Practice (PEI)
Last updated
Last updated
The Mackenzie Education Foundation funds educational projects in a four-state region of the United States. Because of the investment portfolio’s poor benchmark-relative returns, the foundation’s board of directors hired a consultant, Stacy McMahon, to analyze performance and provide recommendations.
McMahon meets with Autumn Laubach, the foundation’s executive director, to review the existing asset allocation strategy. Laubach believes the portfolio’s underperformance is attributable to the equity holdings, which are allocated 55% to a US large-capitalization index fund, 30% to an actively managed US small-cap fund, and 15% to an actively managed developed international fund.
Laubach states that that the board is interested in following a passive approach for some or all of the equity allocation. In addition, the board is open to approaches that could generate returns in excess of the benchmark for part of the equity allocation. McMahon suggests that the board consider following a passive factor-based momentum strategy for the allocation to international stocks.
Q.
Compared with broad-market-cap weighting, the international equity strategy suggested by McMahon is most likely to:
Solution
A is correct. Compared with broad-market-cap weighting, passive factor-based strategies tend to concentrate risk exposure, leaving investors vulnerable during periods when the risk factor (e.g., momentum) is out of favor.
Q.
The international strategy suggested by McMahon is most likely characterized as:
Solution
B is correct. McMahon suggests that the foundation follow a passive factor-based momentum strategy, which is generally defined by the amount of a stock’s excess price return relative to the market during a specified period. Factor-based momentum strategies are classified as return oriented.
McMahon observes that the benchmark used for the US large-cap equity component is a price-weighted index containing 150 stocks. The benchmark’s Herfindahl–Hirschman Index (HHI) is 0.0286.
McMahon performs a sector attribution analysis based on Exhibit 1 to explain the large-cap portfolio’s underperformance relative to the benchmark.
Exhibit 1:
Trailing 12-Month US Large-Cap Returns and Foundation/Benchmark Weights
Sector
Sector Returns
Foundation Sector Weights
Benchmark Sector Weights
Information technology
10.75%
18.71%
19.06%
Consumer staples
12.31%
16.52%
16.10%
Energy
8.63%
9.38%
9.53%
Utilities
−3.92%
8.76%
8.25%
Financials
7.05%
6.89%
6.62%
Q.
The initial benchmark used for the US large-cap allocation:
Solution
C is correct. The initial benchmark used for the US large-cap allocation is a price-weighted index. In a price-weighted index, the weight of each stock is its price per share divided by the sum of all the share prices in the index. As a result, a price-weighted index can be interpreted as a portfolio composed of one share of each constituent security.
Q.
Based on its HHI, the initial US large-cap benchmark most likely has:
Q.
Using a sector attribution analysis based on Exhibit 1, which US large-cap sector is the primary contributor to the portfolio’s underperformance relative to the benchmark?
Solution
C is correct. Below is the attribution analysis for selected sectors of the US large-cap portfolio.
US Large-Cap Core Portfolio
Large-Cap Benchmark
Attribution Analysis
Sector
Sector Return (A)
Sector Weight (B)
Contribution to Return (C) = (A) × (B)
Sector Weight (D)
Contribution to Return (E) = (A) × (D)
Difference (F) = (C) − (E)
Information technology
10.75%
18.71%
2.01%
19.06%
2.05%
−0.04%
Consumer staples
12.31%
16.52%
2.03%
16.10%
1.98%
0.05%
Energy
8.63%
9.38%
0.81%
9.53%
0.82%
−0.01%
Utilities
−3.92%
8.76%
−0.34%
8.25%
−0.32%
−0.02%
Financials
7.05%
6.89%
0.49%
6.62%
0.47%
0.02%
Based on this analysis, the US large-cap portfolio’s information technology sector is the primary contributor to the portfolio’s disappointing equity returns because it provided the largest negative differential relative to the benchmark, with a differential of −0.04%. Although the information technology sector had a positive return, this sector was underweighted relative to the benchmark, resulting in a negative contribution to the portfolio’s returns.
The board decides to consider adding a mid-cap manager. McMahon presents candidates for the mid-cap portfolio. Exhibit 2 provides fees and cash holdings for three portfolios and an index fund.
Exhibit 2:
Characteristics of US Mid-Cap Portfolios and Index Fund
Portfolio 1
Portfolio 2
Portfolio 3
Index Fund
Fees
0.10%
0.09%
0.07%
0.03%
Cash holdings
6.95%
3.42%
2.13%
0.51%
QuestionQ.
Based on Exhibit 2, which portfolio will most likely have the lowest tracking error?
Solution
C is correct. Of the three portfolios, Portfolio 3 has the lowest cash holding and the lowest fees. As a result, Portfolio 3 has the potential for the lowest tracking error compared with the other proposed portfolios.
Evan Winthrop, a senior officer of a US-based corporation, meets with Rebecca Tong, a portfolio manager at Cobalt Wealth Management. Winthrop recently moved his investments to Cobalt in response to his previous manager’s benchmark-relative underperformance and high expenses.
