. 32
( 60 .)


+ =

Long call option Short put option Synthetic long forward

FIGURE 4.26 Use of a long call and a short put to create a synthetic long forward.

file, the price of the bond clearly does not receive any price support on the
downside and indeed has its price appreciation limited on the upside.
In sum, while callable and putable bonds may be viewed primarily as
interest rate risk bond products, they also can be viewed as being important
credit products. In the case of a putable, downside credit risk protection (as
with a downgrade) exists, and favorable credit-related appreciation (as with
an upgrade) is limited. With a callable, favorable credit-related appreciation
is also limited, as is downside credit risk protection.
A propitious choice of currency denomination also can have a favorable
credit impact for a financial product. For example, it is no mere happen-
stance that the so-called Brady bonds of the 1990s were explicitly intended
to assist Latin American countries with servicing their debt obligations, yet
were denominated in U.S. dollars rather than pesos, or sucres, or colons, and
so forth. Aside from any public relations benefit from having the bonds
denominated in dollars, U.S. Treasury zero-coupon bonds and other high-
grade instruments collateralize the principal and certain interest cash flows
of these bonds. In sum, the involvement of the United States, including the
international cachet of the U.S. dollar, greatly enhanced the real and per-
ceived credit benefits of Brady bonds.


Obviously, a portfolio is an amalgamation of products, cash flows, and credit
risks. There are hundreds of thousands of portfolios and investment funds


in the world, typically managed with an orientation to a particular invest-
ment style. For example, funds occasionally are described as being either rel-
ative or absolute return oriented. A relative return fund, as the name
suggests, is a fund whose performance is evaluated relative to a benchmark
or index. For example, a relative return equity fund might be evaluated rel-
ative to the S&P 500 equity index. Accordingly, if a portfolio manager
returns 20 percent in a given year, this may or may not be an impressive feat.
If the S&P 500 returned 33 percent, then the portfolio manager™s perfor-
mance would not be very impressive at all. But if the S&P 500 returned 3
percent, then a 20 percent portfolio return would be very impressive indeed.
Generally speaking, larger institutional fund managers manage relative
return funds.
Conversely, an absolute return fund typically is managed without ref-
erence to a particular benchmark or index; the objective is not so much to
provide a return that is impressive relative to a market benchmark (though
that may be welcomed) as much as it is to provide an attractive return on
an absolute basis. To achieve such a goal, it is expected that an absolute
return fund would experience more return volatility relative to a relative
return fund, but with larger longer-run aggregated returns in exchange for
the higher year-over-year risk being taken. Generally speaking, smaller fund
managers manage absolute return funds, as with hedge funds (special funds
that are subject to special privileges and restrictions relative to more com-
mon investment funds).
Because of their more aggressive objectives, absolute return funds gen-
erally are more likely to bias their investments toward relatively more risky
product, cash flow, and credit profiles in relation to relative return funds. That
is, absolute return funds are more likely to invest in equity than bonds, more
likely to invest in futures and options than spot, and more likely to dip into
lower credit quality investments than higher credit quality securities.

The following list of fund-types are all, broadly speaking, absolute return-
oriented styles.

Aggressive Growth
These funds typically invest in equities expected to experience acceleration
in growth of earnings per share, have generally high P/E ratios and low or
no dividends, and often are smaller-cap stocks. This category also includes
sector specialist funds such as technology, banking, or biotechnology. There
is a general bias toward being long the market.

Financial Engineering

Distressed Securities
These funds buy equity, debt, or trade claims at deep discounts of compa-
nies in or facing bankruptcy or reorganization. Profits are realized from the
market™s underappreciation of the true worth of these securities and from
bargain prices precipitated by selling by institutional investors who cannot
own below-investment-grade securities.

Emerging Markets
These funds invest in equity or debt of emerging (less mature) markets that
tend to have high inflation and volatile growth.

Funds of Hedge Funds
These funds invest in a mix of hedge funds and other pooled investment vehi-
cles. This blending of different funds aims to provide a more stable long-
term investment return than any individual funds. Capital preservation is
often an important consideration.

These funds have a primary focus on yield or current income rather than on
capital gains. These funds may use leverage buying bonds and perhaps other
types of fixed income derivatives.

