CFAI Equity item set

This is a question in CFAI Equity item sets.

My question is regarding the correct answer, as Manager B supposed to have lower excess return due to high tracking error!

Why was it considered luck not a skill, is it because Manager B’s holding number indicates that he is an active manager. So in that case he should have low excess return and low tracking error?

Manager A** Manager B **Manager C Benchmark S&P 500 MSCI EAFE Russell 3000 Number of holdings: Fund/index 498/500 800/928 1,200/3,000 Usage of futures For cash drag For currency overlay No Accounts for covariances No No Yes Tracking error 0.06% 1.97% 0.34% Excess return 0.10% 2.10% –0.15%

In reviewing the relative performance of Manager B from Exhibit 1, Parker makes the following statements:

  • He faced more volatile markets than the others did, based on the tracking errors.
  • He used currency overlays to lever the returns of securities held in foreign currency.
  • His excess return looks like it is more a matter of luck than skill.

Q. Which of Parker’s statements about Manager B in Exhibit 1 is most appropriate? The statement about:

  1. tracking errors.
  2. excess return.
  3. currency overlays.

B is correct. The comment about excess return being luck rather than skill is correct. Replication managers attempt to create a portfolio that tracks the performance and the volatility of the underlying index as closely as possible. The proper measure of skill is the tracking error: Manager B has the highest tracking error among the three managers.

The goal of a passive indexing strategy is to match the returns of the index (minimize tracking error). Excess return is not the aim of the strategy, and since the strategy wasn’t designed to create excess returns, it implies that if there is excess returns it’s due to idiosyncratic risk which had a minimal impact in making holding decisions.

Or, simplier put, since the manager didn’t set out to explicitly create excess returns, any excess returns are due to luck and not skill.

And currency overlays are used for hedging - not levering.

Volatile markets have nothing to do with this, because a well constructed passive strategy should have volatility play out both in the returns of the portfolio & the returns of the benchmark - in which case they’d cancel each other out and you’d still have a minimal tracking error.

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You did learn something in the past few years! :grin:

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Hello. I have a doubt. I dont get why the hedged portfolio approach does have exposure to other risk factor. Wich risk factors? Can someone provide us one example?. If we are long the upper segment and short the lower segment, i dont get the other risk factors.

Thanks in advance.

It could be almost anything.

If you want a pure factor portfolio (i.e., nonzero exposure to exactly one risk factor and zero exposure to all other risk factors), this approach won’t do it. If you think about it, all this approach is doing is, at best, eliminating the exposure to one risk factor: the one on which the rankings are based. (And there’s no guarantee that it’s doing even that.)

Thanks for your answer. I See… but then… it is imposible (very very very difficult) to get exposure only to one factor (in my opinion). Becasue, for example if you focus on the Growth factor and you make a portfolio based on that, obviusly the portfolio will also have exposure to other factor, wont it?

You got it!

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