Winthrop resides in Canada and plans to retire there. His annual salary covers his current spending needs, and his vested defined benefit pension plan is sufficient to meet retirement income goals. Winthrop prefers passive exposure to global equity markets with a focus on low management costs and minimal tracking error to any index benchmarks. The fixed-income portion of the portfolio may consist of laddered maturities with a home-country bias.
Tong proposes using an equity index as a basis for an investment strategy and reviews the most important requirements for an appropriate benchmark. With regard to investable indexes, Tong tells Winthrop the following:
Statement 1
A free-float adjustment to a market-capitalization weighted index lowers its liquidity.
Statement 2
An index provider that incorporates a buffering policy makes the index more investable.
Q.
Which of Tong’s statements regarding equity index benchmarks is (are) correct?
Solution
B is correct. The three requirements for an index to become the basis for an equity investment strategy are that the index be (a) rules based, (b) transparent, and (c) investable. Buffering makes index benchmarks more investable (Statement 2) by making index transitions a more gradual and orderly process.
A is incorrect because basing the index weight of an individual security solely on the total number of shares outstanding without using a free-float adjustment may make the index less investable. If a stock market cap excludes shares held by founders, governments, or other companies, then the remaining shares more accurately reflect the stock’s true liquidity. Thus a free-float adjustment (Statement 1) to a market index more accurately reflects its actual liquidity (it does not lower its liquidity). Many indexes require that individual stocks have float and average shares traded above a certain percentage of shares outstanding.
Winthrop asks Tong to select a benchmark for the domestic stock allocation that holds all sectors of the Canadian equity market and to focus the portfolio on highly liquid, well-known companies. In addition, Winthrop specifies that any stock purchased should have a relatively low beta, a high dividend yield, a low P/E, and a low price-to-book ratio (P/B).
Q.
To satisfy Winthrop’s benchmark and security selection specifications, the Canadian equity index benchmark Tong selects should be:
Solution
B is correct. To address Winthrop’s concerns (sector diversification, liquidity, risk, dividend yield, P/E, and P/B), the Canadian equity index benchmark should consist of large-capitalization stocks with a value tilt. A large-capitalization index contains the largest-cap stocks, which tend to have the highest liquidity. Value stocks tend to exhibit high dividend yields and low P/E and P/B ratios.
A is incorrect because small-capitalization stocks tend to be riskier than large-capitalization stocks. Winthrop has a preference for low-beta (risk) stocks.
C is incorrect because a growth index will not address Winthrop’s preference for a low P/E. Growth stocks exhibit characteristics such as high price momentum, high P/Es, and high EPS growth.
Winthrop and Tong agree that only the existing equity investments need to be liquidated. Tong suggests that, as an alternative to direct equity investments, the new equity portfolio be composed of the exchange-traded funds (ETFs) shown in Exhibit 1.
Exhibit 1:
Available Equity ETFs
Equity Benchmark
ETF Ticker
Number of Constituents
P/B
P/E
Fund Expense Ratio
S&P/TSX 60
XIU
60
2.02
17.44
0.18%
S&P 500
SPY
506
1.88
15.65
0.10%
MSCI EAFE
EFA
933
2.13
18.12
0.33%
Q.
Based on Exhibit 1 and assuming a full-replication indexing approach, the tracking error is expected to be highest for:
Solution
C is correct. An index that contains a large number of constituents will tend to create higher tracking error than one with fewer constituents. Based on the number of constituents in the three indexes (S&P/TSX 60 has 60, S&P 500 has 506, and MSCI EAFE has 933), EFA (the MSCI EAFE ETF) is expected to have the highest tracking error. Higher expense ratios (XIU: 0.18%; SPY: 0.10%; and EFA: 0.33%) also contribute to lower excess returns and higher tracking error, which implies that EFA has the highest expected tracking error.
Question 10 of 14Review Answer On Off64.3% complete
Evan Winthrop, a senior officer of a US-based corporation, meets with Rebecca Tong, a portfolio manager at Cobalt Wealth Management. Winthrop recently moved his investments to Cobalt in response to his previous manager’s benchmark-relative underperformance and high expenses.
Winthrop resides in Canada and plans to retire there. His annual salary covers his current spending needs, and his vested defined benefit pension plan is sufficient to meet retirement income goals. Winthrop prefers passive exposure to global equity markets with a focus on low management costs and minimal tracking error to any index benchmarks. The fixed-income portion of the portfolio may consist of laddered maturities with a home-country bias.
Tong proposes using an equity index as a basis for an investment strategy and reviews the most important requirements for an appropriate benchmark. With regard to investable indexes, Tong tells Winthrop the following:
Statement 1
A free-float adjustment to a market-capitalization weighted index lowers its liquidity.
Statement 2
An index provider that incorporates a buffering policy makes the index more investable.
Winthrop asks Tong to select a benchmark for the domestic stock allocation that holds all sectors of the Canadian equity market and to focus the portfolio on highly liquid, well-known companies. In addition, Winthrop specifies that any stock purchased should have a relatively low beta, a high dividend yield, a low P/E, and a low price-to-book ratio (P/B).
Winthrop and Tong agree that only the existing equity investments need to be liquidated. Tong suggests that, as an alternative to direct equity investments, the new equity portfolio be composed of the exchange-traded funds (ETFs) shown in Exhibit 1.
