Practices

Three years ago, the Albright Investment Management Company (Albright) added four new funds—the Barboa Fund, the Caribou Fund, the DoGood Fund, and the Elmer Fund—to its existing fund offering. Albright’s new funds are described in Exhibit 1.

Exhibit 1:

Albright Investment Management Company New Funds

Fund	Fund Description
Barboa Fund	Invests solely in the equity of companies in oil production and transportation industries in many countries.
Caribou Fund	Uses an aggressive strategy focusing on relatively new, fast-growing companies in emerging industries.
DoGood Fund	Investment universe includes all US companies and sectors that have favorable environmental, social, and governance (ESG) ratings and specifically excludes companies with products or services related to aerospace and defense.
Elmer Fund	Investments selected to track the S&P 500 Index. Minimizes trading based on the assumption that markets are efficient.

Q.

The Barboa Fund can be best described as a fund segmented by:

1. A.size/style.

2. B.geography.

3. C.economic activity.

Solution

C is correct. The Barboa Fund invests solely in the equity of companies in the oil production and transportation industries in many countries. The fund’s description is consistent with the production-oriented approach, which groups companies that manufacture similar products or use similar inputs in their manufacturing processes.

A is incorrect because the fund description does not mention the firms’ size or style (i.e., value, growth, or blend). Size is typically measured by market capitalization and often categorized as large cap, mid-cap, or small cap. Style is typically classified as value, growth, or a blend of value and growth. In addition, style is often determined through a “scoring” system that incorporates multiple metrics or ratios, such as price-to-book ratios, price-to-earnings ratios, earnings growth, dividend yield, and book value growth. These metrics are then typically “scored” individually for each company, assigned certain weights, and then aggregated.

B is incorrect because the fund is invested across many countries, which indicates that the fund is not segmented by geography. Segmentation by geography is typically based upon the stage of countries’ macroeconomic development and wealth. Common geographic categories are developed markets, emerging markets, and frontier markets.

Q.

The Caribou Fund is most likely classified as a:

1. A.large-cap value fund.

2. B.small-cap value fund.

3. C.small-cap growth fund.

Solution

C is correct because the fund focuses on new companies that are generally classified as small firms, and the fund has a style classified as aggressive. A widely used approach to segment the equity universe incorporates two factors: size and style. Size is typically measured by market capitalization and often categorized as large cap, mid-cap, or small cap. Style is typically classified as value, growth, or a blend of value and growth.

Solution

B is correct. The DoGood fund excludes companies based on specified activities (e.g., aerospace and defense), which is a process of negative screening. Negative or exclusionary screening refers to the practice of excluding certain sectors or companies that deviate from accepted standards in areas such as human rights or environmental concerns

A is incorrect because positive screening attempts to identify companies or sectors that score most favorably regarding ESG-related risks and/or opportunities. The restrictions on investing indicates that a negative screen is established.

C is incorrect because thematic investing focuses on investing in companies within a specific sector or following a specific theme, such as energy efficiency or climate change. The DoGood Fund’s investment universe includes all companies and sectors that have favorable ESG (no specific sectors or screens) but with specific exclusions.

Q.

The Elmer fund’s management strategy is:

1. A.active.

2. B.passive.

3. C.blended.

Solution

B is correct. The fund is managed assuming that the market is efficient, and investments are selected to mimic an index. Compared with active strategies, passive strategies generally have lower turnover and generate a higher percentage of long-term gains. An index fund that replicates its benchmark can have minimal rebalancing.

Hans Smith, an Albright portfolio manager, makes the following notes after examining these funds:

Note 1	The fee on the Caribou Fund is a 15% share of any capital appreciation above a 7% threshold and the use of a high-water mark.
Note 2	The DoGood Fund invests in Fleeker Corporation stock, which is rated high in the ESG space, and Fleeker’s pension fund has a significant investment in the DoGood Fund. This dynamic has the potential for a conflict of interest on the part of Fleeker Corporation but not for the DoGood Fund.
Note 3	The DoGood Fund’s portfolio manager has written policies stating that the fund does not engage in shareholder activism. Therefore, the DoGood Fund may be a free-rider on the activism by these shareholders.
Note 4	Of the four funds, the Elmer Fund is most likely to appeal to investors who want to minimize fees and believe that the market is efficient.
Note 5	Adding investment-grade bonds to the Elmer Fund will decrease the portfolio’s short-term risk.

