Bond Portfolio Management Styles

Posted By: Advisor Analyzer Team

In equities, there are various portfolio management strategies. They range from passive indexing strategies, where the manager’s main objective is to replicate index returns, to full blown active strategies where the goal is to outperform the markets and capitalize on asset mispricing. There is generally very little tracking error and alpha generated from the passive approaches, but this cannot be said for active strategies.

 

Similarly, bond portfolio management has a variety of styles and approaches that range from passive to active. However, there are subtle difference due to the overall market structure of the fixed income and equity markets, mainly due to liquidity and low trading activity. Below are five common classifications that are used to identify bond portfolio management styles.

Pure Bond Indexing

The Pure bond indexing strategy is the easiest bond strategy for a portfolio manager to replicate. The mechanics are fairly simple: purchase every bond in the index by its proportional weight and the returns should be identical. Conceptually this strategy is very easy to understand, but it is very difficult to replicate.

 

If one were to mimic the returns of the Dow Jones Industrial Average, one should simply buy every position in the Dow by a proportionate number of shares. (In the absence of ETF’s or other index instruments of course). The stocks traded on the Dow are very liquid, with small bid ask spreads and high trading volume so there are very little market considerations when replicating the index.

 

However, application of this strategy in the real world faces many challenges. While much larger than the equity markets, the bond markets have less frequent trading volume, and a lot more positions. Investors generally purchase Bonds for a longer holding period, and do not buy and sell at the frequency of equities investors. Therefore, a manager trying to mimic a bond index must first be able to purchase the positions that compose the index. Obviously when there are fewer sellers of positions, this task can be quite difficult.

Enhanced Indexing by Matching of Primary Risk Factors

Due to the problem of illiquidity and other cost inefficiencies, replication of bond indices prove more challenging than initially thought. Therefore, portfolio managers utilize a more practical approach by matching primary risk factors that affect the index and the portfolio. Doing so should yield similar results to the indices, without the need to hold the same assets by the identical proportions.

 

The matching process is executed by using a sampling approach to replicate the index’s primary risk factors, while holding a portion of the bonds in the index. By utilizing the sampling approach, costs associated with the construction of the portfolio is significantly reduced, but the risk profile of the index is mimicked closely. In general, due to the lower transaction costs and lower liquidity premiums, the matching of primary risk strategy outperforms the pure indexing approach. However, the enhanced matching approach still tends to underperform the index due to transaction costs and availability of holdings, while not as poorly as the pure index model.

Enhanced Indexing by Small Risk Factors

This is the first indexing strategy that is designed to earn roughly the same returns as the index it replicates. While maintaining exposure to the primary risk factors, such as duration and convexity, the manager of a small risk factor matching approach tilts the portfolio by preserving relative value strategies. Relative value strategies are used to identify mispriced securities versus the index.

 

While the tilts slightly shift the allocation of the portfolio away from the index, they are not significant enough to alter the portfolio’s replication abilities. Generally, the small tilts are used to compensate for administrative costs and inefficiencies, not to generate active returns above the index.

Active Management by Large Risk Factors

The only difference between the active management of large risk factors approach and the enhanced indexing of small risk factors is the degree of the tilt. While both overweight undervalued securities, the portfolio manager of the active approach uses a more pronounced tilt to his allocation. In addition to the amount of tilt, the manager may alter the overall duration of the portfolio.

 

While the portfolio is actively managed, the intent of this allocation strategy is to earn sufficient returns to cover administrative and transaction costs associated with the management process. The manager does not intend to stray too far from the overall risk levels of the index being replicated, or a minimum acceptable level of risk. Therefore, while it may introduce active returns and risks, there should not be too much of a deviation from the index.

Full Blown Active Management

Full blown active management is a no holds barred strategy that provides the manager with complete discretion and flexibility. The manager is usually an expert in analyzing his portfolio holdings, and actively pursues tilting, relative value and duration strategies. Tilting here, is over and underweighting certain sectors and risk factors relative to their expected performance.

 

Relative value strategies often used entail identifying undervalued securities and sectors. This approach usually focuses on credit ratings and credit spreads. For example, if there are certain A rated bonds that trade at a significant discount to AA rated bonds or investment grade bonds, the manager may tilt the allocation to A rated and reduce the allocation to AA rated bonds. In general, unless the manager utilizes a long/short strategy, the overvalued security or sector is underweighted, not shorted.

Conclusion

As the manager’s style shifts towards full blown active management, the likelihood of active returns and tracking error increases. The approach utilized should always be consistent with the objectives and constraints of the investor, and there should be minimal drift or switching of strategies. Investors should be aware of the index being replicated and monitor the performance of the portfolio relative to its benchmark. A good manager isn’t always the one that outperforms the benchmark index, but one that manages the portfolio as intended on a consistent basis. Sometimes, no surprise is the best surprise.