Exhibit 1:
Available Equity ETFs
Equity Benchmark
ETF Ticker
Number of Constituents
P/B
P/E
Fund Expense Ratio
S&P/TSX 60
XIU
60
2.02
17.44
0.18%
S&P 500
SPY
506
1.88
15.65
0.10%
MSCI EAFE
EFA
933
2.13
18.12
0.33%
Winthrop asks Tong about the techniques wealth managers and fund companies use to create index-tracking equity portfolios that minimize tracking error and costs. In response, Tong outlines two frequently used methods:
Method 1
One process requires that all index constituents are available for trading and liquid, but significant brokerage commissions can occur when the index is large.
Method 2
When tracking an index with a large number of constituents and/or managing a relatively low level of assets, a relatively straightforward and technically unsophisticated method can be used to build a passive portfolio that requires fewer individual securities than the index and reduces brokerage commission costs.
Tong adds that portfolio stocks may be used to generate incremental revenue, thereby partially offsetting administrative costs but potentially creating undesirable counterparty and collateral risks.
Q.
Method 1’s portfolio construction process is most likely:
Solution
B is correct. Full replication occurs when a manager holds all securities represented by the index in weightings that closely match the actual index weightings. Thus it requires that all index constituents are liquid and available for trading, and the asset size of the mandate must also be sufficient. Significant brokerage commissions can occur, however, when the index is large.
Q.
Method 2’s portfolio construction process is most likely:
Solution
C is correct. Stratified sampling methods are most frequently used when a portfolio manager is tracking an index that has a large number of constituents, or when managing a relatively low level of assets. Brokerage fees can become excessive when the number of constituents in the index is large.
A is incorrect because optimization does not involve simple techniques. Optimization requires a high level of technical sophistication, including familiarity with computerized optimization software or algorithms, and a good understanding of the output.
B is incorrect because full replication occurs when a manager holds all (not fewer) securities represented by the index in weightings that closely match actual index weightings. Full replication techniques require that the mandate’s asset size is sufficient and that the index constituents are available for trading. Full replication can create significant brokerage commissions when the index is large.
Q.
The method that Tong suggests to add incremental revenue is:
Solution
B is correct. Securities lending is typically used to offset the costs associated with portfolio management. By lending stocks, however, the investor is exposed to the credit quality of the stocks’ borrower (counterparty or credit risk) and to risks involved with the posted collateral (market risk).
A is incorrect because program trading is a strategy of buying or selling many stocks simultaneously. It is used primarily by institutional investors, typically for large-volume trades. Orders from the trader’s computer are entered directly into the market’s computer system and executed automatically.
C is incorrect because attribution analysis is not a method of generating incremental revenue. Attribution analysis is a method that helps the manager understand the sources of return.
After determining Winthrop’s objectives and constraints, the CAD147 million portfolio’s new strategic policy is to target long-term market returns while being fully invested at all times. Tong recommends quarterly rebalancing, currency hedging, and a composite benchmark composed of equity and fixed-income indexes. Currently the USD is worth CAD1.2930, and this exchange rate is expected to remain stable during the next month. Exhibit 2 presents the strategic asset allocation and benchmark weights.
Exhibit 2:
Composite Benchmark and Policy Weights
Asset Class
Benchmark Index
Policy Weight
Canadian equity
S&P/TSX 60
40.0%
US equity
S&P 500
15.0%
International developed markets equity
MSCI EAFE
15.0%
Canadian bonds
DEX Universe
30.0%
Total portfolio
100.0%
In one month, Winthrop will receive a performance bonus of USD5,750,000. He believes that the US equity market is likely to increase during this timeframe. To take advantage of Winthrop’s market outlook, he instructs Tong to immediately initiate an equity transaction using the S&P 500 futures contract with a current price of 2,464.29 while respecting the policy weights in Exhibit 2. The S&P 500 futures contract multiplier is 250, and the S&P 500 E-mini multiplier is 50.
Tong cautions Winthrop that there is a potential pitfall with the proposed request when it comes time to analyze performance. She discloses to Winthrop that equity index futures returns can differ from the underlying index, primarily because of corporate actions such as the declaration of dividends and stock splits.
Q.
In preparation for receipt of the performance bonus, Tong should immediately:
Solution
C is correct. The amount of the performance bonus that will be received in one month (USD5,750,000) needs to be invested passively based upon the strategic allocation recommended by Tong. Using the strategic allocation of the portfolio, 15% (USD862,500.00) should be allocated to US equity exposure using the S&P 500 E-mini contract, which trades in US dollars. Because the futures price is 2,464.29 and the S&P 500 E-mini multiplier is 50, the contract unit value is USD123,214.50 (2,464.29 × 50).
The correct number of futures contracts is (5,750,000.00 × 0.15)/123,214.50 = 7.00.
Therefore, Tong will buy seven S&P 500 E-mini futures contracts.
Q.
The risk that Tong discloses regarding the equity futures strategy is most likely:
Solution
A is correct. Basis risk results from using a hedging instrument that is imperfectly matched to the investment being hedged. Basis risk can arise when the underlying securities pay dividends, because the futures contract tracks only the price of the underlying index. Stock splits do not affect investment performance comparisons.
