CFA Exam Question of the Day

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2022-10-05

Vignette:
Alpha Investment Advisory (AIA) is a consulting company that provides performance evaluation and attribution for pension funds. Alpha Investment Advisory (AIA) has just been hired by the CEO of TrustFuture (T&F) pension fund, Alex Eagle, to conduct a full performance evaluation and attribution analysis. Ian and Nick are the investment advisors for AIA. Ian has five years of experience working for AIA and Nick has recently graduated from The London School of Economics.

First, Ian and Nick scrutinize the risk-adjusted performance of the Anderson Enhanced Indexing portfolio and the Davidson Active Management portfolio over the last year.

Table 1

  Anderson Davidson Market Index T-bill
Return 8.2% 9.3% 7.1% 1.5%
Beta 0.9 1.3 - -
Standard deviation 5.4% 4.6% 3.7% -
Active risk 2.4% 1.5% - -

Alex Eagle, the CEO of T&F, is not quite satisfied with the performance of the Anderson portfolio as an enhanced indexing manager and requests that Ian and Nick discuss his performance. Ian states that the Anderson portfolio has an information ratio of 0.46 and the Davidson portfolio has an information ratio of 1.47. Nick notes that the enhanced indexing strategy is expected to generate a lower active return and hence a lower information ratio compared to any active management strategy. Therefore, the Anderson management performance is in line with the standard for the return - risk relationship of the stated strategy.

Nick continues that a semi-active manager attempts to outperform a benchmark index by identifying stocks that will perform better/worse than the benchmark and respectively buying/avoiding them; and not holding stocks that he or she has no opinion about. He notes that the main limitations of a semi-active approach are:

(1) Successful semi-active managers will be copied and it will become difficult to generate a positive active return consistently over time.

(2) The quantitative models that semi-active managers use to maximize the active return per a given level of active risk may not be applicable in the future because markets experience shocks and cyclical changes.

Secondly, Alex Eagle requests that the AIA consultants come up with a recommendation of one value mid-cap equity manager that T&F would hire. After thorough researching, Ian and Nick select two active equity managers, Morgan and Buick, and are now discussing which manager is a better fit for the value mid-cap strategy. Nick says that based on the information in Table 2, the true information ratio of the Morgan portfolio and the Buick portfolio is 0.75 and 0.48 respectively. Therefore, the Morgan portfolio fits better to the value mid-cap benchmark. Ian disagrees with Nick and states that the true information ratio of the Morgan portfolio and the Buick portfolio is 1.08 and 2.17, respectively. Hence, Buick should be selected as the most suitable manager for the active value mid-cap equity strategy.

Table 2

  Morgan Buick Value Mid-cap Benchmark Broad Market Index
7-year average 7.5% 8.8% 6.2% 7.7%
Standard deviation 6.7% 5.8% 4.2% 3.6%
Total active risk 2.1% 5.5% - -
Misfit active risk 1.2% 1.2% - -
# of independent forecasts 500 200 - -
IC 0.067 0.08 - -

Further, Alex Eagle explains that one of T&F's portfolio managers is currently long an S&P 500 futures contract and long a 90-day Treasury bill. He is not sure how to qualify such a strategy.

Question:
Regarding their statements on the suitability of Morgan Management and Buick Management for the value mid-cap active equity strategy, are Nick and Ian correct or incorrect?

Select an Answer:
Nick is incorrect, Ian is correct.
Nick is correct, Ian is incorrect.
Both Nick and Ian are correct.
Both Nick and Ian are incorrect.
Rationale:
Nick's calculations of the true information ratios and his conclusions are correct.

Morgan portfolio:

True active return = Rp − Rb = 7.5 − 6.2 = 1.3%

True active risk = ((Total active risk)2 − (Misfit risk)2 )0.5 = ( 0.0212 − 0.0122 )0.5 = 1.72%

True information ratio = True active return / True active risk = 1.3 / 1.72 = 0.75%

Buick portfolio:

True active return = Rp − Rb = 8.8 − 6.2 = 2.6%

True active risk = ((Total active risk)2 − (Misfit risk)2 )0.5 = (0.0552 − 0.0122 )0.5 = 5.37%

True information ratio = True active return / True active risk = 2.6 / 5.37 = 0.48%

Ian's calculations of the true information ratios are wrong and, therefore, his conclusions are incorrect. He wrongly used the active misfit risk instead of the active true risk to calculate the true information ratio.

