PROFESSIONAL ASSET MANAGEMENT
1. Private management and advisory firms typically develop a personal relationship with their clients, getting to know the specific investment objectives and constraints of each. The collection of assets held can then be tailored to the special needs of the client. Conversely, a mutual fund offers a general solution to an investment problem and then markets that portfolio to investors who might fit that profile.
Special attention comes at a cost and for that reason private management firms are used mainly by investors with substantial levels of capital, such as pension funds and high net worth individuals. Conversely, individual investors with relatively small pools of capital are the primary clients of investment companies.
The majority of private management and advisory firms are still much smaller and more narrowly focused on a particular niche in the market. A wide variety of funds is available, so an investor can match almost any investment objective or combination of investment objectives.
Management and advisory firms hold the assets of both individual and institutional investors in separate accounts, which allows for the possibility of managing each client’s portfolio in a unique manner. Conversely, investment companies are pools of assets that are managed collectively. Investors in these funds receive shares representing their proportional ownership in the underlying portfolio of stocks, bonds, or other securities.
2. Based upon Exhibit 25.2, there has been a rapid increase in the number of large asset management firms. Much of this asset growth can be explained by the strong performance of the U.S. equity markets during this period, but there has been a trend toward consolidating assets under management in large, multiproduct firms. Still, as of December 2001, there were 48 firms with AUM of at least $100 billion.
3. After the initial public sale of shares in the investment company the open-end fund will continue to sell new shares to the public at the NAV with or without a sales charge and will redeem (buy back) shares of the fund at the NAV. In contrast, the closed-end fund does not buy or sell shares once the original issue is sold. Therefore, the purchase price or sales price for a closed-end fund is determined in the secondary market.
4. A load fund charges a fee for the sale of shares (front end load) and/or redeeming shares (back end load). It will sell shares at its net asset value plus the sales charge. A no-load fund has no initial sales charge, so it will sell its shares at its net asset value.
5. You definitely should care about how well a mutual fund is diversified. One of the major advantages of a mutual fund is instant diversification, so it truly is important. Given the CAPM, it is known that the market only pays for systematic risk so it is important to eliminate unsystematic risk, which is the purpose of diversification. A portfolio that is completely diversified will be perfectly correlated with the market portfolio (R2= + 1.00).
6. The net return for a fund is the return after all research and management costs. The gross return is before these expenses. The net return is the return reported to the stockholder since all expenses have been allowed for in the NAV. To compute the gross return it is necessary to compute the expenses of the fund and add these back to the ending NAV and compute the returns with these expenses added back. Typically, the average difference in return is about one percent a year, but this varies by fund. As an investor, it is the net return that is important because these are the returns that you derive.
7. Just because only half do better than buy-and-hold on the basis of risk-adjusted return does not mean you ignore them, because there are other functions that investment companies perform that are important. These other functions include diversification, flexibility, and record keeping. To derive these other advantages it may be necessary to give up some of the return.
8. It is questionable whether good performance will continue during two successive short-term periods because in many cases it could be a random event of a couple of winners that are not repeated. Empirically, such superior performance has not been consistent beyond what you would expect by chance.
9. Managers are often compensated with a base salary and a bonus that depends on the performance of their portfolios relative to those of their peers. Therefore, a manager with a relative poor performance midway through a compensation period could be more likely to increase the risk of the portfolio in an effort to increase his/her final standing. Of course, altering fund risk to enhance his/her own compensation suggests that some managers may not always act in his/her client’s best interest.
10. Soft dollars are generated when a manager commits the investor to paying a brokerage commission that is higher than the simple cost of executing a stock trade in exchange for the manager receiving additional bundled services from the broker. One example would be for a manager to route her trades through a non-discount broker in order to receive security reports that the brokerage firm produces.
11(a). To derive a quick view of recent performance you can look at a recent quarterly review in Barron’s; the Mutual Fund Scoreboard in Business Week, the annual Forbes review.
