Suggested solutions to R&B Chap 16 exercise questions

Questions
2. Numerous studies have shown that the majority of portfolio managers have been unable
to match the risk-return performance of stock or bond indexes. Following an indexing
portfolio strategy, the portfolio manager builds a portfolio that matches the
performance of an index, thereby reducing the costs of research and trading. he
portfolio manager!s evaluation is based upon how closely the portfolio tracks the
index or "tracking error,# rather than a risk-return performance evaluation.
$nother passive portfolio strategy, buy-and-hold, has the investor purchase securities
and then not trade them%i.e., hold them%for a period of time. &t differs from an
indexing strategy in that indexing does re'uire some limited trading, such as when the
composition of the index changes as firms merge or are added and deleted from the
index.
(. here are a number of active management strategies discussed in the bookl including
sector rotation, the use of factor models, 'uantitative screens, and linear programming
methods.
Following a sector rotation strategy, the manager over-weights certain economic
sectors, industries or other stock attributes in anticipation of an upcoming economic
period or the recognition that the shares are undervalued.
)sing a factor model, portfolio managers examine the sensitivity of stocks to various
economic variables. he managers then "tilt# the portfolios by trading those shares
most sensitive to the analyst!s economic forecast.
hrough the use of computer databases and 'uantitative screens, portfolio managers
are able to identify groups of stocks based upon a set of characteristics.
)sing linear programming techni'ues, portfolio managers are able to develop
portfolios that maximi*e objectives while satisfying linear constraints.
$ny active management techni'ue incorporates fundamental analysis, technical
analysis, or the use the anomalies and attributes. For example, based upon the top-
down fundamental approach, a factor model may be used to tilt a portfolio!s
sensitivity toward those firms most likely to benefit from the economic forecat.
$nomalies and attributes can be used as 'uantitative screens +e..g, seek small stocks
with low ,-. ratios/ to identify potential portfolio candidates.
0. hree basic techni'ues exist for constructing a passive portfolio1 +2/ full replication of
an index, in which all securities in the index are purchased proportionally to their
weight in the index3 +2/ sampling, in which a portfolio manager purchases only a
sample of the stocks in the benchmark index3 and +(/ 'uadratic optimi*ation or
programming techni'ues, which utili*e computer programs that analy*e historical
security information in order to develop a portfolio that minimi*es tracking error.
4. he job of an active portfolio manager is not easy. &n order to succeed, the manager
should maintain his-her investment philosophy, "don!t panic.# 5ince the transaction
costs of an actively managed portfolio typically account for 2 to 2 percent of the
portfolio assets, the portfolio must earn 2-2 percent above the passive benchmark just
to keep even. herefore, it is recommended that a portfolio manager attempt to
minimi*e the amount of portfolio trading activity. $ high portfolio turnover rate will
result in diminishing portfolio profits due to growing commission costs.
26. here are tradeoffs between using the full replication and the sampling method. Fully
replicating an index is more difficult to manage and has higher trading commission
costs, when compared to the sampling method. 7owever, tracking error occurs from
sampling, which should not be the case in the full replication of the index.
Problems
2. Foreman 8-s'uared1 he 8-s'uared could be low if the 59, :66 is not the proper
index to use given the goals of the fund manager. $lthough Foreman may
emphasi*e large cap stocks it may invest some of its assets in preferred stocks or
bonds. $nother possibility is that the fund has a value focus whereas at times the
59, :66 has a growth orientation. hus the average ,-., dividend yield,
price-book, or earnings growth estimates for the stocks held by Foreman may differ
markedly from the 59, :66 stocks.
;opeland may be an actively managed fund that is "gaming# the index. <y
charging fees for active management but not straying far from the index, the fund
can achieve gross returns close to the index and have a high 8-s'uared. &ts net fees,
however, will fall below the index +as the average e'uity fund has fees of 2= or
more/. $nother possibility is we have no information on the beta of ;opeland. &t
may have a high 8-s'uared but its beta can be much different than one.
8isk-adjusted performance1 no information is presented on risk, so it is possible
that total risk +standard deviation/ for ;opeland may be much less than the total
risk of Foreman3 we also have no information on systematic risk +beta/ for the two
funds. >e can only tell that on the basis of gross returns, Foreman outperformed
;opeland. >e can make no judgment, as no data is presented, on net return and
risk-adjusted return performance.
