IS KRAMER CORRECT ABOUT THE COMPONENTS OF ACTIVE RISK

22. Is Kramer correct about the components of active risk?

A. Yes.

B. No, she is incorrect about the first component.

C. No, she is incorrect about the second component.

The following information relates to questions 23 – 26.

Corgan Investments is an investment advisory and portfolio management firm that specializes in

equities in energy sector in various global markets. Brenda Fraser, senior portfolio manager, is

discussing management of the firm’s portfolios with a recently hired analyst Patrick Ricoh.

Fraser states, “We use factor models when analyzing regional energy index expected returns.”

Fraser continues, “Factor models are based on the arbitrage pricing theory (APT), which works

under three key assumptions:

Assumption 1: A factor model describes asset returns.

Assumption 2: Investors can construct well-diversified portfolios that eliminate factor risk.

Assumption 3: No arbitrage opportunities are possible among well-diversified portfolios.”

Fraser adds: “Upon analysis of our three regional portfolios, I have found that all the three

portfolios show sensitivity to price-to-cashflow factor (P/CF) as given in Exhibit 1. Information

from Exhibit 1 shows the possibility of an arbitrage opportunity that can be exploited by buying

Portfolio III while selling short 40% of Portfolio I and 60% of Portfolio II.”

Exhibit 1. Portfolio Sensitivities to P/CF Factor

Portfolio Expected Return Factor Sensitivity

I 12.0% 0.9

II 13.3% 0.4

III 15.3% 0.6

Fraser concludes, “For our securities analysis we use a three-factor model, to compare the mean

expected return of the regional energy index with an individual security’s expected return. The

three factors are:

Factor 1: P/CF factor that compares stocks of firms in the highest P/CF quartile with the stocks

of firms in the lowest P/CF quartile.

Factor 2: A sector excess return factor that compares local energy sector returns with the entire

local equity market (MKT).

Factor 3: A capital investment factor.”