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Suggested answers and examiner’s comments

Portfolio Management February 2014 Important notice When reading these suggested answers, please note that the answers are intended as an indication of what is required rather than a definitive “right” answer. In many cases, there are several possible answers/approaches to a question. Please be aware also that the length of the suggested answers given here may be somewhat exaggerated compared with what might be achieved in the reality of an unseen, time-constrained examination. Examiner’s general comments The performance for this examination session represents a considerable improvement upon the previous session and is encouraging. The pass rate was 71%. The most critical feature of candidates’ study and exam preparation is engagement with the study text. A great deal of effort goes into ensuring that examination questions relate very closely to the content of the study text. Hence, working in a systematic fashion with the study text – reading it, re-reading it, taking care to learn definitions, engaging with the teach-yourself and other exercises, maximises the prospect of doing well in the exam. It is also important that you engage with the entire content of the study text. The exam paper is formulated in such a way that it includes questions referring to all areas of the text. There is little scope for, or value in, prioritising the study of particular parts of the text because you cannot know if and in what form questions will occur.

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Section A Answer all parts of Question 1. Select only one of the options A, B, C or D for each part. 1. (i) The ‘basis’ of a futures contract is:

A. The difference between the futures price and the spot price of the underlying asset.

B. A positive amount that measures the cost of carrying the underlying asset forward to the futures contract delivery date.

C. The amount of the underlying asset that a futures contract holder receives on the

contract delivery date.

D. A sum offered to a futures contract seller as a reward for taking on the risk that the price of the underlying asset might change.

(ii) A nominee account is an account:

A. In the name of a beneficial owner which is used for trading and holding financial

securities.

B. That an investor nominates as the one to which dividends, interest payments and other cash flows from assets should be credited.

C. Used to trade and hold financial assets which is registered in a name other than that of

the beneficial owner of the assets.

D. Used by a stockbroking company to trade and hold securities on its own behalf.

(iii) In portfolio theory, a correlation coefficient of zero between the return profiles of two assets indicates that:

A. A portfolio consisting of the two assets generated a return of 0% over the period in

question.

B. The level of risk associated with a portfolio consisting of the two assets was zero.

C. The return profiles of the two assets exhibited no systematic relationship.

D. A portfolio consisting of the two assets offered no risk reduction benefits to investors over the period in question.

(iv) The following list shows types of bonds in pairs. Identify the pair in which the two terms do

not have the same meaning. A. ‘Zero-coupon bond’ and ‘pure discount bond’.

B. ‘Variable-rate bond’ and ‘index-linked bond’.

C. ‘Coupon-paying bond’ and ‘interest-bearing bond’.

D. ‘Callable bond’ and ‘redeemable bond’.

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(v) When a company declares a dividend, recipients of the dividend will be those who are

shareholders on the:

A. Dividend declaration date. B. Record date. C. Dividend payment date. D. Ex-dividend date.

(vi) A capitalisation issue of shares is another term for a:

A. Bonus issue. B. Rights issue. C. Stock split. D. Stock consolidation.

(vii) The concept of ‘duration’ provides a framework for estimating:

A. By how much the expected return on equity is affected by alterations in the risk-free rate of return.

B. By how much the price of a bond changes in response to a change in the yield on the

bond.

C. The extent to which the yield on a bond is expected to change with the decline in its term to maturity.

D. The average term to maturity of the coupon payments on a bond.

(viii) An ‘alpha return’ is the element of return on an investment:

A. In excess of the risk-free return.

B. Which remains after subtracting the expenses incurred by the asset manager.

C. In excess of the return on a benchmark portfolio.

D. Which the asset manager generates after adjustments for the risk taken.

(ix) The Capital Market Line (CML) model defines the ‘market price of risk’ as a measure of the:

A. Market portfolio risk premium divided by market risk. B. Return on the market portfolio divided by market risk. C. Return on a portfolio divided by market risk.

