1、Chapter 24 Indexing Learning ObjectivesAfter reading this chapter, you will understandv the objectives and motivation for bond indexingv the advantages and disadvantages of bond indexingv the three major broad-based bond market indexesv the sectors of the broad-based indexesv the three methodologies
2、 used for constructing an indexed portfolioLearning Objectives(continued)After reading this chapter, you will understandv the difficulties associated with implementing a bond indexing strategyv the objectives and motivation for enhanced bond indexingv the strategies used in enhanced indexingObjectiv
3、e of and Motivation for Bond Indexingv Bond indexing means designing a portfolio so that its performance will match the performance of some bond index.v In indexing, performance is measured in terms of total rate of return achieved (or simply, total return) over some investment horizon.v Total retur
4、n over some investment horizon incorporates all sources of return from holding a portfolio of bonds.Objective of and Motivation for Bond Indexing (continued)v Several factors explain the popularity of bond indexing. First, the empirical evidence suggests that historically the overall performance of
5、active bond managers has been poor. Second is the reduced advisory management fees charged for an indexed portfolio compared to active management advisory fees. Lower nonadvisory fees are a third explanation for the popularity of indexing.Objective of and Motivation for Bond Indexing (continued)v Ad
6、visory fees charged by active managers typically range from 15 to 50 basis points.v The range for indexed portfolios, in contrast, is 1 to 20 basis points, with the upper range representing the fees for enhanced and customized benchmark funds, discussed later in this chapter.Objective of and Motivat
7、ion for Bond Indexing (continued)v Sponsors have greater control over external managers when an indexing strategy is selected. For example, in an actively managed portfolio, a sponsor who specifies a restriction on the portfolios duration still gives the manager ample leeway to pursue strategies tha
8、t may significantly underperform the index selected as a benchmark. In contrast, requiring an investment advisor to match an index gives little leeway to the manager and, as a result, should result in performance that does not significantly diverge from a benchmark.Objective of and Motivation for Bo
9、nd Indexing (continued)v Critics of indexing point out that although an indexing strategy matches the performance of some index, the performance of that index does not necessarily represent optimal performance.v Moreover, matching an index does not mean that the manager will satisfy a clients return
10、 requirement objective.v Matching an index means that a money manager is restricted to the sectors of the bond market that are in the index, even though there may be attractive opportunities in market sectors excluded from the index.Objective of and Motivation for Bond Indexing (continued)v At the t
11、heoretical level, there are the well-known benefits of diversification as set forth in the Markowitz mean-variance portfolio theory.v Capital market theory tells us a market portfolio offers the highest level of return per unit of risk in an efficient market.v The market portfolio is a capitalizatio
12、n-weighted (value-weighted) portfolio of all risky assets.v Exhibit 24-1 (see Overhead 24-10) summarizes the advantages and disadvantages of bond indexing.Exhibit 24-1 Advantages and Disadvantages of Bond IndexingAdvantagesDisadvantagesNo dependence on expectations and little risk of underperforming
13、 the indexBond indexes do not reflect optimal performanceReduced advisory and nonadvisory feesBond index may not match the sponsors liabilitiesGreater sponsor controlRestrictions on fund; management ignores opportunitiesFactors to Consider in Selecting an Indexv A money manager who wishes to pursue
14、an indexing strategy must determine which bond index to replicate.v There are a number of bond indexes from which to select, and several factors influence the decision.i. The first is the investors risk tolerance.ii. The second factor influencing the selection of an index is the investors objective.