11(b). The long-run analysis and address for the funds are best derived from the Weisenberger Investment Companies book.
Answers to Problems
Current NAV = $75,800/6,250 shares = $12.13
2. Load fund = ($1,000 – $80) x 1.15 = $1,058.00
Represents a 5.80 percent growth
No-load fund = ($1,000 x 1.12) x (1 – .01) = $1,108.80
Represents a 10.88 percent growth
The no-load fund offers an extra $50.80 over the load fund for a $1,000 investment held over a one-year time period. The difference in percent growth is 5.08 percent.
3. Period NAV Premium/Discount Market Price
0 $10.00 0.0 $10.00
1 11.25 -5.0 6.25
2 9.85 +2.3 12.15
3 10.50 -3.2 7.30
4 12.30 -7.0 5.30
3(a). 10.00 = 5.30(PV 4 years) Average return per year = -14.68%
1.8868 = 1/(1+ x)4 (using calculator)
(1 + x)4 = .5300
1 + x = (.5300).25
1 + x = .8532
x = -.1468
3(b). 10.00 = 12.30(PV 4 years) Average return per year = 5.31%
0.8130 = 1/(1+ x)4 (using calculator)
(1 + x)4 = 1.230
1 + x = (1.230).25
1 + x = 1.0531
x = 0.0531
3(c). 6.25 = 12.15(PV 1 year) Average return per year = 94.40%
0.5144 = 1/(1+ x) (using calculator)
(1 + x) = 1.9440
x = 0.9440
3(c). 11.25 = 9.85(PV 1 year) Average return per year = -12.44%
1.142 = 1/(1+ x) (using calculator)
(1 + x) = .8755
x = -.1244
4(a). Client 1 Client 2
.0100 x 5,000,000 = 50,000 .0100 x 5,000,000 = 50,000
.0075 x 5,000,000 = 37,500 .0075 x 5,000,000 = 37,500
.0060 x 10,000,000 = 60,000 .0060 x 10,000,000 = 60,000
.0040 x 7,000,000 = 28,000 .0040 x 77,000,000 = 308,000
27,000,000 175,500 97,000,000 455,500
4(b). 175,500/27,000,000 = .0065 455,000/97,000,000 = .004696
= 0.65% = 0.47%
4(c). Costs of management do not increase at the same rate as the managed assets because substantial economies of scale exist in managing assets.
5. CFA Examination II (1999)
Conduct Potential Conflict
a. Compensation based on commissions from clients’ trades. A fee structure of this type can cause a conflict because the portfolio manager has an incentive to turn over investments in client accounts to increase fees. A high volume of trading may be in conflict with a client’s investment objectives.
b. Use of client brokerage (“soft dollars”). A conflict may be created when client brokerage is used to generate soft dollars for the purchase of goods or services that benefit the firm (i.e., that are used in the management of the firm) rather than benefit the clients whose trades generated the soft dollars. An investment manager may pay higher commissions to obtain “soft dollar” credits to buy goods and services that do not necessarily provide direct benefits to the client whose commissions are being used; such actions, however, must be justifiable on the basis that the goods and services aid the manager in its investment decision-making process. Absent such justification, the manager is putting its own interest ahead of the client’s interest.
c. Purchase of stock in a company whose warrants are owned by the portfolio manager There is a potential conflict of interest when a portfolio manager trades, for the account he manages, in the shares of a company in which he personally owns warrants that can be used to purchase shares of that same company. The conflict arises whether the manager purchases or holds such shares for the fund, because his purchase could be viewed as an attempt to increase the value of the warrants.
d. Reimburse-ment of analyst expenses. Accepting reimbursement for such expenses as meals, lodging, or plane fare from the issuer of the stock about which the analyst is writing a research report creates an obvious conflict of interest. Such conduct gives rise to the perception that the analyst’s independence and objectivity have been compromised.