Arthur Camme, founder of Camme Consulting, Inc., advises endowment funds and private foundations regarding equity manager selection. Because of the poor relative performance and high fees of active management over the past several years, Camme has been fielding an increasing number of inquiries from clients about the best ways to use passive solutions for equity exposure.
Camme meets with client Sylvia Parker, who seeks guidance in establishing passive exposure for her $400 million family foundation. For a portion of equities, Parker wants to use an index approach augmented by factor-based solutions. She comments, “I hear that factor-based approaches can be used when pursuing risk-adjusted returns superior to that of a comparable market cap-weighted index. In addition,
fundamental weighting can enhance return, but when compared with intrinsic values, it has the disadvantages of overweighting overpriced stocks and underweighting underpriced stocks;
value factor funds seek to lower downside risk; and
relative to cap weighting, single-factor funds tend to concentrate risk exposure.”
Which comment by Parker regarding factor-based approaches is most accurate? The comment regarding:
Solution
B is correct. Relative to cap weighting, single-factor funds concentrate risk exposure to the characteristics of the factor used.
A is incorrect. Value factor funds focus on valuation measures, not volatility.
C is incorrect. Fundamental weighting’s intended advantage is overweighting stocks priced below intrinsic value and underweighting overpriced stocks.
Passive Equity Investing Learning Outcome
Compare passive factor-based strategies to market-capitalization-weighted indexing
amme suggests to Parker that the first priority in moving to a passive solution is to consider the choices available for index exposure. Owing to the large size of the fund, Camme recommends choosing a replication manager in order to minimize total costs. He explains the differences between full replication, stratified sampling, and optimization when constructing the portfolio. Parker likes the idea of blending stratified sampling with optimization and asks Camme to identify the appropriate manager based on the data in Exhibit 1.
Exhibit 1
Equity Replication Managers
Manager A
Manager B
Manager C
Benchmark
S&P 500
MSCI EAFE
Russell 3000
Number of holdings: Fund/index
498/500
800/928
1,200/3,000
Usage of futures
For cash drag
For currency overlay
No
Accounts for covariances
No
No
Yes
Tracking error
0.06%
1.97%
0.34%
Excess return
0.10%
2.10%
–0.15%
In Exhibit 1, the replication manager that most likely blends stratified sampling and optimization is:
Solution
C is correct. Manager C demonstrates characteristics consistent with a blended approach of stratified sampling and optimization. The optimization process accounts explicitly for the covariances in the portfolio constituents and results in lowering tracking error when compared with stratified sampling alone. Using 1,200 holdings out of the 3,000 used by the index illustrates stratified sampling. Manager A appears to use a full replication, given the large number of holdings (498 of 500) and the low tracking error. Manager B appears to use stratified sampling alone, given the proportion of holdings (800 out of 928 in the index, or 86%), and does not appear to use optimization, given the large tracking error, which would have been reduced by accounting for covariances.
A is incorrect. It is very likely that Manager A uses a full replication approach as indicated by the number of holdings (498 of 500) and the low tracking error.
B is incorrect. Manager B uses stratified sampling alone. The manager has not reduced tracking error by accounting for covariances as would be done when using optimization. Using 1,200 holdings out of the 3,000 used by the index illustrates stratified sampling.
Passive Equity Investing Learning Outcome
Compare the full replication, stratified sampling, and optimization approaches for the construction of passively managed equity portfolios
In reviewing the relative performance of Manager B from Exhibit 1, Parker makes the following statements:
He faced more volatile markets than the others did, based on the tracking errors.
He used currency overlays to lever the returns of securities held in foreign currency.
His excess return looks like it is more a matter of luck than skill.
Which of Parker’s statements about Manager B in Exhibit 1 is most appropriate? The statement about:
Solution
B is correct. The comment about excess return being luck rather than skill is correct. Replication managers attempt to create a portfolio that tracks the performance and the volatility of the underlying index as closely as possible. The proper measure of skill is the tracking error: Manager B has the highest tracking error among the three managers.
A is incorrect. Tracking error does not measure volatility of the portfolio; rather, it measures the volatility of the excess return between the index and the portfolio.
C is incorrect. A currency overlay assists a portfolio manager in hedging (not levering) the returns of securities that are held in foreign currency back to the home country’s currency.
Passive Equity Investing Learning Outcome
Discuss potential causes of tracking error and methods to control tracking error for passively managed equity portfolios
Another client is Ken Dashe, the new chairman of the investment committee of the Daventown Arts Endowment. He wants Camme to help him understand the primary investment strategy being followed by the MultiFAK fund, which uses several factors to structure and maintain its large-cap active portfolio. The fund uses benchmark segments of four mutually exclusive sub-categories as shown in Exhibit 2.
Exhibit 2
Attribution Data for MultiFAK Fund and Benchmark
MultiFAK Portfolio
Benchmark Portfolio
Factor
Weight
Return (%)
# of stocks
Weight
Return (%)
# of stocks
Yield
0.28
3.5
25
0.28
3.5
25
Momentum
0.14
8.1
20
0.17
8.1
20
Low Volatility
0.31
9.3
30
0.28
9.3
30
Quality
0.27
4.9
16
0.27
4.1
25
Total
1.00
6.3
91
1.00
6.1
100
From Exhibit 2, MultiFAK’s primary strategy is most likely:
Solution
A is correct. MultiFAK uses a risk reduction strategy. It overweights low volatility (31% versus 28%), which is a risk reduction approach; underweights momentum (14% versus 17%), which is a return-oriented approach; and uses fewer securities (91 versus 100) overall than the index, which is not a diversification approach.
