Q16I The following is part of the com... [FREE SOLUTION]

Use the following information to answer Problems l2–16:

Primo Management Co. is looking at how best to evaluate the performance of its managers. Primo has been hearing more and more about benchmark portfolios and is interested in trying this approach. As such, the company hired Sally Jones, CFA, as a consultant to educate the managers on thebest methods for constructing a benchmark portfolio, how best to choose a benchmark, whether the style of the fund under management matters, and what they should do with their global funds in terms of benchmarking.

For the sake of discussion, Jones put together some comparative two-year performance numbers that relate to Primo’s current domestic funds under management and a potential benchmark.

As part of her analysis, Jones also takes a look at one of Primo’s global funds. In this particular portfolio, Primo is invested 75% in Dutch stocks and 25% in British stocks.

The benchmark invested 50% in each—Dutch and British stocks. On average, the British stocks outperformed the Dutch stocks. The euro appreciated 6% versus the U.S. dollar over the holding period, while the pound depreciated 2% versus the dollar. In terms of the local return, Primo outperformed the benchmark with the Dutch investments but underperformed the index with respect to the British stocks.

Question: Calculate the amount by which the Primo portfolio out- (or under-) performed the market over the period, as well as the contribution to performance of the pure sector allocation and security selection decisions.

Return again to the previous problem. Now suppose that the manager misestimates thebeta of Waterworks stock, believing it to be .50 instead of .75. The standard deviation ofthe monthly market rate of return is 5%.

a. What is the standard deviation of the (now improperly) hedged portfolio?

b. What is the probability of incurring a loss over the next month if the monthly marketreturn has an expected value of 1% and a standard deviation of 5%? Compare youranswer to the probability you found in Problem 16.

c. What would be the probability of a loss using the data in the previous problem if themanager similarly misestimated beta as .50 instead of .75? Compare your answer tothe probability you found in the previous problem.

d. Why does the misestimation of beta matter somuch more for the 100-stock portfoliothan it does for the 1-stock portfolio?

Question: The following is part of the computer output from a regression of monthly returns on Waterworks stock against the S&P 500 Index. A hedge fund manager believes that Waterworks is underpriced, with an alpha of 2% over the coming month.

a. If he holds a \(3 million portfolio of Waterworks stock and wishes to hedge market exposure for the next month using one-month maturity S&P 500 futures contracts, how many contracts should he enter? Should he buy or sell contracts? The S&P 500 currently is at 1,000 and the contract multiplier is \)250.

b. What is the standard deviation of the monthly return of the hedged portfolio?

c. Assuming that monthly returns are approximately normally distributed, what is the probability that this market-neutral strategy will lose money over the next month?

Assume the risk-free rate is .5% per month.

The investment policy statement of an institution must be concerned with all of the followingexcept:

a. Its obligations to its clients.

b. The level of the market.

c. Legal regulations.

d. Taxation.

Here are data on three hedge funds. Each fund charges its investors an incentive fee of 20% of total returns. Suppose initially that a fund of funds (FF) manager buys equal amounts of each of these funds and also charges its investors a 20% incentive fee. For simplicity, assume also that management fees other than incentive fees are zero for all funds.

a. Compute the rate of return after incentive fees to an investor in the fund of funds.

b. Suppose that instead of buying shares in each of the three hedge funds, a stand-alone (SA) hedge fund purchases the same portfolio as the three underlying funds. The total value and composition of the SA fund is therefore identical to the one that would result from aggregating the three hedge funds. Consider an investor in the SA fund.

After paying 20% incentive fees, what would be the value of the investor’s portfolio at the end of the year?

c. Confirm that the investor’s rate of return in SA is higher than in FF by an amount equal to the extra layer of fees charged by the fund of funds.

d. Now suppose that the return on the portfolio held by hedge fund 3 were 2 30% rather than 1 30%. Recalculate your answers to parts ( a ) and ( b ). Will either FF or SA charge an incentive fee in this scenario? Why then does the investor in FF still do worse than the investor in SA?

Bill Smith is evaluating the performance of four large-cap equity portfolios: funds A, B, C,and D. As part of his analysis, Smith computed the Sharpe ratio and the Treynor measurefor all four funds. Based on his finding, the ranks assigned to the four funds are as follows:

The difference in rankings for funds A and D is most likely due to:

a. A lack of diversification in fund A as compared to fund D.

b. Different benchmarks used to evaluate each fund’s performance.

c. A difference in risk premiums.

Short Answer

Step by step solution

Calculation of Hedge ratio ‘a’

Calculation of SD of monthly return ‘b’

Calculation of the probability ‘c’

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