3.

2 Indexing (pure and enhanced)

Why would an investor consider investing in an indexed portfolio?
 lower fees than actively managed accounts (non-advisory fees also much lower)

 outperforming a broadly based market index on a consistent basis is difficult

 index provide excellent diversification  lower risk for a given level of return than other less
diversified portoflios (provide US bond market indices that show this)

3.2.1 Selection of a Benchmark Bond Index

Which index should I choose? Short or long duration? Is the credit quality appropriate for my
portfolio? You should choose an index with characteristics which match the desired characteristics of
your portfolio.

The choice depends heavily on four factors (example?):

 Market value risk: inherent possibility that a bond's price will fluctuate due to overall market
movements, desired market value risk of the portfolio of portfolio and index should be
comparable. Given a normal upward-sloping yield curve, a bond portfolio’s yield to maturity
increases as the maturity of the portfolio increases. Does this mean that the total return is
greater on a long portfolio than on a short one? Not necessarily. Because a long duration
portfolio is more sensitive to changes in interest rates, a long portfolio will likely fall more in
price than a short one when interest rates rise. In other words, as the maturity and duration of
a portfolio increases, the market risk increases.

 Income risk: index should provide an income stream comparable to that desired for the
portfolio. Investing in a long portfolio can lock in a dependable income stream over a long
period of time and does not subject the income stream to the vagaries of fluctuating interest
rates. If stability and dependability of income are the primary needs of the investor, then the
long portfolio is the least risky and the short portfolio is the riskiest.

 Credit risk: average credit risk should be appropriate for the role in the investor’s overall
portfolio and satisfy any constraints placed on credit quality in the investor’s investment
policy statement. Diversification among issuers is fundamental to minimize this risk.

 Liability framework risk: this risk should be minimized. It is prudent to match the investment
characteristics of assets and liabilities. The choice of an appropriate index reflects the nature
of the liabilities. Investors with long-term liabilities would choose a long index. Investors with
no liabilities have a much more flexible choice of the index.

For the taxable investor, returns and risk need to be evaluated on an after-tax basis.

From a macro perspective, the bond market may be separated into sectors in which similar securities
are grouped together. Bond market may be divided by:
- Issuer (corporate bonds, government bonds, asset-backed securities and mortgage-backed
securities)
 - Credit risk sector (investment-grade bonds with low credit risk and high yield bonds with high
credit risk)

Even finer sectors could be defined:

- Corporate bonds can be divided into industrial, utility and financial sectors.
- Investment grade bonds can be divided by the specific investment rating.

Bonds can also be separated by other key features such as:

- Maturity
- Fixed/floating coupons rates
- Callable/non-callable
- Link to inflation or not

(example 1 pg.538-539???)

3.2.2 Bond Index Investability and Use as Benchmarks

Many bond indices are difficult to track and not fully investable. Creation of a bond index requires
many decisions and choices:

 country

 credit risk

 liquidity

 maturity

 currency

 sector classification
Compared with equities there are more issuers of bonds.

Most issuers have only one type of common stock outstanding but several bond issues of different
maturities, seniority and other features.

Total market capitalization of the global bond market was almost twice as large as the global equity
market (look for data)
Infrequent trading

Most bond issues have less active secondary markets (compared with equities), and may not trade on
a daily basis or their trades may not be reported if they do not trade through a centralized center:

 The values of many issues constituting bond indices do not represent recent trading but are
often estimated on the basis of the inferred current market value from their characteristics.
 Delays in data about spreads used in price estimation can cause large errors in valuation
(corporate bond market trading data have typically been less readily accessible than equity).
Infrequent trading can be explained by:
  the long-term investment horizon of many bond investors

 limited number of distinct investors in many bond issues

 limited size of many bond issues

Also, corporate bond market trading data have typically been less readily accessible than equity
trading data.