B and C are incorrect.
Passive Equity Investing Learning Outcome
Compare passive factor-based strategies to market-capitalization-weighted indexing
Based on Exhibit 2, the excess return of MultiFAK arising from active factor weighting is closest to:
Solution
A is correct. The excess return arising from active factor weights is 0.04%. Compare the weights between the portfolio and the index: The only two that differ are the weights for Low Volatility and Momentum. From the following table, the total contribution to the return caused by active sector weighting is the sum of
0.28% Overweighting Low Volatility + (–0.24%) Underweighting Momentum = 0.04% rounded.
Note that MultiFAK used fewer holdings for the Quality segment and, therefore, incurred active security selection risk—but not active factor risk since the Quality segment weight is the same as that of the index. Here is the full calculation:
MultiFAK Portfolio
Benchmark Index
Return Contribution
Total Active Difference
Active Effect Due to:
Factor
Weight (A)
Return (B)
Weight (C)
Return (D)
MultiFAK (E) = (A) × (B)
Benchmark (F) = (C) × (D)
Active Effect = (E) – (F)
Factor Weight
Security Selection
Yield
0.28
3.5%
0.28
3.5%
0.980%
0.980%
0.000%
Momentum
0.14
8.1%
0.17
8.1%
1.134%
1.377%
–0.243%
–0.243%
Low Volatility
0.31
9.3%
0.28
9.3%
2.883%
2.604%
0.279%
0.279%
High Quality
0.27
4.9%
0.27
4.1%
1.323%
1.107%
0.216%
0.216%
Total
1.00
1.00
6.32%
6.07%
0.252%
0.036%
0.216%
0.036% rounds to 0.04%.
B is incorrect. Results of all active management are shown at the bottom of the Total Active Difference column of the table. This is the full attribution of the active segment overweights plus the result of the active security selection on the Quality segment.
C is incorrect. This is the value of the active overweight to the Low Volatility segment, but it excludes the active underweight to Momentum. See the Low Volatility row in the Factor Weight column of the table.
Passive Equity Investing Learning Outcome
Explain sources of return and risk to a passively managed equity portfolio
Due to a recent fund raising campaign, Daventown experienced sizable cash inflows and the funds were applied in accordance with policy weights.
Exhibit 3
Excerpts from Daventown Arts Endowment Investment Policy Statement
Purpose and mandate
To support all forms of non-performance art within a 100-mile radius. In each year, the fund is required to spend at least 3% of prior year-end assets.
Active investment philosophy
Seek excess returns through the use of active equity and fixed-income managers.
Allocation guideline
60% equity (± 5%), 40% fixed income (± 5%). Cash maximum of 2%. Fixed income is to consist of 50% US Treasuries and 50% investment-grade corporate bonds.
Derivative usage
1. Cash drag can be addressed through derivatives. 2. Allocation guidelines can be achieved with derivatives. 3. Notional amount of derivatives shall be limited to 10% of total assets.
Several months later, Dashe and Camme meet again. Dashe needs advice on how to handle a new pressing issue. A significant market correction has resulted in a current asset allocation of 51% equities, 2% cash, and 47% fixed income. These values are now inconsistent with the investment policy statement guidelines. In addition, the tracking error with equity benchmarks has increased because of a disproportional decline in values of some of the actively managed funds. Camme recommends a cost-efficient strategy to address the situation that will put the portfolio back in line with allocation guidelines and reduce the tracking error.
The most cost efficient strategy to deal with Dashe’s concerns following the equity market correction is a(n):
Solution
C is correct. The most cost efficient rebalancing strategy is to implement an overlay using equity index futures. This approach can get the equity exposure up to at least the guideline range without impacting the active managers. Equity index futures will very likely have less tracking error than the active managers.
A is incorrect. Buying equities and selling bonds will incur trading costs and disrupt the present active managers’ execution. This is not the most cost-effective solution compared with a derivatives overlay.
B is incorrect. The IPS does not allow for index ETFs; it allows for only active managers and derivatives.
Passive Equity Investing Learning Outcome
Compare different approaches to passive equity investing
Sapphire Bay Foundation Case Scenario
Edward Cullen advises the board of directors of the Sapphire Bay Foundation (Sapphire) regarding all aspects of the investment portfolio of Sapphire’s endowment fund. Traditionally, Cullen drove the selection of active investment managers for the various asset classes. Despite historically ranking well among peers, several of the managers have performed below the level of their respective benchmarks in the past few years. Cullen’s colleague Paige Stapleton recommends that some passive management should be introduced into Sapphire’s investment mix using pooled investments. They agree to introduce the idea to Sapphire’s board at its next meeting.
