Portfolio Management

Question 1

Which of the following is most likely to represent a passive strategy for constructing an ETF?

Answer 1

Representative sampling/optimization.

Replicating index performance by using an optimized sample rather than investing in all the securities in the index is considered a passive ETF strategy. Active management strategies used in the construction of ETFs include factor (smart beta), discretionary active, alternatively weighted, dynamic asset allocation and multi-asset strategies.

(Study Session 16, Module 43.3, LOS 43.h)

Question 2

Soft Closure

Answer 2

Soft closures entail creation halts and changes in investment strategy.

Question 3

ETN

Answer 3

When creations are halted by bank ETN issuers, those ETNs may trade at a significant premium to their NAV as the arbitrage mechanism breaks down.

Question 4

ETF spreads

Answer 4

The maximum spread on an ETF is positively related to creation/redemption fees plus other trading costs, spread on the underlying securities, risk premium for carrying the trade until close of trading, and AP’s normal profit margin.

Maximum spread is negatively related to the probability of offsetting the trade in the secondary market.

Question 5

ETF spreads in fragmented markets

Answer 5

The increased settlement complexity from fragmented markets will lead to an increase in the quoted spreads.

Question 6

A large bank’s decision to issue exchange traded notes (ETNs) that track the S&P500 index is most likely to be motivated by the belief that:

Answer 6

the yield on bank’s unsecured debt would be higher than the swap fixed rate.

If a large bank that wants to issue unsecured debt at a fixed interest rate finds that the rate demanded by the market is significantly higher than the swap fixed rate for same maturity, the bank may instead issue an ETN that pays the return on an equity index. The bank then would simultaneously enter into an equity swap as the equity return receiver and the (swap) fixed rate payer. The index return received is used to service the ETN and the bank’s effective borrowing cost becomes the swap fixed rate.

(Study Session 16, Module 43.3, LOS 43.f)

Question 7

An ETF’s tracking difference is most accurately measured as the:

Answer 7

difference between the ETF’s return (based on its NAV) and the return on the index tracked.

Question 8

Which of the following risk measures are most likely to be used by a traditional asset manager?
A) Maximum drawdown
B) Active share.
C)Surplus at risk

Answer 8

Active Share.

Traditional active managers are concerned about underperforming against their benchmark and hence use active share as a relative measure of risk. Surplus at risk is used by pension plans and maximum drawdown is most commonly used by hedge funds.

Question 9

A tracking portfolio is a portfolio with:

Answer 9

a specific set of factor sensitivities designed to replicate the factor exposures of a benchmark index.

Question 10

Arbitrage pricing models assume which risk is priced?

A)
Systematic.

B)
Both systematic and unsystematic.

C)
Unsystematic.

Answer 10

Unsystematic risk can be diversified away. Thus, arbitrage pricing reflects only systematic risk. It is assumed that the portfolio manager will take steps to diversify and reduce risk.

Question 11

Creation Basket is

Answer 11

the list of required in-kind securities published each day by the ETF sponsor

Question 12

The redemption basket published by an ETF sponsor, must be ____ the creation basket

Answer 12

can be different than the creation basket. The basket of securities the AP receives when it redeems the ETF shares is called the redemption basket. This basket often has the same security composition as the creation basket, but it may be different if the EFT portfolio manager is tying to sell particular securities for tax, compliance, or investment reasons

Question 13

with respect to ETFs, a soft closure is what?

Answer 13

a change in investment strategy

Question 14

ETF price may be a more accurate reflection of fair value than NAV when

Answer 14

The underlying securities are less actively traded.

Question 15

An intraday fair value estimate of an ETF’s share based on its creation basket for the day is called ___?

Answer 15

Indicated NAV

Question 16

Index fund ETF is expected to ____

Answer 16

underperform its benchmark by the amount of its expense ratio

Question 17

ETF bid -ask spreads are generally less than or equal to the combination of the following …

Answer 17

• creation / redemption fees and other direct trading costs, such as brokerage and exchange fees
• • bid-ask spreads of the underlying securities held in the ETF
• • compensation to market maker or liquidity provider for the risk of hedging or carrying positions for the remainder of the trading day
• • market maker’s desired profit spread, subject to competitive forces
• • discount related to the likelihood of receiving an offsetting ETF order in a short term frame

Question 18

When an investor buys shares of an ETF on an exchange …

Answer 18

the ETF sponsor is not involved in the transaction

Question 19

With respect to the transactions between AP and the ETF sponsor to create shares …

Answer 19

neither the price paid for the shares nor the price of the ETF closing NAV are relevant

To create new shares, an AP acquires the securities in the creation basket in the specified share amounts, the AP then delivers this basket of securities to the ETF manager in exchange for an equal value in ETF shares.

The pricing of both the ETF and basket is of minimal concern in this exchange, because it is an in-kind transaction, all that matters is that a specified number of shares of the required stocks move from the AP’s account to the ETF account.

Question 20

Index tracking is often evaluated using ___

Answer 20

the one-day difference in returns between the fund, as measured by its NAV, and its index.

Tracking error, on the other hand, is defined as the standard deviation of difference in daily performance between the index and the fund tracking the index, and a reported tracking error number is typically for a 12 month period

Question 21

The primary market for ETF trading is ____

Answer 21

OTC between authorized participants and the fund sponsor

Question 22

Which source of tracking error would contribute to overperformance

1) sec lending
2) dividend recapture
3) foreign tax withholding

Answer 22

Sec Lending provides income to the portfolio above what the benchmark does.

Dividend recapture simply attempts to reclaim foreign tax withholdings - so it doesn’t contribute to overperformance in as much as it minimizes underperformance.

Question 23

ETF 1

Answer 23

ETFs trade on both primary and secondary markets. Primary market trades occur between authorized participants and an ETF sponsor or manager. The ETF manager discloses a list of securities on a daily basis as part of the creation basket.

Question 24

ETF 2

Answer 24

Authorized participants pass on the creation/redemption costs in the form of bid-ask spreads, which means that only transacting shareholders pay these costs, unlike with mutual funds where all shareholders bear this cost. Similarly, unlike mutual funds, ETFs are tax fair because redemptions are in-kind and do not affect the nontransacting shareholders; hence, capital gains distributions tend to be lower for ETFs compared to traditional mutual funds.

Question 25

The covariance between a risk-averse investor’s intertemporal rate of substitution and expected future price is negative or positive or no relationship

Answer 25

The covariance between a risk-averse investor’s intertemporal rate of substitution and expected future price is negative.

Question 26

Breakeven inflation

Answer 26

The breakeven inflation rate equals expected inflation plus a risk premium for inflation uncertainty.

Question 27

VaR

Answer 27

Five percent VaR is the minimum loss 5% of the time, or maximum loss with a 95% confidence level.