2020 Mock - LIII morning session (with solutions)

CFA® Society Boston Level III 2020 Practice Exam
Morning Session
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The following list contains the command words used on the Morning Session of the CFA Society Boston Level III 2020 Practice Exam. Candidates may want to refer to this list as they formulate their answers.
Calculate:To find (the value of something) by using mathematics.
Classify:To assign to categories or groups.
Compare: To note the similarities and differences of two or more things.
Contrast: To state the differences between.
Describe: To portray in words.
Determine:To decide; to ascertain.
Discuss: To examine critically and in detail.
Explain:To make clear the meaning of.
Identify:To recognize and correctly name.
Justify: To show to be valid or appropriate in a particular context.
Recommend: To offer as being appropriate or good.
Select: To choose as being the best or most suitable.
State:To express in words the probability of an event in terms odds for or
against the event; to provide.
Support:To provide corroboration for each response with one reason.
The morning session of the CFA Society Boston Level III 2020 Practice Exam has 8 questions. For grading purposes, the maximum point value for each question is equal to the number of minutes allocated to that question.
Question Topic Minutes
1 Portfolio Management – Behavioral 16
2 Portfolio Management – Derivatives and 12
Currency Management
3 Portfolio Management – Trading, Performance 12
Evaluation, and Manager Selection
4 Portfolio Management – Equity 28
5 Portfolio Management – Individual 30
6 Portfolio Management – Alternative Investments 18
7 Portfolio Management – Fixed Income 34
8 Portfolio Management – Institutional 30
Total 180
QUESTION 1 HAS A TOTAL OF FOUR PARTS (A, B, C, D) FOR A TOTAL OF 16 MINUTES.
Alexander James, CFA, is the head of asset management at AJ Investments, where he has worked for eight years. James is meeting with Samuel and Nikita Erving and their son, Louis, to discuss their personal investment strategies. All of the Erving family members have been clients of AJ Investments for the last ten years.
Samuel Erving is 59 years of age and has been a manager at a blue-chip technology firm for 30 years. He has consistently invested in the company’s stock and employee stock options. Samuel has accumulated a portfolio of $1.8 million, of which 80% is invested in his firm. Samuel recognizes that he has no investment experience and considers himself to be a low to medium risk taker. He relies on AJ Investments for advice and actively follows leads from research reports and friends.
A. Identify the behavioral investment type (BIT) that most likely describes Samuel.
3 minutes (Answer 1-A on page 6)
James recommends to Samuel that he reduce his exposure to his employer in the portfolio. The current stock price of the employer’s stock is $98. Samuel is reluctant to sell and believes that the share price will rebound towards its 52-week high of $160. After deciding to hold the stock, Samuel observes that the quarterly sales of his firm have declined from the previous quarter. He believes that this decline in sales is temporary because of the stock’s past success and reaffirms his belief in his employer’s stock.
B. Identify two behavioral biases exhibited by Samuel. State how he can overcome these
biases with one recommendation for each.
5 minutes (Answer 1-B on page 7)
Nikita Erving is a 49-year-old entrepreneur who attributes most of her success to the textile firm she founded 15 years ago. Nikita recently sold the firm for $4 million, which is currently invested in a diverse mix of stocks and bonds. Her total income is generated by the $4 million portfolio. Nikita states that her objectives are 1) not losing capital, and 2) that her portfolio generate enough income to cover all of her routine expenses. She also expresses an interest to hold various buckets of investments, where each bucket is dedicated to generating monthly, quarterly and annual income.
C. Identify the behavioral bias exhibited by Nikita and describe briefly one consequence
of the bias.
3 minutes (Answer 1-C on page 8)
Louis Erving is 34 years old, single and a medical doctor. Louis indicates he has a low risk tolerance on his existing $2.5 million portfolio composed exclusively of health care stocks, most of which have realized a decline in value since their initial purchase. Because his earnings as a physician cover his current expenses, he views the health care portfolio as providing the capital for the purchase of a luxury home and a high-end vacation property. He also reiterates his interest to preserve wealth without taking significant risk.
James makes the recommendation to sell the health care stocks and to diversify into a broader market exposure. Louis declines this recommendation and states that he wants to hold on to the health care positions for another year in anticipation of future price increases. He does not wish to sell at a loss. Further, he would not want to miss out on any subsequent recovery if he were to sell as James recommends.
Louis recently inherited real estate investments from his grandfather totaling $2 million. Louis indicates his desire to sell the real estate properties and to redeploy his portfolio into stocks and bonds for his retirement. Louis is determined to sell his properties above their current market valuation of $2.5 million.