D. Return on a portfolio divided by the total risk of the portfolio.

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(x) Which of the following is not registered as a Nationally Recognized Statistical Rating

Organization with the Securities and Exchange Commission in the USA?

A. Moody’s Investors Service

B. Standard & Poor’s Ratings Service

C. Fitch

D. Experian (Total: 10 marks)

Suggested answers

(i) A. The difference between the futures price and the spot price of the underlying asset.

(ii) C. Used to trade and hold financial assets which is registered in a name other than that of the beneficial owner of the assets.

(iii) C. The return profiles of the two assets exhibited no systematic relationship.

(iv) B. ‘Variable-rate bond’ and ‘index-linked bond’. (v) B. Record date.

(vi) A. Bonus issue.

(vii) B. By how much the price of a bond changes in response to a change in the yield on the

bond.

(viii) D. Which the asset manager generates after adjustments for the risk taken.

(ix) A. Market portfolio risk premium divided by market risk.

(x) D. Experian

Examiner’s comments Candidates are advised to read the different options to each question carefully before choosing an answer. A hallmark of multiple-choice questions (MCQs) is that the different options often look similar on a quick reading. Hence, it can result in marks being needlessly lost as a result of not taking a little more time.

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Section B Answer all ten questions. 2. An investor owns bonds offering fixed annual interest payments for the next five years. Having

come to the view that interest rates are set to rise, the investor intends to enter into a swap agreement to convert the fixed payments into floating rate payments. Explain two advantages of using a swap rather than a series of forward rate agreements. (4 marks) Suggested answer

In the case of FRAs, the investor would need to enter into an agreement for each interest payment. Hence, the number of contracts negotiated grows with the number of payments hedged. A swap offers risk management for multiple cash flows bundled into a single contract. There are benefits associated with the reduced time and expense of creating and managing the arrangement.

Secondly, each FRA will have a different forward rate of interest corresponding to each payment. Swaps are based on a single forward rate applicable to all the payments, known as the swap rate.

Examiner’s comments

The initial requirement is that candidates appreciate how the conversion from fixed to floating rates could benefit the bondholder in the event that rates do rise. Furthermore, it requires that candidates are able to articulate an understanding of interest rate swaps and FRAs.

3. Define the concept of a yield curve and provide one reason why they are useful to practitioners in

financial markets. (4 marks)

Suggested answer A yield curve provides a graphical representation of yields on fixed-interest securities that differ solely with respect to maturity. In deriving a yield curve, techniques are employed to rid data of the effects from different coupon rates and varied credit ratings so that all that is left is the relation between yield and maturity. Yield curves are usually plotted using data from government securities. Uses:

Yield curves facilitate the measurement of credit-risk premiums on non-government securities. The higher the premium, the greater the perceived credit risk.

The slope of the yield curve provides insights into how yields on issued bonds are liable to alter as their terms to maturity decline.

The structure of yields helps to form expectations regarding future yield changes and, by implication, the consequences for future bond prices.

Examiner’s comments

The definition of ‘yield curve’ needs to be precise. The marks on offer were not awarded for vague formulations.

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4. Explain the difference between a value-oriented investment outlook and a growth-oriented

investment outlook. (4 marks) Suggested answer Value-oriented asset managers seek to acquire assets that they deem to be cheap relative to current earnings. Typically, they regard low price/earnings ratios (PERs) and price/book values (PBVs) as powerful indicators of ‘cheapness’. There is a clear intuitive sense to this perspective. A dollar of earnings is a dollar of earnings irrespective of which company it comes from. The lower the price of buying earnings, the better. Value investors are well aware that low PER companies are often higher-risk companies, but contend that there is still excess return even after accounting for additional risk. In other words, low PER investments really are, or at least tend to be, cheap. Growth-oriented investors are less interested in current asset prices relative to current earnings; and focus more on prospects for future earnings. Growth-oriented investors are more willing to trade at higher PERs if they believe that earnings potential justifies the cost. Examiner’s comments Explaining the difference implies being able to provide clear definitions of both perspectives. Otherwise, the difference will be unclear.

