2019 CFA level 3 qbank reading 29 active equity investing portfolio construction answers

Study Session 14, Module 29.3, LOS 29.d Related Material SchweserNotes - Book 4 Question #2 of 24 Exposure to rewarded factors can be achieved through A Systematic active management appr

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Question #1 of 24

An active equity portfolio manager is benchmarked by their domestic large-cap equity index If

the manager signi cantly lowers the allocation to cash in the portfolio by buying benchmark

securities, this is most likely to:

A) decrease active risk and increase absolute risk

B) increase active risk and decrease absolute risk

C) increase active risk and increase absolute risk

Explanation

Cash is likely to have a low correlation with the benchmark and hence lowering the allocation

to cash and buying benchmark securities is likely to increase the correlation of the portfolio

with the benchmark and hence lower the active risk of the portfolio The absolute risk of the

portfolio measured by standalone standard deviation is likely to increase as the portfolio is

allocating to more risky assets

(Study Session 14, Module 29.3, LOS 29.d)

Related Material

SchweserNotes - Book 4

Exposure to rewarded factors can be achieved through

A) Systematic active management approaches only

B) Discretionary active management approaches only

C) Both systematic and discretionary active management approaches

Explanation

Systematic approaches are likely to explicitly target exposures to rewarded factors that are

expected to generate excess returns Whilst a discretionary approach may be less formal in

its nature, the judgement employed by discretionary managers could be aimed at identifying

better factor proxies that are expected to outperform

(Study Session 14, Module 29.1, LOS 29.b)

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An analyst estimates the following data for two active equity fund managers:

Manager Breadth Active Risk Transfer Coe cient

If manager B has the same excess return as manager A, then the Information coe cient of

manager A is closest to:

A) 2 times the information coe cient of manager B

B) 1.4 times the information coe cient of manager B

C) 0.7 times the information coe cient of manager B

Explanation

According to the fundamental law of active management:

Where

E(RA) = excess return of the manager

IC = Information coe cient

BR = breadth

σRA = active risk

TC = transfer coe cient

The excess return of manager A = ICA x √50 x 0.08 x 0.55 = ICA x 0.311

The excess return of manager B = ICB x √100 x 0.08 x 0.55 = ICB x 0.44

If the manager's excess returns are the same this implies

ICA x 0.311 = ICB x 0.44

And, hence, ICA = ICB x (0.44/0.311) = ICB x 1.4

(Study Session 14, Module 29.1, LOS 29.a)

E ( ) = IC RA √ σ BR ‾ ‾ ‾ R ATC

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A security has an active weight of 10% and the covariance of the security's active returns and

portfolio active returns is 0.005 The contribution of the security to portfolio active variance is

closest to:

A) 0.0005

B) 0.05

C) 0.005

Explanation

The contribution of a security to active variance is the product of the security's active weight

and the covariance of the security's active returns and portfolio active returns In this case

this equals 0.1 x 0.005 = 0.0005

(Study Session 14, Module 29.3, LOS 29.d)

Manager A generates excess return by maintaining a consistent positive active exposure to the

size factor Manager B has the same benchmark and generates excess return by varying their

exposure to the size factor according to their view on when the factor will outperform Both

managers are highly diversi ed According to the building blocks of active management, which

manager is most likely to be generating return from alpha skills?

A) Manager B only

B) Both Manager A and Manager B

C) Manager A only

Explanation

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Manager A is generating excess return through maintaining a di erence in factor weights.

