James Leonard is a fund-of-funds manager with Future Generation, a large sovereign fund. He is considering whether to pursue more in-depth due diligence processes with three large-cap long-only funds proposed by his analysts. Although the funds emphasize different financial metrics and use different implementation methodologies, they operate in the same market segment and are evaluated against the same benchmark. The analysts prepared a short description of each fund, presented in Exhibit 1.
Exhibit 1
Description of Each Candidate Fund
Fund | Description |
Furlings | Furlings Investment Partners combines sector views and security selection. The firm’s head manager uses several industry and economic indicators identified from his own experience during the last two decades, as well as his personal views on market flow dynamics, to determine how to position the fund on a sector basis. Sector deviations from the benchmark of 10% or more are common and are usually maintained for 12 to 24 months. At the same time, sector managers at Furlings use their expertise in dissecting financial statements and their understanding of the corporate branding and competitive landscape within sectors to build equally weighted baskets of securities within sectors. Each basket contains their 7 to 10 highest-conviction securities, favoring firms that have good governance, strong growth potential, competitive advantages such as branding, and attractive relative valuations. The Furlings master fund holds approximately 90 securities. |
Asgard | Asgard Investment Partners is a very large asset manager. It believes in investing in firms that have a strong business model and governance, reasonable valuations, solid capital structures with limited financial leverage, and above-average expected earnings growth for the next three years. Although the Asgard master fund invests in fewer than 125 securities, each sector analyst builds financial models that track as many as 50 firms. To support them in their task, analysts benefit from software developed by the Asgard research and technology group that provides access to detailed market and accounting information on 5,000 global firms, allowing for the calculation of many valuation and growth metrics and precise modeling of sources of cash-flow strengths and weaknesses within each business. Asgard analysts can also use the application to back-test strategies and build their own models to rank securities’ attractiveness according to their preferred characteristics. Security allocation is determined by a management team but depends heavily on a quantitative risk model developed by Asgard. Asgard has a low portfolio turnover. |
Tokra | Tokra Capital uses a factor-based strategy to rank securities from most attractive to least attractive. Each security is scored based on three metrics: price to book value (P/B), 12-month increase in stock price, and return on assets. Tokra’s managers have a strong risk management background. Their objective is to maximize their exposure to the most attractive securities using a total scoring approach subject to limiting single-security concentration below 2%, sector deviations below 3%, active risk below 4%, and annual turnover less than 40%, while having a market beta close to 1. The master fund holds approximately 400 positions out of a possible universe of more than 2,000 securities evaluated. |
Exhibit 2 presents key financial information associated with each manager’s portfolio and also with the index that all three managers use.
Exhibit 2
Key Financial Data
Fund | Index | Furlings | Asgard | Tokra |
Dividend/price (trailing 12-month) | 2.3% | 2.2% | 2.2% | 2.6% |
P/E (trailing 12-month) | 26.5 | 24.7 | 26.6 | 27.3 |
Price/cash flows (12-month forward) | 12.5 | 13.8 | 12.5 | 11.6 |
P/B | 4.8 | 4.30 | 4.35 | 5.4 |
Average EPS growth (three to five years forward) | 11.9% | 11.0% | 13.1% | 10.8% |
Net income/assets | 2.8% | 4.5% | 4.3% | 3.2% |
Average price momentum (trailing 12 months) | 10.5% | 14.0% | 10.0% | 12.0% |
Q. Based on the information provided in Exhibits 1 and 2, which manager’s portfolio characteristics are most likely at odds with its declared style?
A.Furlings
B. Asgard
C. Tokra
The answer to the question is C: TOKRA.
Explanation:
C is the correct answer. Tokra indicates that it emphasizes three metrics: P/B, 12-month price momentum, and return on assets. Although the portfolio consists of securities that have stronger momentum than those of the index on average, and although the ratio of net income to assets is also favorable, the average P/B is somehow higher than that of the index. Although this scenario could normally be explained by an emphasis on specific sectors with a higher P/B than other sectors, the low level of sector deviation tolerated within the strategy weakens that explanation. This should be explored with Tokra’s managers.
Query:
I am not able to understand the quoted part of the CFAI explanation. Can you please help?
“the low level of sector deviation tolerated within the strategy weakens that explanation. This should be explored with Tokra’s managers.”
The fund is at odds with the declared style which is to target low p/b stocks but the average p/b is higher than the index 5.4 vs 4.8 (exhibit 2).
The possible reason could be investment in certain sectors which have a very high p/b that might have pushed the average p/b upwards. But it also states that l sector deviations are limited to 3%, so that could not be the reason. so this needs to be discussed with the managers.
another question from the same case study.
Q. Which activist investing tactic is Asgard least likely to use?
I’m unable to understand the rationale why Asgard will not launch legal proceedings against existing management if they will breach fiduciary duties.