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Passage
Denise Duckworth is the chief investment officer at Duckworth Financial, Inc. (DFI), her father’s firm specializing in international opportunities. In addition to other duties, Duckworth manages the high-net-worth (HNW) portfolio managers (PMs) at DFI. One of her PMs, Emile Arroyo, is attempting to select from among the equity securities of three companies in Exhibit 1.
Exhibit 1: Arroyo – Equity Securities List
Company Description
| A | Aggressive management. Development of new products and markets. Simultaneous acquisitions in pursuit of those strategic goals. No dividends. Perhaps slightly overvalued based on DFI analysis. Headquartered in Brazil. |
| B | Natural resources company headquartered in Argentina. Expected to benefit from rising commodity prices. Able to pass cost increases on to its customers. |
| C | Well-established company with great share liquidity in international markets. Consistent and slowly growing dividend payments to shareholders. Headquartered in Belgium. DFI analysis has indicated “C” to be undervalued. |
Arroyo’s client, Aleksandr Dmitri, had recently come to him with concerns about lacking inflation protection in his equity portfolio. Arroyo then brought the situation to Duckworth’s attention. “I’m sure you’ll make the right decision,” Duckworth told him.
Arroyo, who has all actively managed portfolios, tells Patty Llewellyn, another PM with all passively managed portfolios, that he will constructively engage with the management of whichever company or companies he chooses for his client portfolios from now on. Llewellyn notes that Companies B and C are in her benchmark index.
Later that evening, Duckworth is approached at a social function by Charles Millicent, a well-known trust fund beneficiary. Millicent expects to receive a scheduled distribution of capital from the trust and wishes to reinvest rather than spend it. “I’m more interested in something that will produce an ongoing stream of income while protecting me from inflation,” he says. “At the same time, I have doubts that any of the widely followed companies that would meet my criteria will earn returns substantial enough to recover active management expenses.”
Duckworth agrees that she will have one of her many PMs call Millicent the next day.
Which of the following is correct regarding Duckworth’s assignment of Millicent’s account?
- Arroyo is more likely than Llewellyn to get the account.
- Llewellyn is more likely than Arroyo to get the account.
- Neither Arroyo nor Llewellyn is likely to get the account.
Using a derivative that is imperfectly matched to the underlying will most likely result in:
Passage
Serena Escobar is the chief investment officer (CIO) for Hiltl Investments, a large mutual fund company. Escobar has been discussing liquidity risk and tail risk with a group of interns in the portfolio management program. During the conversation, Escobar made two statements about bid-ask spread in high-yield and investment-grade markets.
| Statement 1: | High-yield spread is usually measured in currency units. |
| Statement 2: | Investment-grade spread is measured in basis points over a reference rate, usually a government fixed-income security. |
One of the interns asks Escobar about a list of bonds for potential inclusion in the Hiltl Emerging Markets Opportunities Fund (HEMOX). The candidate, Amar Elba, is surprised to see that Pinkston Mining, a multinational commodities producer, has the same credit rating as its country’s BB+ sovereign debt. “That company is in a lot of portfolios and I thought it was a stronger credit,” Elba says, somewhat surprised.
Other interns are more interested in the new Hiltl Structured Financial Instruments Fund (HSFIX). Escobar agrees with the interns that the fund offers opportunities for investors wishing to avoid holding individual MBS/ABS securities. She describes the situation in which a high-net-worth (HNW) client held a senior tranche and a subordinated tranche of an ABS with default correlation that changed from +1 to −1. The HNW client had no idea how to properly hedge the risk.
“Jenny Henley specifically looks at the relative value of tranches for any CDO investments in the Structured Financial Instruments Fund,” Escobar tells her interns, introducing Henley. During her explanation, Henley makes three comments.
| Comment 1: | Collateralized loans are CDOs with leverage loans serving as the underlying. |
| Comment 2: | Mezzanine and equity tranches essentially leverage the assets from the underlying credits. |
| Comment 3: | During a financial crisis, the triple-A and double-A tranches are likely to survive; therefore, a PM would short the more secure credits and go long the mezzanine and equity tranches. |
As Henley closes, Escobar takes that opportunity to announce a new fund, Hiltl Fixed-Income Strategic Opportunities Fund (HFISX). During her discussion of the new fund, she notes that the fund is likely to include high-yield credits and floating-rate notes. She then makes three observations.
| Observation 1: | It is appropriate to use spread duration rather than modified duration for the new portfolio. |
| Observation 2: | If interest rates change, a portfolio of floaters is unlikely to experience much change in value. |
| Observation 3: | If interest rates change, an investment-grade portfolio is unlikely to experience much change in spread. |
Based on Elba’s description of HSFIX, the fund most likely focuses on:
- covered bonds.