Smith discusses means of enhancing income for the three funds with the junior analyst, Kolton Frey, including engaging in securities lending or writing covered calls. Frey tells Smith the following:

Statement 1	Securities lending would increase income through reinvestment of the cash collateral but would require the fund to miss out on dividend income from the lent securities.
Statement 2	Writing covered calls would generate income, but doing so would limit the upside share price appreciation for the underlying shares.

Q.

Based on Note 1, the fee on the Caribou Fund is best described as a:

1. A.performance fee.

2. B.management fee.

3. C.administrative fee.

Solution

A is correct. Performance fees serve as an incentive for portfolio managers to achieve or outperform return objectives, to the benefit of both the manager and investors. Several performance fee structures exist, although performance fees tend to be “upward only”—that is, fees are earned by the manager when performance objectives are met, but fund investors are not reimbursed when performance is negative. Performance fees could be reduced following a period of poor performance, however. Fee calculations also reflect high-water marks. As described in Note 1, the fee for the Caribou Fund is a 15% share of any capital appreciation above a 7% threshold, with the use of a high-water mark, and is therefore a performance fee.

B is incorrect because management fees include direct costs of research (such as remuneration and expenses for investment analysts and portfolio managers) and the direct costs of portfolio management (e.g., software, trade processing costs, and compliance). Management fees are typically determined as a percentage of the funds under management.

C is incorrect because administrative fees include the processing of corporate actions such as rights issues and optional stock dividends, the measurement of performance and risk of a portfolio, and voting at company meetings. Generally, these functions are provided by an investment management firm itself and are included as part of the management fee.

Q.

Which of the following notes about the DoGood Fund is correct?

1. A.Only Note 2

2. B.Only Note 3

3. C.Both Note 2 and Note 3

Solution

B is correct because the fund becomes a free-rider if it allows other shareholders to engage in actions that benefit the fund, and therefore Note 3 is correct. In theory, some investors could benefit from the shareholder engagement of others under the so-called “free rider problem.” Specifically, assume that a portfolio manager using an active strategy actively engages with a company to improve its operations and was successful in increasing the company’s stock price. The manager’s actions in this case improved the value of his portfolio and also benefitted other investors that own the same stock in their portfolios. Those investors that did not participate in shareholder engagement benefit from improved performance but without the costs necessary for engagement.

Note 2 is incorrect because a conflict of interest arises on the part of the DoGood Fund if it owns shares of a company that invests in the fund. Conflicts of interest can result for a company. For example, a portfolio manager could engage with a company that also happens to be an investor in the manager’s portfolio. In such a situation, a portfolio manager may be unduly influenced to support the company’s management so as not to jeopardize the company’s investment mandate with the portfolio manager.

Q.

Which of the notes regarding the Elmer Fund is correct?

1. A.Only Note 4

2. B.Only Note 5

3. C.Both Note 4 and Note 5

Solution

A is correct. For passively managed portfolios, management fees are typically low because of lower direct costs of research and portfolio management relative to actively managed portfolios. Therefore, Note 4 is correct.

Note 5 is incorrect because the predictability of correlations is uncertain.

Q.

Which of Frey’s statements about securities lending and covered call writing is correct?

1. A.Only Statement 1

2. B.Only Statement 2

3. C.Both Statement 1 and Statement 2

Solution

B is correct. Writing covered calls also generates additional income for an equity portfolio, but doing so limits the upside from share price appreciation of the underlying shares. Therefore, Statement 2 is correct.

A is incorrect because dividends on loaned stock are “manufactured” by the stock borrower for the stock lender—that is, the stock borrower ensures that the stock lender is compensated for any dividends that the lender would have received had the stock not been loaned. Therefore, Statement 1 is incorrect. Frey is incorrect in stating that the funds would miss out on dividend income on lent securities.