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

10/12/2018

Learning Management System

Question #1 of 24
An active equity portfolio manager is benchmarked by their domestic large-cap equity index. If
the manager signi cantly lowers the allocation to cash in the portfolio by buying benchmark
securities, this is most likely to:

A) decrease active risk and increase absolute risk
B) increase active risk and decrease absolute risk
C) increase active risk and increase absolute risk

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Explanation

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

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Cash is likely to have a low correlation with the benchmark and hence lowering the allocation
to cash and buying benchmark securities is likely to increase the correlation of the portfolio
with the benchmark and hence lower the active risk of the portfolio. The absolute risk of the
portfolio measured by standalone standard deviation is likely to increase as the portfolio is
allocating to more risky assets.

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Question #2 of 24

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Exposure to rewarded factors can be achieved through

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A) Systematic active management approaches only
B) Discretionary active management approaches only
C) Both systematic and discretionary active management approaches
Explanation
Systematic approaches are likely to explicitly target exposures to rewarded factors that are
expected to generate excess returns. Whilst a discretionary approach may be less formal in
its nature, the judgement employed by discretionary managers could be aimed at identifying
better factor proxies that are expected to outperform.
(Study Session 14, Module 29.1, LOS 29.b)
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Question #3 of 24
An analyst estimates the following data for two active equity fund managers:

Manager Breadth Active Risk Transfer Coe
A

50

8%

0.55

B

100

8%

0.55

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manager A is closest to:

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A) 2 times the information coe cient of manager B

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

B) 1.4 times the information coe cient of manager B
C) 0.7 times the information coe cient of manager B

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Explanation

According to the fundamental law of active management:
E (RA ) = I C√BR
‾‾‾σRA T C

Where

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E(RA) = excess return of the manager

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BR = breadth

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IC = Information coe cient

σRA = active risk

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TC = transfer coe cient

The excess return of manager A = ICA x √50 x 0.08 x 0.55 = ICA x 0.311
The excess return of manager B = ICB x √100 x 0.08 x 0.55 = ICB x 0.44
If the manager's excess returns are the same this implies
ICA x 0.311 = ICB x 0.44
And, hence, ICA = ICB x (0.44/0.311) = ICB x 1.4
(Study Session 14, Module 29.1, LOS 29.a)
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Question #4 of 24
A security has an active weight of 10% and the covariance of the security's active returns and
portfolio active returns is 0.005. The contribution of the security to portfolio active variance is
closest to:

A) 0.0005
B) 0.05
C) 0.005

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Explanation

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Question #5 of 24

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

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The contribution of a security to active variance is the product of the security's active weight
and the covariance of the security's active returns and portfolio active returns. In this case
this equals 0.1 x 0.005 = 0.0005

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

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size factor. Manager B has the same benchmark and generates excess return by varying their
exposure to the size factor according to their view on when the factor will outperform. Both
managers are highly diversi ed. According to the building blocks of active management, which

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

A) Manager B only
B) Both Manager A and Manager B
C) Manager A only
Explanation

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Learning Management System

Manager A is generating excess return through maintaining a di erence in factor weights.
This source of return is not considered alpha since it is not related to manager skill in
identifying mispriced securities and can be easily passively replicated. Manager B is engaging
in market timing of the size factor in order to generate excess return, which requires skill in
understanding when the size factor is likely to outperform and when it is likely to
underperform. This skill is deemed to be alpha.
(Study Session 14, Module 29.1, LOS 29.a)
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SchweserNotes - Book 4

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Question #6 of 24

An active equity investment manager has a target active risk of 8%, a maximum sector
deviation of 12% and maximum risk contribution from a single security of 2%. This manager is

A) Closet Indexer
B) Sector Rotator
C) Concentrated stock picker

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Explanation

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best described as a:

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A high maximum sector deviation and a signi cant target active risk suggests this manager is
a sector rotator. A closet indexer would have signi cantly lower target active return, and a
concentrated stock picker would likely have higher maximum risk contribution from a single
security and a lower maximum sector deviation.
(Study Session 14, Module 29.2, LOS 29.c)

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Question #7 of 24

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James Greco, CFA, is an investment analyst working as a consultant to institutional clients. One
of his clients has asked him about recent innovations in factor-based equity investing. In
response to his client's questions, Greco makes the following two statements:
Statement 1: 'Managers that have the ability to short sell in their portfolios are more
likely to generate higher information ratios when pursuing diversi ed factor
exposure strategies than long only managers'
Statement 2: 'Due to the ability to short sell and the inherent hedging that entails,
the long term returns of long/short managers is always expected to be lower than
those of long-only managers'

B) Statement 2 only
C) Statement 1 only

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Explanation

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A) Both Statement 1 and Statement 2

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Which of Greco's statements is correct?