6(a). Beginning value = $27.15 x 257.876 = $7,001.33
Capital gain & dividends = $1.12 x 257.876 = 288.82
Ending value = $30.34 x 257.876 = 7,823.96
($7,823.96 – $7,001.33) + 288.82
Return = = 15.87%
6(b). Assuming that the tax rate of 30% is applied to all cash flows:
($7,823.96 – $7,001.33) + 288.82 = $1,111.45
$1,111,45(1 – .30) = $778.02
Return = $778.02/$7,001.33 = 11.11%
6(c). Alternatively, the $1,111.45 could be reinvested at the year-end NAV of $30.34. The investor could purchase $1,111.45/$30.34 = 36.63 shares
Stock Year 1 Year 2 Proportion Dollar Liquidated No. of shares
A $ 4,525,000 $ 4,875,000 5.63% $297,594 6,104
B 5,710,500 5,568,750 6.44% 339,943 13,735
C 5,437,500 4,642,500 5.37% 283,401 22,892
D 10,019,950 11,327,500 13.09% 691,485 7,020
E 8,701,000 9,625,000 11.12% 587,557 9,401
F 11,025,000 13,475,000 15.57% 822,579 10,683
G 6,784,000 8,189,560 9.46% 499,930 12,942
H 4,193,750 2,406,250 2.78% 156,889 16,787
I 4,333,500 12,352,500 14.28% 754,056 27,470
J 6,412,500 6,784,200 7.84% 414,140 5,494
K 3,665,310 4,317,810 4.99% 263,580 5,311
L 2,723,560 0 0.00% 0 0
M 0 2,962,500 3.42% 180,845 9,157
$73,531,570 $86,526,570 100.00% $2,127,000
7(a). Portfolio value of $73,531,570
Net Asset Value $76,343,570/5,430,000 = $14.06
7(b). Portfolio value of $86,526,570
Net Asset Value $88,569,570/5,430,000 = $16.31
Growth = ($16.31 – $14.06)/$14.06 = 16.0%
7(c). $2,873,000/$16.31 = 176,149.61 shares
7(d). 500,000 – 176,149.61 = 332,850.39 shares (or $5,282,000 based on NAV of $16.31)
(See table on previous page.) Each stock’s percentage of portfolio was calculated arriving at the percentages presented in the table. Each percentage was applied to the $5,282,000 to arrive at the dollar amount for each stock that must be liquidated. Finally, each stock price was divided into the liquidation amount per stock to determine the number of shares of each stock that would have to be sold.
8(a). (1) 3 percent front-end load = $100,000 (1 – .03) = $97,000
$97,000 (1 + .12)3 = $97,000(1.4049) = $136,278
(2) a 0.50 percent annual deduction
Year 1: $100,000(1 + .12) = $112,000 (1 – .005) = $111,440
Year 2: $111,440(1 + .12) = $124,812.80(1 – .005) = $124,188.74
Year 3: $124,188.74(1 + .12) = $139,091.38(1 – .005) = $138,395.93
(3) a 2 percent back-end load
$100,000(1 + .12)3 = $100,000(1.4049) = $140,492.80
$140,492.80(1 – .02) = $137,682.94
Choice (2) with ending wealth of $138,395.93
8(b). (1) 3 percent front-end load = $100,000 (1 – .03) = $97,000
$97,000 (1 + .12)10 = $97,000(3.10585) = $301,267.28
(2) a 0.50 percent annual deduction
$100,000(1 + .12) 10 (1 – .005) 10 = $100,000(3.10585)(.9511)
(3) a 2 percent back-end load
$100,000(1 + .12)10 = $100,000(3.10585) = $310,584.82
$310,584.82(1 – .02) = $304,373.12
Answer would change, now choice (3) with ending wealth of $304,373.12
8(c). A front-end load takes the money out right away, thus reducing your initial deposit.
The annual fee is usually less than one percent, which is a small amount and based on the example the preferred choice for a holding period of three years.
A back-end load is usually a smaller percentage than a front-end load, though the dollar amount has typically grown during the holding period. However, back-end loads are not due until the fund is liquidated, in this case, a long period of time.