5. Explain what is meant by the term ‘contrarian investing’. (4 marks)

Suggested answer Contrarian investing is rooted in the belief that short-term investors, including professional fund managers, systematically overreact to new information that contains some element of surprise or shock. Overreaction to ‘positive’ surprises causes prices to overshoot fair values, resulting in investors being prepared to pay over the odds. Overreaction to ‘negative’ surprises causes values to undershoot and results in investors being willing to sell too low. The contrarian strategy is, thus, to trade against the crowd, and profit from the ‘reversion to the mean’, i.e. the eventual shift of asset prices back to fair values. The upshot is that a contrarian strategy ought to offer alpha returns.

Examiner’s comments

A good answer would include a comment on the rationale behind contrarian investing; namely, that it is rooted in the belief that most investors tend to over-react to news which leads to asset values often being too high or too low.

6. Explain two ways in which option contracts differ from futures contracts.

(4 marks)

Suggested answer (Any two of the following)

An option combines a hedge against the effects of an adverse movement in the price of the underlying asset with a leveraged stake on a favourable movement, whereas, futures, as a mechanism for hedging against potential losses on the underlying asset, entail having to give up gains from favourable price movements.

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Options command an up-front purchase price, referred to as the option premium. Futures do not. Instead, futures traders are required to trade via margin accounts that stipulate initial and maintenance margins designed to minimise counterparty risk.

For those buying options, potential losses are limited to the size of the premium initially paid, whereas holders of futures contracts experience losses growing if underlying asset prices move against them.

With options, profits/losses accumulate in the form of rising or falling option premiums, whereas, with futures, profits and losses are marked-to-market, i.e. they are effectively cash settled at the end of each day.

Options can be either exchange-traded or over-the-counter, whereas, futures are exchange- traded securities.

Examiner’s comments

Differences are rooted in underlying characteristics. Hence, if candidates are able to define an option contract and a futures contract in a precise manner, the issue of differences is straightforward.

7. Explain what a ‘haircut’ is in the context of a sale and repurchase agreement (‘Repo’).

(4 marks)

Suggested answer A repo involves an investor purchasing securities and simultaneously selling them to a broker with an agreement to buy them back at a fixed price on a predetermined future date. The broker does not offer the full market price for the securities, instead purchasing them at a discount. The difference is known as a haircut; and is usually expressed as a percentage of the amount paid by the broker. The purpose of the haircut is to provide the broker with some protection in the event that the counterparty fails to fulfil the repurchase leg of the repo, an event that could result in the broker being left holding assets that may have declined in value. Another way of looking at the repo arrangement is that, in substance, the broker lends the investor a portion of the purchase price, and holds the assets as collateral. The haircut constitutes an element of over-collateralisation; the share of the purchase price that is funded by the investor rather than the broker.

Examiner’s comments

If candidates develop a good understanding of repo arrangements, then explaining a ‘haircut’ should not present major difficulties given that it is such a critical feature or repos.

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8. When investors receive entitlements to new shares under a rights issue they have four basic

options in terms of how to respond. Explain the four choices. (4 marks)

Suggested answer Subscribe to the full entitlement. A stockbroker will complete the documentation for shares held in a nominee name, and will arrange payment for the right by the specified date. In this case, the shareholder will not suffer any dilution in their holding. Sell the entire rights via a stockbroker. The price obtained is primarily dependent on the difference between the prevailing share price and the rights subscription price.

Subscribe to one portion of the rights, and sell sufficient rights to enable the remainder to be paid for from the proceeds. Do nothing, allowing the entitlement to lapse thereby suffering dilution. Assuming the rights are underwritten, the shareholder will receive a cash settlement in lieu of their rights. Examiner’s comments

This question required a precise understanding of rights issues.

