The Mathematics of Financial Modelingand Investment Management

21-Bond Portfolio Man Page 650 Wednesday, February 4, 2004 1:12 PM

650 The Mathematics of Financial Modeling and Investment Management

calculations.^2 The specialized bond market indexes focus on one sector

of the bond market or a subsector of the bond market.

There are risk factors associated with a bond market index which

we discuss later in this chapter. The proper way to categorize bond port-

folio strategies is in terms of the degree to which a manager constructs a

portfolio with a risk profile that differs from the risk profile of the bond

market index that is the manager’s benchmark. The following general

categorization of bond portfolio management strategies has been pro-

posed by Kenneth Volpert of the Vanguard Group:^3

■ Pure bond index matching

■ Enhanced indexing/matching risk factors

■ Enhanced indexing/minor risk factor mismatches

■ Active management/larger risk factor mismatches

■ Active management/full-blown active

In terms of risk and return, a pure bond index matching strategy

involves the least risk of underperforming a bond market index.

An enhanced indexing strategy can be pursued so as to construct a

portfolio to match the primary risk factors associated with a bond mar-

ket index without acquiring each issue in the index. While in the spec-

trum of strategies defined by Volpert this strategy is called an “enhanced

strategy,” some investors refer to this as simply an indexing strategy.

Two commonly used techniques to construct a portfolio to replicate an

index are cell matching (stratified sampling) and tracking error minimi-

zation using a multifactor risk model. Both techniques assume that the

performance of an individual bond depends on a number of systematic

factors that affect the performance of all bonds and on an unsystematic

factor unique to the individual issue or issuers. With the cell matching

approach the index is divided into cells representing the risk factors.

The objective is then to select from all of the issues in the index one or

more issues in each cell that can be used to represent that entire cell.

This approach is inferior to the second approach, minimizing tracking

error using a multifactor risk model discussed later.^4

Another form of enhanced strategy is one in which the portfolio is

constructed so as to have minor deviations from the risk factors that affect

the performance of the index. For example, there might be a slight over-

(^2) The securities in the SSB BIG index are all trader priced. For the two other indexes,
the securities are either trader priced or model priced.
(^3) Kenneth E. Volpert, “Managing Indexed and Enhanced Indexed Bond Portfolios,”
Chapter 3 in Frank J. Fabozzi (ed.), Fixed Income Readings for the Chartered Financial
Analyst Program: First Edition (New Hope, PA: Frank J. Fabozzi Associates, 2000).