D. Identify Louis’s behavioral investor type. Identify three emotional biases or cognitive
errors exhibited by him to support your choice.
5 minutes (Answer 1-D on page 9)
Identify the behavioral investment type (BIT) that most likely describes Samuel.
Identify two behavioral biases exhibited by Samuel. State how he can overcome these biases with one recommendation for each.
Behavioral Bias Recommendation
1.
2.
Identify the behavioral bias exhibited by Nikita and describe briefly one consequence of the bias.
Behavioral Bias Consequence
Identify Louis’s behavioral investor type. Identify three emotional biases or cognitive errors exhibited by him to support your choice.
Behavioral Investor Type
1.
2.
3.
QUESTION 2 HAS A TOTAL OF THREE PARTS (A, B, C) FOR A TOTAL OF 12 MINUTES. Jake Piesz, CFA, and Carol Chlapowski, CFA Level II candidate, are senior analysts at Ankit Capital Management (Ankit), a US investment firm that provides multiple investment services for its clients. Piesz is in charge of managing client portfolios. Chlapowski is in charge of hedging portfolio risk using derivative instruments. Piesz and Chlapowski are meeting with Ankit Gehlot, CFA, the head of investment services, to discuss recent developments in client portfolios. Kai Dong, a US client at Ankit, is a high net worth individual with investments in Switzerland, the UK and Germany. Exhibit 1 provides the details of Dong’s international portfolio. Dong’s IPS gives Ankit discretion in managing currency risk in the portfolio. Gehlot requests that Piesz calculate the overall return on Dong’s portfolio and evaluate the effects of exchange rate fluctuations. Exhibit 1 Kai Dong’s Portfolio Details Country Percentage of Overall Portfolio February 1, 2019 Foreign Asset Return February 1, 2020 Germany 45% USD/EUR = 1.10 3.6% USD/EUR = 1.14 UK 25% USD/GBP = 1.30 4.1% USD/GBP = 1.27 Switzerland 30% CHF/USD = 0.96 -2.7% CHF/USD = 1.01 A. Calculate the overall domestic (USD) currency returns on Dong’s portfolio using the information in Exhibit 1. 4 minutes (Answer 2-A on page 12) Gehlot then turns his attention to Dong’s Swiss Franc (CHF) exposures, which have depreciated approximately 5% against the USD. He requests that Chlapowski recommend ways to hedge the CHF exposure at a minimal hedging cost. Chlapowski explains the usage of option contracts in Dong’s portfolio and presents the details in Exhibit 2. Exhibit 2 Option Prices for USD/CHF on February 1, 2020 USD/CHF Strike Put Option Price Call Option Price 0.99 $0.17 $0.08 0.98 $0.15 $0.10 0.97 $0.11 $0.16 0.96 $0.09 $0.18 0.95 $0.07 $0.21
B. Calculate the cost of implementing a put spread using USD/CHF strike prices 0.98 and
0.95 shown in Exhibit 2.
4 minutes (Answer 2-B on page 13)
Gehlot asks Chlapowski to provide input regarding foreign exchange management. Chlapowski presents spot and forward rates in Exhibit 3. She also states:
Statement 1:A positive roll yield could be created in Dong’s portfolio by selling a USD/EUR forward contract.
Statement 2:A positive roll yield could be created in Dong’s portfolio by selling a CHF/USD forward contract.
Exhibit 3
Spot and Forward Rates
Currency Pair Spot Rates Six-Month Forward Rates
USD/EUR USD/EUR = 1.14 USD/EUR = 1.20
USD/GBP USD/GBP = 1.27 USD/GBP = 1.31
CHF/USD CHF/USD = 1.01 CHF/USD = 1.05
C. Identify which of Chlapowski’s statements is most likely to be correct based on the
information provided in Exhibit 3. Calculate the forward premium or discount for each statement.
4 minutes (Answer 2-C on page 14)
Calculate the overall domestic (USD) currency returns on Dong’s portfolio using the information in Exhibit 1.
Calculate the cost of implementing a put spread using USD/CHF strike prices 0.98 and 0.95 shown in Exhibit 2.
Identify which of Chlapowski’s statements is most likely to be correct based on the
information provided in Exhibit 3.
Statement 1
(circle your response) Correct Incorrect
Statement 2 Correct Incorrect Calculate the forward premium or discount for each statement.