9. Explain the difference between a ‘top-down’ and ‘bottom-up’ approach to asset management. (4 marks)

Suggested answer Top-down is a fund management style that starts from the analysis of broad economic fundamentals, and works down towards specific investment decisions. The classic top-down asset- allocation strategy relates to the business cycle. Other managers adopt a bottom-up approach. The hallmark of the bottom-up style is to search markets for assets that are under- and over-valued assets irrespective of the broader economic circumstances. Managers use various methods to decide whether asset prices are significantly different from their perceived fair values. Examiner’s comments

These concepts have specific meanings in the context of investment management. Candidates needed to demonstrate knowledge of these meanings in order to score well.

10. Explain the significance of the fact that exchange-traded futures are marked-to-market. (4 marks)

Suggested answer Marked-to-market describes the practice of booking market gains and losses on asset holdings immediately, irrespective of whether they (the gains or losses) are actually realised via the sale of those assets. In the case of futures, contracts a settlement price is declared at the end of each trading day. It is used as a basis for settling daily profits and losses on contracts each day, i.e. gains/losses are realised immediately. An important implication is that futures contract dealers cannot carry losses forward: instead, they must cover losses immediately via debits from their margin accounts being credited to winning traders. In effect, the practice of marking-to-market means that default risk on futures is extremely low.

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Examiner’s comments This question required an understanding of two concepts: namely, futures, and marked-to-market. An appreciation of the significance of marked-to-market practices in relation to futures contracts is bound up with the issue of counterparty risk.

11. Many finance experts make extensive use of technical analysis to inform their investment

decisions. Briefly discuss the implications of this for the claim that capital markets are efficient. (4 marks) Suggested answer Technical analysis is a catch-all term for a wide variety of trading techniques reliant on the examination of past asset prices and other trading data. It implies the belief that insights can be extracted from the data that can be used as the basis for profitable trading strategies. It is antithetical to the claims of market efficiency; in particular, weak-form market efficiency. The latter insists that current asset prices fully incorporate the value of all insights discernible from any examination of the past. Hence, it ought not to be possible to generate profits on a consistent basis by relying on technical analysis.

Examiner’s comments As with many other concepts in finance, technical analysis has a precise meaning despite the fact that it is a term open to being articulated in looser, general terms. In order to score well, candidates had to be able to demonstrate understanding of its meaning in the context of efficient market theory.

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Section C Answer two questions only.

12. Identify and discuss five characteristics which you might expect to encounter when examining an asset portfolio.

(25 marks) Suggested answer (Any five of the following) Ownership of diverse assets An investment portfolio combines different types of assets. Savings accounts, treasury bills and other instruments are mechanism for holding wealth as a reserve. Corporate and government bonds are mechanisms for lending-style investment. Company shares constitute ownership stakes in the issuing corporations. The individual securities contained within these categories themselves have distinct characteristics from one another. A portfolio may consist of stakes in collective investment schemes (pension funds and unit trusts) that provide exposure to both debt-and-equity-type assets. Residential and commercial property can also figure in a portfolio. Different degrees of risk Assets in a portfolio exhibit differing degrees of risk. Savings accounts and government (‘Treasury’) bills are generally considered the safest investments, not least because bank deposits are, in many jurisdictions, guaranteed by the state. Property investment is riskier because experience tells us that property values are subject to considerable swings. Returns on equity investments depend upon the market values of the constituent shares together with any income streams accruing to the securities. The values of company shares are subject to considerable risk primarily connected to economic developments and the vagaries of commerce. Liquidity of assets The liquidity of an asset refers to the ease with which its value can be realised as an agreed cash amount. Some assets are ‘highly liquid’, being easily convertible into cash with little dispute among parties regarding their worth. A standard savings account is highly liquid given that it can be converted into an agreed amount of cash on demand (‘at sight’). The shares of large publicly-quoted corporations are normally deemed liquid with much of the trade initiated and settled rapidly via automated matching systems. On occasions, liquidity becomes scarce. This could be rooted in market-wide, systemic events or in company specific problems. Shares in smaller companies tend to be less liquid. Because they are traded less frequently, the most recent transaction prices may be deemed poor/unreliable measures of current worth; investors may not be prepared to deal at such prices because they feel that circumstances have changed. Financial leverage Financial leverage is about the extent to which investments are financed from borrowing. It is a relative concept, whereby the level of debt is compared to the total value of an asset portfolio. Leverage is an important consideration for investors. It alters the scale of risk that the investor faces, adding a further element of uncertainty over and above that associated with the investments themselves. Leverage may be present in a portfolio in less noticeable forms than loans. Derivative securities such as futures and options contracts can be used to create commitments that closely resemble assets acquired with loans.

