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Bond Portfolio Management 651weighting of issues or sectors where the manager believes there is relative
value. A feature of this strategy is that the duration of the constructed
portfolio is matched to the duration of the benchmark index. That is,
there is no duration bet for this strategy, just as with the pure index match
strategy and the enhanced index with matching risk strategy.
Active bond strategies are those that attempt to outperform the
bond market index by intentionally constructing a portfolio that will
have a greater index mismatch than in the case of enhanced indexing.
Volpert classifies two types of active strategies. In the more conservative
of the two active strategies, the manager constructs the portfolio so that
it has larger mismatches relative to the benchmark index in terms of risk
factors. This includes minor mismatches of duration. Typically, there
will be a limitation as to the degree of duration mismatch that a client
will permit. In full-blown active management, the manager is permitted
to make a significant duration bet without any constraint.Tracking Error and Bond Portfolio Strategies
In Chapter 18, we explained forward-looking (ex ante) tracking error.
Tracking error, or active risk, is the standard deviation of a portfolio’s
return relative to the return of the benchmark index.^5 Forward-looking
tracking error is an estimate of how a portfolio will perform relative to
a benchmark index in the future. Forward-looking tracking error is used
in risk control and portfolio construction. The higher the forward-look-
ing tracking error, the more the manager is pursuing a strategy in which
the portfolio has a different risk profile than the benchmark index and
there is, therefore, greater active management.
We can think of the spectrum of bond portfolio strategies relative to
a bond market index in terms of forward-looking tracking error. In con-
structing a portfolio, a manager can estimate forward-looking tracking
error. When a portfolio is constructed to have a forward-looking track-
ing error equal or close to zero, the manager has effectively designed the
portfolio to replicate the performance of the benchmark. If the forward-
looking tracking error is maintained for the entire investment period,
the portfolio’s return should be close to zero. Such a strategy—one with(^4) For a discussion and illustration of both approaches to bond indexing, see Lev
Dynkin, Jay Hyman, and Vadim Konstantinovsky, “Bond Portfolio Analysis Rela-
tive to a Benchmark,” Chapter 23 in Frank J. Fabozzi and Harry M. Markowitz
(eds.), The Theory and Practice of Investment Management (Hoboken, NJ: John
Wiley & Sons, 2002).
(^5) There are two types of tracking error—backward-looking tracking error and for-
ward-looking tracking error. Backward-looking tracking error is calculated based on
the actual performance of a portfolio relative to a benchmark index.