Problem 1

You are working for a consultant firm that provides services to a Foundation for the
management of its equity portfolio. The Foundation has recently reviewed its equity investment
policy and has made the following observations :

- It agrees that security prices reflect publicly available information

- It fired the previous equity manager because the portfolio had tracking-error exceeding
1%
- The Foundation pays taxes on interest, dividends and realized capital gains
- It is willing to accept a low information ratio as long as returns are sufficient to maintain
targeted spending

1. Which investment approach should you recommend ? Could you give three reasons ?
Passive investments (index strategies)
4 reasons:
- The Foundation believes in market efficiency
- Tracking-error should be lower than 1%
- Limited turnover
- No need for outperformance

2. The equity benchmark is the Russell 3000, which consists of 3,000 large US publicly-traded
companies. The value of the equity portfolio is 5,000,000 USD. The foundation prefers not to
use complicated mathematical models that would be challenging to explain to donors.

Determine the most appropriate approach for constructing the equity portfolio. Justify your
answer with two reasons

A pure replication strategy does not seem appropriate given the high number of securities and
thesmall size of the portfolio. We should favour sampling strategies. However, the statistical
approach(optimization) is not relevant as it is based on models. Hence, a stratified approach seems the
most appropriate.
Other solutions : pure replication but not through direct investments. Investments in ETFs or
indexswaps or futures (Russell 2000)

Problem 2

1. Explain which transactions can be implemented in order to make a profit if the ETF
share price is below its fundamental value based on its underlying securities. Please
describe in detail the flows for each transaction

The fundamental value of the ETF (S0) is based on the current market price of the ETF’s holdings.
Buy the ETF on the secondary market at P0 and sell short instantaneously the basket of the ETF’s
holdings at S0
Sell the ETF on the primary market at the NAV. Receive the underlying securities at a market equal
to NAV
The ETF position is closed: long and short position. The underlying securities can be delivered to the
short-selling counterparty’s profit is S0 - P0

Remarks:
The primary market, also known as the "new issue market" or "issuance market," is where newly
issued securities are sold for the first time to investors. This is where companies, governments, or
other entities raise capital by issuing new stocks, bonds, or other financial instruments.

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The secondary market, also known as the "aftermarket," is where previously issued securities are
bought and sold among investors. It involves the trading of existing stocks, bonds, and other financial
instruments.
2. Please see the table below and explain what intraday-premium and end-of-day premium
are for ETFs. Which factors could have an impact on these premia ?

Source: The big ETF parade, Brian Jacobsen, The Journal of Portfolio Management, winter 2015

Intraday premium; deviation between the ETF’s market on the secondary market and the the
simultaneous market price of its underlying securities
End of day premium: deviation between the ETF closing price and its NAV
Factors: high ETF trading volume, high liquidity of underlying securities, low portfolio turnover

Problem 3

1) Jeff Stone, a trustee of the Shailor College endowment, has questioned the Consultant's
recommendation to employ an active management strategy for the entire equity portion of the
endowment portfolio. Stone made the following statements :
Statement 1 : Active management is appropriate for large-cap stocks, where managers can take
big enough positions to capitalize on pockets of inefficiency
Statement 2 : Because the S&P is price-weighted, out-performing stocks tend to have more and
more influence on its value
Statement 3 : The endowment should employ a passive index vehicle for our small-cap portfolio.
The market for small-caps tends to be more efficient than the market for large-caps and would
provide more opportunities for us to benefit from active management
Indicate whether or not you agree or disagree with each of Stone's statements.

Statement 1 : Incorrect.
Large cap stocks tend to be more efficiently priced due to the amount of publicly held information
andthe amount of analyst and portfolio manager attention paid to them. Excess returns are difficult
togenerate with large caps. More likely to generate excess returns in small and micro cap markets
whereprivileged information is somewhat easier to obtain.

Statement 2: Incorrect
The S&P is market-value weighted. Stocks of larger firms are weighted more heavily in market value-
weighted indexes while higher priced stocks have a greater impact on the value of a price weighted
index.

