Sam Ellington is chief investment officer at L&C Fund Investors. Ellington hires a third-party adviser to develop a custom benchmark for three actively managed balanced funds he oversees: Fund X, Fund Y, and Fund Z. (Balanced funds are funds invested in equities and bonds.) The benchmark needs to be composed of 60% global equities and 40% global bonds. The third-party adviser submits the proposed benchmark to Ellington, who rejects the benchmark based on the following concerns:

Concern 1: Many securities he wants to purchase are not included in the benchmark portfolio.

Concern 2: One position in the benchmark portfolio will be somewhat costly to replicate.

Concern 3: The benchmark portfolio is a float-adjusted, capitalization-weighted portfolio.

After the third-party adviser makes adjustments to the benchmark to alleviate Ellingtons concerns, Ellington accepts the benchmark portfolio. He then asks his research staff to develop risk and expected return forecasts for Funds X, Y, and Z as well as for the benchmark. The forecasts are presented in Exhibit 1.

Exhibit 1. Forecasted Portfolio Statistics for Funds X, Y, and Z and the Benchmark

	Fund X	Fund Y	Fund Z	Benchmark
Portfolio weights:
Global equities (%)	60.0	65.0	68.0	60.0
Global bonds (%)	40.0	35.0	32.0	40.0
Expected return (%)	10.0	11.6	13.2	9.4
Expected volatility (%)	17.1	18.7	22.2	16.3
Active risk (%)	5.2	9.2	15.1	N/A
Sharpe ratio (SR)	0.45	0.50	0.49	0.44

Note: Data are based on a risk-free rate of 2.3%.

Ellington decides to add a fourth offering to his group of funds, Fund W, which will use the same benchmark as in Exhibit 1. Ellington estimates Fund Ws information ratio to be 0.35. He is considering adding the following constraint to his portfolio construction model: Fund W would now have maximum over- and underweight constraints of 7% on single-country positions.

Ellington conducts a search to hire a manager for the global equity portion of Fund W and identifies three candidates. He asks the candidates to prepare risk and return forecasts relative to Fund Ws benchmark based on their investment strategy, with the only constraint being no short selling. Each candidate develops independent annual forecasts with active return projections that are uncorrelated and constructs a portfolio made up of stocks that are diverse both geographically and across economic sectors. Selected data for the three candidates portfolios are presented in Exhibit 2.

Exhibit 2. Forecasted Portfolio Data for Equity Portion of Fund W

	Candidate A	Candidate B	Candidate C
Rebalancing	Annually	Annually	Annually
Number of securities	100	64	36
Information ratio (IR)	0.582	0.746	0.723
Transfer coefficient (TC)	0.832	0.777	0.548
Information coefficient*	0.07	0.12	0.22

* Information coefficient based on previously managed funds.

Question 9.1 (3 marks)

Which of Ellingtons concerns best justifies his decision to reject the proposed benchmark?

A. Concern 1

B. Concern 2

C. Concern 3

Question 9.2 (3 marks)

Based on Exhibit 1, the expected active return from asset allocation for Fund X is:

A. negative.

B. zero.

C. positive.

Question 9.3 (3 marks)

Based on Exhibit 1, which fund is expected to produce the greatest consistency of active return?

A. Fund X

B. Fund Y

C. Fund Z

Question 9.4 (3 marks)

Based on Exhibit 1, combining Fund W with a fund that replicates the benchmark would produce a Sharpe ratio closest to:

A. 0.44.

B. 0.56.

C. 0.89.

Question 9.5 (3 marks)

Based on the data presented in Exhibit 2, the candidate with the greatest skill at achieving active returns appears to be:

A. Candidate A.

B. Candidate B.

C. Candidate C.