01 equity portfolio management

Equity Portfolio Management

Test ID: 7428130

Question #1 of 106

Question ID: 466224

Which of the following is most accurate regarding equity style index methodology? If style is viewed as a quantity then:
ᅞ A) stocks will be placed in either value or growth indices with no overlap.
ᅚ B) the market cap of some stocks will be split between value and growth indices.
ᅞ C) there will be a neutral style index category.
Explanation
If style is viewed as a quantity, then there will be overlap when the style index is constructed. Some of a stock's market cap
may be assigned to value and another part could be assigned to growth. This would occur when a stock is not clearly value or
growth. Whether style is viewed as a quality or a quantity does not affect whether there will be a neutral category.

Questions #2-7 of 106
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 tradeoff 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.

Question #2 of 106

Question ID: 466173

To best meet Tupper's index requirements, Borchard should select:
ᅞ A) an index reconstituted by committee, rather than by rule.
ᅚ B) a capitalization-weighted index.
ᅞ C) a price-weighted index.
Explanation
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 23.d)

Question #3 of 106

Question ID: 466174

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

ᅚ A) "The potential returns of this strategy are higher than those of passivemanagement strategies, yet the risk-reward trade-off is appealing. The
information ratio for active management is higher than the ratio for passive
management."
ᅞ B) "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 largecap, a mid-cap, and small-cap."
ᅞ C) "My optimization approach limits risk by using a factor model that takes into account
the covariance of different risk factors."
Explanation
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 23.b)

Question #4 of 106

Question ID: 466175

Assuming a 30 percent weighting in large-cap stocks, Borchard's enhanced indexing strategy for Tupper should generate an
active return closest to:
ᅚ A) 0.81%.
ᅞ B) 13.51%.
ᅞ C) 5.11%.
Explanation
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 23.r)

Question #5 of 106

Question ID: 466176

Based on his belief in mean reversion, Tupper should pursue a strategy of:
ᅞ A) momentum investing.
ᅞ B) optimization.
ᅚ C) value investing.
Explanation
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 23.g)

Question #6 of 106

Question ID: 466177

Which of the following statements about holdings-based analysis is least accurate? It:
ᅞ A) can yield different results depending on the method used.
ᅞ B) can pick up style drift faster than returns-based analysis.
ᅚ C) requires the use of less data than returns-based analysis.
Explanation
Holdings-based analysis requires more data than returns-based analysis. The other statements are true. (Study Session 11,
LOS 23.i)

Question #7 of 106

Question ID: 466178


Assuming a 25 percent weighting in small-cap stocks, Borchard's enhanced indexing strategy for Tupper should generate
active risk closest to:
ᅞ A) 5.12%.
ᅞ B) 14.08%.
ᅚ C) 3.17%.
Explanation
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 23.r)

Question #8 of 106

Question ID: 466250

Which of the following statements is least accurate? An investor's utility of the active return:
ᅞ A) increases as active risk decreases.
ᅚ B) increases as the investor's risk tolerance for active risk decreases.
ᅞ C) increases as the investor's risk aversion to active risk decreases.
Explanation

The utility function for active return is similar to the utility function for total return. The utility of the active return increases as
active return increases, active risk decreases, and as the investor's risk aversion to active risk decreases. Risk tolerance is the
opposite of risk aversion. Lower risk tolerance would imply lower utility from a risky return.

Question #9 of 106

Question ID: 466169

Which of the following equity strategies would provide the lowest expected tracking risk?
ᅞ A) Risk-controlled active management.
ᅚ B) Passive.
ᅞ C) Enhanced indexing.
Explanation
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.

Questions #10-15 of 106
Michelle St. Jacques analyzes industrial stocks and manages portfolios for Candid Capital, a full-service brokerage in Rhode
Island. St. Jacques is given charge of the assets of clients interested in a growth-oriented strategy using large-cap stocks.
Barnard Walters also manages portfolios for Candid Capital, focusing on a midcap value strategy.
Lance Johnson, Candid's investment director, is happy with the performance of client portfolios but concerned about the
returns-based analysis performed about six months ago on both the St. Jacques and Walters portfolios. Here are the results of
the analysis:

Style

St. Jacques Portfolios

Walters Portfolios

Large-Cap

0.77

0.15

Midcap

0.12

0.57

Small-Cap

0.02

0.18

Fixed-Income

0.09

0.10

Johnson decides to do the analysis again, being far more thorough. This time, he regresses the returns of portfolios managed
by St. Jacques and Walters against a variety of style categories. Here are the results of the regression:

St. Jacques

Walters

Portfolios

Portfolios

Large-Cap Value

0.14

0.09

Large-Cap Growth

0.44

0.0

Midcap Value

0.02

0.56

Midcap Growth

0.12

0.03

Small-Cap Value

0.0

0.06

Small-Cap Growth

0.0

0.0

Foreign Large-Cap

0.20

0.02

Foreign Small-Cap

0.0

0.0

Long-Term Treasuries

0.03

0.0

0.02

0.0

Money Markets

0.0

0.22

Corporate Bonds

0.03

0.0

Real Estate

0.0

0.02

Style

Intermediate-Term
Treasuries

While Johnson is working on his regression analysis, St. Jacques faces a problem of her own. Shares of Wellman Industries
look appealing at current levels, but the analyst is concerned about the behavior of company management.
A half-dozen former executives looted the company and fled to Argentina, leaving Wellman Industries with an attractive
product portfolio, a solid market position, and a leadership vacuum. Company founder Josephine Wellman has come out of
retirement to take over the firm on an interim basis. Her mandate is to increase both investor confidence and management
accountability, and St. Jacques is trying to assess whether her efforts will have the desired effect. So far, Josephine Wellman
has done the following:
Abolished cash bonuses.
Tied executives' stock-option compensation to the amount of profit their division generates over the next year.
Changed the composition of the board, adding four new independent directors and giving the audit committee more
power.
Altered the stock-option program to issue options at higher strike prices than the current price in order to stave off
criticisms about excessive compensation.
Required all board members to agree to be legally responsible for their actions while serving on the board.
Required all executives to invest 2% of their base pay in company stock every year and not sell any company stock they
already own.
Required all board members to own a sizable stake in Wellman Industries and changed the compensation policy so that
they receive stock and not cash.

Question #10 of 106

Question ID: 466215

In the wake of the second regression analysis, what changes should be made in the analysts' stated investment styles?
ᅚ A) Neither St. Jacques' nor Walters' stated style should be changed.
ᅞ B) St. Jacques' stated style should change, but Walters' should not.
ᅞ C) Walters' stated style should change, but St. Jacques' should not.
Explanation
St. Jacques is purported to use a large-cap growth strategy. She does have some exposure to midcap stocks and to value
stocks. But some overlap is to be expected. The definitions of growth and value differ depending on who you ask, and the line

between large-cap and midcap is blurred. She does have a 44% exposure to large-cap growth stocks and a 20% exposure to
foreign large-cap stocks. Given her growth focus in U.S. stocks, we should conclude that the foreign stocks also have a growth
slant. As such, St. Jacques probably has at least a 60% exposure to large-cap growth stocks, and substantially smaller
exposures to everything else. No other style box is more appropriate than large-cap growth. Walters' 56% exposure to midcap
value does not sound high, but the blurred line between market-cap categories can explain some of that, as he also has
exposure to large-cap and small-cap value stocks. Of more importance, however, is the money-market exposure. The high
exposure to money markets and lack of exposure to other types of fixed-income securities suggest he has taken on a larger
cash position (money-market funds and short-term bond funds are often used as a cash plug, and a large cash position is
likely to have a high correlation with money market or short-term bond returns). While a large position in other fixed-income
investments might suggest a move toward an equity/income blend, the increase in money-market weighting does not
necessarily affect the investment style. Many managers routinely hold cash, adding to the cash position during difficult market
periods and deploying the cash when stocks look more attractive. Given some overlap between equity styles and the large
position in money market funds (cash) the majority of Walters' portfolios is invested in midcap value stocks. He remains a
midcap value manager. (Study Session 11, LOS 23.i)

Question #11 of 106

Question ID: 466216


Which statement about regression analysis is least accurate?
ᅞ A) St. Jacques' portfolio composition changed little between the two tests.
ᅞ B) Correlation probably skews the data.
ᅚ C) Regression works better for growth and value strategies than for blend strategies.
Explanation
In the second analysis, St. Jacques' large-cap, midcap, small-cap, and fixed-income weightings changed by no more than 2%.
Holdings-based analysis does require more data than the returns-based analysis Johnson used. In real life, large-cap growth
and value benchmarks are likely to have significant correlation. Capitalization-specific benchmarks also have substantial
correlation. While the percentages have value and can help assess a manager's style, the likely correlation between different
style categories suggests the numbers are not truly representative of the percentage of the portfolios' returns attributable to

price movements within that asset class. Returns-based analysis should work just as well for blend funds as it does for value
or growth funds. (Study Session 11, LOS 23.i)

Question #12 of 106

Question ID: 466217

Which of the following is least likely to improve the effectiveness of Wellman Industries' board?
ᅞ A) Paying directors with stock.
ᅚ B) Holding directors legally responsible for their actions.
ᅞ C) Requiring directors to own shares in the company.
Explanation
Holding directors legally responsible for their actions could spark excessive conservatism or drive the best candidates to turn
down board service. The other actions are all recommended by independent analysts as strategies for improving director
behavior. Adding independent directors reduces management's influence on board actions, which is often a good thing.
Paying directors in stock and requiring them to own a stake in the company ties their personal well-being to that of the
company. (Study Session 12, LOS 25.c)

Question #13 of 106

Question ID: 466218

The change in regression-analysis data for Walters' portfolios can be best explained by:
ᅚ A) a rise in Walters' bearishness.
ᅞ B) style drift.
ᅞ C) increased appeal of value stocks relative to growth stocks.
Explanation
Since the first regression analysis didn't measure Walters' value slant, we have no information to suggest he increased the
value weighting in his portfolio because he found value stocks more appealing. Style drift is not the answer, as the lack of
benchmarks in the first analysis does not assess his value slant, and the second regression analysis shows a smaller effect

from large and small stocks, suggesting that if anything, Walters tightened up his style focus. Of the choices provided, the best
explanation for a rise in money-market exposure is increased bearishness. Apparently, Walters wanted to take more of his
assets out of the market, and he sold off mostly large-cap and small-cap stocks to raise the cash. (Study Session 11, LOS
23.i)