At the next board meeting, Cullen begins by introducing passive investing to Sapphire’s board. He states that open-end mutual funds and exchange-traded funds (ETFs) are appropriate approaches. Both alternatives are readily available, offer a broad spectrum of investment choices, and are easy to buy and sell. He makes the following comments comparing the two alternatives.
Both mutual funds and ETFs can be purchased on margin.
Investors can take short positions in ETFs but not in mutual funds.
Both mutual funds and ETFs have the same degree of liquidity.
In comparing mutual funds and ETFs, Cullen is most accurate in:
Solution
B is correct. Only ETF investors can take short positions.
A is incorrect. Only ETF investors can purchase shares on margin.
C is incorrect. Mutual funds and ETFs do not have the same degree of liquidity. Although ETFs allow for inter-day trading they could experience periods of market illiquidity. Mutual fund units are redeemed directly from the mutual fund.
Passive Equity Investing Learning Outcome
Compare different approaches to passive equity investing
Stapleton then begins a description of factor-based strategies. These include common equity factors, such as value, size, and
other investors, which can reduce the advantages of a strategy.
When comparing factor-based strategies relative to the market-cap weighting of an index, Stapleton’s comments are most likely:
Solution
C is correct. Stapleton’s comment is incorrect regarding risk exposure. Relative to broad-market-cap-weighting, passive factor-based strategies tend to concentrate risk exposures, leaving investors exposed during periods when a chosen risk factor is out of favor.
A is incorrect. Stapleton’s comment is correct regarding transparency. Passive factor-based strategies tend to be transparent in terms of factor selection, weighting, and rebalancing. The strategies can be easily replicated by other investors which can produce overcrowding and reduce the realized advantages of a strategy.
B is incorrect. Stapleton’s comment is correct regarding transparency but incorrect regarding risk exposure. Passive factor-based strategies tend to be transparent in terms of factor selection, weighting, and rebalancing. The strategies can be easily replicated by other investors which can produce overcrowding and reduce the realized advantages of a strategy. Relative to broad-market-cap-weighting, passive factor-based strategies tend to concentrate risk exposures, leaving investors exposed during periods when a chosen risk factor is out of favor.
Passive Equity Investing Learning Outcome
Compare passive factor-based strategies to market-capitalization-weighted indexing
Cullen provides Sapphire’s board with an example comparing the performance of the River Valley Fund, a factor-based fund, with its benchmark portfolio (Exhibit 1). The fund uses benchmark segments of four mutually exclusive sub-categories. Cullen calculates the percentage of River Valley’s excess return that resulted from active factor-weighting decisions.
Exhibit 1
Attribution Data for River Valley Fund and Benchmark
River Valley Fund
Benchmark Portfolio
Factor
Weight
% Return
# of Stocks
Weight
% Return
# of Stocks
Growth
0.22
7.9
23
0.25
7.9
23
Value
0.19
5.2
27
0.19
5.2
27
Quality
0.29
6.7
20
0.26
6.7
20
Momentum
0.30
3.9
24
0.30
4.5
30
Total
1.00
5.84
94
1.00
6.06
100
In Exhibit 1, the percentage of the excess return of the River Valley Fund arising from active factor weighting is closest to:
-0.03 * 7.9 + 0.03 * 6.7 = -0.036 ~= -0.04
-0.036 (Factor weighting) + 0.3 * -0.6% (security selection) = - 0.216
so excess return from factor weighting = -0.036 / -0.216 = 16.67
if rounded up -> -0.04 / -0.22 = 18.18%
Solution
A is correct. The percentage of excess return arising from active factor weighting is 18.18%. In comparing the weights between the fund and the benchmark, the factors with different weights are Growth and Quality. The total contribution to the return caused by active factor weighting is
(Underweighting of the Growth factor + Overweighting of the Quality factor) ÷ Total effect
= (–0.24% + 0.20%) ÷ –0.22% = –0.04% ÷ –0.22% = 18.18%.
The fund’s holding of Momentum securities was less than the benchmark’s (24 versus 30), and thus, the fund incurred active security selection risk. But it did not incur active factor risk, since the factor weight is the same as that of the benchmark.
River Valley Fund
Benchmark
Return Contribution
Attribution Analysis
Difference Due to:
Factor
Weight (A)
Return (B)
Weight (C)
Return (D)
River Valley (A) × (B) = (E)
Benchmark (C) × (D) = (F)
Total Effect (E) – (F) = (G)
Factor Weight
Security Selection
Growth
0.22
7.9%
0.25
7.9%
1.74%
1.98%
–0.24%
–0.24%
Value
0.19
5.2%
0.19
5.2%
0.99%
0.99%
0.00%
Quality
0.29
6.7%
0.26
6.7%
1.94%
1.74%
0.20%
0.20%
Momentum
0.30
3.9%
0.30
4.5%
1.17%
1.35%
–0.18%
–0.18%
Total
1.00
1.00
5.84%
6.06%
–0.22%
–0.04%
–0.18%
B is incorrect. The candidate did not divide the sum of the difference due to factor weights (–0.04%) by the total effect (–0.22%).
C is incorrect. This is the value of the total effect (–0.22%).