Statement 1
Statement 2
QUESTION 3 HAS A TOTAL OF FOUR PARTS (A, B, C, D) FOR A TOTAL OF 12 MINUTES. Steve Beckman manages the Global Equity Fund (Fund) at NavalMemes Asset Management. Beckman uses a top-down investment approach that utilizes technical analyses and econometric models to forecast country and sector return expectations . Beckman does not take idiosyncratic risks, and he hedges the aggregate market risk of the Fund. The Fund seeks a target rate of return (minimum acceptable return) of T-bill return plus 4%. A. Recommend the risk attribution approach best suited in evaluating the Fund. 1 minute (Answer 3-A on page 17) Bill Weiss, the head of manager research at Harvard Analytics, is engaged in a performance evaluation of the Fund. Weiss turns his attention to analyzing performance. Weiss considers both returns-based and holdings-based attribution methods. B. Contrast the two attribution methods by describing the most appropriate use of each method. Identify one drawback of each attribution method. 3 minutes (Answer 3-B on page 18) In preparation for the attribution analysis, Weiss collects the country weights and returns for the Fund and the benchmark for the last year. He proceeds to evaluate the impact of allocation and selection decisions as detailed in Exhibit 1. Exhibit 1 C. Calculate the allocation, selection and interaction effects for both Japan and the Fund. Discuss briefly the allocation and selection effects for each of the individual countries and for the overall Fund. 6 minutes (Answer 3-C on page 19) Fund Weight Benchmark Weight Fund Return Benchmark Return Allocation Selection Interaction France 25.00% 20.00% 10.80% 8.00% –0.20% 0.56% 0.14% Germany 15.00% 20.00% 16.50% 13.70% –0.09% 0.56% –0.14% China 35.00% 25.00% 8.40% 6.00% –0.60% 0.60% 0.24% United States 18.00% 30.00% 21.10% 20.00% –0.96% 0.33% –0.13% Japan 7.00% 5.00% 1.30% 3.20% ? ? ? Total 100.00% 100.00% 12.00% 12.00% ? ? ?
D.Calculate the Sortino ratio of the Fund given the information provided below.
•The average Fund return over the measurement period is 12%.
•The T-bill rate is constant at 4%.
•The average standard deviation of returns is 14%.
•The average target semi-standard deviation is 8%.
2 minutes (Answer 3-D on page 20)
Recommend the risk attribution approach best suited in evaluating the Fund.
Contrast the two attribution methods by describing the most appropriate use of each method. Returns-based attribution
Holdings-based attribution
Identify one drawback of each attribution method.
Attribution Method Drawback
Returns-based
Holdings-based
Calculate the allocation, selection and interaction effects for both Japan and the Fund.
Allocation Effect Selection Effect Interaction Effect Japan
Total Fund
Discuss briefly the allocation and selection effects for each of the individual countries and for the overall Fund.
France
Germany
China
United States
Japan
Total Fund
Calculate the Sortino ratio of the Fund given the information provided.
QUESTION 4 HAS A TOTAL OF FOUR PARTS (A, B, C, D) FOR A TOTAL OF 28 MINUTES.
Richard Rizzitano is the new CIO of Big Time Management Company, an investment company established by Big Time University (BTU) to manage the university’s endowment. Today, Rizzitano is meeting with Anthony Swanson, the founder of Americana Capital. Americana is a US large-cap equity manager with $1 billion in assets under management (AUM). Swanson manages the firm’s Legends Fund, one of the best performers in its category over the last ten years. BTU’s endowment has committed $25 million to the Legends Fund, and Rizzitano wants to learn more about Swanson’s investment philosophy and strategy.
The meeting begins with Rizzitano asking Swanson to explain his investment philosophy and portfolio construction process. Swanson tells Rizzitano he believes strongly that only high-quality companies outperform the benchmark over a long horizon. As such, Swanson’s process involves screening the S&P 500 to identify the seventy-five highest-quality companies in the index. This includes research activities such as reviewing historical SEC filings, meeting with company management and interviewing key constituents. To calculate a company’s intrinsic value, Swanson then develops a financial model and projects five years of free cash flow for all seventy-five companies. The intrinsic value is compared to the current market price for each company. The forty names trading at the largest discount to their fair value are then included in the portfolio.
A. Classify Swanson’s approach to portfolio construction. Justify your response with two
supporting reasons.
