As
you may surmise from this LOS, there
are many different strategies that can be followed when managing a
bond portfolio. For example, the manager can assume a completely
passive approach and not have to forecast anything. In other words,
the manager who feels he has no reason to disagree with market
forecasts has no reason to assume he can outperform an indexing
strategy through active management. On the other hand, a manager
who is confident in his forecasting abilities and has reason to
believe market forecasts are incorrect can generate significant
return through active management.
The differences between the various active
management approaches are mostly matters of degree. That is, bond
portfolio management strategies form more or less a continuum from
an almost do-nothing approach (i.e., pure bond indexing) to a
do-almost-anything approach (i.e., full-blown active management) as
demonstrated graphically in
In Figure 1, you
will notice the increase of three characteristics as you move from
pure bond indexing to full-blown active management. The
first, increasing active
management, can be
defined as the gradual relaxation of restrictions on the manager's
actions to allow him to exploit his superior forecasting/valuation
abilities. With pure bond indexing, the manager is restricted to
constructing a portfolio with all the securities in the index
and
in the same weights as the index. This means the
portfolio will have exactly the same risk
exposures as the index. As you move
from left to right, the restrictions on the manager's actions are
relaxed and the portfolio risk factor exposures differ more and
more from those of the index.
The next
characteristic, increasing expected return,
refers to the increase in portfolio
expected return from actions taken by the manager. Unless the
manager has some superior ability that enables him to identify
profitable situations, he should stick with pure bond indexing or
at least match primary risk factors.
The third
characteristic, increasing tracking error,
refers to the degree to which the
portfolio return tracks that of the index. With pure bond indexing,
even though management fees and transactions are incurred, the
reduced return on the portfolio will closely track the return on
the index. As you move to the
right, the composition and
factor exposures of the portfolio differ more and
more from the index. Each enhancement is intended to increase the
portfolio return, but is not guaranteed to do so. Thus, the amount
by which the portfolio return exceeds the index return can be quite
variable
from period to
period and even negative. The difference between the portfolio and
index returns (i.e., the portfolio excess return) is referred to as
alpha. The standard deviation of alpha across several periods is
referred to as tracking error, thus it is the
variability of the portfolio
excess return that increases as you move towards full-blown active
management. This increased variability translates into increased
uncertainty.
The
five classifications of bond portfolio management can be described
as: (1) pure bond
indexing, (2) enhanced indexing by matching
primary risk factors, (3) enhanced indexing by small risk
foetor mismatches, (4)
active management by larger risk foetor mismatches,
and (5)
full-blown active management.
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Pure Bond
Indexing
This is the easiest strategy to describe as well
as understand. In a pure bond indexing strategy, the manager
replicates every dimension of the index. Every bond in the index is
purchased and its weight in the portfolio is determined by its
weight in the index. Due
to varying bond liquidities and availabilities,
this strategy, though easy to describe, is difficult and costly to
implement.
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passive
management approach. She constructs a
portfolio that mimics the index along several dimensions of risk,
and the return on the portfolio should track the return on the
index fairly closely.