Answers to Questions

1. Passive portfolio management strategies ha

ve grown in popularity

because investors are

recognizing that the stock mark

et is fairly efficient and that the costs of an actively

managed portfolio are substantial.


Numerous studies have shown that the major

ity 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 build

s a portfolio that matches the performance

of an index, thereby reducing

the costs of research and trad

ing. The portfolio manager’s

evaluation is based upon how cl

osely the portfolio tracks th

e index or “tracking error,”

rather than a risk-retur

n performance evaluation.

Another passive portfolio stra

tegy, buy-and-hold, has the in

vestor purchase securities and

then not trade them—i.e., hold them—for a peri

od of time. It differs from an indexing

strategy in that indexing does require some

limited trading, such as when the composition

of the index changes as firms merge or

are added and deleted from the index.

3. There are a number of active

management strategies discu

ssed in the chapter including

sector rotation, the use of

factor models, quantitative sc

reens, and linear programming


Following a sector rotation strategy, the mana

ger over-weights certain

economic sectors,

industries or other stock attri

butes in anticipation of an

upcoming economic period or the

recognition that the shares are undervalued.

Using a factor model, portfolio managers examine the sensitivity of stocks to various

economic variables. The managers

then “tilt” the

portfolios by trading

those shares most

sensitive to the analys

t’s economic forecast.

Through the use of computer databases and qua

ntitative screens, por

tfolio managers are

able to identify groups of stocks

based upon a set of characteristics.

Using linear programming techniqu

es, portfolio managers are able to develop portfolios

that maximize objectives while satisfying linear constraints.

4. Three basic techniques exist for constructing a

passive portfolio: (1)

full replication of an

index, in which all securities in the index ar

e purchased proportionally to their weight in

the index; (2) sampling, in which a portfolio

manager purchases only a sample of the

stocks in the benchmark index; and (3

) quadratic optimiza

tion or programming

techniques, which utilize computer programs th

at analyze historical security information

16 – 2

in order to develop a portfolio

that minimizes tracking error.

5. Managers attempt to add value to their port

folio by: (1) timing their investments in the

various markets in light of market forecasts

and estimated risk premiums; (2) shifting

funds between various equity sectors, industries,

or investment styles in order to catch the

next “hot” concept; and (3) stockpicking of

individual issues (buy low, sell high).

6. The job of an active portfolio manager is

not easy. In order to succeed, the manager

should maintain his/her investment philosophy,

“don’t panic.” Since

the transaction costs

of an actively managed portfolio typically

account for 1 to 2 percent of the portfolio

assets, the portfolio must earn 1-2 percent abov

e the passive benchmark just to keep even.

Therefore, it is recommended th

at a portfolio manager attempt to minimize the amount of

portfolio trading activity. A hi

gh portfolio turnover rate w

ill result in diminishing

portfolio profits due to growing commission costs.

7. The four asset allocat

ion strategies are: (1) integrat

ed asset allocatio

n strategy, which

separately examines capital market condi

tions and the investor’s objectives and

constraints to establish a portfolio mix;

(2) strategic asset a

llocation strategy, which

utilizes long-run projections;

(3) tactical asset

allocation strategy, which adjusts the

portfolio mix as capital market expectations

and relative asset valuations change while

assuming that the investor’s objectives and constraints remain constant over the planning

horizon; and (4) insured asset

allocation strategy, which pres

umes changes in investor’s

objectives and constraints as his/her wealth chan

ges as a result of risi

ng or falling market

asset values.


CFA Examination III (1994)

Value-oriented investors (1) focus on the curren

t price per share, specifically, the price of

the stock is valued as “inexpensive”; (2) not

be concerned about current earnings or the

fundamentals that drive earnings growth; and/or

(3) implicitly assume that the P/E ratio is

below its natural level and that

the (an efficient) market w

ill soon recognize the low P/E

ratio and therefore drive the stock price upwar

d (with little or no change in earnings).

Growth-oriented investors (1) focus on earnin

gs per share (EPS) and what drives that

value; (2) look for companies that expect to

exhibit rapid EPS growth in the future;

and/or (3) implicitly assume that the P/E ratio will remain constant over the near term,

that is, stock price (in an efficient market)

will rise as forecasted earnings growth is


Another perspective is that beta is not the onl

y risk factor that is priced by the efficient

market; other risk factors explain the differe

nce in risk-adjusted

returns between value

and growth portfolios.


A price momentum strategy is based on the

assumption that a stock’s recent price

behavior will continue to hold. Thus an

investor would buy a st

ock whose price has

recently been rising, and sell (or short)

a stock whose price has been falling.Category: BusinessGeneral Busines

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