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Jay Sullivan is a portfolio manager at Global Alpha Capital (GACP), one of 10 managers used by Kohl University’s endowment fund. GACP, an active manager, follows a global long‐only multi‐cap equity strategy. Eighty percent of its portfolio is invested in a core‐satellite approach, with the core invested in the stocks of the All Countries World Index (ACWI) and the remainder equally distributed among a small number of additional active positions, which currently comprise seven stocks.GACP seeks to add alpha to the portfolio by overweighting sectors it believes will outperform the market. The active positions add specific sector exposure to the ACWI index portfolio. The potential contribution to risk and return of each selected sector is evaluated, and the security selection process results in using a minimal number of securities believed to most efficiently replicate the respective sector overweight. A acroeconomic factor model is used to evaluate sector sensitivity to macro factors. GACP has a high degree of confidence in its macro outlook and assumes no error in the forecast.During the presentation to the endowment fund’s finance committee, Sullivan refers to Exhibit 1 and Exhibit 2 showing GACP’s micro and macro forecasts, which he prepared to help explain the firm’s investment rocess.   Johnson Rogers, Kohl’s finance committee chair, addresses Sullivan:“I have read about the advantages of the Treynor‐Black model over the capital asset pricing model (CAPM). Is that your basis for holding three Pharma stocks instead of two? It seems the Treynor‐Black model could result in outsized overweights of specific stocks.”Sullivan replies:“Our larger exposure to the Pharma sector is not related to the Treynor‐Black methodology. If wehad employed Treynor‐Black, we would have weighted all seven stocks differently. However, we do consider each sector’s potential contribution to volatility. The correlations of the three Pharma stocks prevent that sector from performing as a single stock overweight. I did not include correlation information in the exhibits. NOLP’s correlation with SAIN is only 20%; its correlation with ZAHN is 60%; and SAIN’s correlation with ZAHN is 80%. We are also not employing the CAPM to select our stocks. The committee is likely familiar with the use of historical beta, so those are the values shown in the exhibit. If we were to use the CAPM, we would likely not use historical beta as a measure.”Rogers then comments:“Our other managers have explained the CAPM and arbitrage pricing theory (APT) to us in the past, and I can see from Exhibit 2 that your stock selection process is consistent with the CAPM. Can you explain to us how the CAPM is different from the APT?”Sullivan responds with the following statements:Statement 1: Unlike CAPM, APT assumes that all investors have identical views about security returns, variances, and correlations.Statement 2: APT assumes that no arbitrage opportunities exist among well‐diversified portfolios. The CAPM makes no such assumption.Statement 3: Under APT, asset returns are described by a multifactor model, whereas under the CAPM, security returns are driven by one factor, the market portfolio. |
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