TO 24 RELATE TO EQUITY PORTFOLIO MANAGEMENT SONERA ENDOWM...

Questions 19 to 24 relate to Equity Portfolio Management

Sonera Endowment Fund Case Scenario

William Gatchell, CFA, is an investment analyst with the Sonera Endowment Fund. Sonera is considering

hiring a new equity investment manager. In preparation, Gatchell meets with Anjou Lafite, another

analyst at the fund, to review a relevant part of the endowment’s investment policy statement:

“Funds will be invested in the most efficient vehicle that meets the investment objective. Each manager

must demonstrate the efficiency with which the tracking error they take on delivers active return. In

addition, each manager must consistently adhere to his stated style.”

Gatchell is given the task of reviewing three investment managers and selecting a manager that is most

likely to adhere to Sonera’s investment policy statement. Information about the investment managers is

found in Exhibit 1.

Exhibit 1

Investment Manager Data

Investment Manager

A B C

Assets under management ($ millions) 1,325 3,912 524

Information ratio –0.27 0.50 0.75

Small-cap value index– beta 0.95 0.98 1.05

Small-cap growth index– beta 0.32 0.43 0.48

Large-cap value index – beta 1.05 1.10 0.96

Large-cap growth index – beta 0.47 0.39 0.37

Manager stated style Value Value Growth

Manager stated sub-style Low P/E High yield Momentum

Gatchell is reviewing the fee structures proposed by the three investment managers. He finds the

following reference in the investment policy statement:

“The fee structure must be easy to understand and avoid undue complexity wherever possible. Also, the

fee structure must be predictable, so Sonera can reasonably forecast these costs on a yearly basis as an

input to the annual budgeting process.”

He understands there are many different fee structures, and he wants to make sure he chooses the

most appropriate one for the Sonera Endowment Fund. He prepares a recommendation to the

investment policy committee regarding the most appropriate fee structure.

Sonera has followed an active investment style for many years. Gatchell would like to recommend to the

investment policy committee that a portion of the funds be invested using a passive investment style.

His research shows there are a number of methods used to weight the stocks in an index, each having its

own characteristics. The one key feature he feels is important is that the method chosen not be biased

towards small-capitalization stocks.

Gatchell is also examining different ways to establish passive equity exposure. He states to Lafite, “There

are a number of ways to get passive equity exposure; we can invest in an equity index mutual fund, a

stock index futures contract, or a total return equity swap. Stock index futures and equity swaps are

low-cost alternatives to equity index mutual funds; however, a drawback of stock index futures is they

have to be rolled over periodically. One advantage of investing in equity mutual funds is that shares can

be redeemed at any point during the trading day.”

Gatchell is reviewing the performance of another investment manager, Far North, which employs a

value-oriented approach and specializes in the Canadian market. Gatchell would like to recommend to

the investment policy committee that the fund diversify geographically. The information for Far North

and the related returns are found in Exhibit 2.

Exhibit 2

Far North: Return Information

Rate of Return

Far North 14%

True active return –1%

Misfit active return 5%

The investment policy committee reviews the information in Exhibit 2 and is not familiar with the terms

true active return and misfit active return. Gatchell responds with the following statement:

“The true active return is the return Far North made above its normal benchmark return. The misfit

active return is the return Far North made above the investor’s benchmark return. The term investor’s

benchmark refers to the benchmark the investor uses to evaluate performance for a given portfolio or

asset class.”

19. Based on Exhibit 1, which investment manager most likely meets the criteria established in the

endowment’s investment policy statement?

A. Manager A

B. Manager B

C. Manager C

20. Based on Exhibit 1, is there sufficient information for Gatchell to create and interpret the results

of a style box?

A. Yes

B. No, because additional index data are required

C. No, because additional holdings data are required

21. Which fee structure is most appropriate for Sonera based on the criteria in the investment

policy statement?

A. An ad valorem fee structure

B. A performance-based fee structure with a fee cap

C. A performance-based fee structure with a high water mark

22. If the investment policy committee decides to accept Gatchell’s recommendation to also use

passive investing, the index structure that least likely meets Gatchell’s requirement is:

A. a price-weighted index.

B. a value-weighted index.

C. an equal-weighted index.

23. In his statement to Lafite, Gatchell is least likely correct with respect to:

A. cost.

B. redemption.

C. periodic rollover.

24. Is Gatchell’s statement regarding true active return and misfit active return correct?

A. Yes

B. No, he is incorrect about true active return

C. No, he is incorrect about misfit active return