Passive Equity Investing Learning Outcome
Explain sources of return and risk to a passively managed equity portfolio
For the large-cap US equity portion of Sapphire’s investment portfolio, Cullen believes that there are some existing passive indexed-based funds that track the S&P 500 Index that the foundation should consider. Cullen presents Exhibit 2 to Sapphire’s board.
Exhibit 2 S&P
500 Index Funds
Manager A
Manager B
Manager C
Benchmark
S&P 500
S&P 500
S&P 500
Number of holdings: fund/index
498/500
504/500
475/500
Dividends reinvested
Next day
Same day
Next day
Management fee (in basis points)
12
15
10
Rebalance
Quarterly
Quarterly
Quarterly
Reconstitution
Quarterly
Quarterly
Semi-Annually
Based on Exhibit 2, the portfolio manager most likely to have the largest tracking error is:
Solution
B is correct. Tracking error indicates how closely the portfolio behaves like its benchmark and measures a manager’s ability to replicate the benchmark return. Manager C is most likely to have the largest tracking error for three reasons:
The portfolio contains a smaller number of the index holdings than the other two portfolios, resulting in a lower level of replication.
Dividends are reinvested the day following receipt rather than the same day, which would cause cash drag relative to Manager B.
The portfolio is reconstituted less frequently than the other two portfolios.
Although Manager C has a slightly lower management fee, which would result in a lower tracking error, the benefit is unlikely to offset the combined higher tracking error related to the other portfolio characteristics.
A and C are incorrect.
Passive Equity Investing Learning Outcome
Discuss potential causes of tracking error and methods to control tracking error for passively managed equity portfolios
For the international portion of the investment portfolio, Stapleton suggests that Sapphire invest in an MSCI EAFE index portfolio specifically tailored for the foundation rather than investing in an existing index fund. Anne Rowland, Sapphire’s board chair, asks her how this could be accomplished, given that the initial allocation is only $15 million. Stapleton suggests that Sapphire hire a manager to purchase a portfolio of securities that are a mutually exclusive yet comprehensive subgroup of the index designed to track the index return and risk characteristics.
Question
The portfolio method suggested by Stapleton to replicate the MSCI EAFE Index is best described as:
Solution
B is correct. The portfolio method that Stapleton is describing is stratified sampling. In equity indexing, stratified sampling methods are most frequently used when the portfolio manager wants to track indexes that have a large number of constituents or when dealing with a relatively low level of assets under management. In stratified sampling, the portfolio manager holds a limited sample of the index constituents arranged in distinct strata or subgroupings. Arranged correctly, the various strata will be mutually exclusive and also exhaustive and should closely match the characteristics and performance of the index.
A is incorrect. Optimization typically involves maximizing a desirable characteristic or minimizing an undesirable characteristic, subject to one or more constraints.
C is incorrect. An indexed portfolio can be managed using a blended approach consisting of full replication for more liquid issues and stratified sampling or optimization for less liquid issues.
Passive Equity Investing Learning Outcome
Compare the full replication, stratified sampling, and optimization approaches for the construction of passively managed equity portfolios
As an indexing technique, the number of holdings in Manager B’s index most likely illustrates:
Solution
C is correct. Buffering involves establishing ranges around breakpoints that define whether a stock belongs in one index or another. Some index providers have adopted policies intended to limit stock migration problems and keep trading costs low for investors who replicate indexes. Size rankings may change daily with market price movements, so buffering makes index transitions a more gradual and orderly process. As long as stocks remain within the buffer zone, they stay in the current index, and as a result, the holdings of the fund may exceed the holdings of the index.
A is incorrect. Reconstitution involves deleting names that are no longer in the index and adding names that have been approved as new index members.
B is incorrect. Packeting involves splitting stock positions into multiple parts. For example, if a mid-cap stock’s capitalization increases and breaches the breakpoint between the mid-cap and large-cap indexes, a portion of the total holding is transferred to the large-cap index but the rest stays in the mid-cap index. On the next reconstitution date if the stock value remains large cap and all other qualifications are met, the remainder of the shares are moved out of the mid-cap index into the large-cap index.
Passive Equity Investing Learning Outcome
Discuss considerations in choosing a benchmark for a passively managed equity portfolio
With a view overlooking one of the Great Lakes, Seeblick Cemetery is an outdoor homage to over 100,000 interred residents in the US Midwest, with the grounds covering over 300 acres. The Seeblick Cemetery Foundation Investment Committee controls the $200 million endowment fund that supports operations. Committee members include representatives of many of the oldest, wealthiest, and most influential families in the area. As a compromise to differing philosophical views of the members, the fund is divided into three separate investment pools, each with its own stated equity investment mandate. Moncrief Gentry is the equity director for all pools. He oversees the selection of investment managers and determines benchmarks to use to evaluate performance.
The investment mandate for Pool 1 includes two primary goals:
A goal to be cost conscious with a preference for index investing
A goal to be ESG (environmental, social, and governance) sensitive by preferring investments that focus on companies that help the environment with respect to clean energy and climate change
In Pool 1, the investment approach used to implement the ESG goal is best described as:
Solution
B is correct. Focusing on a specific sector, such as clean energy or climate change, is thematic investing.
A is incorrect. Impact investing may target environmental objectives but additionally influences measurable financial returns through engagement with a company or by direct investment.