15、Bond Indexesv The wide range of bond market indexes available can be classified as broad-based market indexes and specialized market indexes.v Broker/dealer firms developed and aggressively marketed their bond indexes because of the potential profit that the firm will make by executing trades to set
16、 up an indexed portfolio and rebalance it.v Typically, a broker/dealer charges a money manager who wants to set up or rebalance an index a nominal amount for providing the necessary data but expects that the bulk of the trades will be executed through its trading desks.Bond Indexes (continued)v The
17、two broad-based U.S. bond market indexes most commonly used by institutional investors arei.the Lehman Brothers U.S. Aggregate Bond Indexii. the Salomon Smith Barney (SSB) Broad Investment-Grade Bond Index (BIG)v There are more than 5,500 issues in all three broad-based indexes. They include only in
18、vestment-grade securities. Each index is a market-value weighted index. The pricing of the securities in each index is as follows. 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. Each index is broken into
19、sectors.Bond Indexes (continued)v For the Lehman Brothers U.S. Aggregate Bond Index, the agency sector includes agency debentures, not mortgage-backed or asset-backed securities issued by federal agencies.v The mortgage pass-through sector includes agency pass-through securities.v What are not inclu
20、ded in the index are agency collateralized mortgage obligations and agency stripped mortgage-backed securities.v These mortgage derivatives products are not included because it would be double counting since they are created from agency pass-throughs.Indexing Methodologiesv After a money manager has
21、 decided to pursue an indexing strategy and has selected an index (broad-based bond market index, specialized market index, or customized benchmark), the next step is to construct a portfolio that will track the index.v Any discrepancy between the performance of the indexed portfolio and the index (
22、whether positive or negative) is referred to as tracking error.v Tracking error has three sources:i.transaction costs in constructing the indexed portfolioii.differences in the composition of the indexed portfolio and the index itselfiii. discrepancies between prices used by the organization constru
23、cting the index and transaction prices paid by the indexerIndexing Methodologies (continued)v Generally speaking, the fewer the number of issues used to replicate the index, the smaller the tracking error due to transactions costs but the greater the tracking error risk due to the mismatch of the ch
24、aracteristics of the indexed portfolio and the index.v In contrast, the more issues purchased to replicate the index, the greater the tracking error due to transaction costs and the smaller the tracking error risk due to the mismatch of the indexed portfolio and the index.v Obviously, then, there is
25、 a trade-off between tracking error and the number of issues used to construct the indexed portfolio.Indexing Methodologies (continued)v There are three methodologies for designing a portfolio to replicate an index:i. the stratified sampling or cell approachii. the optimization approachiii. the vari
26、ance minimization approachv Each approach assumes that the performance of an individual bond depends on a number of systematic factors that affect the performance of all bonds and on a factor unique to the individual issue.Indexing Methodologies (continued)v Stratified Sampling or Cell ApproachUnder
27、 the stratified sampling approach to indexing, the index is divided into cells, each cell representing a different characteristic of the index.The most common characteristics used to break down an index are:1.duration2.coupon3.maturity4.market sectors (Treasury, corporate, mortgage-backed)5.credit r
28、ating6.call factors7.sinking fund featuresThe last two factors are particularly important because the call and sinking fund features of an issue will affect its performance.Indexing Methodologies (continued)v Stratified Sampling or Cell Approach Suppose that a manager selects the following character
29、istics to partite in a Treasury/agency/corporate bond index:Characteristic 1: effective duration range: (1) less than or equal to five years, and (2) greater than five yearsCharacteristic 2: maturity range: (1) less than five years, (2) between five and 15 years, and (3) greater than or equal to 15
30、yearsCharacteristic 3: market sectors: (1) Treasury, (2) agencies, and (3) corporatesCharacteristic 4: credit rating: (1) AAA, (2) AA, (3) A, and (4) BBB The total number of cells would be equal to 2 x 3 x 3 x 4 = 72.Indexing Methodologies (continued)v Stratified Sampling or Cell Approach The object
31、ive, then, is to select from all the issues in the index one or more issues in each cell that can be used to represent the entire cell. The total dollar amount purchased of the issues from each cell will be based on the percentage of the indexs total market value that the cell represents. For exampl
32、e, if 40% of the market value of all the issues in the index is made up of corporate bonds, 40% of the market value of the indexed portfolio should be composed of corporate bond issues.Indexing Methodologies (continued)v Stratified Sampling or Cell Approach The number of cells that the indexer uses