These funds seek to profit from changes in global economies, many times
brought about by shifts in government policy that impact interest rates, cur-
rencies, stocks, and bond markets; though the funds may not be invested in
all of these markets at the same time. Leverage and derivatives may be used
to maximize the impact of market moves.

Market Neutral”Arbitrage
These funds attempt to hedge most market risk by taking offsetting posi-
tions, often in different securities of the same issuer. The funds may be long
convertible bonds and short the underlying issuers equity, and may focus on
obtaining returns with low or no correlation to both the equity and bond
markets These relative value strategies include fixed income arbitrage,
mortgage-backed securities, capital structure arbitrage, and closed-end fund


Market Neutral”Securities Hedging
These funds invest equally in long and short equity positions, and generally
in the same sectors of the market. Market risk may be greatly reduced, but
effective stock analysis and stock picking can be essential to obtaining mean-
ingful results. Leverage may be used to enhance returns, and there is usu-
ally low or no correlation to the market.

Market Timing
These funds allocate assets among different asset classes depending on the
fund™s view of investment opportunities. Portfolio emphasis may swing
widely between asset classes. Unpredictability of market movements and the
difficulty of timing entry and exit from markets add to the volatility of this

The investment theme for these funds changes from strategy to strategy as
opportunities arise so as to profit from events such as IPOs, sudden price
changes caused by unique events like earnings disappointments, hostile bids,
and other kinds of event-driven opportunities.

The investment approach for these funds consists of employing various
strategies simultaneously to realize short- and long-term gains. Strategies may
involve systems trading such as trend following or technical strategies.

Short Selling
The fund sells securities short in anticipation of being able to buy them again
at a future date at a lower price due to the fund™s assessment of the over-
valuation of the securities the market, in anticipation of earnings disap-
pointments often due to accounting irregularities, new competition, change
of management, and so forth.

Special Situations
These funds invest in event-driven situations such as mergers, hostile
takeovers, reorganizations, or leveraged buyouts. Strategies may involve
simultaneous purchase of stock in companies being acquired and the sale of
stock in its acquirer.

Financial Engineering

These funds invest in securities perceived to be selling at deep discounts to
their intrinsic or potential worth. Such securities may be out of favor or not
actively followed by analysts. Long-term holding, patience, and strong dis-
cipline are often required until the ultimate desired value is achieved.

In the strictest possible sense, indexing means striving to match a portfolio™s
return to the return of a given index return exactly. While this might sound
rather simple to do in theory”just buy every security that is in the index”there
is the matter of costs associated with those purchases. Indices are typically con-
structed and maintained with some unrealistic assumptions about the ways of
trading an actual portfolio. In the appendix of this chapter we highlight these
unrealistic assumptions in the context of how portfolio managers may use them
to achieve better fund performance. The point here is not to criticize the indices
for not being more like real portfolios. The role of an index is to be an index
and the role of a portfolio is to be a portfolio. The point merely is that the “sim-
ple” task of getting a portfolio to exactly explicate the performance of an index
can be a challenge. Investors who prefer putting their money into indexed funds
are essentially saying that they either do not believe in a portfolio™s ability to
do much better than what the index itself can do, or are satisfied with what
the index consists of and what its potential is, and that is all that they want;
nothing more and nothing less. In Table 4.4 we present a variety of fund man-
agement themes in the context of product types and relative return styles.
Now let us consider detailed descriptions of each of the fund categories
cited above.

Total Return
Total return investing is typically when a market index of some kind comes
into play as a sort of referee. For example, the S&P 500 is an equity mar-
ket index; a variety of market indices exist for bonds as well. Accordingly,
a mandate of a portfolio may be to generate a superior performance, and
generally with that outperformance being defined as a better-than-index per-
formance. Unlike indexed funds, where the goal is just to do as well as the
relevant index, with total return funds portfolio managers may receive some-
thing more in their fee package when they outperform an index. The appen-
dix of this chapter considers various ways that a portfolio manager might
seek to engage in some opportunistic though risk-controlled (if properly
managed) strategies that can help to add some total return potential to an
index-oriented management philosophy.


TABLE 4.4 Fund Management Themes Used with Product Types
Fund Theme Bonds Equities Currencies

√ √
√ √
Total return

√ √




Yield enhancement


. 32
( 60 .)