C is incorrect. The production-oriented approach groups companies that manufacture similar products or use similar inputs in their manufacturing processes.
Overview to Equity Portfolio Management Learning Outcome
Describe the roles of equities in the overall portfolio
Gentry interviews a potential investment manager, who explains that his expertise lies in being able to enhance return or reduce cost using three techniques:
Dividend capture
Security lending
Covered-call writing
Of the three techniques mentioned by the potential investment manager, which would result in the greatest limitation to the upside return potential of the pools?
Solution
C is correct. Writing covered calls limits the upside potential of the pools, because the underlying shares will be sold if the share price exceeds the exercise price of the written calls.
A is incorrect. The dividend capture strategy is independent from the shares owed by the pool; shares that are about to go ex-dividend are purchased and sold following the ex-dividend date. The pool‘s return is not limited on the upside.
B is incorrect. Security lending does not limit the upside potential of the pool, because the underlying shares are retained by the pool.
Overview to Equity Portfolio Management Learning Outcome
Describe the types of income and costs associated with owning and managing an equity portfolio and their potential effects on portfolio performance
The mandate of Pool 2 also consists of two primary goals:
A goal that the overall stock portfolio should consist of mature companies that have stable net incomes and high dividend yields
A goal of expressing strong views on many major corporate issues through proxy voting
Of the three techniques mentioned by the potential investment manager, which is most likely to interfere with Pool 2’s goal associated with corporate governance issues?
Solution
B is correct. When using security lending, the voting rights are transferred to the borrower of the securities. Thus, Pool 2 would not be able to exercise its voting rights through proxy on those shares.
A is incorrect. The dividend capture strategy is independent from the shares owed by the pool; shares that are about to go ex-dividend are purchased and sold after they go ex-dividend. There would be no impact on the core shareholdings in the portfolio being held for governance reasons.
C is incorrect. Writing covered calls involves selling call options on stocks that are already owned in the portfolio. It does not conflict with the desire to vote shares expressed in Pool 2.
Passive Equity Investing Learning Outcome
Compare different approaches to passive equity investing
A goal that the overall stock portfolio should consist of mature companies that have stable net incomes and high dividend yields
Which of the following index methodologies is most appropriate to use as a benchmark for the overall stock portfolio described in Pool 2?
Solution
A is correct. The value risk factor is associated with mature companies that have stable net incomes and high dividend yields. This factor-based method would create the most appropriate benchmark for the Pool 2 equity portfolio.
B is incorrect. Although cap-weighted index construction is widely used, it does not fit the description of the mandate for the overall portfolio in Pool 2.
C is incorrect. Fundamental weighting is an alleged improvement on cap-weighted indexing that uses a cluster of fundamentals, such as book value, cash flow, revenue, dividends, and employee count, as a basis for constituent weighting. These are not included in the description of the mandate for the overall portfolio in Pool 2.
Passive Equity Investing Learning Outcome
Compare passive factor-based strategies to market-capitalization-weighted indexing
Gentry then considers the mandate for Pool 3:
Since equity markets are believed to be efficient, the pool should use index approaches.
The portfolio should be tracked on the basis of large cap versus small cap, as well as domestic, developed, and emerging markets.
The most important benchmark feature is the liquidity of the component stocks.
Gentry reviews additional file notes from Pool 3 related to investing in exchange-traded funds (ETFs) and mutual funds:
Mutual funds tend to have smaller taxable events than similarly managed ETFs. The foundation does not benefit from this characteristic because it is tax exempt.
Disadvantages of using ETFs include the need to buy at the offer and sell at the bid price, paying commissions, and possibly facing illiquid markets at either purchase or sale.
Margin buying and being able to short sell apply to ETFs, not mutual funds.
Of the additional file notes from Pool 3 that Gentry reviews, which is the least accurate? The note regarding:
Solution
B is correct. The note on taxable events is inaccurate. ETFs have smaller taxable events than mutual funds because of the in-kind transfer of securities between an authorized participant and the fund when redemptions occur.
A is incorrect. Unlike traditional open-end mutual funds, ETF shares can be bought by investors using margin borrowing; moreover, investors can take short positions in an ETF.
C is incorrect. These are indeed the disadvantages of using an ETF instead of a mutual fund.
Passive Equity Investing Learning Outcome
Discuss considerations in choosing a benchmark for a passively managed equity portfolio
In order to select the most appropriate benchmark index to fit the description in the mandate of Pool 3, the index construction should:
Solution
B is correct. The mandate of Pool 3 emphasizes liquidity as a benchmark feature. Free-float weighting is a form of capitalization weighting. A cap-weighted index can be thought of as a liquidity-weighted index because the largest-cap stocks tend to have the highest liquidity and the greatest capacity to handle investor flows at a manageable cost.
A is incorrect. Exhaustive inclusion uses every stock in an index regardless of its liquidity.
C is incorrect. The mandate of Pool 3 explicitly states a belief in efficient markets. Fundamental weighting intends to exploit possible inefficiencies in market pricing caused by the overuse of cap-weighted approaches.
Passive Equity Investing Learning Outcome
Explain sources of return and risk to a passively managed equity portfolio.
9
Further explanation in