This source of return is not considered alpha since it is not related to manager skill in

identifying mispriced securities and can be easily passively replicated Manager B is engaging

in market timing of the size factor in order to generate excess return, which requires skill in

understanding when the size factor is likely to outperform and when it is likely to

underperform This skill is deemed to be alpha

An active equity investment manager has a target active risk of 8%, a maximum sector

deviation of 12% and maximum risk contribution from a single security of 2% This manager is

best described as a:

A) Closet Indexer

B) Sector Rotator

C) Concentrated stock picker

Explanation

A high maximum sector deviation and a signi cant target active risk suggests this manager is

a sector rotator A closet indexer would have signi cantly lower target active return, and a

concentrated stock picker would likely have higher maximum risk contribution from a single

security and a lower maximum sector deviation

(Study Session 14, Module 29.2, LOS 29.c)

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James Greco, CFA, is an investment analyst working as a consultant to institutional clients One

of his clients has asked him about recent innovations in factor-based equity investing In

response to his client's questions, Greco makes the following two statements:

Statement 1: 'Managers that have the ability to short sell in their portfolios are more likely to generate higher information ratios when pursuing diversi ed factor

exposure strategies than long only managers' Statement 2: 'Due to the ability to short sell and the inherent hedging that entails, the long term returns of long/short managers is always expected to be lower than those of long-only managers'

Which of Greco's statements is correct?

A) Both Statement 1 and Statement 2

B) Statement 2 only

C) Statement 1 only

Explanation

Statement 1 is correct Factor returns are usually built from long/short portfolios, for

example the size factor is represented by a portfolio that is long small cap securities and

short large cap securities Hence the ability to target a diversi ed exposure to di erent

factors relies upon the manager being able to short sell securities It is likely that a long-only

manager will have a large exposure to the market risk factor that will dominate other factors

and hence not be su ciently diversi ed across factors

Statement 2 is incorrect Long/short managers can employ signi cant leverage to magnify

expected returns A manager that employs signi cant leverage could match or exceed the

expected returns of a long only portfolio, but may employ leverage levels that some investors

are not comfortable with

(Study Session 14, Module 29.5, LOS 29.h)

When a benchmark security held in an active portfolio is replaced with a similar security that is

not held in the benchmark, the most likely outcome is:

A) Active Share increases by more than active risk

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B) Active Share decreases and active risk increases

C) Active Share and active risk both increase by similar proportions

Explanation

Swapping a security that is in the benchmark for a security that is not in the benchmark will

certainly increase Active Share because Active Share is a direct measure of the amount of the

portfolio that is not included in the benchmark Active risk however will not necessarily

increase since it is a measure of the volatility of relative returns – this is unlikely to increase if

the new security that is introduced in to the portfolio behaves in a similar way to the

benchmark security that was originally held in the portfolio

(Study Session 14, Module 29.2, LOS 29.c)

Factor timing is a technique most likely employed by a strategy that is:

A) Top down and systematic

B) Bottom up and systematic

C) Top down and discretionary

Explanation

Factor timing Is a di cult challenge, and as such there are few successful systematic

strategies that have integrated factor timing in their approach The judgement required to

enact successful factor timing usually means the strategy is top-down and discretionary

(Study Session 14, Module 29.1, LOS 29.b)

All of the following characteristics are features of the 'well-constructed portfolio' except:

A) The portfolio delivers results consistent with investor expectations in a

cost-e cicost-ent way

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B) The portfolio delivers results consistent with investor expectations in a risk-e cient

way

C) The portfolio guarantees excess returns relative to the benchmark

Explanation

The well-constructed portfolio does not guarantee excess return vs the benchmark It is

designed to deliver results consistent with investor's risk and return expectations in a cost

and risk-e cient way

(Study Session 14, Module 29.5, LOS 29.g)

An active equity investment manager follows a strategy which has the following investment

constraints:

Maximum position size is the lesser of 5x the index weight or the index weight plus 2%

No position size is allowed that represents more than 10% of the security's average daily volume (ADV)

No investment is allowed in any security whose index weight is less than 0.1% of the index

Details of the fund and benchmark index are as follows:

Fund size: $500 million Approximate number of positions: 350 Approximate total market capitalisation of benchmark index: $10 trillion Approximate daily trading volume of smaller securities in the benchmark: 0.5% of shares outstanding

The level of assets under management at which the manager's strategy is likely to be a ected

by liquidity and concentration constraints is closest to:

A) $10 billion.

B) $1 billion.