2022-10-04

Vignette:
John de la Rocha has just been hired as a senior manager overseeing various trading desks at KLK Capital. John has decided that he would like to familiarize himself with the different approaches used to implement trades, and with the algorithmic tools that the firm uses for their trading.

John is also meeting with the head counsel of the firm, Kirk Rattenhaus, to discuss trade governance.

Question:
John is reviewing procedures for each of the desks he currently oversees.

Which of the following would be typical for both currency and equity trading?

Select an Answer:
dealers
algorithms
dark pools
clearinghouses
Rationale:
Dark pools are most often associated with equity trading but not for currencies. Dealer structures are more common in fixed-income markets, while clearinghouses are a staple of derivative markets. Algorithms are typically used in equity and currency markets.

2022-10-03

Vignette:
Susan Stewart, the chief economist of an asset management company, is responsible for the valuation of Latin American equity markets. In her research, she intends to apply the neoclassical approach to growth accounting for the first time. Currently, she is discussing the specifics of the Cobb-Douglas production function with her assistant Martha Miller.

Stewart asks Miller about the type of growth rate that this function is intent to forecast - long-term economic growth rate, dividend growth rate, or corporate profit growth rate.

Further, she asks Miller if the Cobb-Douglas production function is applicable to developed economies only, or if it is useful for both developing and developed markets.

From the initial research, Stewart learns that the Cobb-Douglas model can be used with both the Gordon growth model and the H-model. She is not quite sure which version is more applicable to the markets for which she is responsible. Stewart is quite familiar with the Gordon growth model and wonders if there are any additional variables in the H-model that are not needed in the constant growth model.

In addition, Stewart asks Miller what is the main assumption of the Cobb-Douglas production function with respect to the return to scale of the capital stock and the labor input, and what is the possible range of values the output elasticity of capital can take up.

Question:
Indicate the main assumption of the Cobb-Douglas production function with respect to the return to scale of the capital stock and the labor input (constant versus variable), and the possible range of values that the output elasticity of capital (alpha) can take up.

Select an Answer:
constant; 0 < alpha < 1
variable; 0 < alpha < 1
constant; -1 < alpha < 1
variable; -1 < alpha < 1
Rationale:
The production function assumes constant return to scale, i.e., a given percentage change in labor input or capital stock results in an equal percentage change in the output.

Alpha, the output elasticity of capital, can take values between 0 and 1.

2022-10-02

Question:
Rachel Cronkite has invested with Lorne and Demaris for over 15 years. From the beginning, her portfolio manager, Daniel Negron, CFA, has helped Rachel prepare and revise her investment policy statement on a yearly basis.

Rachel had been satisfied with the performance of her portfolio until she spoke to one of her closest friends, Millicent Bromberg, who revealed that the return on her portfolio through the years has been substantially higher than that of Rachel's. Nine months ago, Rachel began a new job with the Sure Front advertising agency. She was pleasantly surprised with a bonus from Sure Front that was well above what she expected to receive. Millicent suggested that Rachel give most of her bonus to her (Millicent's) financial advisor for him to invest. Rachel not only agreed to do this, but decided against telling Negron about her newfound money. She told Negron that she had only received a modest bonus and wasn't going to invest the money at all.

Several weeks later, Negron made an investment on Rachel's behalf that he would not have made had he been aware of the full value of the bonus and how it was being invested. This investment was not suitable for Rachel, given her current situation.

Has Negron violated Standard III(C) Suitability?

Select an Answer:
If the investment makes money for Rachel's portfolio, then the investment is suitable and the Standard has not been violated.
Yes; Negron should have updated Rachel's investment policy statement before making the investment.
Yes; Negron made an investment for Rachel that was not suitable to her needs.
No; Negron has not violated Standard III(C) because Rachel failed to disclose relevant information about her finances to him.
Rationale:
Rachel's investment policy statement was updated on a yearly basis. Negron cannot be held accountable for making suitable investments for her if Rachel fails to disclose relevant information for Negron to consider. Therefore, Negron was basing his recommendation on the investment policy statement and had no reason to do otherwise.

2022-10-01

Question:
If 215 futures contracts are required to meet the target, the current dollar duration without futures is $34,000, and the dollar duration of one futures contract is $75,050, what is the target dollar duration?

Select an Answer:
$21,232,444
$12,343,323
$16,169,750
$345,555
Rationale:
We know that the number of contracts =



It follows that Target dollar duration = Number of contracts × Dollar duration of one contract + Current dollar duration without futures

= 215 × 75,050 + 34,000

= $16,169,750