Chapter 23Active Bond Portfolio Management Strategies 1Copyright 2010 Pearson Education, Inc. Publishing as Prentice HallLearning ObjectivesAfter reading this chapter, you will understand q the five basic steps involved in the investment management process q the difference between active and passive strategies q what tracking error is and how it is computed q the difference between forward-looking and backward -looking tracking error q the link between tracking error and active portfolio management q the risk factors that affect a benchmark index q the importance of knowing the market consensus before implementing an active strategy2Copyright 2010 Pearson Education, Inc. Publishing as Prentice HallLearning Objectives (continued)After reading this chapter, you will understandqthe different types of active bond portfolio strategies: interest-rate expectations strategies, yield curve strategies, yield spread strategies, option-adjusted spread-based strategies, and individual security selection strategies qbullet, barbell, and ladder yield curve strategies qthe limitations of using duration and convexity to assess the potential performance of bond portfolio strategies qwhy it is necessary to use the dollar duration when implementing a yield spread strategy qhow to assess the allocation of funds within the corporate bond sector qwhy leveraging is used by managers and traders and the risks and rewards associated with leveraging qhow to leverage using the repo market3Copyright 2010 Pearson Education, Inc. Publishing as Prentice HallOverview of the Investment Management Process qRegardless of the type of financial institution, the investment management process involves the following five steps: i. setting investment objectives ii. establishing investment policy iii.selecting a portfolio strategy iv.selecting assets v. measuring and evaluating performance4Copyright 2010 Pearson Education, Inc. Publishing as Prentice HallOverview of the Investment Management Process (continued)q Setting Investment Objectives The first step in the investment management process is setting investment objectives. The investment objective will vary by type of financial institution. q Establishing Investment Policy The second step in investment management process is establishing policy guidelines for meeting the investment objectives. Setting policy begins with the asset allocation decision so as to decide how the funds of the institution should be distributed among the major classes of investments (cash equivalents, equities, fixed-income securities, real estate, and foreign securities).5Copyright 2010 Pearson Education, Inc. Publishing as Prentice HallOverview of the Investment Management Process (continued)qSelecting a Portfolio Strategy Selecting a portfolio strategy that is consistent with the objectives and policy guidelines of the client or institution is the third step in the investment management process. Portfolio strategies can be classified as either active strategies or passive strategies. Essential to all active strategies is specification of expectations about the factors that influence the performance of an asset class. Passive strategies involve minimal expectational input.6Copyright 2010 Pearson Education, Inc. Publishing as Prentice HallOverview of the Investment Management Process (continued)qSelecting a Portfolio Strategy Strategies between the active and passive extremes have sprung up that have elements of both extreme strategies. For example, the core of a portfolio may be indexed, with the balance managed actively. Or a portfolio may be primarily indexed but employ low-risk strategies to enhance the indexed portfolios return. This strategy is commonly referred to as enhanced indexing or indexing plus.7Copyright 2010 Pearson Education, Inc. Publishing as Prentice HallOverview of the Investment Management Process (continued)qSelecting a Portfolio Strategy In the bond area, several strategies classified as structured portfolio strategies have commonly been used. A structured portfolio strategy calls for design of a portfolio to achieve the performance of a predetermined benchmark. Such strategies are frequently followed when funding liabilities. When the predetermined benchmark is the generation of sufficient funds to satisfy a single liability, regardless of the course of future interest rates, a strategy known as immunization is often used. When the predetermined benchmark requires funding multiple future liabilities regardless of how interest rates change, strategies such as immunization, cash flow matching (or dedication), or horizon matching can be employed.8Copyright 2010 Pearson Education, Inc. Publishing as Prentice HallOverview of the Investment Management Process (continued)qSelecting a Portfolio Strategy Given the choice among active, structured, or passive management, the selection depends on i.the client or money manag