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Structured products The key characteristic of structured financial products is that they aim to offer the upside potential associated with equity-style investments whilst also granting some capital protection. It relies on a bond investment with a counterparty to produce the capital protection and an equity option to replicate the risk taking aspect of the relationship. For the investor, the downside of the market risk is replaced by (i) counterparty risk connected to the bond investment, and (ii) a cap on the upside gains. Doesn’t offer complete protection against downside; in market decline, it could result in capital loss. Hedging Investors take risks. They accept uncertainty in the expectation of being rewarded for doing so. They appreciate that sometimes the rewards are not forthcoming; the occasional failure is integral to investment. It follows that investors should not expose themselves to risks for which there is no economic rationale for rewards. Such risks ought, in principle, to be hedged. A typical example is that of buying shares denominated in a foreign currency. The aim is to acquire a share in any rewards generated by productively-deployed capital assets, not to speculate on the vagaries of exchange rates. The investment should be hedged so that the outcome isn’t affected by currency variations.

Examiner’s comments

The inclusion of other relevant points were deemed acceptable and awarded accordingly; for instance, a discussion on the distinction between:

investors who self-manage, and

those who prefer to place the responsibility for portfolio management in the hands of professionals.

Question 12 was the least popular of the Section C questions. There was a need for candidates to ensure that their answers covered five characteristics in a thorough and reasonably even manner. A Section C question represents one-quarter of the marks available to candidates. There is an expectation that examinees are able to elaborate upon, discuss and assess relevant points.

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13. (a) Explain the main benefits that the institutionalisation of asset management offers to

investors. (15 marks)

(b) Discuss the dangers of institutionalised asset management for investors and the mechanisms for protecting investors’ interests. (10 marks)

(Total: 25 marks)

Suggested answer (a) Investors are inclined to entrust the management of capital to institutions such as investment

companies, pension funds and hedge funds for a number of reasons:

Institutions acquire information about the risks and returns of a huge array of investment opportunities across different markets, and are therefore in a better position to deliver these opportunities to investors, and to advise on the associated uncertainties. In the absence of institutional arrangements, investors would lack much of the essential information needed to make considered judgements on many types of investment.

Institutions offer knowledge of the investment opportunities and trading customs in different markets. This has become a more significant consideration given that capital markets worldwide have tended to become more open.

Institutions offer expertise in dealing with legal and regulatory issues. They therefore help to overcome many technical obstacles to security trading and investment that most individuals would find insurmountable.

By pooling capital from many individuals, investment institutions reduce the transaction costs per investor (brokerage, settlement, money transfer and custody) given that it is much cheaper, relatively speaking, to trade securities in large volumes. Savings also arise in other ways. For instance, funds with an overseas investment focus can manage the related currency-risk issues more effectively and economically than would be possible for individual investors (wholesale vs. retail exchange rates, use of risk-management tools).

Pooling also makes spreading risk more economically viable than it would be for an individual with limited resources. It thereby alleviates the exposure to non-systematic risk for each investor.