Question #14 of 106

Question ID: 466219

Josephine Wellman's actions are least likely to spur:
ᅞ A) company managers to use equity swaps.
ᅚ B) company managers to become whistleblowers.
ᅞ C) company managers to take more risks.
Explanation
Tying compensation directly to profitability will probably drive managers of weak departments to take extra risks to boost
income. Out-of-the-money options can cause the same problem. If managers are required to buy stock, some may opt to use
equity swaps to monetize their holdings. Company employees are not likely to become more willing to blow the whistle on
improper conduct until they are confident of their anonymity and/or the board's willingness to act, neither of which has been
addressed. (Study Session 12, LOS 25.c)

Question #15 of 106

Question ID: 466220

The first returns-based analysis probably has Johnson least concerned about:
ᅞ A) misfit active risk.
ᅚ B) inaccurate risk measurement.
ᅞ C) a low style fit.
Explanation

Because the regression has fewer variables and doesn't attempt to measure growth or value content, it probably does not
explain too much of the analysts' returns, resulting in a low style fit. The use of poor benchmarks often leads to misfit active
risk. However, the returns-based analysis is not a risk-measurement tool, and is unlikely to raise concerns about risks that
have not already been sparked by a different type of analysis. (Study Session 11, LOS 23.i)

Question #16 of 106

Question ID: 466245

Manager X follows the stocks in a broad market index and has made independent forecasts for 300 of them. Her information
coefficient is 0.03. Manager Y has made independent forecasts for 100 stocks. His information coefficient is 0.05. Which
manager has the better performance and why?
ᅚ A) Manager X because she has greater breadth.
ᅞ B) Manager Y because he has more accurate forecasts.
ᅞ C) Manager Y because he has greater breadth.
Explanation
The information ratio for each manager is calculated as the information coefficient times the square root of the investor's
breadth:

Although Manager X's depth of knowledge (as measured by the information coefficient) is not as great, she has better


performance as measured by the information ratio because she has a greater breadth of decisions.

Question #17 of 106

Question ID: 466244

Which of the following selling disciplines would be best for an investor who is concerned about the tax implications of a trade?
ᅞ A) Deteriorating Fundamentals.

ᅞ B) Up-from-cost.
ᅚ C) Opportunity cost.
Explanation
If an investor factors in the transactions costs and tax consequences of the sale of the existing security and the purchase of
the new security, this approach is referred to as an opportunity cost sell discipline.

Question #18 of 106

Question ID: 466203

Which of the following is least likely to be a rationale for investing in small cap stocks?
ᅞ A) Higher returns are more likely when starting from a smaller stock price base.
ᅚ B) The higher betas for small cap stocks indicate that their future returns should be
higher.
ᅞ C) Smaller firms are more likely to be underpriced than larger cap stocks with greater
coverage.
Explanation
Although small-cap stocks may have a higher beta, this is not given as a rationale for investing in them. Both remaining
responses indicate the most common rationales for investing in these stocks.

Question #19 of 106

Question ID: 466201

An investor would like to track an index. Comparing optimization, stratified sampling, and replication; in which of the following
indexes would the investor be least likely to use replication?
ᅚ A) An equal-weighted index.
ᅞ B) A free float-adjusted market capitalization index.
ᅞ C) A value-weighted index.
Explanation

An equal-weighted index usually has a large representation in small-cap stocks. Replication would involve purchasing all the
stocks in the index and this would be less feasible when there are small-cap stocks involved. The reason is that small-cap
stocks tend to have lower liquidity and higher trading costs.


Question #20 of 106

Question ID: 466185

Which of the predominant weighting schemes used in the construction of equity share indices assumes that the investor holds
each company in the index according to its relative weight in the index?
ᅞ A) The price-weighted index.
ᅚ B) The market capitalization-weighted index.
ᅞ C) The free float-adjusted market capitalization index.
Explanation
The market capitalization-weighted index, also known as the value-weighted index, assumes that the investor holds each
company in the index according to its relative weight in the index. The price-weighted index assumes that the investor holds
one share of each stock in the index.

Question #21 of 106

Question ID: 466264

Which of the following is least likely to be an objective of optimization after decomposing total active return into true and misfit
components?
ᅞ A) Generate a positive "true" information ratio.
ᅚ B) Eliminate misfit risk.
ᅞ C) Maximize total active return.
Explanation
The decomposition of the total active performance into true and misfit components is useful for optimization. The objective is

maximize the total active return for a given level of total active risk, while still allowing for an optimal amount of misfit risk. Note
that misfit risk is not optimized at zero because a manager may be able to generate a level of true active return for some level
of misfit risk. In other words, if you let the manager specialize in the style they are familiar with, the manager is more likely to
generate excess returns relative to their normal portfolio.

Question #22 of 106

Question ID: 466232

Which of the following is least likely to be a reason pricing inefficiencies exist on the short-side?
ᅞ A) There are more potential buyers than sellers of stock.
ᅞ B) Management has options in firm's stock.
ᅚ C) The securities exchanges in the developed world prohibit short sales.
Explanation
Although there may be limitations on short sales, they are not prohibited by securities exchanges. There are more potential
buyers than sellers of stock so analysts are reluctant to lose these potential customers with a sell recommendation. Also
management may hold their firm's stock and options and put pressure on analysts to not issue sell recommendations.


Question #23 of 106

Question ID: 466182

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?
ᅞ A) Low tracking risk and high information ratio.
ᅚ B) Low tracking risk and low information ratio.
ᅞ C) High tracking risk and low information ratio.
Explanation
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.

