Assignment 2

Problem 1 : Style Analysis

You want to compare 2 equity fund managers who try to outperform the S&P 500. The
following table gives the monthly returns of Fund manager 1 and the benchmark over one year
:

Benchmark return FM 1 return

1 2.0% 3.0%
2 1.0% 3.0%
3 0.5% -2.0%
4 -1.0% -2.0%
5 -0.5% 0.0%
6 1.0% 3.0%
7 1.0% 0.0%
8 0.5% -0.5%
9 -0.5% 2.5%
10 2.0% 1.5%
11 0.5% 2.5%
12 0.5% -1.0%

1.Calculate the Tracking-error and information ratio of Fund Manager 1. Annualized tracking
error is obtained by using the square root of time rule.
Fund Manager 2 has delivered a 9% return for a 2% Tracking error.
Compare and analyse the returns of the 2 Fund managers. What is their investment style ?

Remarks:
- Instead of simply mirroring the index, fund managers make selective changes to the portfolio
in an attempt to achieve better returns.

2. A style analysis performed over the last 5 years gives the following results when Fund
managers monthly returns are regressed on equities and bond returns :

alpha US bonds S&P 500

FM 1 -0.10% 0.3 0.7
FM 2 0.10% 0.05 0.95

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The R2 are respectively 60% and 88%

Please comment the results. Which strategy is followed by Fund Manager 1 ?

What could explain the lower R2 for Fund Manager 1 ?

FM 2 is managing an equity portfolio. Strategic allocation explains a very important portion of return
volatility (high R²)
FM 1 manages a balanced fund (mix of equities and bonds). Strategic allocation is less important.FM
1 is active in tactical allocation (dynamic weights in equities and bonds) and security selection

Remarks:
- Strategic allocation, in the context of investment and portfolio management, refers to a long-
term or "strategic" plan for allocating assets within an investment portfolio
- Tactical allocation is an investment strategy that involves making short- to intermediate-term
adjustments to a portfolio's asset allocation in response to changing market conditions,
economic factors, or investment opportunities

3. Over the last 5 years, the cumulative performance of equity and bond indexes have been
respectively 28% and 15%.
Calculate the cumulative performance of Fund Managers 1 and 2 based on the results of
question 2. It is reminded that the results of question 2 are based on monthly returns.

What is the proportion of cumulative performance explained by strategic allocation for each
Fund Manager ? Comment the results

Problem 2 : Core-satellite

Core-satellite investing combines a core portfolio and a satellite portfolio. The core portfolio
objective is to meet an investor’s long-term goals. It is invested in traditional asset classes and
generally passively managed. The satellite portfolio is actively managed and can be invested in
less traditional asset classes.
An investor uses a core-satellite approach to allocate funds amongst equity managers. The
equity manager’s active risk (Tracking error), active return, and allocations are shown as
follows :

Expected active Expected Tracking Allocations

return error
Passive Index 0% 0% 15%
Enhanced Indexing 1.7% 2.5% 45%
Active manager X 1.9% 3% 25%
Active manager Y 3.3% 5.5% 10%

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Active manager Z 3.9% 7.2% 5%

Describe the investor’s core and satellite.

Calculate the investor’s active return , tracking error and information ratio given the above
allocations. Assume that the correlations between the equity managers’ active returns are zero.

Problem 3 : Information Ratio

Gary Lowenstein is selecting Funds for institutional investors. He has to determine how the
Fundamental Law of Active Management applies to three hypothetical managers who invest
against the broad large-cap US market, as represented by the S&P 500 index.
Manager A underweights and overweights the 500 individual stocks of the S&P 500 index as she
sees appropriate, keeping industry exposures similar to those of the index. She has an
information coefficient of 0.05 and is restricted to long-only positions.
Manager B holds cash and long S&P futures. He tries to generate excess returns by altering the
duration of the cash position and has an information coefficient of 0.05
Manager C has an information coefficient of 0.07 and she uses a long-short strategy for the 500
stocks in the S&P 500 index.

Determine which of the three managers will most likely have the highest information ratio

The fundamental law of active management states that the information ratio is a function of skill(information coefficient)
and the breadth (number of independent active positions). The information ratio is also a function of the constraints
(transfer coefficient)
The breadth of manager B is very limited. Basically, there is only one active position: choice of the
duration of the cash position. The information ratio of Manager B is not very high: same than manager
A and lower than manager C. Hence, manager B has the lowest information ratio
Managers A and C actively follow and analyze stocks. They have the same breadth. However,manager
C has a higher information coefficient and a higher transfer coefficient (possibility to takeshort
positions). Hence, manager C has the highest ratio among the three manage

Problem 4 : Behavorial Finance (source : CFA)

Louise and Christopher Maclin live in London and currently rent an apartment. During an
initial discussion of the Maclin’s financial plans, Christopher Maclin makes the following
statements to the Maclin’s financial adviser, Grant Webb :

1. I have used the Internet extensively to research the outlook for the housing market over
the next 5 years, and I believe now is the best time to buy a house
2. I do not want to sell any bond in my portfolio for a lower price than I paid for the bond
3. I will not sell any of the stocks of my country because I know these companies and I
believe that they have excellent prospects for the future

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For each statement, please identify the behavorial finance concept and explain how it is affecting
Christopher’s investment decision making.

1.Overconfidence.2. Regret avoidance. Not taking into account new environment.3. Home bias-familiarity bias. Lack of
diversification

Problem 5 : SAA

A Sovereign Wealth Fund has determined the following SAA for the next 5 years :
- Developed Equity : 25%
- Emerging Equity : 5%
- Sovereign Bonds : 45%
- IG Corporate Bonds : 15%
- HY Corporate Bonds : 10%

The expectations in terms of risk, return and correlation are the following :

1. What is the goal of SAA ?

2. Comment on the figures for expected risk, return and correlation
3. Compute the expected Sharpe Ratio of the SAA

1. Asset allocation for the long-term (3-5 yr). The goal is to maximise the risk-adjusted return, taking into
account liabilities.
2. The expected returns, volatilities and correlations are globally consistent with economic theory and
intuition. Higher returns and risks for equities. Low return and risk for Government Bonds. Intermediate
returns and risks for IG and HY Bonds. HY bonds have the highest Sharpe ratio. Government Bonds
are weakly correlated to other assets and are the diversifying asset. Credit asset classes have a
significant correlation with Equities