Ross & Co. manages a $60 million portfolio of stocks for Sharpe Institutional Fund. Robert Biller, the CFO of Sharpe indicated that Ross had outperformed the market among Sharpe’s 7 portfolio managers. Ross’s portfolio had outperformed the market in the last 5 to 6 years. In one unlucky year, there were losses but the losses were insignificant. Ross & Co is basically an investment firm which does not actively time the market. It emphasises stock selection rather than considering the industries that the stocks are in. The 7 portfolio managers do not adhere to any investment management styles. The 6 managers other than Ross manage portfolios totalling $500 million which comprise of more than 300 individual issues. Robert is convinced that Ross is able to choose stocks skillfully but is impeded by the high diversification in his portfolio. Throughout the years, the portfolio generally held 80-100 equities with approximately 4% to 6% of total funds dedicated to each issue. The reason Ross was able to perform well those past years was that the firm was able to identify 20 or 24 issues each year which achieve huge returns. Based upon this overview, Robert generated a plan to the Sharpe pension committee:

“Let’s tell Ross to impose constraints on the portfolio by putting investment limitations on the portfolio to a maximum of 40 stocks. Ross will double the commitments to the equity which it really favours and eliminate the balance. Except for this restriction, Ross is free to manage the portfolio as previously”.

All the pension committee members supported Robert’s proposal generally because all agreed that Ross had seemed to demonstrate stock selection superior skills. The proposal deviates from past practice and a few committee members raise questions.

(a)   Answer the below :

(i)   Will the constraints of 40 equities likely lead to higher or lower risk of the portfolio ? Explain.

(ii)   Is there any method Ross can lower the no. of issues from 80 to 40 by not significantly influencing risk ? Explain.

(b)   One member of the committee demonstrate high interest with respect to Robert’s proposal. He suggested that Ross’s performance might benefit from reduction in the no. of issues to 20. If the reduction to 40 could be expected to be advantageous, explain why reduction to 20 could be less beneficial (Assume that Robert will evaluate the Ross portfolio in an independent manner).

(c)   Another member of the committee suggested that rather than evaluate each managed portfolio independently of other portfolios, it’s better to take into consideration of the changes in Ross portfolio on the aggregate fund. Explain how this view can influence the decision of the committee to restrict the holdings of Ross portfolio to either 20 or 40 issues.