- the senior tranches of the securities.
- the mezzanine tranches of the securities.
Passage
Dava Vij is assessing several strategies for implementing a passive factor-based strategy for the Bela Planta Fund (BPF), the USD 1 billion fund of a tax-exempt organization that promotes the tropical ecosphere in Mozambique. Vij is working with the chief programs officer (CPO) at BPF, Grace Cabral, and makes the following three statements:
| Statement 1: | Passive factor-based investing may also be known as “smart alpha.” |
| Statement 2: | Passive factor-based investing requires making active management decisions upfront rather than continuously. |
| Statement 3: | Passive factor-based investing strategies tend to concentrate risk exposures relative to broad-market-capitalization-weighted approaches. |
Cabral likes the idea of doing this but is concerned that it will increase management costs. Based on their working documents and the BPF investment policy statement (IPS), Vij is also aware that the fund cannot use leverage or any type of derivative security. Cabral has indicated that the fund would like to be able to passively manage the funds but perhaps engage in shareholder activism where BPF can influence factors that address the fund’s mandate.
Vij describes three implementation approaches:
| Approach 1: | Derivatives-based approaches |
| Approach 2: | Separately managed equity index-based portfolios |
| Approach 3: | Pooled investments such as open-end mutual funds and ETFs |
Cabral then asks Vij how the funds in a separately managed account could be cost-effectively employed given that they have chosen to benchmark against the MSCI ACWI, which has over 3,000 constituents and includes emerging markets where some securities may have limited liquidity. Vij describes three index replication methods.
Cabral and Vij meet two quarters later. During that time, the portfolio value declined more than the MSCI ACWI, but rose quickly toward the end of the measurement period. Cabral was surprised by the resulting tracking error over the period.
Which of the following is correct regarding use of market-on-close (MOC) transactions to replicate the benchmark index for the passive strategy?
- Approach 1 is unlikely to use MOC transactions.
- Only Approaches 1 and 3 are likely to use MOC transactions.
- Any of the three approaches are likely to use MOC transactions.
Passage
Afshid Burnette directs fixed-income portfolio management for Diller Investments. Burnette has several newly promoted assistant portfolio managers (PMs) with varying degrees of experience. In a meeting with these managers, Burnette makes the following statements:
| Statement 1: | The standard deviation of high-yield—that is, less than investment grade—bonds can rise significantly during periods of financial stress. |
| Statement 2: | Long-maturity bonds are particularly susceptible to increasing return volatility during periods of financial stress. |
| Statement 3: | Portfolios laddered to receive high-quality bond income and principal payments on specific dates are particularly susceptible to large cash flow misses during periods of financial stress. |
Reggie Stansfield, one of the assistant PMs, told Burnette after the meeting that he really had his hands tied by a client portfolio and that they should speak with the client. The IPS for that portfolio required cash flow matching along with minimum cost constraints on each of the matching positions. Stansfield was puzzled by how he would meet those contradictory constraints given a portfolio already in place. He recognized that several less expensive securities would easily reduce portfolio capital needs after transactions costs.
Stansfield provides one example of a very long-term liability that has been theoretically defeased using on-the-run shorter-term securities that can be rolled over until needed to pay the liability. The last of the expected rolled positions will mature at the time the liability is due. The low return on the instruments and trading costs for rollovers has reduced portfolio return over time.
Another assistant PM, Juliana duBois, asked Burnette how a parallel decrease in the yield curve would affect a cash-flow-matched portfolio with maturities exactly paired to the liability due date.
Elena Machado, the newest assistant PM, helps manage a portfolio that employs leverage. She expressed to Burnette that she had been pleased with the return enhancement achieved by using a reverse repo agreement.
Paul Hemingway is the manager of a taxable investor’s portfolio. Hemingway is concerned that the portfolio manager for the account has misled the investor about taxes he will pay on a recent zero-coupon bond investment. The investor’s jurisdiction considers imputed interest the same as coupon cash flows for tax purposes. The manager, however, suggested the investor could pay tax at a capital gains rate on the price change over the term. Hemingway is certain the investor will keep the zero-coupon bonds through their maturity.
Stansfield’s concerns with switching to a longer-maturity security would most likely relate to:
- liquidity.
- higher transactions costs at rollover.
- portfolio volatility resulting from higher duration.
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