9. CFA Examination II (1995)
9(a). The following AIMR Standards of Professional Conduct apply to Clark if C&K provides all three functions on a combined basis.
1. According to AIMR Standard V, Disclosure of Conflicts, C&K must disclose to its clients any material conflict of interest relating to the firm that might be perceived by clients to influence C&K’s objectivity. If the Europension Group is hired as a pension consultant and it recommends to the client that C&K International be hired to manage the pension portfolio, C&K needs to disclose to the client C&K’s interest in the affiliate. If C&K International executes pension portfolio securities transactions through Alps Securities, C&K needs to disclose to clients C&K’s interest in the affiliate so that they can decide whether C&K’s self interests are compromising its interests.
2. According to AIMR Standard VI.A, Disclosure of Additional Compensation Arrangements Compensation, C&K must inform its customers and clients of compensation or other benefit arrangements concerning its services to them that are in addition to compensation from them for such services. Therefore, C&K needs to disclose to clients that C&K earns through its affiliates additional compensation in the management of portfolios and in brokerage transactions.
3. According to AIMR Standard VI. B, Disclosure of Referral Fees, C&K must inform prospective customers or clients of any considerations paid or other benefits delivered to any of its affiliates for recommending to them (the clients or customers) services of a sister organization. Such disclosure should help the customer or client evaluate any possible partiality shown in any recommendation of services or evaluate the full cost of such services.
4. According to AIMR Standard III. G, Fair Dealing with Customers and Clients, C&K must deal fairly with all customers and clients when taking investment actions. Alps Securities needs to deal fairly with all customers when executing security orders and not favor the pension clients of C&K International over the other customers of Alps Securities.
9(b). The following AIMR Standards of Professional Conduct apply to this situation:
1. According to AIMR Standard III. C1, Portfolio Investment Recommendations and Actions, C&K must, when taking an investment action for a specific portfolio or client, consider its appropriateness and suitability for such a portfolio or client. In considering such matters, C&K must consider the needs and circumstances of the client. C&K must also use reasonable judgment to determine the applicable relevant factors. According to these requirements, C&K should consider differences in relevant factors in various countries. If the duties, practices, and customs in that country stipulate a particular pension fund asset allocation, then C&K may reasonably be expected to respect this practice. Because his clients and pension beneficiaries specifically want to conform to conservative asset allocation practices in their country, C&K may reasonably be expected to respect its clients’ investments policies.
2. According to AIMR Standard VII. C, Fiduciary Duties, Clark should determine applicable fiduciary duties in that country and comply with them. Clark must also determine to whom the duties are owed and what asset allocation is best suited to the investment objectives of the respective clients together with the investment conditions and circumstances in the host country. If the prevailing fiduciary practice stipulates a particular asset allocation, C&K may have to respect that practice. Therefore, the practice of allocating at least 80 percent of pension fund assets to fixed-income securities may be appropriate within the context of this European country’s practices, as opposed to a North American context.
9(c). The following AIMR Standards of Professional Conduct apply in this situation.
1. According to AIMR Standard II. A, Required Knowledge and Compliance, Clark must comply with the AIMR Standards of Professional Conduct and the accompanying Code of Ethics. Although local laws, rules, and regulations may not relate specifically to the use of material nonpublic information, any violation of another standard would be considered a violation of Standard II. A. Therefore, the latter standard applies.
2. According to AIMR Standard II. B, Prohibition Against Assisting Legal and Ethical Violations, Clark must not knowingly participate in any act that would violate the AIMR Standards of Professional Conduct. Lacking specific local or other regulatory requirement in a country, or when the AIMR Standards impose a higher degree of responsibility or higher duty than that required by local or other law or custom, Clark is held to the AIMR Standards.
3. According to AIMR Standard II. C, Prohibition Against Use of Material Nonpublic Information, Clark cannot use insider information in his investment actions. Specifically, Clark must not take investment actions based on material nonpublic information if (1) such actions violate a special or confidential relationship with an issuer or with others, or (2) such information was disclosed to him in a breach of a duty or was misappropriated. If a breach of duty exists, Clark should try to achieve public distribution of the information.