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Statement 1 is correct. Factor returns are usually built from long/short portfolios, for
example the size factor is represented by a portfolio that is long small cap securities and
short large cap securities. Hence the ability to target a diversi ed exposure to di erent
factors relies upon the manager being able to short sell securities. It is likely that a long-only
manager will have a large exposure to the market risk factor that will dominate other factors
and hence not be su ciently diversi ed across factors.

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Statement 2 is incorrect. Long/short managers can employ signi cant leverage to magnify
expected returns. A manager that employs signi cant leverage could match or exceed the
expected returns of a long only portfolio, but may employ leverage levels that some investors
are not comfortable with.

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(Study Session 14, Module 29.5, LOS 29.h)
Related Material
SchweserNotes - Book 4

Question #8 of 24
When a benchmark security held in an active portfolio is replaced with a similar security that is
not held in the benchmark, the most likely outcome is:

A) Active Share increases by more than active risk
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B) Active Share decreases and active risk increases
C) Active Share and active risk both increase by similar proportions
Explanation
Swapping a security that is in the benchmark for a security that is not in the benchmark will
certainly increase Active Share because Active Share is a direct measure of the amount of the
portfolio that is not included in the benchmark. Active risk however will not necessarily
increase since it is a measure of the volatility of relative returns – this is unlikely to increase if
the new security that is introduced in to the portfolio behaves in a similar way to the
benchmark security that was originally held in the portfolio.
(Study Session 14, Module 29.2, LOS 29.c)

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Related Material

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SchweserNotes - Book 4

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Question #9 of 24

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

A) Top down and systematic
B) Bottom up and systematic

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Explanation

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C) Top down and discretionary

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Factor timing Is a di cult challenge, and as such there are few successful systematic
strategies that have integrated factor timing in their approach. The judgement required to
enact successful factor timing usually means the strategy is top-down and discretionary.

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(Study Session 14, Module 29.1, LOS 29.b)
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SchweserNotes - Book 4

Question #10 of 24
All of the following characteristics are features of the 'well-constructed portfolio' except:

A) The portfolio delivers results consistent with investor expectations in a coste cient way
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B) The portfolio delivers results consistent with investor expectations in a risk-e cient
way
C) The portfolio guarantees excess returns relative to the benchmark
Explanation
The well-constructed portfolio does not guarantee excess return vs. the benchmark. It is
designed to deliver results consistent with investor's risk and return expectations in a cost
and risk-e cient way.
(Study Session 14, Module 29.5, LOS 29.g)
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Question #11 of 24

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

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constraints:

Maximum position size is the lesser of 5x the index weight or the index weight plus 2%
No position size is allowed that represents more than 10% of the security's average daily
volume (ADV)

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index

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

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Details of the fund and benchmark index are as follows:
Fund size: $500 million

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

The level of assets under management at which the manager's strategy is likely to be a ected
by liquidity and concentration constraints is closest to:

A) $10 billion.
B) $1 billion.
C) $2 billion.
Explanation
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The manager cannot invest in stocks whose market cap is below approximately 0.001 x $10
trillion = $10 billion.
The ADV of this smallest cap holding would be about 0.005 x $10bn = $50 million.
The maximum absolute position size for this smallest cap holding is therefore 0.10 x $50m =
$5 million.
The maximum position for the smallest cap security is the lesser of 5 x 0.1% = 0.5% and 0.1%
+ 2% = 2.1%. This means the maximum position size in the fund for the smallest cap security
is 0.5%.
If the manager cannot hold up to 0.5% of the fund in the smallest capitalization position, then

the ability to carry out the strategy is potentially impaired.

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Question #12 of 24

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SchweserNotes - Book 4

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

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Given that the manager cannot hold more than $5 million in the smallest capitalization
holding, this means the ability to carry out the strategy is impaired by illiquidity when AUM
reach $5,000,000/0.005 = $1 billion.

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

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Liquidity constraint: It should always be possible to liquidate 85% of the portfolio in 10

trading days or less without su ering signi cant market impact costs

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

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

How many of these constraints are heuristic in nature?

A) Two
B) Three
C) One
Explanation

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Heuristic risk constraints are based on experience and deemed good practise without
rigorous backing of empirical evidence. The liquidity constraint and the leverage constraint

are examples of such heuristic risk constraints. The tracking error and Conditional Var
constraints are formal constraints in that they are statistical in nature and directly linked to
the distribution of the returns of the portfolio.
(Study Session 14, Module 29.3, LOS 29.e)
Related Material
SchweserNotes - Book 4

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Question #13 of 24

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Which of the following active equity managers is likely to generate most of their active return
from idiosyncratic risk?

