CFA CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA level 3 finquiz item set answers, study session 7, reading 20

Cummings is following a passive management mandate and so her fund must track the index return.. This will make this index less representative of emerging market SRI companies and may bi

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CFA Level III Item-set - Solution

Study Session 9 June 2018

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FinQuiz Level III 2018 – Item-sets Solution

Reading 20: Market Indexes and Benchmarks

1 Question ID: 21876

Correct Answer: C

C is correct Out of the three managers, Cummings’ annual performance is most worthy of a bonus Cummings is following a passive management mandate and so her fund must track the index return

By successfully doing so, Cummings demonstrates that she is able to deliver the performance

expected of her

A is incorrect There is lack of evidence to judge whether Malkovich’s fund performance is worthy of

a bonus When using a manager universe as benchmark, fund return must be compared to the middle

or median fund performance Even though Alpha’s annual return exceeds that of the top performing manager, information concerning median manager (fund) performance is needed to appraise the manager’s performance

B is incorrect Ruben’s annual fund return does not qualify as being eligible for a bonus This is because he is following an active management mandate and any fund returns achieved must exceed that of the benchmark Since he has failed to do so, he will not receive the annual bonus

Correct Answer: A

A is correct When using the MSCI SRI index as asset allocation proxy, factors which may weaken the use of the index include the inclusion of only top performing SRI stocks This will make this index less representative of emerging market SRI companies and may bias index performance Thus, the index may not be a good representative of SRI emerging market stock performance

B is incorrect The index can serve as a basis for investment vehicles for the reason being that it selects the most liquid stocks for investment Additionally, the index is reconstituted once a year which decreases the trading costs associated with tracking an index Therefore, it is possible to

replicate the index at low cost without much difficulty

C is incorrect Constituents of the designated index are determined by objective rules which make predicting the contents of the index easier Although the index is cap-weighted, limitations on

concentration of any stock will ensure large-cap securities do not dominate the performance of the index; a drawback typically associated with cap-weighted indexes All these factors support the use of the MSCI SRI index as an investment manager mandate

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A is correct The tradeoff which poses a limitation on index construction is completeness vs

investibility The index does not provide full coverage to emerging market SRI securities as it only allocates to the top-performing, most liquid SRI stocks However, by doing so the index has a high degree of investibility In seeking to ensure investibility, index constructors compromise on

completeness

B is incorrect The tradeoff concerning reconstitution and rebalancing vs turnover is balanced as index providers reconstitute the index on an annual basis; this will significantly reduce index turnover

as the frequency with which securities enter and exit the index is considerably reduced

C is incorrect The constituents of the index are determined based on objective rules, the existing fund constituents This allows for transparency as investors can more readily predict changes in index constituents Hence the tradeoff concerning transparency and objectivity vs subjective judgment is balanced

Correct Answer: B

B is correct The S&P 500 index is float-adjusted, cap-weighted; these indexes require less frequent rebalancing relative to other indexes

A is incorrect Because Cummings’ fund is subject to maximum fund holdings, she may not be able

to track a capitalization-weighted index This is because she will be unable to purchase all the

securities in the index and so portfolio risk and return may deviate substantially from the benchmark

C is incorrect The chosen benchmark is inappropriate given Cummings’ investment strategy The S&P 500 comprises large-cap stocks and is an inappropriate benchmark for the Beta fund, which seeks small-cap exposure Thus, a valid benchmark property is being violated

A is correct Statement 1 is correct The performance of a cap-weighted index reflects the

performance of a portfolio which holds all the outstanding value of each index security As the price

of the stock rises (falls), the index will own more (less) of the particular company

B is incorrect See above

C is incorrect A (n) decrease (increase) in the representation of undervalued (overvalued) securities will make the index more susceptible to market bubbles and will not represent an efficient investment from a risk-return perspective

Correct Answer: C

C is correct In contrast to an all-inclusive index, one with a fixed number of securities will need to be reconstituted frequently as securities periodically enter and exit the index This increases the degree

of index turnover

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