Question #24 of 106

Question ID: 466236

Which of the following is least likely to be an advantage of using an ETF instead of a futures contract to equitize a market
neutral long-short strategy?
ᅞ A) ETFs can be more cost effective.
ᅚ B) ETFs are subject to less regulation.
ᅞ C) ETFs can be more convenient.
Explanation
The review does not specify that ETFs are subject to less regulation than futures. ETFs may be more cost effective and
convenient than futures contracts.

Question #25 of 106

Question ID: 466249

In which of the following situations would an investor be most risk averse?
ᅞ A) When allocating funds to a passive index.
ᅚ B) When allocating funds to active equity managers.
ᅞ C) When allocating assets to stocks, bonds, and other assets.
Explanation
At the asset allocation level, the focus is on maximizing expected return for a given level of risk. Once an investor has made a
decision to invest in equity, the tradeoff focuses on active risk and active return. As one moves from passive management to
enhanced indexing to active management, the expected active return and active risk increase.
Investors are more risk averse when facing active risk. To believe that an active return is possible, the investor must believe
that there are active managers who can produce it and that the investor will be able to pick those successful managers.
Second, an active equity style will also be judged against a passive benchmark. It is difficult to earn alpha and those investors

who don't will face pressure from their superiors. Lastly, higher active returns mean more is invested with the high return
active manager, and this results in less diversification.


Question #26 of 106

Question ID: 466210

In comparing returns-based style analysis with holdings-based style analysis it is most accurate to say that:
ᅞ A) returns-based style analysis can capture changes in style more quickly, but
holdings-based style analysis is more quickly executed.
ᅚ B) holdings-based style analysis can capture changes in style more quickly, but returnsbased style analysis is more quickly executed.
ᅞ C) holdings-based style analysis aggregates the effect of the investment process, and
returns-based style analysis is more forward looking.
Explanation
Holdings-based style analysis captures changes more quickly because returns-based style analysis uses historical data, and
holdings-based analysis is based upon current holdings in the portfolio. Holdings-based style analysis requires more time and
work because it requires analyzing each position, and returns-based style analysis uses historical data in a regression.
Returns-based style analysis aggregates the effect of the investment process and requires more theory in the process.

Question #27 of 106

Question ID: 466166

Which of the following statements regarding using equities as an inflation hedge is most accurate? They have been a good
inflation hedge:
ᅞ A) but only in the U.S for a short time span.
ᅞ B) in many countries over a short time span.
ᅚ C) in many countries over a long time span.
Explanation

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).

Question #28 of 106

Question ID: 466246

Manager X follows the stocks in a broad market index and has made independent forecasts for 500 of them. Her information
coefficient is 0.02. Manager Y has made independent forecasts for 175 stocks. His information coefficient is 0.04. Which
manager has the better performance and why?
ᅚ A) Manager Y because he has more accurate forecasts.
ᅞ B) Manager X because she has greater breadth.
ᅞ C) Manager Y because he has greater breadth.
Explanation
The information ratio for each manager is calculated as the information coefficient times the square root of the investor's
breadth:


The information coefficient is measured by comparing the investor's forecasts against actual outcomes. More skillful managers
will have a higher information coefficient. Manager Y's depth of knowledge is greater which accounts for his greater
information ratio and better performance.

Question #29 of 106

Question ID: 466225

If two analysts are classifying a portfolio by style using a style box which of the following statements is most accurate? The
characterization of the fund's size will likely be:
ᅞ A) the same for each analyst and the characterization of the fund's style will likely
be the same for each analyst.

ᅞ B) different for each analyst and the characterization of the fund's style will likely be
different for each analyst.
ᅚ C) the same for each analyst and the characterization of the fund's style will likely be
different for each analyst.
Explanation
Categorizing portfolios by size is fairly standard in that market cap is the usual metric for evaluating size. However, different
analysts may use different categorizations of value and growth attributes. For this reason, the categorization of portfolios can
differ a great deal depending on the analyst.

Question #30 of 106

Question ID: 466266

Which of the following is least likely to be a limitation of an alpha and beta separation approach?
ᅞ A) Some long-short strategies may have a degree of systematic risk.
ᅚ B) The investor may be exposed to systematic risk.
ᅞ C) It may be difficult to implement in markets.
Explanation
One of the main reasons to undertake an alpha and beta separation approach is to gain an exposure to systematic risk (the
beta) through a long position in an equity index. The alpha is picked up using a long-short approach.

Question #31 of 106
A short extension strategy can be described as:
ᅞ A) a long position in equities with a relaxed constraint on short sales.
ᅞ B) shorting part of the portfolio to reduce exposure to over-valued stocks and gaining
market exposure through the use of derivatives.

Question ID: 466237

ᅚ C) going short in part of the portfolio and purchasing an equal amount of equities
resulting in a position that is more than 100% long.
Explanation
A short extension is characterized by shorting part of the portfolio, for example shorting 20% and taking the proceeds from the
short sale and purchasing undervalued securities in the same amount so the net amount of capital invested is 100% (= 100%
long − 20% short + 20% long) but the long position is 120% (= 100 from the initial long position + 20 from the proceeds of the
short sale). A short extension strategy does not use derivatives but instead only takes long and short positions in equities. A
market neutral strategy is characterized by equal amounts of long and short positions to produce an overall beta of 0 whereas
a short extension strategy has a beta of greater than 0.