As a consequence of these facts many bond indices are not as investable as major equity indices. One
issue with bond index investability is, because of the infrequent trading, heterogeneity and limited
size of bond issues, that a passive manager faces challenges in tracking a broad index.

Impact on price from investing in less frequently traded bonds can be substantial due to their
illiquidity.

 Discount on Sale: When you need to sell an illiquid bond, you might have to accept a lower
price than its fair market value. This is because there might be fewer potential buyers for the
bond, and you may need to offer a discount to incentivize someone to take it off your hands.

 Wider Bid-Ask Spread: Illiquid bonds typically have a wider bid-ask spread. The bid price
is the highest price a buyer is willing to pay, and the ask price is the lowest price a seller is
willing to accept. With fewer buyers and sellers, the spread between these prices widens,
further reducing the price you can potentially receive when selling.

 Increased Difficulty in Rebalancing: If your portfolio strategy targets a specific asset

allocation between bonds and other investments, illiquid bonds can make it harder to
rebalance when needed. To rebalance, you might need to sell some bonds, but if they're
illiquid, it can be challenging to find a buyer at a fair price.

 Potential for Fire Sale: In times of market stress, when investors are rushing to sell assets,
the lack of liquidity in your bond portfolio can be particularly problematic. You might be
forced to sell your bonds at fire-sale prices to meet your cash needs.

Heterogeneity

Bond indices that appear similar may have very different composition and performance (example).

 S&P 500 Bond Index vs. Bloomberg Barclays Global Aggregate Bond Index (Global
Agg)
o Similarity: Both indices track a large basket of bonds. The S&P 500 Bond Index
focuses on US investment-grade corporate bonds issued by the largest 500 companies
in the US stock market. The Global Agg tracks a much wider range of bonds globally,
including government, corporate, and some securitized debt.
o Difference in Composition: The key difference lies in the geographic scope and credit
quality. The S&P 500 Bond Index focuses solely on US corporate bonds, while the
Global Agg offers exposure to bonds from developed and emerging markets, including
government and corporate bonds with varying credit quality.
Assumptions concerning the reinvestment of coupon income are not consitent across indices because
some reinvest at a short-term rate and others do not.
Imagine two bond indices tracking a basket of similar investment-grade corporate bonds in the US:

 Index A: Short-Term Reinvestment (STR)

 Index B: Long-Term Reinvestment (LTR)

Both indices assume all coupon payments are automatically reinvested, but with different
assumptions about the reinvestment rate:

 STR: Reinvests coupons at a hypothetical short-term interest rate, like the yield on a 1-year
Treasury bill. (Let's assume a current short-term rate of 2% for this example).

 LTR: Reinvests coupons at a hypothetical long-term interest rate, like the yield on a 10-year
Treasury note. (Let's assume a current long-term rate of 5% for this example).

Scenario:
Both indices start by tracking the same basket of bonds with a 4% annual coupon rate. After one year,
let's say:
 The interest rates remain unchanged (short-term at 2% and long-term at 5%).

 There are no significant changes in the underlying bond prices within the indices. (This
simplifies the example to focus on reinvestment assumptions).

Impact on Total Returns:

Index A (STR):
 Earns the 4% coupon payment on the bonds.

 Reinvests the coupon at the assumed short-term rate of 2%.

 Total return for Index A after one year: 4% (coupon) + 2% (reinvestment) = 6%

Index B (LTR):
 Earns the 4% coupon payment on the bonds.

 Reinvests the coupon at the assumed long-term rate of 5%.

 Total return for Index B after one year: 4% (coupon) + 5% (reinvestment) = 9%

Composition

Index composition tends to change frequently. Bond indices are usually recreated monthly.

 charcteristics of outstanding bonds are continually changing as maturities change (issuers sell
new bonds and call in others)

As the composition changes, index’s risk does too

  shift in index weighting from government to corporate bonds would result in greater index
risk (use this as example, make the question which change in the composition of the index
would change its risk?)

 A bond portfolio manager needs to watch how new bond offerings affect the makeup of the
index. Index changes can still impact investors, even if their individual bonds are affected
similarly. Still, investors tracking a bond index still need to be aware of potential composition
shifts to understand the evolving risk profile of their investment. (check again)

Bums

Bums are issuer a lot of debt. Because of this big debt they are considered riskier and not performing.
Capitalization-weighted bond indices give more weight to issuers that borrow the most.

 More risk for investors: Bond indexes that favor "bums" can be riskier overall. Investors
following these indexes might end up holding riskier bonds than they intended.

 Not as efficient: These indexes might not be the most efficient way to invest. They might not
offer the best balance between risk and return.
Solutions:

 Capped Indexes: Some bond indexes try to solve this by limiting how much of the index any
one issuer can own. This reduces the risk from "bums."  Trade-off: Capped indexes might
include smaller, less traded bonds. These can be harder to buy and sell quickly, which can be
inconvenient for investors.

 Equal weighted indices, GDP-weighted indices, fundamental-weighted indices

Such weighting schemes may not solve the problem entirely, they may contain less-liquid bonds or
may be constructed using subjective inclusion criteria

Portfolio matching

Investors may not be able to find a bond index with risk characteristics that match their portfolio’s
exposure. Bonds differ in terms of

 credit rating

 duration

 prepayment risk

 others

bond index will have its unique exposure, unlikely to exactly match that desired for the portfolio.
Risk characteristics of a bond index will reflect the bond issuers’ preferences, which are not
necessarily the same as those of the investors.

If bond indices are not investable we cannot epect a manager to match its performance. Bond indices
often do not serve as valid benchmarks.

For many investors the typical bond index is not replicable or will not serve as an optimal benchmark.
The passive manager usually buys a representative subset of the index (samplig approach).

Example from the book???

3.2.3 Risk Profiles

Manager’s goal is to build a portfolio that mimics the characteristics of the benchmark index. (exhibit
2).

Identification and measurement of risk factors will play a role both in index selection and portfolio
construction.

Major source of risk is the yield curve

 parallel shift

 twist

 other curvature changes

When assessing bond market indices as potential candidates manager must examine each index’s risk
profile: how sensitive is the index’s return to

 Changes in the level of interest rates - Interest rate risk

 Changes in the shape of the yield curve - Yield curve risk

 Changes in the spread between treasuries and non-treasuries - Spread risk

 Issuer of the bond will default and not repay the principal amount you invested, or make the
promised interest payments - Credit risk

 Callable bonds - Optionality risk

 Risk that the entire sector a company operates in experiences a downturn - Sector risk

 Interest rates fall, borrowers are more likely to refinance with a lower rate, and the investor
loses out on the promised interest from the original bond (loans backed bonds)- Prepayment
risk
 How much the price of a bond changes when interest rates move. Bonds with embedded
options, like prepayment options in mortgages, can have convexity. It means the price change
isn't a straight line but a curve. So, larger interest rate movements can have a bigger impact
on the bond's price than expected. - Convexity risk

Various techniques to align the portfolio’s risk exposures with those of the index:

- Cell matching technique, divides the index into cells that represent qualities designed to
reflect the risk factors of the index. selects bonds from those in each cell to represent the entire
cell taking account of the cell’s relative importance to the index.
What does it mean?
- Multifactor model technique, it makes use of a set of factors that drive bond returns.
 1. Duration, index’s duration measures the sensitivity of the index’s price to small
parallel shifts in interest rates. Inadequate since large changes are not rare so we would
need a convexity adjustment.
2. Key rate duration and PV distribution of CF, these two separate measures can capture
non-parallel shifts in the yield curve. Key rate measures shifts in key points of the
yield curve but one (hold spot rates constant for all points along the yield curve but
one  measure the portfolio’s sensitivity to a change in that maturity), the other
measure is a list that associates with each time period the fraction of the portfolio’s
duration that is attributable to CF falling in that time period (show process!!! pg. 546)
a) portfolio’s creator will project the CF for each issue in the index for specific
periods. Total CF for each period is calculated by adding the CFs for all
issues. PV of each period’s cashflow is computed and a totPV is obtained by
adding individual periods’ PVs.
b) Each period’s present value is then divided by the total present value to arrive
at a percentage for each period.
c) Calculate the contribution of each period’s cash flows to portfolio duration.
Because each cash flow is effectively a zero-coupon payment, the time
period is the duration of the cash flow. By multiplying the time period times
the period’s percentage of the total present value, we obtain the duration
contribution of each period’s cash flows.
d) Add each period’s contribution to duration and obtain a total that represents
the bond index’s contribution to duration. We then divide each of the
individual period’s contribution to duration by the total.
If this distribution is duplicated, non-parallel shifts in the yield curve and twists in the
curve will have the same effect on the portfolio and the index.
3. Sector and quality percent, to ensure that the index’s yield is replicated by the
portfolio, manager matches the percentage weight in the various sectors and qualities
of the index.
4. Sector duration contribution, portfolio must achieve same same duration exposure to
each sector as the index.
5. Quality spread duration contribution, spread duration measures how a non-Treasury
security’s price will change as a result of the widening or narrowing of the spread.
Spread between qualities of bonds will affect the rate of return.
6. Sector/coupon/maturity cell weights, to match the call exposure we can match sector,
coupon and maturity weights of the callable sectors. As rates change, the changes in
call exposure of the portfolio will be matched to the index.
7. Issuer exposure, if manager attempts to replicate the index with too few securities,
issuer event risk takes on greater importance.

3.2.4 Tracking Risk

The tracking risk tells you how closely your portfolio actually follows the benchmark. It basically
measures the unexpected difference in returns between your portfolio and the benchmark.
Tracking risk arises primarily from mismatches between a portfolio’s risk profile and the
benchmark’s risk profile. The previous section listed seven primary risk factors that should be
matched closely if the tracking risk is to be kept to a minimum. Any change to the portfolio that
increases a mismatch for any of these seven items will potentially increase the tracking risk.

1. Portfolio duration: If the benchmark’s duration is 5.0 and the portfolio’s duration is 5.5, then
the portfolio has a greater exposure to parallel changes in interest rates, resulting in an increase
in the portfolio’s tracking risk.
2. Key rate duration and present value distribution of cash flows. Mismatches in key rate
duration increase tracking risk. In addition, if the portfolio distribution does not match the
benchmark, the portfolio will be either more sensitive or less sensitive to changes in interest
rates at specific points along the yield curve, leading to an increase in the tracking risk.
3. Sector and quality percent. If the benchmark contains mortgage-backed securities and the
portfolio does not, for example, the tracking risk will be increased. Similarly, if the portfolio
overweights AAA securities compared with the benchmark, the tracking risk will be increased.
4. Sector duration contribution. Even though the sector percentages (e.g., 10 percent Treasuries,
4 percent agencies, 20 percent industrials) may be matched, a mismatch will occur if the
portfolio’s industrial bonds have an average duration of 6.2 and the benchmark’s industrial
bonds have an average duration of 5.1. Because the industrial sector’s contribution to duration
is larger for the portfolio than for the benchmark, a mismatch occurs and the tracking risk is
increased.
5. Quality spread duration contribution. Exhibit 5 shows the spread duration for a 60-bond
portfolio and a benchmark index based on sectors. Th e portfolio’s total contribution to spread
duration (3.43) is greater than that for the benchmark (2.77). Th is difference is primarily
because of the overweighting of industrials in the 60-bond portfolio. Th e portfolio has greater
spread risk and is thus more sensitive to changes in the sector spread than the benchmark is,
resulting in a larger tracking risk.
6. Sector/coupon/maturity cell weights.
7. Issuer exposure.