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Statement3: Incorrect
Active management tends to be more productive for small caps (see statement 1)

2) The Shailor College endowment has decided to delegate the management of the equity portion
of the endowment portfolio to Amy Morgan working for Capital Management. Amy has
suggested changes to her benchmark and made the following statements :
- For a benchmark to be considered valid, it must be investable. To be investable, I should be
able to recreate and hold the benchmark as a portfolio.
- Although I agree that market value-weighted benchmarks are generally considered the most
valid, the benchmark used in performance appraisal is not truly market value-weighted because
it is based on free float and not on the total market capitalization of all the benchmark firms.
- You could compare my performance to the average equity manager. At least that way I know
exactly who I'm up against.

Indicate whether you agree or disagree with each of Morgan's statements.

Statement 1 : Agree. Fundamental property of benchmarks.

Statement 2: Disagree. Need to adjust for float. Total market capitalisation should not be considered
Statement 3 : Agree and Disagree. Can be used for peer group analysis but should not be consideredas
a benchmark (not known ahead of time, survivorship bias)

Problem 4

1.Consider two Multi-asset portfolios which are managed against the same benchmark. The
benchmark and the portfolios follow a constant-mix strategy, which means that asset classes
weights remain constant over time (systematic daily rebalancing).

The portfolios and the benchmark are invested in the following asset classes :

- Euro Government Bonds 1-3 year

- Euro Government Bonds All maturities
- Euro Inflation-Linked Bonds
- Euro Corporate Bonds
- Euro equities

The portfolios and the benchmark are invested as shown in the following table

Euro Gvt 1-3 Euro Gvt All mat Euro Inflation Euro corporate Euro equities
Benchmark 25% 25% 10% 10% 30%
Portfolio1 20% 25% 10% 10% 35%
Portfolio2 15% 35% 15% 5% 30%

Historical weekly returns for asset classes are given in problems 1.0 excel File.

Based on nominal weights, explain which portfolio seems to take more active risk.

Calculate the annualized tracking-error over the whole period for each portfolio. Use the square
root of time rule to annualize tracking-error. Comment the results.

Calculate the rolling one-year tracking-error for each portfolio. Comment the results.

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2.Consider a Multi-asset portfolio and its benchmark invested in the following asset classes :

- Euro Corporate Bonds

- Euro High Yield
- Europe ex UK equities
- Emerging market Bonds Hard Curency
- Emerging market Bonds Local Currencies
- Euro Government Bonds
- Global equities
- Liquidity

The benchmark and the portfolio are invested as shown in the following table.

Euro Euro Europe ex GEM GEM debt Euro Global Liquidity

Corporate High Uk equities Debt Hard Local debt Gvt equities
Yield Currency Bonds
Benchmark 23% 10% 26% 5% 5% 5% 25% 1%
Portfolio 20% 5% 30% 5% 5% 7% 27% 1%

The monthly ex ante covariance matrix is given in the assignment Excel file.

Calculate the ex ante tracking-error. Use the square root of time rule to annualize tracking-
error.

1.Portfolio 2 seems to take more active risk as the active weights against the benchmark are higher
than for portfolio 1We calculate the weekly returns of portfolio 1 and portfolio 2. Then, we can
calculate the weekly returns of the difference between each portfolio and the benchmark. Lastly, we
can estimate the standard deviation of the returns of the difference between each portfolio and the
benchmark by using the Excel function.
The tracking error is annualized by multiplying it by the square root of 52.
The tracking error of portfolios 1 and 2 are 1.13% and 0.48% respectively. The tracking error depends
on the active weights against the benchmark but also on asset risk. Portfolio 1 has the highest tracking
error as it takes an active position in the most risky asset (equities).

2. We use the formula :Ex ante TE² = (XP – XB )’ Σ (XP – XB)

We annualize the monthly tracking error by multiplying monthly tracking error by the square root
of12 TE = 0.71%

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