Institutions find it easier and cheaper to construct investments with specific risk-return profiles by resort to leverage and derivatives. For instance, investors seeking a leveraged exposure are likely to find the personal cost of borrowing significantly greater than the costs levied on institutions.

Institutions can more readily securitise investments into tradable claims, thereby offering investors more flexible methods of adjusting asset portfolios in accordance with changing views or needs.

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(b) Institutionalised asset management implies a great deal of trust on the part of investors in

financial institutions. Hazards:

Criminal behaviour on the part of fund managers; managers secretly using investors’ contributions for purposes other than those claimed. There have been high-profile cases (Madoff being the most famous in recent years).

Opacity of some investment products. For instance, structured investments are marketed as being similar to savings accounts. But they involve the use of derivatives, embody counterparty risk, and do not guarantee preservation of capital.

Opacity also occurs in relation to operating costs. In the fund management industry there has been a shift from highlighting annual management charges towards a focus on the total expense ratio as a truer measure of the costs of institutional fund management.

Misrepresentation of risk. For instance, index tracker-type investments (ETFs and mutual fund trackers) are marketed as the safer alternative to active funds. But market (systematic) risk is itself considerable. The gyrations in global stock markets of recent years testify to this.

Mechanisms of investor protection include (i) government laws and regulations regarding the disclosure of information, professional behaviour, product marketing, and criminality (examples of fines for mis-selling, pressure on banks to increase capital reserves, convictions of fund managers), (ii) compliance codes and practices within institutions, (iii) codes of professional and ethical practice articulated by self-regulatory organisations (for example, the ICMA), and (iv) media focus on hidden risks and unwarranted claims.

Examiner’s comments

The inclusion of other relevant points was deemed acceptable and awarded accordingly.

Candidates must note that the balance of marks between the two parts is deliberate and reflects an expectation that examinees will place more emphasis, and spend more time, on part (a). On the other hand, part (b) does constitute a significant portion of the overall mark. Hence, the need to avoid taking too long on (a), and finding oneself forced to rush (b).

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14. A portfolio consists of three assets whose beta values are provided in the table below.

Asset 1 Asset 2 Asset 3

Beta 1.2 1.25 1.4

The risk free rate of return was 3% and the return on the market portfolio was 9%.

(a) Using the Capital Asset Pricing Model, calculate the expected return for each of the three

assets.

Expected return = risk free return + beta(market return – risk-free return)

1

2 (3 marks)

(b) You have invested 40% of your funds in Asset 1, 30% in Asset 2 and 30% in Asset 3.

Calculate the portfolio beta and the expected return on your investment.

Portfolio beta = sum of each asset’s weighting x its beta

(3 marks)

(c) The actual return on the three-asset portfolio was 17%. Calculate the Treynor ratio for the

market portfolio (for which the beta value is 1) and for your three-asset portfolio. Comment on whether the results suggest that your skill in choosing the assets was responsible for at least some of the return. Treynor ratio = portfolio risk premium/portfolio beta

(6 marks)

(d) Many actively managed funds have been criticised for being little more than expensive

‘closet trackers’ or ‘index huggers’. Discuss the rationale for actively managed investment funds and the reasoning behind the criticism.

(13 marks)

(Total: 25 marks) Suggested answer (a) Er(1) = 3 + 1.2(9-3) = 10.2

Er(2) = 3 + 1.25(9-3) = 10.5

Er(3) = 3 + 1.4(9-3) = 11.4

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(b) Portfolio beta = 0.4(1.2) + 0.3(1.25) + 0.3(1.4) = 1.275

Er(p) = 3 + 1.275(9-3) = 10.65

(c) Treynor (Market) = 6/1 = 6% Treynor (Portfolio) = 14/1.275 = 10.98%

Treynor ratios suggest that the portfolio has outperformed the market even after adjustment for risk – by more than six (6) percentage points. We should be careful in putting this down to asset management skills. It may just be luck; a three-asset portfolio will have substantial non-systematic risk which may have worked in favour of the fund manager on this occasion. We would need to examine the track record of those behind the investment decision-making over an extended period to decide whether the Treynor ratio represents skilful decision-making.

(d) Actively managed funds should:

Seek to generate returns that exceed benchmark returns: (i) on a risk-adjusted basis, (ii) over an extended investment horizon.

Otherwise, investors are liable to be better off investing in funds that merely replicate the benchmark because running costs tend to be significantly lower. For instance, total expense ratios for index trackers are generally below 1% of assets under management. For actively managed unit trusts, total expense ratios (TERs) are two or more times as great. This means that actively managed funds need to exceed the performance of passive funds to a degree that more than covers the additional expenses.

Investment Trusts (ITs) employ active management techniques but charge management fees noticeably lower than those of open-ended investment companies (OEICs). Some factors should be noted: (i) Investors in ITs pay brokerage commissions and stamp duty on trading IT shares on top

of the trading and other expenses of the IT itself. With OEICS, comparable expenses form part of the TER. On the other hand, where investors use saving schemes run by ITs, the costs of associated with the monthly contributions and reinvestment of dividends are not onerous. Furthermore, IT investors tend to invest for long periods, in some cases very long periods such as Self-Invested Personal Pensions. Spread over such long periods, the trading costs are negligible, thereby making ITs, with their lower annual management charges, less costly than actively managed OEICS.

(ii) IT share prices typically deviate from net asset values (NAVs) (more often trading at a discount to NAV, and less frequently at a premium). The main problem for investors is not discounts/premiums themselves but the fact that they vary. Investors might not reap returns suggested by changes in the values of an IT’s assets if the scale of the discounts/premiums shifts.

(iii) ITs generally have more scope to use financial leverage as part of their investment

strategies than OEICS. Hence care is required when making performance comparisons with OEICS in order to ensure that financial risk is taken into account.

On balance, ITs do appear to offer performance benefits for investors compared to OEICS, with reasonable amounts of capital to invest. This, together with the uncertainties of the NAV relation and restrictions on ITs marketing themselves to the general public, means that ITs continue to attract most interest from investors who regard themselves as relatively well informed.

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Rationale behind the criticism:

The closet tracker accusation is that many managed portfolios contain a significant replication element. This is partly related to structure of many indices used as benchmarks, which tend to be heavily weighted towards a narrow range of companies. For instance, the largest ten companies of the FTSE-100 list account for 45% of the aggregate market value. Hence, it is difficult for a fund containing, say, 30 of the constituents to outperform the benchmark systematically and significantly. Its performance is likely to exhibit a propensity to perform like the benchmark index.

If this is the case, then the higher expense ratios typically associated with actively managed funds are not justified. Investors do not get anything that a tracker does not offer for the extra expense.

There are many funds deserving of the closet tracker moniker. However, there is a tendency to question the worth of active fund management in principle. Furthermore, there has been a significant growth of tracker-style investment funds – notably in the form of synthetic exchange-traded funds (ETFs) – perhaps reflecting a growing scepticism about the worth of active fund management and/or conservatism towards surrounding equity investment.

Examiner’s comments

Question 14 was the most popular question in Section C. Future candidates are advised to read the question carefully to ensure that they associate numbers and mathematical expressions correctly. It might even be worth noting each expression separately, attaching the relevant numbers and using this as a reference. It will reduce the possibility of using the wrong number in the wrong place arising from the pressure of limited time. The essay element of the question constitutes marginally more than half the total marks for the question. Candidates must ensure that their endeavours reflect this. Spending most of the time on the numbers can result in not being able to pay sufficient attention to other parts of the question.

The scenarios included here are entirely fictional. Any resemblance of the information in the scenarios to real persons or organisations, actual or perceived, is purely coincidental.