7 minutes (Answer 4-A on page 23)
After explaining his investment philosophy and portfolio construction process, Swanson is asked about the Legends Fund’s active share. Swanson explains that the active share of the fund is typically very high and is currently at 90%. One of the reasons the active share is high is due to Swanson’s large relative bets on different sectors. Twelve of the fund’s thirty-five holdings are in the technology sector, whereas not a single financial sector name is held in the portfolio. Swanson also notes that Legends’s active risk is also quite high, and comments that not much can be done to lower it, as active risk is based on the correlations and variances of different securities.
B. Identify two changes Swanson could make to lower active risk. Support each of your
proposed changes.
7 minutes (Answer 4-B on page 24)
After answering a few additional questions, Swanson provides Rizzitano with a one-page document comparing the Legends Fund to the Kingston Fund. The information in this document is displayed in Exhibit 1. Swanson notes that the Kingston Fund is the Legends Fund’s closest competitor and employs a very similar investment philosophy focused on quality. Swanson tells Rizzitano that the document demonstrates that the Legends Fund has a much more efficient portfolio structure than the Kingston Fund.
Exhibit 1
Fund Comparison (January 2014 – December 2019)
Legends Fund Kingston Fund
# of Securities 40 120
Active risk (annualized) 4.9% 4.7%
Active share (average) 0.88 0.38
Volatility (annualized) 14.1% 14.2% Maximum drawdown 22.7% 21.2%
Total return (annualized) 11.3% 7.9% Management fee 75 basis points 75 basis points Factor Risk Contribution
Market 99.5% 83.2%
Size 1.3% 7.2%
Value 7.7% –2.2%
Momentum –0.4% –0.2%
Quality –12.2% –0.2%
Unexplained 4.1% 12.2%
Total 100.0% 100.0%
C. Identify two fund characteristics in Exhibit 1 that support Swanson’s comment regarding
the Legends Fund’s relatively efficient portfolio structure.
7 minutes (Answer 4-C on page 25)
Before the meeting ends, Swanson mentions that Americana is launching a new market-neutral fund. This fund will take full advantage of the stock-picking expertise of Americana’s research team by expressing negative views through short positions. Swanson’s comments to Rizzitano on this topic are captured in Statement 1.
Statement 1: I suggest taking $5 million of the $25 million that the BTU endowment has invested in the Legends Fund and investing the proceeds in this new market-
neutral fund. Doing so would allow the BTU endowment to reduce its total equity
portfolio market risk (i.e., beta), increase the portfolio’s diversification across
other non-market risk factors and reduce the portfolio’s tracking error. Rizzitano tells Swanson that he will consider the suggestion.
D. State whether Swanson’s justification in Statement 1 is correct. Explain your reason
briefly.
7 minutes (Answer 4-D on page 26)
Classify Swanson’s approach to portfolio construction. Justify your response with two supporting reasons.
Approach Reason 1
Reason 2
Identify two changes Swanson could make to lower active risk. Support each of your proposed changes.
Change 1 Support
Change 2 Support
Identify two fund characteristics in Exhibit 1 that support Swanson’s comment regarding the Legends Fund’s relatively efficient portfolio structure.
Characteristic 1
Characteristic 2
State whether Swanson’s justification in Statement 1 is correct. Explain your reason briefly.
(circle your answer)
Correct Incorrect
Explain briefly
QUESTION 5 HAS SIX PARTS (A, B, C, D, E, F) FOR A TOTAL OF 30 MINUTES. Kathleen Cheng, CFA, is the personal investment advisor and financial consultant to Louis, Charles and Edmund Bray, brothers who founded the publicly traded retail chain Three Brothers Auto Parts Stores (Three Brothers), headquartered in New Cumberland, Pennsylvania. The company began operations in the mid-1980s and has grown rapidly over the years. It now has over 2,000 stores nationwide. As the three principal shareholders, the brothers have done well financially. At present, however, the firm is at a critical junction. Louis, the middle brother, is planning to retire next month and relinquish all his duties and responsibilities. Louis, aged 65, is a widower in excellent health and has an adult daughter who is successful and financially independent in her own right. He plans to remain in his current home and intends to be active in community and charitable activities throughout his retirement years. Louis has no debts and no extraordinary charitable or testamentary intentions. He will receive a pension from Three Brothers in addition to social security benefits and his own retirement plan withdrawals. He has an adequate emergency fund to meet unexpected liabilities. He is taxed at a flat 30% rate on all earned and investment income (interest, dividends and capital gains). This tax rate is expected to remain constant throughout his remaining life. In anticipation of his imminent retirement, Louis is reviewing his insurance coverage to determine possible savings opportunities by reducing these costs. His current insurance coverage and costs are shown in Exhibit 1. All premiums are paid entirely by Louis. Exhibit 1 Insurance Coverage and Costs of Louis Bray Insurance Coverage Annual Cost Disability insurance 60% of compensation $5,500 Life insurance $2 million (annual renewable term) $26,500 Property & casualty (primary residence) 100% replacement with $300,000 liability $3,500 Property & casualty (vacation home) 100% replacement with $300,000 liability $2,500 Property & casualty (autos) Actual cash value* of asset with $300,000 liability $2,000 Property & casualty (boat) Actual cash value* of asset with $300,000 liability $2,000 Excess liability (“umbrella”) $2 million in addition to other liability coverages $2,000 Total $44,000 * Property coverage limited to fair market value of the underlying asset at time of loss
A.Determine Louis’s likely insurance cost savings in his first year of retirement.
