1. (16 Points) Suppose you are a chief officer for a money management firm that specializes in advising individual investors. You use an integrated asset allocation strategy. You are trying to establish a strategic asset allocation for two clients, Mrs. Howard and Mr. Thomson. Mrs. Howard has a risk tolerance factor of 7. Mr. Thomson has a risk tolerance factor of 32.

The table below shows the characteristics of four possible portfolios.

                                           Asset Mix
Stock   Bond    ER  2

Portfolio 1 10% 90% 6% 5%
Portfolio 2 30% 70% 7% 11%
Portfolio 3 70% 30% 8% 19%
Portfolio 4 90% 10% 9% 29%

a) Calculate the expected utility for each possible portfolio for each of the two clients. Show your calculations.

b) Which portfolio is the optimal strategic allocation for Mrs. Howard?

c) Which portfolio is the optimal strategic allocation for Mr. Thomson?

d) Why is there a difference between the strategic allocations of Mrs. Howard and Mr. Thomson? Explain.

2. (8 Points)

a) “The portfolio turnover ratio is the best measure of the tax efficiency of an active portfolio.”

Is this statement true or false? Explain your answer.

b) “Suppose we look at the S&P 500 Index for today. Suppose we make a list of the 12 best-ranking earnings momentum stocks (in the S&P 500 Index). Suppose we make another list containing the 12 best ranking earnings momentum stocks (in the S&P 500 Index). We are likely to have the same stocks in our two lists.”

Is this statement true or false? Explain your answer.

3. (15 Points) You are given the style analysis grid shown below.

a) Draw points on this grid that show the positions of the following portfolio managers:

• Mr. Sharp is a manager whose portfolio produced returns best mimicked by returns to indexes representing a small-cap growth style.
• Mr. Smart is a manager whose portfolio produced returns best mimicked by returns to indexes representing a large-cap value style.
• Mr. Lucky is a manager whose portfolio produced returns best mimicked by returns to indexes representing a small-cap value style.
• Mr. Clear is a manager whose portfolio produced returns best mimicked by returns to indexes representing a mid-cap blend style.

b) On the same grid, show points for the following indexes:

• S&P 500
• NASDAQ

c) Can we use a regression analysis to identify a manager’s style? Explain.

d) Suppose we analyze a fund created by Mr. Brown. We look at the past six years. We find that Mr. Brown’s fund has shown a considerable “style drift”. What does this mean? Explain.

e) Mr. Blue is a manager whose fund exhibits too much unintentional style drift. Would you be comfortable putting your money in Mr. Blue’s fund?

Read the article “The Right to Answer to the Wrong Question: Identifying Superior Active Portfolio Management” by W.V. Harlow and Keith C. Brown in Journal of Investment Management, 2006, and answer the following questions:

4. (7 Points) Is the financial literature agreed on whether investors should choose active or passive portfolio management? Explain.
5. (4 Points) According to the authors, what is the “right” question that needs to be addressed? Explain.
6. (5 Points)

a) What are the two characteristics of a good fund manager that the authors were able to identify, based on their empirical work?

b) Do the authors of this article believe that some active portfolio managers can produce “alpha”?

7. (5 Points) Do you agree with the views of the authors? Why or why not?

Sample Solution

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