Question #32 of 106

Question ID: 466212

Harold Bowers, CFA, and Bill Hoffman, CFA, are analyzing the returns of several portfolios. Bowers is performing an analysis
based upon the characteristics of the investments in each of the portfolios, and Hoffman is performing a regression analysis
using historical data. Based upon this, with respect to returns-based style analysis and holdings-based style analysis, it is most
likely that:
ᅞ A) Bowers and Hoffman are both using variations of holdings-based style
analysis.
ᅞ B) Bowers is performing returns-based style analysis and Hoffman is performing
holdings-based style analysis.
ᅚ C) Bowers is performing holdings-based style analysis and Hoffman is performing
returns-based style analysis.
Explanation
Bowers is clearly performing holdings-based style analysis. Of the two approaches, regression is used in the return's-based
style analysis by regressing historical returns on factors.

Questions #33-38 of 106
Bob Hageman is the Chief Investment Officer for the pension fund of Wapitechnology Industries. Wapitechnology is a producer

of a variety of customized software solutions for service and distribution industries, currently entering its second decade in
business. Wapitechnology offers a generous defined benefit pension plan, but because of the firm's comparatively recent
founding and the industry in which it operates, Wapitechnology has a very young and mobile workforce. Few employees have
vested in its pension plan, and no employee has acquired sufficiently long service to retire.
The demographics of the defined benefit plan's beneficiaries give Wapitechnology an extremely long time horizon for the
management of its pension fund. Bob Hageman has suggested to Yvette Vargas, Wapitechnology's Chairman and Chief
Executive, that they should change the investment policy statement for the pension fund to accommodate a higher risk level.
Specifically, Hageman thinks that Wapitechnology should increase its asset allocation to equities because the exceptionally
long time horizon of the pension fund enables it to take on an unusually high degree of risk in its investment strategy.
Vargas wonders about the suitability of passive management for the Wapitechnology pension fund. She points out, "Asset
allocation is more likely to favor passive management for taxable investors than for non-taxable investors because of reduced
portfolio turnover in a passive management approach."


Vargas cites the statistics, saying, "On average after expenses, historical data shows that active management does not
outperform passive management." Hageman reminds Vargas, "International equity markets are less informationally efficient
than the U.S. market, so a U.S. based investor would be wise to pursue an active strategy abroad to exploit the informational
inefficiencies, rather than a passive strategy."
Since Vargas is interested in passive investing, Hageman presents the following indexes as possible benchmarks for a passive
portfolio:

Index

Region

Type

Standard & Poor's 500 Composite (S&P 500)

US

capitalization-weighted

Value Line Composite Average

UK

equally weighted

Nikkei Stock Average

Japan

CAC 40

France capitalization-weighted

Dow Jones Industrial Average (DJIA)

value-weighted

US

price-weighted

He also details the advantages and disadvantages of different types of indexes:
Statement 1: Price-weighted indexes are biased in that higher priced stocks have a greater impact on the index's value
than lower priced stocks, but the price of a stock is somewhat arbitrary and dependent on splits, stock dividends, and
repurchases.
Statement 2: The free float-adjusted index is considered the best type by many investors because it removes the float

from the index calculation.
Statement 3: A market capitalization-weighted index automatically adjusts for stock splits of individual firms.
Statement 4: A price-weighted index must be periodically rebalanced.
Hageman explains to Vargas that equity investment approaches can be described by tracking risk and information ratio.
Hageman explains, "Tracking risk is the excess of fund return relative to the appropriate benchmark." He suggests to Vargas
that the Wapitechnology pension fund's long time horizon enables them to take on significant tracking risk.
Vargas suggests that she thinks they should pay close attention to the information ratio of any equity strategy or manager they
consider for the pension fund. She explains, "Historically, the information ratio has been highest for active management and
lowest for passive management, with semi-active management falling in the middle."
Hageman tells Vargas that he has interviewed a wide range of equity managers for potential addition to Wapitechnology's
stable of managers. He adds that Cytologic Fund Management has shown an information ratio of 0.082, but says that their
tracking risk recently has been lower than the historical average. "If their tracking risk remains low, that would lower their
information ratio."

Question #33 of 106

Question ID: 466191

The best description of the accuracy of Hageman's statements regarding the advantages and disadvantages of different types
of equity indexes is:
ᅚ A) Statements 2 and 4 are incorrect, Statements 1 and 3 are correct.
ᅞ B) Statements 1 and 3 are incorrect, Statements 2 and 4 are correct.
ᅞ C) Statement 2 is incorrect, Statement 1, 3 and 4 are correct.


Explanation
Statement 2 is incorrect because a free float-adjusted index does not remove the float, it considers only the float. Statement 4
is incorrect because an equal-weighted index must be periodically rebalanced. Price weighted indexes are adjusted by
adjusting the divisor. Statements 1 and 3 are correct. (Study Session 11, LOS 23.e)

Question #34 of 106

Question ID: 466192

Is Hageman correct with regard to his definition of tracking risk and the impact of tracking risk on the information ratio?
Definition

Impact

ᅞ A) Correct

Incorrect

ᅚ B) Incorrect

Incorrect

ᅞ C) Incorrect

Correct

Explanation
Hageman is incorrect with respect to both statements. Active return is the excess return of a manager relative to the
benchmark, and tracking risk is the standard deviation of active return. The information ratio is active return divided by tracking
risk, so a decrease in tracking risk would tend to raise, not lower, the information ratio. (Study Session 11, LOS 23.b, s)