2 minutes (Answer 5-A on page 31)
A substantial portion of Louis’s wealth is comprised of Three Brothers stock, with a tax basis of effectively zero. Cheng advises Louis to mitigate this risk, especially as market volatility is rising, and he agrees. Louis has no emotional attachment to the stock and no aversion to selling it. His two brothers are not interested in purchasing his interest in the company.
Cheng lists a number of potential strategies for Louis that address the management of risks associated with a concentrated stock position in an individual’s portfolio. She notes that active and liquid markets exist on exchanges and OTC for all Three Brothers related derivative products. Cheng warns Louis, however, that the removal of all market risk in any of the strategies will be treated as a constructive sale by the Internal Revenue Service with immediate capital gains tax due.
The strategies Cheng lists are:
•Outright sale
•Shorting against the box
•Establishing a collar
•Entering into a total return equity swap
•Buying a put
•Establishing a prepaid variable forward
•Using options to effect a forward conversion
•Selling the stock forward
In response, Louis identifies his preferences and conditions regarding the disposition of the Three Brothers stock.
•He does not want to borrow or incur debt in any way.
•He seeks the lowest cost solution.
•He does not want to incur any tax liability this year.
•He does not want to be exposed to uncertainty in the tax treatment of the sale.
•He wants to retain the stock at least until the next Three Brothers shareholder meeting in six months in order to vote his shares on a restructuring proposal before the board.
B. Identify two strategies Louis might consider with regard to his concentrated position in
Three Brothers shares. Justify each of your selections with three reasons.
6 minutes (Answer 5-B on page 32)
Louis asks Cheng to explain how some of his investments are performing. Three of his accounts are shown in Exhibit 2. All three derive their returns from current income (i.e., no net unrealized capital gains or losses). After five years, Louis plans to liquidate the three accounts and purchase an annuity with the proceeds.
Exhibit 2
Selected Accounts of Louis Bray
Account Current Value/Tax Basis Nominal Return Standard Deviation Tax-exempt $1 million 6% 10% Taxable $1 million 10% 13%
Tax-deferred $1 million 9% 12%
C.Identify which of the accounts will have the smallest and the largest after-tax return and
which accounts exhibit the lowest and highest risk over the next five years.
6 minutes (Answer 5-C on page 33)
D. Identify the relative advantages and disadvantages for Louis of fixed and variable
annuities by citing two advantages and two disadvantages for each type of annuity.
6 minutes (Answer 5-D on page 34)
Charles Bray is 75 years old, a widower with no offspring, and is in poor health. As part of a recent estate planning exercise following his retirement from Three Brothers, Charles liquidated nearly all of his assets, including his home, taxable accounts and retirement accounts. He purchased a series of inflation-indexed life annuities and a lifetime residency contract at an assisted living facility. These actions, coupled with a comprehensive health insurance plan, have resulted in all of Charles’s future living, spending and health care costs being covered.
When he was liquidating his assets, Charles only retained a single balanced fund in the amount of $3 million in a tax-exempt account. This is his only remaining financial asset. As he no longer has any future expenses, Charles would like to use this fund to benefit his deceased wife’s favorite niece.
Because of previous gifting, Charles has no tax credits or allowances available to shelter either future gifts or bequests from taxation. The tax rate that would apply to both gifts and bequests would be a flat 50% and the tax would be due immediately, payable by Charles or by his estate. The niece is in the same income tax bracket as Charles and the fund would earn the same rate of return whether held by Charles or the niece.
Charles asks Cheng whether he should gift the balanced fund to the niece now or leave it to her, including any interim reinvested appreciation, at his death. He wishes for her to receive the maximum possible economic benefit.
