Active or Passive Asset selection

Question 1

Why wouldn’t an index have a tracking zero of zero?

Answer 1

• Transaction costs that occur when constructing an index tracking portfolio or when occasional rebalancing occurs due to change in the composition of the index, contributions, withdrawals/dividend received
• Timing of buying / selling stocks when they leave or enter the index
• Round-lot purchases – stocks may only be able to be bought in 100s which means that there may be a slight mismatch in the weight that a stock has in the index and the weight actually allocated in the tracking portfolio.
• Possible restrictions on foreign ownership, if index has not only domestic constituents.
• Index, if total return, normally assumes ex-dividend date is payment date. Payment date may be 6 weeks following ex-dividend date
• Dividend reinvested may be performed gross when in the fund it is reinvested net. Some dividend payments may be too small to be amenable to reinvestment.

Question 2

What are the active bond selection strategies?

Answer 2

• Riding the yield curve:
  
  • Yield curve usually shows a smoot relationship between yield and maturity but on occasion at various maturities there may be humps or dips in the curve.
  • Depends on which way investors feel the yield curve will go. If the humps or dips are expected to disappear, then the prices of the bonds on the hump can be expected to rise and the prices of the bonds in the dips can be expected to fall.
• Policy switching:
  
  • Involves switching between two types of bonds, purchasing the high yield bond and selling the low-yield bond.
  • A bridge swap is an example.
  • Selling the bond with the higher yield means overall duration remains the same while expected return is increased.
  • The strategy may involve switching between dissimilar bonds or similar bonds in maturity credit rating and sector.

Question 3

What is a bonds duration?

Answer 3

• Meausres the average maturity of the bonds promise cash flows.
• Found by taking the time weighted PV of all future cash flows of a bond.
• Measures the price sensitivity of a bond to changes in interest rates.
• Is the same as the volatility for equities
• Macaulay’s duration equals the weighted average of the time until each payment is received, with the weights proporational to the PV of the payment.
• A high coupon, short duration will not vary in price as much as a low coupon high duration bond.
• Duration is shorter than maturity for all bonds expect ZCBs
• Duration is equal to maturity for ZCBs.
• Formula:
  
  • Macaulay duration = (pv x No.years)
  • Sum up the Macaulay duration and divide by the price of the bond
  • Modified duration is then macaulay duration / 1 + YTM

Question 4

What is convexity?

Answer 4

• Duration states that the % price change is linear to the change in yield but in fact the relationship between price and yield is convex becuase duration changes as the yield changes.
• Convexity measures this by making an adjustment to the Macaulay’s duration.
• Bonds with greater convexity have more curvature in the price-yield relationship.
• Duration is a good approx for only small changes in bond yields.
• Duration always understates the value of the bond, it understates the increase in the bond price when the yield falls, it overestiamtes the decline in price when the yield rises.

Question 5

What does passive bond management mean?

Answer 5

• This applies to the whole bond portfolio not just a section of it.
• Takes bond prices as fairly set and mostly seeks to control only the risk of the portfolio.
• Two passive strategies are indexation and immunixation and both see prices as efficient.
  
  • Bond index funds has the same risk reward as the bond market index.
  • Immunization will seek to establish a zero-risk profit, in which interest rate movements have no impact on the value of the bonds.

Question 6

What is bond indexing?

Answer 6

• Mirrors the composition of an index based on a broad market and are market value weighted and total return.
• Will inclue a variety of issuers, government, corporate and MBS.
• Some issues may be infequently trades, and it can be difficult to purchase each security in the index in proportion to its market value.
• Also face rebalancing issues with bonds as they drop out of the index as maturities fall below 1 year.
• As new bonds are issued, they are added.
• Means turnover is high to ensure a close match between the composition of the portfolio and the bonds included in the index.
• Often a stratified sampling approach is taken and ensures that the maturity, coupon, credit risk and industrial representation match the characterstics of the index and the performance of the portfolio should match.

Question 7

What is Immunization?

Answer 7

• Investors try to insulate their portfolio from interest rate risk altogether.
• Many DB pension schemes are concerned with protecting the FV of their portfolios and the ability to meet future obligations fluctuates with interest rates.
• Investors seek to match the interest rate exposure of their assets and liabilities. The value of the asset will track the value of the liabilities whether rates rise or fall and is done by matching the duration of the assets and liabilities.
• If done right, bond price risk and reinvestment risk are cancelled out.
• FI investors care because they face two types of risk:
  
  • Price risk:
    
    • Increases in rate will cause prices to fall
  • Reinvestment risk:
    
    • If rate fallscoupons can only be reinvsted at that lower rate
  • However, if they portfolio duration is correct the two effects will cancel out.
• As such we guarantee the GRY.
• As interest rates and durations change the manager must rebalance the portfolio to realign its duration with the duration of the obligation. Even if rates do not change, asset durations will change soley because of the passage of time as duration decreases less rapidly than does maturity.
• This makes immunisation a passive strategy only in the sense that it does not invlove attempt to identify undervalued securities.

Question 8

What is active bond management?

Answer 8

• Active management includes forecasting the entire spectrum of the fixed income market.
• If rates are anticapated to decline the manager will increase portfolio duration.
• Might also include the indentification of relative mispricing within the fixed income market, e.g. he might believe that the default premium on one bond is to large and therefore that the bond is under-priced.

Question 9

What are two types of active bond management?

Answer 9

• Duration switching:
  
  • If the manager is expecting a fall in the general level of interest rates, he should increase the duration of his portfolio.
  • If he is expecting interest rates to rise he should reduce duration.
  • If the yield curve is upward sloping, the manager can buy bonds with greater maturities than his required time horizon and then can sell them at the end of his investment period. If the yield curve has not shifted in that time, the investment manager will generate higher returns than had he bought bonds with maturities equivalent to his time horizon.
  • As the time to maturity declines, the YTM falls and the price of the bond rises, thereby generating a capital gain. These gains would be higher for the longer-term bonds than the shorter ones.
• Bond Switching:
  
  • Anomaly switch is a switch between two bonds with very similar characterstics but whose prices are out of line with each other.
  • The expensive bond will be sold and the cheaper one purchased.
  • The bonds could be exchanged on the basis of yield differentials.
  • A policy switch is between two dissimilar bonds designed to take advantage of an anticipated change in 1) rates 2) yield curve 3) changes in credit ratings and 4) sector relationships.