Question #35 of 106

Question ID: 466193

The primary advantage of a price-weighted index is that it:
ᅞ A) is easiest to mimic with minimal tracking risk.
ᅞ B) implicitly assumes that each investor holds one share of each stock in the index.
ᅚ C) is computationally simple.
Explanation
The primary advantage of a price-weighted index is that it is computationally simple. The fact that it implicitly assumes that
each investor holds one share of each stock in the index is generally considered a disadvantage because that approach to
investing is rarely adopted in practice. The best representation of aggregate investor wealth is a market capitalization weighted
index. The float-adjusted index is generally viewed as easiest to track. (Study Session 11, LOS 23.d)

Question #36 of 106

Question ID: 466194

Is Vargas correct in her statements about the information ratio and the advantage of passive management for taxable
investors?
Information
ratio

Passive management

ᅞ A) Correct

Correct

ᅚ B) Incorrect

Correct

ᅞ C) Incorrect

Incorrect


Explanation
Vargas is incorrect with regard to the information ratio because, historically, the information ratio has been highest for
semiactive management and lowest for passive management, with active management falling in the middle. Vargas is correct
that passive management is more likely to appeal to a taxable investor because of the reduction in capital gains taxes
associated with lower portfolio turnover. (Study Session 11, LOS 23.b)

Question #37 of 106

Question ID: 466195

Which of the following best describes of the accuracy of the index data in the table?
ᅞ A) The CAC 40 and the Nikkei are incorrect, the others are correct.
ᅞ B) The Value Line and CAC 40 are incorrect, the others are correct.
ᅚ C) The Nikkei and Value Line are incorrect, and the others are correct.
Explanation
The description of the Value Line index is incorrect because it is based in the US, not the UK. The description of the Nikkei is
incorrect because it is price-weighted, not value-weighted. The others are correct. (Study Session 11, LOS 23.d)

Question #38 of 106

Question ID: 466196

Are Vargas and Hageman correct in their descriptions of active versus passive strategies with respect to the historical data
and international investors?
Vargas

Hageman

ᅞ A) Incorrect

Incorrect

ᅞ B) Correct

Correct

ᅚ C) Correct

Incorrect

Explanation
Vargas is correct that active managers do not, on average, outperform passive strategies after consideration of expenses.
Hageman is incorrect that a US based investor should use active strategies abroad since foreign investors may lack
information that local investors have and thus active investing would be futile and the manager should follow a passive
strategy. (Study Session 11, LOS 23.c)

Questions #39-44 of 106
Caroline Corbin has recently come into a large inheritance, and is consulting with her wealth advisor, Kathy Berg, about
investing the allocation to equities. Corbin is in her 40s and thus has a very long time horizon for the investment of the funds.
Berg has suggested a fairly substantial equity allocation in view of the risk that can be accommodated by this long time
horizon.
Berg describes aspects of the investor utility function and allocation process for active risk:
Statement 1: If an investor wants higher active return positions, he must be willing to give up some diversification across
managers.

Statement 2: An efficient frontier analysis is not useful to assess active return because the efficient frontier plots expected
total return and expected total risk, not active return and active risk.
Statement 3: Utility of active return decreases as active return increases and as active risk decreases.
Statement 4: Investors are usually less risk averse when facing active risk than they are when dealing with total risk.
Corbin asks about the possibility of employing a core-satellite approach, which uses a core stable of active managers and a
rotating stable of satellite active managers. Corbin points out, "In a core-satellite approach, the core is benchmarked to the
asset class benchmark, and the satellites are benchmarked to a more specific benchmark."
Berg provides the following table of active managers for Corbin's consideration, along with a potential allocation approach:

Manager

Expected Active Return Expected Active Risk Allocation

Hardley Management

1.50%

2.20%

20%

Noskia Investment Advisors

3.80%

7.10%

25%

Floode Funds

3.20%

6.50%

25%

Triumphant Returns Partners

2.75%

4.25%

15%

Goodright Wynnes Partnership

2.20%

3.20%

15%

Corbin complains about the proposed asset allocation and selection of managers, saying, "The information ratio of that
portfolio would be approximately 1.1." She suggests to Berg that they should calculate the true information ratio:
True information ratio = True active return / Misfit active return

Berg completes her description of the equity allocation process to Corbin by explaining, "Once the investor has made a
decision to invest in equity, the tradeoff between risk and return focuses on active risk and active return." Corbin rephrases the
comment back to Berg, saying, "The investor needs to decide how to maximize active risk relative to a passive management

baseline."

Question #39 of 106

Question ID: 466253

Expected active return and expected active risk for the allocation shown in the table are closest to:
Return

Risk

ᅚ A) 2.8%

2.6%

ᅞ B) 0.7%

2.6%

ᅞ C) 2.8%

0.07%

Explanation
Active return is 2.79%:

Return

Allocation

Contribution

1.50%

20%

0.30

3.80%

25%

0.95


3.20%

25%

0.80

2.75%

15%

0.41

2.20%

15%

0.33

Sum

2.79%

Active risk is 2.57%:

Risk

Allocation

Contribution

2.20%

20%

0.000019

7.10%

25%

0.000315

6.50%

25%

0.000264

4.25%

15%

0.000041

3.20%

15%

0.000023

sum

0.000662

square root

0.025729

(Study Session 11, LOS 23.r)

Question #40 of 106

Question ID: 466254

Are Corbin and Berg correct in their description of active risk and the equity allocation process?

