) PRIORAT IS MOST LIKELY CORRECT WITH REGARD TO WHICH STRUCTURAL TR...

6.) Priorat is most likely correct with regard to which structural trade?

A. Putables

B. Bullets

C. Callables

Sonera

William Gatchell, CFA, is an investment analyst with the Sonera Endowment Fund. Sonera is

considering hiring a new equity investment manager. In preparation, Gatchell meets with Anjou

Lafite, another analyst at the fund, to review a relevant part of the endowment’s investment

policy statement:

Funds will be invested in the most efficient vehicle that meets the investment objective.

Each manager must demonstrate the efficiency with which the tracking error they use

delivers active return. In addition, each manager must consistently adhere to his or her

stated style.

Gatchell is given the task of reviewing three investment managers and selecting a manager that

is most likely to adhere to Sonera’s investment policy statement. Information about the

investment managers is shown in Exhibit 1.

Exhibit 1: Investment Manager Data

Investment Manager

A B C

Assets under management ($

millions) 1,325 3,912 524

Information ratio –0.27 0.5 0.75

Small-cap value index, beta 0.95 0.98 1.05

Small-cap growth index, beta 0.32 0.43 0.48

Large-cap value index, beta 1.05 1.1 0.96

Large-cap growth index, beta 0.47 0.39 0.37

Manager-stated style Value Value Growth

Manager-stated sub-style Low P/E High yield Momentum

Gatchell is reviewing the fee structures proposed by the three investment managers. He finds

the following reference in Sonera’s investment policy statement:

The fee structure must be easy to understand and avoid undue complexity wherever

possible. Also, the fee structure must be predictable, so Sonera can reasonably forecast

these costs on a yearly basis as an input to the annual budgeting process.

He understands there are many different fee structures, and he wants to make sure he chooses

the most appropriate one for the Sonera. Gatchell prepares a recommendation for the

investment policy committee regarding the most appropriate fee structure.

Sonera has followed an active investment style for many years. Gatchell would like to

recommend to the investment policy committee that a portion of the funds be invested using a

passive investment style. His research shows there are a number of methods used to weight the

stocks in an index, each having its own characteristics. The one key feature he believes is

important is that the method chosen not be biased toward small-capitalization stocks.

Gatchell is also examining different ways to establish passive equity exposure. He states to

Lafite:

There are a number of ways to get passive equity exposure; we can invest in an equity

index mutual fund, a stock index futures contract, or a total return equity swap. Stock

index futures and equity swaps are low-cost alternatives to equity index mutual funds;

however, a drawback of stock index futures is that they have to be rolled over

periodically. One advantage of investing in equity mutual funds is that shares can be

redeemed at any point during the trading day.

Gatchell is reviewing the performance of another investment manager, Far North, which uses a

value-oriented approach and specializes in the Canadian market. Gatchell would like to

recommend to the investment policy committee that the fund diversify geographically. The

information for Far North and the related returns are shown in Exhibit 2.

Exhibit 2: Far North—Return Information

Rate of Return

Far North 14%

True active return –1%

Misfit active return 5%

The investment policy committee reviews the information in Exhibit 2 and is not familiar with

the terms “true active return” and “misfit active return.” Gatchell responds with the following

statement:

The true active return is the return Far North made above its normal benchmark return. The

misfit active return is the return Far North made above the investor’s benchmark return. The

term “investor’s benchmark” refers to the benchmark the investor uses to evaluate

performance for a given portfolio or asset class.