C) $2 billion.

Explanation

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The manager cannot invest in stocks whose market cap is below approximately 0.001 x $10

trillion = $10 billion

The ADV of this smallest cap holding would be about 0.005 x $10bn = $50 million

The maximum absolute position size for this smallest cap holding is therefore 0.10 x $50m =

$5 million

The maximum position for the smallest cap security is the lesser of 5 x 0.1% = 0.5% and 0.1%

+ 2% = 2.1% This means the maximum position size in the fund for the smallest cap security

is 0.5%

If the manager cannot hold up to 0.5% of the fund in the smallest capitalization position, then

the ability to carry out the strategy is potentially impaired

Given that the manager cannot hold more than $5 million in the smallest capitalization

holding, this means the ability to carry out the strategy is impaired by illiquidity when AUM

reach $5,000,000/0.005 = $1 billion

(Study Session 14, Module 29.4, LOS 29.f)

An active equity investment manager has the following four risk constraints:

Liquidity constraint: It should always be possible to liquidate 85% of the portfolio in 10 trading days or less without su ering signi cant market impact costs

Leverage: Explicit leverage is not allowed Leverage using derivates is allowed but restricted to a portfolio assets/equity ratio of 1.5

Maximum tracking error of 5% per annum The 1 % Conditional VaR should not exceed 3%

How many of these constraints are heuristic in nature?

A) Two

B) Three

C) One

Explanation

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Heuristic risk constraints are based on experience and deemed good practise without

rigorous backing of empirical evidence The liquidity constraint and the leverage constraint

are examples of such heuristic risk constraints The tracking error and Conditional Var

constraints are formal constraints in that they are statistical in nature and directly linked to

the distribution of the returns of the portfolio

(Study Session 14, Module 29.3, LOS 29.e)

Which of the following active equity managers is likely to generate most of their active return

from idiosyncratic risk?

A) A manager following an enhanced indexing factor-tilt approach

B) A manager following a quantitative factor-based approach

C) A stock-picking manager following a fundamental approach

Explanation

Idiosyncratic risk comes from large concentrated positions Quantitative factor-based

managers tend to hold many hundreds of position to generate their desired exposures and

therefore will likely diversify away idiosyncratic risk Similarly, an enhanced indexing manager

will hold a broad portfolio very close to the benchmark index and therefore is likely to be

diversi ed Fundamental stock-picking managers are likely to hold fewer positions since they

generate few high-conviction ideas through time consuming research, hence are likely to be

the least diversi ed and have the highest contribution to active return from idiosyncratic risk

factors

Which of the following statements regarding risk constraints is most accurate?

A) Formal risk constraints are appropriate for fundamental managers, heuristic risk

constraints are appropriate for quantitative managers

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B) Both Heuristic constraints and formal constraints are equally likely to be

appropriate for both fundamental and quantitative managers

C) Heuristic risk constraints are appropriate for fundamental managers, formal risk

constraints are appropriate for quantitative managers

Explanation

Fundamental managers are likely to run more concentrated portfolios and hold fewer

positions – this increases the estimation errors for return distributions and makes the use of

formal risk constraints that directly relate to estimate return distributions less useful Hence

fundamental managers are more likely to nd heuristic risk constraints more appropriate

Conversely, quantitative active equity managers are likely to integrate formal risk constraint

measures into portfolio optimizers when constructing their portfolios

(Study Session 14, Module 29.3, LOS 29.e)

All else equal, the well-constructed portfolio for an active equity investment strategy will most

likely have

A) A greater number of positions and lower active share

B) Fewer positions and higher active share

C) A greater number of positions and higher active share

Explanation

Managers that can achieve the desired exposure to risk factors with fewer positions are more

likely to be focussed on risk management and are therefore behaving in a risk-e cient

manner All else equal, portfolios with a higher active share are preferable since these

portfolios will bene t most from the alpha skills of the managers and should therefore have

higher expected returns

(Study Session 14, Module 29.5, LOS 29.g)

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