Corbin

Berg

ᅚ A) Incorrect

Correct

ᅞ B) Correct

Incorrect

ᅞ C) Incorrect

Incorrect

Explanation
Berg is correct that once the investor has made a decision to invest in equity, the tradeoff between risk and return focuses on
active risk and active return. Corbin is incorrect because the investor needs to decide how to minimize active risk while
maximizing active return. (Study Session 11, LOS 23.q)

Question #41 of 106
Which of the following least accurately describes a completeness fund?
ᅞ A) Complements the active portfolio so that the combined portfolios have a risk
exposure similar to the benchmark.
ᅞ B) Active return can be maintained while active risk is minimized.
ᅚ C) Increases misfit risk.

Question ID: 466255

Explanation
A completeness fund results in a reduction of misfit risk since the goal of a completeness fund is to have a risk exposure that is
closer to the investor's benchmark. Thus a disadvantage of a completeness fund is that it may result in a reduction of active
returns arising from misfit risk. The other statements are all accurate. (Study Session 11, LOS 23.r)

Question #42 of 106

Question ID: 466256

Is Corbin correct in her description of how a core-satellite approach is implemented and how it is benchmarked?
Implemented

Benchmarked

ᅞ A) Incorrect

Incorrect

ᅞ B) Correct

Correct

ᅚ C) Incorrect

Correct

Explanation
Corbin is incorrect about how a core-satellite approach is implemented. A core-satellite approach uses a core holding of a
passive or enhanced index complemented by a satellite of active manager holdings. She is correct that a core-satellite

approach benchmarks the core to the asset class and the satellites to a more specific benchmark. (Study Session 11, LOS
23.r)

Question #43 of 106

Question ID: 466257

Which of the following is the best description of the accuracy of Berg's statements regarding the investor utility function and
allocation process for active risk?
ᅞ A) Statements 1 and 3 are correct, Statements 2 and 4 are incorrect.
ᅚ B) Statement 1 is correct, Statements 2, 3 and 4 are incorrect.
ᅞ C) Statements 1, 2 and 3 are incorrect, Statement 4 is correct.
Explanation
Statement 1 is correct. Statement 2 is incorrect because it is possible to use efficient frontier analysis to plot and analyze
active return and active risk using combinations of available equity managers. Statement 3 is incorrect because utility of active
return increases as active return increases and active risk decreases. Statement 4 is incorrect because investors are usually
more risk averse when facing active risk than total risk. (Study Session 11, LOS 23.q)

Question #44 of 106

Question ID: 466258

Which is the most accurate description of Corbin's statements regarding the information ratio and true information ratio?
ᅚ A) The value of 1.1 for the information ratio is correct, but the formula for the true
information ratio is incorrect.
ᅞ B) Both statements are correct.
ᅞ C) Both statement are incorrect.
Explanation

The information ratio of the portfolio is active return (see calculations in Question 1) of 2.8% divided by active risk of 2.6%, or
(2.8/2.6 = 1.1). The true information ratio equals true active return divided by true active risk. (Study Session 11, LOS 23.s)

Question #45 of 106

Question ID: 466228

What are the two main benefits to monitoring the potential style bias resulting from socially responsible investing? The benefits
are the:
ᅞ A) investor can change his or her social screen and the manager can determine
the appropriate benchmark.
ᅞ B) portfolio manager can take steps to minimize the bias and the manager can suggest
alternative socially responsible portfolios to the investor.
ᅚ C) portfolio manager can take steps to minimize the bias and the manager can determine
the appropriate benchmark.
Explanation
Socially responsible portfolios tend to be biased towards growth and small-cap stocks. The benefits to monitoring this style
bias are that the portfolio manager can take steps to minimize it and can determine the appropriate benchmark for the socially
responsible portfolio.

Question #46 of 106

Question ID: 466275

An investment management firm is preparing to hire an independent analyst to recommend security selections for the firm's
portfolio. The firm would like to keep the manager's compensation straightforward and predictable. Which of the following best
describes the firm's situation? The investment management firm wants to hire a:
ᅞ A) buy-side analyst and pay them for each piece of researched purchased.
ᅚ B) sell-side analyst and pay them performance-based fees.
ᅞ C) buy-side analyst and pay them on an ad valorem basis.

Explanation
Sell-side analysts often work for an investment bank that uses the research to promote stocks the bank is selling. Sell-side
research is also conducted by independent firms available for hire by investment managers as in this case. Ad valorem fees
are based on assets under management thus are straightforward and predictable. This is useful when the investor is
budgeting investment fees. Performance-based fees are more complex to administer but since the analyst is not managing
any assets they could be paid partially based on the performance of their recommended investments.

Question #47 of 106

Question ID: 466238

If an investor wanted to equitize a market neutral long-short strategy with a S&P 500 futures contract, which of the following
would be the correct amount of the notional principal of the S&P 500 futures contract?
ᅞ A) The value of the long position.
ᅞ B) 250 times the value of one contract.


ᅚ C) The cash from the short sale.
Explanation
If the investor wishes to add systematic risk to a market neutral strategy, the investor would take a long position in an equity
futures contract with a notional principal equal to the cash from the short sale.

Question #48 of 106

Question ID: 466187

Compared to ETFs, index mutual funds have:
ᅞ A) higher license fees and are less tax efficient.
ᅞ B) lower license fees and are more tax efficient.
ᅚ C) lower license fees and are less tax efficient.

Explanation
Index mutual funds usually pay lower license fees to index providers than ETFs do. Index mutual funds are also less tax
efficient. Index mutual funds usually sell securities to satisfy redemptions, which increases taxes. ETFs ordinarily do not
engage in taxable events to satisfy redemptions, as the ETF may exchange ETF shares for the underlying. Also, an ETF
investor usually sells their ETF shares to another investor, so there is no tax implications for the ETF itself.