(+a/. ,ortfolio turnover is the dollar value of securities sold in a year divided by the
average value of the assets1
Fund >1 (?.2-2@A.0 B .22@: or 22.@:=
Fund C1 :4A.(-4:(.? B 6.@?6A or @?.6A=
Fund D1 2,0:(.@-2,2A@.0 B 2.22A? or 222.A?=
Fund E1 0(?.2-:,:4?.( B 6.6?@: or ?.@:=
+b/ ,assively managed funds will have low portfolio turnover ratios and should have
low expenses ratios. Fn this basis, Funds > and E are the most likely passively
managed portfolios3 C and D are most likely to be actively managed.
+c/ he tax cost ratio is compute as G2 - +2 H $8/-+2H,8/I x 266 where $8
represents tax-adjusted return and ,8 is the pre-tax return. Fur calculations are as
follows1
Fund >1 G2 - +2 H 6.6A0(/-+2H6.6AA@/I x 266 B 6.:6=
Fund C1 G2 - +2 H 6.6@@?/-+2H6.264:/I x 266 B 2.42=
Fund D1 G2 - +2 H 6.6A(0/-+2H6.2622/I x 266 B 6.?2=
Fund E1 G2 - +2 H 6.6A:0/-+2H6.6A@(/I x 266 B 6.24=
he tax cost ratio represents the percentage of an investor!s assets that are lost to
taxes on a yearly basis due to the trading strategy employed by the fund manager.
Funds E and > are the most tax-efficient +least assets lost to taxes/ and Funds C
and D were the least tax-efficient.
0.
0+a/. he following arguments could be made in favor of active management.
.conomic diversity J the diversity of the Ftunian economy across various
sectors may offer the opportunity for the active investor to employ "top down#,
sector rotation strategies.
7igh transaction costs J very high transaction costs may discourage trading
activity by international investors and lead to inefficiencies that may be
exploited successfully by active investors.
Kood financial disclosure and detailed accounting standards J good financial
disclosure and detailed accounting standards may provide the well-trained
analyst an opportunity to perform fundamental research analysis to identify
inefficiently priced securities.

;apital restrictions J restrictions on capital flows may discourage foreign
investor participation and serve to segment the Ftunian market, thus creating
exploitable market inefficiencies for the active investor.
Leveloping economy and securities market J developing economies and
markets are often characteri*ed by inefficiently priced securities and by rapid
economic change and growth3 these characteristics may be exploited by the
active investor, especially one using a Mtop down!, longer-term approach.
5ettlement problems J long delays in settling trades by non-residents may serve
to discourage international investors, leading to inefficiently priced securities
that may be exploited by active management.
,otential deregulation of capital restrictions J potential deregulation of key
industries in Ftunia +media and transportation, for example/ may be anticipated
by active management.
,oorly constructed index J a common characteristic of emerging country
indices is domination by very large capitali*ation stocks which may not capture
the diversity of the markets or economy3 to the extent that the Ftunian index
exhibits this poor construction, active management would be favored.
Narketing appeal J it would be consistent for K$;, and appealing to K$;!s
clients, if K$; were to develop local Ftunian expertise in a regional office
+similar to K$;!s other regional offices/ to conduct active management of
Ftunian stocks.
he following arguments could be made in favor of indexation.
.conomic diversity J economic diversity across a broad sector of industries
implies that indexing may provide a diverse representative portfolio that is not
subject to the risks associated with concentrated sectors.
7igh transaction costs J indexation would be favored by the implied lower
levels of trading activity and thus costs.
5ettlement problems J indexation would be favored by the implied lower levels
of trading activity and thus settlement activity.
Financial disclosure and accounting standards J wide public availability of
reliable financial information presumably leads to greater market efficiency,
reducing the value of both fundamental analysis and active management and
favoring indexation.
8estrictions of capital flows J indexation would be favored by the implied
lower levels of trading activity and thus smaller opportunity for regulatory
interference.
Oower management fees J clients would receive the benefit of K$;!s cost
savings by paying lower management fees for indexation than for regulatory
interference.
0+b/. $ recommendation for active management would focus on short-term
inefficiencies in and long term prospects for the developing Ftunian markets
and economy, inefficiencies and prospects which would not be easily found in
more developed markets.
$ recommendation for indexation would focus on the factors of economic
diversity, high transaction costs, settlement delays, capital flow restrictions, and
lower management fees.