E. Determine whether Charles should gift or bequeath the assets to the niece a nd
determine the financial advantage of the strategy chosen. [Note: No generation-skipping transfer tax would apply in this case.]
4 minutes (Answer 5-E on page 35)
Edmund Bray is the CFO of Three Brothers and the chair of the investment committee overseeing the company’s defined benefit pension plan. Cheng has repeatedly and strongly recommended the development of investment policy statements for Edmund and the pension plan, but none exist currently.
Before proceeding in this matter, Edmund would like to obtain some general background information from Cheng regarding the similarities and differences between the two IPSs Cheng recommends.
F. Contrast and compare, in general terms, the likely objectives and constraints sections of
Edmund’s IPS versus those of the Three Brothers pension plan.
6 minutes (Answer 5-F on page 36)
Determine Louis’s likely insurance cost savings in his first year of retirement.
Identify two strategies Louis might consider with regard to his concentrated position in Three Brothers shares. Justify each of your selections with three reasons. Strategy Reasons
1. 1.
2.
3.
2. 1.
2.
3.
Identify which of the accounts will have the smallest and the largest after-tax return and which accounts exhibit the lowest and highest risk over the next five years. (circle your answers)
Smallest return Largest return
Taxable Tax exempt Tax deferred
Taxable Tax exempt Tax deferred
Lowest risk Highest risk
Taxable Tax exempt Tax deferred
Taxable Tax exempt Tax deferred
Identify the relative advantages and disadvantages for Louis of fixed and variable annuities by citing two advantages and two disadvantages for each type of annuity.
Advantage Disadvantage
Fixed Annuity 1. 1.
2. 2.
Variable Annuity 1. 1.
2. 2.
Determine whether Charles should gift or bequeath the assets to the niece and determine the financial advantage of the strategy chosen. [Note: No generation-skipping transfer tax would apply in this case.]
(circle your answer)
Gift Bequeath
Financial Advantage
Contrast and compare, in general terms, the likely objectives and constraints sections of Edmund’s IPS versus those of the Three Brothers pension plan.
Edmund’s IPS Pension Plan IPS Objectives
Return
Risk
Constraints
Liquidity
Time Horizon
Tax
Legal/Regulatory
QUESTION 6 HAS A TOTAL OF FOUR PARTS (A, B, C, D) FOR A TOTAL OF 18 MINUTES.
William Gary, CFA, is meeting with his client, Ross Franco, to discuss the addition of hedge fund exposure to Franco’s portfolio. Franco has been reading recently about the benefits of alternative investments and is considering adding these to his portfolio.
Franco is especially interested in Alpha Fund, a hedge fund that creates and uses complex quantitative strategies with the goal of eliminating any impact of general market movements. Franco admits that, while he has a vague understanding of what different hedge fund strategies entail, he would like Gary to explain the market-neutral concept in more detail. Gary begins by discussing the strengths and weaknesses of a market-neutral strategy and when its implementation is most appropriate.
Gary uses a hypothetical example of a pairs trade to demonstrate how an investor could create a market-neutral strategy. Gary bases his example on two stocks: DTY and GHT. These stocks are peers in a competitive industry, and have a high historical correlation and similar historical betas. Recently, the performance of these two stocks has deviated considerably. Share prices of DTY have risen sharply and are considered by most analysts to be overvalued. Share prices of GHT have also risen, but are considered fairly valued. Gary describes how a strategy combining these two stocks could be protected from general market movement.
Franco is happy with the pairs trade explanation and asks Gary about the proposed allocation of alternative investments to his portfolio. Gary recommends an allocation to hedge funds of 15%. To demonstrate how the addition of hedge fund exposure would impact Franco’s portfolio, Gary presents Franco with the information in Exhibit 1. The table shows how Franco’s current portfolio metrics would change with a 15% allocation to the three different hedge funds.
Exhibit 1
Mean Return (%)
Standard
Deviation (%)
Sharpe
Ratio
Sortino
Ratio
Max Drawdown
(%)
Current 8.56 10.67 0.61 1.18 18.11 Adding Fund 1 8.88 9.28 0.74 1.25 25.26 Adding Fund 2 8.04 9.85 0.61 1.33 12.54 Adding Fund 3 9.42 10.54 0.70 1.30 17.74 Franco tells Gary to move forward with the fund he thinks would provide the best performance with the current portfolio.
A.Identify three potential benefits of investing with Alpha Fund over a typical long- s hort
strategy fund.
6 minutes (Answer 6-A on page 39)。