CHAPTER 7 Martellini Lecture


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CHAPTER 7 MARTELLINI PASSIVE FIXED INCOME PORTFOLIO MANAGEMENT Way to manage a portfolio is to match index returns. The easiest way to copy an index is to buy most of the securities in the index in the proper proportions. But purchasing most of the securities in the index in the proper proportions is practical and cost efficient for the largest index funds. For smaller portfolios, maintaining the necessary proportions of a large number of bonds would mean: buying odd lots and high transaction, or brokerage, costs This is where bond indexing can be used by smaller investors: Building index proxies or portfolios that contain only a small number of securities yet deviate minimally from the returns of much larger target indices. There are different methods for bond indexing. STRAIGHTFORWARD REPLICATION This technique involves duplicating the target index precisely by having all its securities in their exact proportions. Once replication is done, any trading in the indexed portfolio is necessary only when: the index makeup changes, or as a method of reinvesting cash flows The problem is that for bonds this method is not practical. The problems with trying to replicate a bond fund is: including all bonds from a particular portfolio, such as the Lehman Brothers Aggregate index forgoing all substantial volume discounts at auction many of the bonds in the indices are thinly traded the makeup of the index changes regularly, as the bonds mature 1
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An alternative to replicating is Optimization or Sampling, which tries to reproduce the overall attributes of the index (such as yield, credit quality, duration, convexity, etc.) with a limited number of issues. There is a problem with this concept: There still must be activity in the management of the portfolio process in order to have reliable index performance with low tracking error. There must be extensive portfolio modeling and monitoring There must be very disciplined and cost conscious trading capabilities Under this approach fund managers will: consider each broad segment of the benchmark, and within each segment select a set of US dollar denominated bonds that is representative of key benchmark traits The key traits of straight forward replication are: interest rate sensitivity credit quality sector diversification REPLICATION BY STRATIFIED SAMPLING To replicate the stratified sampling bond index, an investor must: represent every important part that it has with a few securities the holdings of securities in a particular cell are usually computed to match that cell’s contribution to the overall duration Steps to replicate the stratified sampling bond index: 1. a portfolio manager maps a benchmark to an arbitrary grid, or dividing the index into cells, each cell representing a different characteristic 2. sets portfolio allocations to each of the cells that match those of the benchmark, or buying bonds to match those characteristics set forth in
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This note was uploaded on 04/07/2012 for the course ECONOMICS 101 taught by Professor Tillet during the Spring '12 term at Broward College.

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