10. CFA Examination III (1999)
The Muellers’ portfolio can be evaluated in terms of the following criteria:
i. Preference for “Minimal Volatility.” The volatility of the Muellers’ portfolio is likely to be much greater than minimal. The asset allocation of 95 percent stocks and 5 percent bonds indicates that substantial fluctuations in asset value will likely occur over time. The asset allocation’s volatility is exacerbated by the fact that the beta coefficient of 90 percent of the portfolio (i.e., the four growth stock allocations) is substantially greater than 1.0. Thus the allocation to stocks should be reduced, as should the proportion of growth stocks or higher beta issues. Furthermore, the 5 percent allocation to bonds is in a long-term zero coupon bond fund that will be highly volatile in response to long-term interest rate changes; this bond allocation should be exchanged for one with lower volatility (perhaps shorter maturity, higher grade issues.)
ii. Equity Diversification. The most obvious equity diversification issue is the concentration of 35% of the portfolio in the high beta small cap stock of Andrea’s company, a company with a highly uncertain future. A substantial portion of the stock can and should be sold, which can be done free or largely free of tax liability because of the available tax loss carry forward. Another issue is the 90 percent concentration in high beta growth stocks, which contradicts the Muellers’ preference for minimal volatility investments. The same is true of the portfolio’s 45 percent allocation to higher volatility small cap stocks. Finally, the entire portfolio is concentrated in the domestic market. Diversification away from Andrea’s company’s stock, into more value stocks, into more large cap stocks, and into at least some international stocks is warranted.
iii. Asset Allocation (including cash flow needs). The portfolio has a large equity weighting that appears to be much too aggressive given the Muellers’ financial situation and objectives. Their below average risk tolerance and limited growth objectives indicate that a more conservative, balanced allocation is more appropriate. The Muellers are not invested in any asset class other than stocks and the small bond fund holding. A reduction in equity investments, especially growth and small cap equities, and an increase in debt investments is warranted to produce more consistent and desired results over a complete market cycle.
In addition, the Muellers have no cash reserve or holdings of short-term high grade debt assets. In the very near future, the Muellers will need $50,000 (up front payment) and at least $40,000 (first year tuition and living expenses) for their daughter’s college education, as well as a reserve against normal expenses. In addition, they expect to have negative cash flow each year their daughter is in college, which should lead them to increase their cash reserve. The current portfolio is likely to produce a low level of income because of the large weighting in growth stocks and because the only bond holding is a long-term zero coupon bond fund. Also, the marketability of Andrea’s company stock unknown and could present a liquidity problem if it needs to be sold quickly. After their immediate cash needs are met, the Muellers will need a modest, ongoing allocation to cash equivalents.
11(a). Based upon a market return (S&P) of 13.3%, Portfolio A had an average annual return of
only 10.2% (underperformed), while Portfolio B with an average annual return of 15.4% outperformed the market.
11(b). Additional risk measures such as standard deviation and risk/return measures should be calculated. Portfolio style (value, growth, market-oriented or small-capitalization) should be identified. What fees are involved (front-load, back-load, management, etc.). What is the expense ratio? What is the portfolio turnover rate? What are the funds’ objectives and constraints? Consistency of results – the reported results are for the last five years, what about the previous 5 or 10 years? Same portfolio manager, or has there been a change?
11(c). Since Portfolio C has an average return of 13.2% which is close to the index return of 13.3%, with a beta of .99, I would assume that the portfolio manager had designed the portfolio to replicate the index. Portfolio A has a lower than market beta which would explain the lower than market return, following a very conservative investment approach.
11(d). Portfolio B has a much higher beta value than either of the two other portfolios and the market, thus one would expect a higher return for the portfolio – more risk, more return. Probably this portfolio has been investing in high return stocks such as technology companies, thus explaining the lower diversification level.