the correct answer is B. (i used the word “eliminate” and “most likely” because this is verbiage the CFAI likes to use).
as someone noted above, one main disadvantage of adding a Completeness Fund to a portfolio tends to reduce/eliminate misfit risk, which is the part of active risk they were looking to gain exposure to.
A is not correct. There is nothing in the question that makes a suggestion that adding the Fund will “most likely” increase the IR. It may increase the IR, it may decrease the IR. It is likely that adding the Fund will actually reduce the IR.
C is not correct, for similar reasons as A. There is no information on the returns/risk of this Completeness Fund, so it is not “most likely” that adding it will do anything to the mgr’s true active return. In fact, it is more likely that the addition of a Completeness Fund will REDUCE the true active return as the completeness fund will bring the portfolio returns more in line with the benchmark.
*Hopefully this is helpful… and hopefully for all our sakes, a question just like this will be on the exam - sparking this dialogue is a different way of “learning” and it will definitely help some remember this minutae material on test day. I’ll post another question later today/tonight (I’m in US Eastern time zone).
This is a great initiative Junior thanks. However, do you think that maybe the word ‘eliminate’ is the best choice? I almost picked B but changed my mind because I thought eliminate was too strong of a statement.
zina, i hear what you’re saying. the reason i put “eliminate” as opposed to something softer (and why i chose to use “most likely”) is because, in my experience, this is the type of “tricky” question/verbiage the CFAI likes to use. A and C have no validity as correct answers, and they are not likely, and since there is a high likelihood misfit return can be “eliminated” by adding the Fund, B is “most likely” correct.
i promise not to throw CFAI-like tricks in the next one
Well I agree with Matt. Information ratio ia undetermined. But the word eliminate causes a hind sight bias to dominante the overconfidence. studying hard will compensate us with such tricks question.
Excellent points Junior and shame on me. Goes to show that no tricks can overthrow people if they master the concepts (in my case, I need to nail down the completeness fund approach concept - my understanding is not very solid on that).
I think B as well although i think there’s a more specific formula.
But to question 2 above, can someone please explain a completeness fund or at least tell me where i can find it in the curriculum, I’m absolutely blanking out on that .
Although b pops out as the right choice, there is at least one reason why it might not be the correct answer:
This is the reason: sharpe(small cap)>sharpe(portofolio)*corr(small cap,portofolio).
I go with C. The reason is because if the two shapre ratios are equal, then the only case where you wouldn’t add small cap the portofolio is when the correlation between small cap and portofolio is equal to 1.
The Sharpe ratio of the small cap fund is important, but the correlation between the fund and the portfolio, per the equation, is a relatively more important factor. The sharpe of the new could could be higher or lower than the sharpe of the existing portfolio, but the fund would MOST LIKELY be added if the correlation is low. A “low” correlation, for all intents and purposes, is something below 0.50. A and C are not correct, for fairly similar reasons.
Examples: sharpe new = 0.20; sharpe existing = 0.20…and correlation less than 1 (which is still high) you’d add the new fund
anothrt example. Sharpe new = 0.10; sharpe existing = 0.20…if correlation is any number below 0.50 (relatively low), you’d add the new fund.
i still hold that c encompasess a greater range of scenarios.
Here is an example that would show that even if you have a low correlation, you wouldn’t add the asset:
Sharpe new .2; sharpe portofolio .6, correl is .4. If you only look at correlation, you will fail to see that adding the new asset adds no value to the portofolio.
C seems like a better answer because under all secenarios except for 1case, you would add the asset to the portofolio. If the two sharpe ratios are equal, you would not add it if the new asset is perfectly correlated to the existing one (which I can’t imagine happening in the real world).
I don’t see, out of all 3 answer choices, how C could be remotely correct. If the Sharpe Ratios are equal, the ONLY way you’d add the new fund is if the correlation is higher than 1.0; however, through all 3 levels and particularly in this curriculum, it stresses the correlation being the most important factor in adding an investment to an existing portfolio. For diversification purposes, it is not highly likely (but could happen yes) that you’d add a fund to a portfolio when the correlation is high (anything close to or greater than 1).
I don’t know if you’re overthinking it, but there is no doubt the correct answer is B. The question stem said “most likely,” not “always” or whatever.
The curriculum specifically states on page 198, “all else equal, a lower correlation makes it MORE LIKELY that the new asset class should be added to the existing portfolio.”
I made this question up myself, love it or hate it; however, as a retaker, I’m aware that this is the little minutae shit we need to know if you’d like to pass.
This question is very poor because there’s no outcome that Mr. Jackass is looking for. Why is he adding the asset should be the underlying fundamental question that arises when reading this question.
Correlation benefits = diversifying
Sharpe ratio = measure of risk-adjsuted returns.
The combination of the two analyzes whether the diversifying benefit AND the risk-adjusted return make adding the asset benefical to the portfolio. I.e, the incremental risk-adjusted return adds a diversifying benefit at no expense to risk.
ink I typed it wrong, I meant lower (which proves my point further)
Either way, if a question like this pops up on the exam, be sure to select the answer that says “lower correlation.” Per the curriculum, that’s what is important (re-read pg 198 if you think I’m wrong or the answer is wrong, seriously, re-read it).
Galli, the reason for adding the portfolio is irrelevant - nowhere in the curriculum does that state it is relevant. Bottom line, there could be an instance when you’d add a fund that has a lower or the same Sharpe as the existing portfolio, but as the CFAI book states, you will MORE LIKELY add the fund if the correlation is low.
