NATHANI IS LEAST LIKELY TO USE THE SHARPE RATIO TO EVALUATE THE POR...

3. Nathani is least likely to use the Sharpe ratio to evaluate the portfolio returns of:

A. Manager 1.

B. Manager 2.

C. Manager 3.

The following information relates to questions 4 – 6.

Ling Mei, is the chief investment officer at Drexel Corp. responsible for the company’s

employees’ pension fund. She is interviewing Karl Seyfried for the post of an analyst. Mei wants

to determine whether Seyfried is familiar with the portfolio construction and management

process. Mei asks Seyfried about the fundamental law of active management. Seyfried responds,

“According to the fundamental law, the expected active return, is the product of four key

parameters: the transfer coefficient (TC), the information coefficient (IC), breadth, and portfolio

active risk. Managers with better ability to forecast returns or higher IC will add more value over

time. The transfer coefficient is low when there are constraints over portfolio construction, and

breadth is lower for positively correlated securities.”

Mei shares the following information (Exhibit 1) with Seyfried and asks him to evaluate the

portfolio managers.

Exhibit 1. Portfolio Manager Comparison

Manager A Manager B

Based on monthly forecasts of commodity

Based on internal forecasts, the manager

prices and interest rates, the manager

may allocate weights to 20 developed

countries using country-specific ETFs with

allocates weights between a short-term US

treasury bond fund and a commodity

quarterly rebalancing.

exchange-traded fund (ETF). The

benchmark portfolio is 50% commodity

and 50% US T-bond.

Seyfried makes the following notes:

I. Manager A would improve its information ratio by rebalancing more frequently.

II. Manager B has a lower breadth than specified because of the likelihood of positive

correlation of country returns.

III. Because both managers have constrained portfolios, therefore information

coefficients will generally increase with aggressiveness of the strategy.

Mei questions Seyfried about practical limitations of the Fundamental Law of Active

Management. Seyfried answers as follows: