FN369: Investment Management
Outline Solutions – May 2015
Question 1
“UK money market instruments such as Treasury bills are considered to be the risk-free asset for
all investors whereas government bonds are not.”
Discuss this statement taking into account the UK credit rating downgrade in 2013 and different
types of risks associated with fixed income instruments.
T-bills are risk-free assets for all investors in theory. Given their short term nature, they will carry
reinvestment risk when it comes to a long term investor/investment. It is expected that price risk,
reinvestment risk, liquidity risk (for off the run issues in particular), call risk and credit risk (in
view of the UK credit downgrade and credit crisis in general) to be addressed. Bonds whose
duration is equal to an investor’s investment horizon can be considered an investment free from
reinvestment risk and price risk.
Question 2
Explain the principles of multi-factor models using the Arbitrage Pricing Theory (APT) model as
your example. Specify what factors would be appropriate for APT model and outline the main
applications of this model in practice. Why would that model be preferred to the Capital Asset
Pricing Model (CAPM) by some investors?
Multi-factor models (incl. APT model) allow for several factors, thus can provide better description
of returns. However, the factors to be used in the model are not pre-specified as in CAPM, which is
both advantage and disadvantage. The factors would be expected to be related to fundamental
economic factors such as economic activity, interest rates, oil prices, and inflation. For equity
returns, commonly used explanatory factors are dividend yields, market values, price-to-book ratios
and P/E ratios. However, APT does not specify how many factors there are, what they are, nor their
size and sign. This is perceived as the main drawback of the APT model, as it demands that
investors identify the sources of risk themselves and that they can reasonably estimate factor
sensitivities. Nevertheless, the linear factor model structure of the APT is used as the basis for many
of the commercial risk systems employed by asset managers such as MSCI Barra. One of the main
applications of the APT model in practice is for building portfolios with specific characteristics or
for sensitivity analysis of portfolio performance.
Question 3
Alternative investments have become an increasingly important segment in a typical UK fund
manager’s asset allocation in recent years. Discuss why this has been the case and use any 3
(three) alternative asset classes to describe how they would contribute to the risk/return profile, if
added to a more traditional mixed assets portfolio, composed of equity, bonds and money market
instruments.
Any three alternative asset classes could be picked: private equity, real estate, hedge funds,
commodities for instance. It is expected that students would explain the characteristics of the
chosen alternative asset classes, their correlation with other asset classes, illustrate possible
benefits of including them in the portfolio (eg, diversification) and negatives of that too. The answer
could include the performance of chosen asset classes in response to changes in macroeconomic
drivers (i.e. inflation, growth) and comments on their associated risk and return.
Page 1 of 2
FN369: Investment Management (MS)
May 2015
Question 4
The major objective of any portfolio insurance strategy is to limit the downside risk of a risky asset
(or a portfolio of risky assets), while simultaneously maintaining most of the upside return potential.
Critically evaluate 3 (three) portfolio insurance techniques of your choice.
Students are expected to evaluate portfolio insurance techniques that may include “stop-loss”
technique, constant portfolio insurance (CPPI), option based portfolio insurance (OBPI), OBPI
with option replication and others. The demonstration of understanding of the portfolio insurance
process, its advantages and disadvantages and the areas of application is expected.
Question 5
In recent years, the Investment Management Association surveys have been reporting an increase
in passively managed assets in the UK. While they still represent only 22% of the total, passive
mandates exhibit an annual growth of 11%, which exceeds that of the active ones (5.4% p.a.).
Discuss the reasons driving this increase and any implications it may have for the future, clearly
differentiating between active and passive management philosophies.
A standard active vs. passive management discussion throughout this answer addressing
performance aims, risks, diversification levels, historical performance etc. is expected. The focus of
the answer should be around the fact that the main reason behind large growth in passive investing
is the increase in popularity of and availability of Exchange traded Funds (ETFs). Additionally,
lower cost of passive relative to active investing contributes to its increased popularity. Students
could mention that the implication of this increase in supply and variety of ETFs is that the balance
between active and passive mandates may become more even in the future.
Question 6
Why are mutual funds restricted from equity short-selling? Explain the differences between the
efficient frontiers or risky assets with and without short-selling restriction. Is there a difference in
how investors select the optimal portfolio on each of those efficient frontiers?
Risks associated with short-selling need to be discussed to address why mutual funds are restricted
from it (infinite losses, short squeeze, uptick rule for instance). Students could note that with
unlimited short-selling portfolios in theory have infinite rates of return, because securities with low
expected returns are sold and the proceeds are used to purchase securities with high returns. As the
result, an investor also increases standard deviation (risk) due to the fact that short-selling may
incur unlimited losses. On the other hand, when short-selling is not allowed, the efficient set has a
finite point, which is where the portfolio with the maximum return is. It doesn’t continue to infinity
because investor has no other funds to finance further investment. On both efficient frontiers (with
and without short-selling of risky assets) investors chose optimal portfolios using indifference
curves (tangency point). Students may use relevant graphs to illustrate their answer.
Question 7
Critically evaluate different approaches to portfolio performance appraisal. Within your answer,
distinguish among the following performance measures: The Sharpe ratio, The Treynor ratio and
Jensen’s alpha and explain how each measure relates excess return and the relevant risk.
The answer should include principles of portfolio performance evaluation at various levels
(meeting set portfolio objectives, which strategies worked the best, evaluation of managers’ skills
etc.). Students could look at the evaluation against a benchmark and highlight issues with selecting
the correct benchmark as well. It is expected to see the explanations of each measure, its
comparative advantages and disadvantages (possible modifications) and areas of application.
Page 2 of 2
FN369: Investment Management (MS)
May 2015