking risk and transaction costs, but are not relevant to investability and how effectively an index reflects the market. (Study Session 11, LOS 27.d)

---

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

A) "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."

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

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."

---

None of the arguments is particularly compelling, but at least the statement about the information ratio is true and relevant. Active management does have a higher information ratio than passive management. Optimization applies to passive or semiactive management, not active management. Regressing returns against cap-weighted indexes will not determine whether the fund emphasizes value or growth stocks, so it will not detect growth or value style drift. Bottom-up approaches depend little on industry conditions, relying mostly on the fundamentals of individual stocks. (Study Session 11, LOS 27.b)

---

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) 5.11%.

C) 0.81%.

---

The strategy’s active return represents the weighted average of the active returns of each component. To calculate the active return, subtract the expected market return from the expected returns of each strategy.
The large-cap manager has an estimated 13.8% return. Subtract the projected 12.7% market return, and the active return is 1.1%. For the small-cap strategy, the active return is 4.8%. The index fund is expected to earn the market return of 12.7%, for an active return of 0%. 1.1% × 30% + 4.8% × 10% + 0% × 60% = 0.81%. That’s the strategy’s expected active return. (Study Session 11, LOS 27.r)

---

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

A) value investing.

B) momentum investing.

C) optimization.

---

Tupper is a believer in mean reversion, which is a cornerstone of value investing. Momentum investors don't want mean reversion. Optimization is an indexing technique for which mean reversion is unimportant. As far as market-cap investing goes, reversion to the mean is no more or less important for one capitalization group relative to any other capitalization group. (Study Session 11, LOS 27.g)

---

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) can yield different results depending on the method used.

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

---

Holdings-based analysis requires more data than returns-based analysis. The other statements are true. (Study Session 11, LOS 27.i)

---

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

A) 3.17%.

B) 14.08%.

C) 5.12%.

---

A portfolio’s active risk is the square root of the sums of the squares of the weighted average active risk.
To calculate the active risk, subtract the expected market risk from the risk of each portfolio component. The large-cap strategy’s risk is 27.5%. Subtract the market’s 18.6% risk, and you have active risk of 8.9%. The small-cap strategy’s active risk is 11.5%, and the index fund’s active risk is 0%, because the index tracks the market. Here’s how to calculate the complete strategy’s active risk:
Large-cap strategy: 8.9%2 × 15%2 = 0.0178%.
Small-cap strategy: 11.5%2 × 25%2 = 0.0827%.
Index fund: 0%2 × 60%2 = 0%.
The sum of the squares is 0.1005%. The square root of 0.001005 is 3.17% and that is the portfolio’s active risk. (Study Session 11, LOS 27.r)

Gypsy

Which of the following equity strategies would provide the lowest expected tracking risk?

A) Enhanced indexing.

B) Passive.

C) Risk-controlled active management.

---

Passive management will have the lowest expected tracking risk. Semiactive management is also known as enhanced indexing or risk-controlled active management. A semiactive manager will have an expected tracking risk between active and passive managers.

Gypsy

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

A) Active.

B) Passive.

C) Enhanced indexing.

---

The information ratio is the expected active return divided by the tracking risk. Enhanced indexing provides the highest information ratio. Active management has the second highest information ratio on average while indexing strategies have the lowest.

Gypsy

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

A) Active.

B) Enhanced indexing.

C) Risk-controlled active management.

---

Active management will provide the highest expected active return. Semiactive management is also known as enhanced indexing or risk-controlled active management. A semiactive manager will have an expected active return between active and passive managers.

Gypsy

In which of the following situations should an equity investor generally consider a passive management strategy?

A) When investing in global markets.

B) When investing in large cap markets.

C) The manager should consider a passive strategy in both of these cases.

---

Passive strategies are generally recommended in both of these situations. When investing in large cap stocks, a passive strategy is suitable because these markets are usually informationally efficient. In international equity markets, the foreign investor may be at an informational disadvantage compared to the local investor.

Gypsy

Which of the following investors would be more likely to pursue passive equity management strategies?

A) A taxable investor who believes markets are efficient.

B) A nontaxable investor who believes markets are efficient.

C) A taxable investor who believes markets are inefficient.

---

Passive strategies have low turnover, fewer realized capital gains, and hence lower associated taxes. If an investor believes markets are efficient, he or she would be more likely to pursue a passive strategy because the investor would not believe that beating the market was possible through an active strategy.

Gypsy

An investor believes markets are efficient and pursues an equity investment strategy consistent with their beliefs. Which of the following best characterizes their portfolio, relative to other possible equity strategies?

A) Low tracking risk and low information ratio.

B) High tracking risk and low information ratio.

C) Low tracking risk and high information ratio.

---

If an investor believes markets are efficient, the investor will pursue a passive strategy. Relative to active and semiactive strategies, passive strategies are characterized by low expected active return, low tracking risk, and low information ratio.