Question #49 of 106

Question ID: 466272

Which of the following would least likely be included in bottom-up equity research?
ᅞ A) Price-multiple.
ᅚ B) Currency forecasts.
ᅞ C) Dividend yield.
Explanation
Bottom-up equity research focuses on individual stock valuation so the firm's dividend yield and price-multiple would likely be
included. Currency valuations are at the macroeconomic level and would be less likely to be included in a bottom-up approach.

Question #50 of 106

Question ID: 466208

Which of the following is least likely to be an advantage of returns-based style analysis?
ᅞ A) Low cost.
ᅞ B) The use of different models provides similar results.
ᅚ C) It will detect style changes quickly.
Explanation
Returns-based style analysis may detect style changes slowly because the regression requires historical data that may not

reflect the current focus of the fund. Holdings-based style analysis will detect style changes more quickly than returns-based
analysis.

Question #51 of 106

Question ID: 466223

If an equity style index has buffering rules, the index will have:
ᅞ A) more turnover and there will be lower transactions costs from rebalancing for
managers tracking the index.
ᅞ B) more turnover and there will be higher transactions costs from rebalancing for
managers tracking the index.
ᅚ C) less turnover and there will be lower transactions costs from rebalancing for managers
tracking the index.
Explanation
If an index has buffering rules, a stock is not immediately moved to a different style category when its style characteristics
have slightly changed. The presence of buffering means that there will be less turnover in the style indices and hence lower
transactions costs from rebalancing for managers tracking the index.

Question #52 of 106

Question ID: 466260

An investor uses a core-satellite approach to allocate funds amongst equity managers in the table below. What is the
investor's information ratio?
Expected Active Return

Expected Active Risk

Allocations

Manager W

0%

0%

10%

Manager X

1.80%

2.90%

20%

Manager Y

3.20%

5.60%

15%

Manager Z

3.90%

7.30%

10%

Enhanced Indexing

1.60%

2.40%

45%

ᅚ A) 1.17.
ᅞ B) 0.97.
ᅞ C) 1.04.
Explanation
The investor's active return is calculated as a weighted average return:

To calculate the portfolio active risk, we assume that the correlations between the managers' active returns are zero and use
the active risks and allocations:


The investor's information ratio is then 1.95% / 1.66% = 1.17 if you have rounded the active risk and return to two digits. If you
have carried the answers for the active return and risk in your calculator's memory, the answer is 1.18.

Question #53 of 106

Question ID: 466183

Which of the following indices would be biased towards small cap stocks?
ᅞ A) A value-weighted index.

ᅚ B) An equal-weighted index.
ᅞ C) A price-weighted index.
Explanation
The equal-weighted index is biased towards small-cap companies because they will have the same weight as large-cap firms
even though they have less liquidity. Many equal-weighted indices also have more small companies in them than large firms,
creating a further bias towards small companies. Value-weighted indices are biased towards large cap stocks and priceweighted indices are biased towards high priced stocks.

Question #54 of 106

Question ID: 466167

Which of the following is least accurate regarding using equities as an inflation hedge?
ᅚ A) Their ability to hedge is unaffected by taxes.
ᅞ B) The effectiveness of an individual stock as a hedge depends on its product market.
ᅞ C) The historical record is impressive as to their effectiveness.
Explanation
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.

Question #55 of 106

Question ID: 466198

A manager wishes to use a passive strategy to mimic the returns of a price-weighted stock index that consists of 50 stocks.
Which of the following would be the best method to use in composing this portfolio?
ᅞ A) To compose a portfolio that consists of an equal number of shares of a sample
of the stocks in the index.
ᅚ B) Using the full replication method.

ᅞ C) To compose a portfolio that is equally weighted using a sample of stocks in the index.


Explanation
For indices with fewer than 1000 positions, full replication is possible and recommended.

Question #56 of 106

Question ID: 466251

Which of the following assumptions is typically used to calculate the portfolio active risk from a group of equity managers? The
correlation between equity managers' active returns are:
ᅞ A) positive, ranging from 0.3 to 0.8.
ᅞ B) a function of the amount allocated to each manager.
ᅚ C) zero.
Explanation
To calculate the portfolio active risk, it is typically assumed that the correlations between the equity managers' active returns
are zero. This is not an unreasonable assumption if the managers are following different styles.

Question #57 of 106

Question ID: 466197

An investor would like to track an index and is considering using optimization. Optimization is characterized by:
ᅞ A) the use of a factor model and infrequent rebalancing.
ᅞ B) the use of a matrix model and frequent rebalancing.
ᅚ C) the use of a factor model and frequent rebalancing.
Explanation
An optimization approach uses a factor model to match the factor exposures of the fund and the index. Optimization must be
updated to reflect changes in risk sensitivities from the factor model and this leads to frequent rebalancing.

Question #58 of 106

Question ID: 466269

Which of the following provisions in an equity manager's compensation plan would create symmetry in the compensation?
ᅚ A) A high water mark provision.
ᅞ B) A fee cap.
ᅞ C) Stock options.
Explanation
Symmetry refers to when the manager receives both rewards for good performance and punishment for bad performance. A
high water mark provision states that a manager must compensate for past underperformance before receiving a
performance-based fee. This is the only compensation provision mentioned in the responses that punishes for bad
performance so it is the only one that provides symmetry.