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

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B) A manager following a quantitative factor-based approach

C) A stock-picking manager following a fundamental approach
Explanation

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Idiosyncratic risk comes from large concentrated positions. Quantitative factor-based
managers tend to hold many hundreds of position to generate their desired exposures and
therefore will likely diversify away idiosyncratic risk. Similarly, an enhanced indexing manager
will hold a broad portfolio very close to the benchmark index and therefore is likely to be
diversi ed. Fundamental stock-picking managers are likely to hold fewer positions since they
generate few high-conviction ideas through time consuming research, hence are likely to be
the least diversi ed and have the highest contribution to active return from idiosyncratic risk
factors.

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(Study Session 14, Module 29.1, LOS 29.a)
Related Material
SchweserNotes - Book 4

Question #14 of 24
Which of the following statements regarding risk constraints is most accurate?

A) Formal risk constraints are appropriate for fundamental managers, heuristic risk
constraints are appropriate for quantitative managers
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B) Both Heuristic constraints and formal constraints are equally likely to be
appropriate for both fundamental and quantitative managers
C) Heuristic risk constraints are appropriate for fundamental managers, formal risk
constraints are appropriate for quantitative managers
Explanation

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Fundamental managers are likely to run more concentrated portfolios and hold fewer
positions – this increases the estimation errors for return distributions and makes the use of
formal risk constraints that directly relate to estimate return distributions less useful. Hence
fundamental managers are more likely to nd heuristic risk constraints more appropriate.
Conversely, quantitative active equity managers are likely to integrate formal risk constraint
measures into portfolio optimizers when constructing their portfolios.
(Study Session 14, Module 29.3, LOS 29.e)

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Question #15 of 24

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SchweserNotes - Book 4

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

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A) A greater number of positions and lower active share

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B) Fewer positions and higher active share

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C) A greater number of positions and higher active share
Explanation

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Managers that can achieve the desired exposure to risk factors with fewer positions are more
likely to be focussed on risk management and are therefore behaving in a risk-e cient
manner. All else equal, portfolios with a higher active share are preferable since these
portfolios will bene t most from the alpha skills of the managers and should therefore have
higher expected returns.
(Study Session 14, Module 29.5, LOS 29.g)
Related Material
SchweserNotes - Book 4

Question #16 of 24
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Forward looking risk estimates are required for:

A) Formal risk constraints only
B) Heuristic risk constraints only
C) Both formal risk constraints and heuristic risk constraints
Explanation

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Formal risk constraints are directly linked to the expected return distribution of the portfolio
and as such require estimation of the distribution of portfolio returns. Heuristic risk
measures on the other hand are based on experience and perceived good practice and not
directly related to the expected return distribution of the portfolio, hence estimation is not
required.
(Study Session 14, Module 29.3, LOS 29.e)

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Question #17 of 24

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SchweserNotes - Book 4

Two active equity investment managers have similar sized investment funds and the same
investment universe. Active equity manager A follows a concentrated stock-picking strategy

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with a high turnover of portfolio positions. Active equity manager B follows a diversi ed factor

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exposure strategy with a low turnover of portfolio positions. Which manager is most likely to be

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able to sustain a higher level of Assets Under Management (AUM)?

A) Manager B

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B) Manager A

C) Both managers are likely to sustain a similar level of AUM
Explanation
All else equal, managers with lower turnover and smaller positions are likely to have lower
market impact costs due to the less frequent need to trade and the lower need for liquidity
from markets in order to establish positions in the fund. Manager B is likely to have
signi cantly more securities in their fund than manager A since they are diversi ed. With a
lower portfolio turnover, it is likely manager B will be able to sustain a higher level of AUM
than manager A due to the lower market impact costs of the strategy.
(Study Session 14, Module 29.4, LOS 29.f)
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Question #18 of 24
An investor is most likely to consider introducing short selling into a long-only portfolio when
their primary concern is:

A) Hedging
B) Earning long-term risk premiums
C) Capacity

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Explanation

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The ability to short-sell securities allows managers to better hedge risks they are unwilling to
face. Short selling strategies tend not to have the capacity of long only strategies due to being
constrained by the availability of securities to borrow, hence managers who are concerned
with scalability and capacity issues would be less inclined to use short selling strategies. Long
term risk premiums tend to be earned by going long risky securities, therefore managers
focussed on earning long term risk premiums are not likely to consider introducing short
positions into their portfolios.
(Study Session 14, Module 29.5, LOS 29.h)
Related Material

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SchweserNotes - Book 4

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Question #19 of 24

Which of the following factor-based strategies is least likely to su er signi cant scaling issues

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due to increased slippage costs caused by higher levels of assets under management (AUM)?

