Financial Risk Manager Part 2
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An investment firm’s portfolio manager is responsible for overseeing multiple client accounts. They are currently analyzing the dispersion in returns across these accounts, referred to as variance. Variance, in this context, is defined as the difference between the highest and lowest returns recorded among the accounts. The manager is evaluating various factors that contribute to this variance and is considering strategies to mitigate it.
An investment firm’s portfolio manager is responsible for overseeing multiple client accounts. They are currently analyzing the dispersion in returns across these accounts, referred to as variance. Variance, in this context, is defined as the difference between the highest and lowest returns recorded among the accounts. The manager is evaluating various factors that contribute to this variance and is considering strategies to mitigate it.
Explanation:
The correct conclusion for the portfolio manager to reach is option B: A portfolio manager's tracking error and dispersion tend to be proportional to each other over time. This is because dispersion measures the spread of returns among the portfolios managed by the manager, and tracking error is a measure of how closely a portfolio's performance matches that of a benchmark. The more portfolios a manager oversees, the more likely it is that their performance will vary, leading to a proportional increase in both tracking error and dispersion.
Option A is incorrect because while dual-benchmark optimization can help reduce dispersion, it does so at the cost of potentially lower returns. Option C is incorrect because dispersion can arise not only from client-driven factors, such as specific constraints placed by clients, but also from manager-driven factors, such as differences in portfolio characteristics like betas and factor exposures due to a lack of attention by the manager. Finally, option D is incorrect because it is not feasible or optimal to reduce dispersion to zero due to factors like transaction costs; instead, managers should aim to control dispersion to an optimal level.