33、will depend on the dollar amount of the portfolio to be indexed. In indexing a portfolio of less than $50 million, for example, using a large number of cells would require purchasing odd lots of issues. This increases the cost of buying the issues to represent a cell and thus would increase the trac
34、king error. Reducing the number of cells to overcome this problem increases tracking error risk of index mismatch because the characteristics of the indexed portfolio may differ materially from those of the index.Indexing Methodologies (continued)v Optimization Approach In the optimization approach
35、to indexing, the money manager seeks to design an indexed portfolio that will match the cell breakdown and satisfy other constraints, but also optimize some objective. An objective might be to maximize the portfolio yield, to maximize convexity, or to maximize expected total returns. Constraints oth
36、er than matching the cell breakdown might include not purchasing more than a specified amount of one issuer or group of issuers, or overweighing certain sectors for enhanced indexing.Indexing Methodologies (continued)v Tracking Error Minimization using Multifactor Risk Models A portfolio can be cons
37、tructed such that its forward-looking tracking error is minimized. Vendors of multi-factor risk models provide software that permits the construction of a portfolio that will accomplish tracking error minimization. The forward-looking tracking error for each security included in the index is obtaine
38、d from a statistical analysis of historical returns.Logistical Problems in Implementing an Indexing Strategyv An indexer faces several logistical problems in constructing an indexed portfolio.i. First, the prices for each issue used by the organization that publishes the index may not be execution p
39、rices available to the indexer.ii. Second, there are logistical problems unique to certain sectors in the bond market.Logistical Problems in Implementing an Indexing Strategy (continued)v Consider the corporate bond market. Because of the illiquidity of this sector of the bond market, not only may t
40、he prices used by the organization that publishes the index be unreliable, but many of the issues may not even be available. Also, for the mortgage-backed securities market, the organizations that publish indexes lump all these issues into a few hundred generic issues. The indexer is then faced with
41、 the difficult task of finding pass-through securities with the same risk return profiles of these hypothetical issues.Logistical Problems in Implementing an Indexing Strategy (continued)v Recall that the total return depends on the reinvestment rate available on coupon interest.v If the organizatio
42、n publishing the index regularly overestimates the reinvestment rate, the indexed portfolio could underperform the index by 10 to 15 basis points a year.Enhanced Indexingv The objective of an enhanced indexing strategy is to replicate the total return performance of some predetermined index.v In enh
43、anced indexing (also called “indexing plus”), the objective is consistently to exceed the total return performance of the index by an amount sufficient to justify a higher management advisory fee and a higher level of risk of underperforming the index.v The total return on the index becomes the mini
44、mum total return objective rather than the target total return.v Thus enhanced indexing brings active strategies back into the portfolio management process, although they are assumed to employ only low-risk strategies.Enhanced Indexing (continued)v Basically, any departure of a portfolios compositio
45、n from that of the benchmark represents the risk exposure of a portfolio.v In plain vanilla indexing, the portfolio manager attempts to replicate the benchmark index as best as possible subject to the limitations discussed earlier regarding implementation.v In enhanced indexing, there is a controlle
46、d departure of the portfolios composition from that of the benchmark index.v As the departure from the benchmark index becomes greater, the portfolio manager crosses over into the area of active management.v Just where that crossover occurs differs from manager to manager.Enhanced Indexing (continue
47、d)vAnother way to define enhanced indexing is in terms of tracking error.vWhile there is no industry standard, Kenneth Volpert, principal and senior portfolio manager at The Vanguard Group, feels that under normal conditions a tracking error of one to 15 basis points per year is reasonable.vHowever,
48、 sampling risk has increased in recent years as corporate issuer “blow-ups” have occurred with greater frequency and with greater downside, which has resulted in actual tracking error being greater than model predicted tracking error.vMany multi-factor risk models are being recalibrated to capture t
49、his greater idiosyncratic credit risk.vFor enhanced bond indexing, tracking error ranges from 15 to 50 basis points under normal conditions.vThe range in the tracking error is due to the wide range of enhanced indexing portfolio strategies that can be pursued.Enhanced Indexing (continued)vAny of the
50、 strategies employed in enhanced indexing would involve only those issues in the Index.vAnother strategy for enhancing total return is to use securities not included in the index.vFor example, the broad-based indexes do not include derivative mortgage-backed securities, such as collateralized mortga