A) Short-Term Reversal
B) Size
C) Value
Explanation

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The size risk premium is earned by overweighting small cap stocks and underweighting large
cap stocks. Due to the lower trading volume of small cap stocks, slippage costs are likely to
increase as a manager scales up in asset size. The short-term reversal factor risk premium is
earned by selling recent outperformers and buying recent underperformers on a short-term
investment horizon. This is likely to have a relatively high turnover compared to other more
passive factor strategies and as such will likely have higher slippage costs as the manager's
assets under management increase. The factor with the most scalability is the value factor
since this can be earned through passively holding securities that are likely to be larger in
market cap.
(Study Session 14, Module 29.4, LOS 29.f)
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SchweserNotes - Book 4

Question #20 of 24

The chief investment o cer of a large endowment is considering allocating to a new core active

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equity portfolio manager. The endowment requires core active equity managers to have a
large-cap value bias and has a benchmark equal to the NCSI World Equity Index. The risk factor
exposures of the benchmark and the custom portfolio of a potential new manager are
displayed below:

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Factor Exposures

Size

0.92

-0.21

0.15

0.05

0.25

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Value

1.00

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Market

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NCSI World Index Custom Portfolio

Which of the factor exposures is least likely to be consistent with a well-constructed portfolio?

A) Market
B) Size
C) Value
Explanation

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The requirements of the foundation are that core managers have a large cap value bias. This
is likely to lead to an allocation to more mature, larger companies creating a lower market
beta, higher value factor exposure and more negative exposure to the size factor than the
benchmark index (recall that the size factor exposure is generated through long exposure to
smaller cap companies). Hence the positive exposure to the size factor here is a concern
since it represents exposure to small cap companies which is not in line with the
requirements of the foundation.
(Study Session 14, Module 29.5, LOS 29.g)
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SchweserNotes - Book 4

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Question #21 of 24

An analyst collects the following data regarding a portfolio of three securities:

Covariance

10% 0.040000 0.012000 0.002400

Asset B

35% 0.012000 0.014400 0.001440

Asset C

55% 0.002400 0.001440 0.003600

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Asset A

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Portfolio 100% 0.009520 0.007032 0.002724

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A) 0.000952

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The contribution of Asset C to total portfolio variance is closest to:

B) 0.002461

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C) 0.001498

Explanation

Asset C's contribution to total portfolio variance =
Weight of Asset A x weight of Asset C x Covariance of asset A with Asset C
+ Weight of Asset B x weight of Asset C x Covariance of asset B with Asset C
+ Weight of Asset C x weight of Asset C x Covariance of asset C with Asset C
=(0.1 x 0.55 x 0.0024) + (0.35 x 0.55 x 0.001440) + (0.55 x 0.55 x 0.003600) = 0.001498
(Study Session 14, Module 29.3, LOS 29.d)
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Question #22 of 24
Relative to discretionary active equity managers, systematic active equity managers will likely
have

A) Higher exposure to idiosyncratic risk
B) Lower exposure to idiosyncratic risk
C) Similar exposure to idiosyncratic risk

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Explanation

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Question #23 of 24

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

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Systematic approaches to active equity management are more likely to design portfolios
around extracting risk premiums from a balanced exposure to known, rewarded risk factors.
To achieve the desired factor exposure these systematic approaches use broadly diversi ed
portfolios with low levels of idiosyncratic risk. Conversely, discretionary managers tend to
hold more concentrated portfolios and hence have higher levels of idiosyncratic risk.

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Long extension strategies are best de ned as strategies that have:

A) net exposure equal to zero

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B) gross exposure equal to 100%
C) net exposure equal to 100%
Explanation
A long extension strategy is de ned as having a net exposure (long positions – short
positions) of 100% of investor's funds. For example, this could be achieved by having a long
portfolio equal to 130% of investors assets and shorting assets in value equal to 30% of
investor's funds (giving a gross exposure of 130% + 30% = 160%). A net exposure of zero is a
feature of an equity market neutral fund.
(Study Session 14, Module 29.5, LOS 29.h)
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SchweserNotes - Book 4
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Question #24 of 24
An active equity investment manager who holds no benchmark holdings in her portfolio will
have an active share equal to:

A) 1
B) 0
C) 0.5

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Explanation

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

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Active Share takes a value between 0 and 1. If a manager holds a portfolio of stocks that are
not in the benchmark, their active share equals 1, whereas if they hold the benchmark
weights in their portfolio their Active Share will be 0. If a portfolio has an Active Share of 0.5,
we can conclude that 50% of the portfolio is identical to that of the benchmark and 50% is
not.

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