Describe advantages and disadvantages of bond indexing relative to active bond management.

QUESTION

Carol Harrod is the investment officer for a $100 million U.S. pension fund. The fixed-income portion of the portfolio is actively managed, and a substantial portion of the funds large capitalization U.S. equity portfolio is indexed and managed by Webb Street Advisors.
Harrod has been impressed with the investment results of Webb Streets equity index strategy and is considering asking Webb Street to index a portion of the actively managed fixed income portfolio.
a. Describe advantages and disadvantages of bond indexing relative to active bond management.
b. Web Street manages indexed bond portfolios. Discuss how an indexed bond portfolio is constructed under stratified sampling (cellular) methods.
c. Describe the main source of tracking error for the cellular method.
Active Bond Management The objective of an actively traded bond fund is to outpace a individual index The managers expect the sec unties that they hold will do better than the overall index For this they do lots of investigate. There are two sources of profit by full of life management of bonds first through concentration rate forecasting. It tries to assess the pressure group across the fixed-income market if the rate assessed to rise, then the managers will decrease the duration the other source of profit is the classification of the misspending within the market these sources generate abnormal returns. Bond indexing refers to investing in a portfolio of bonds which is premeditated to match the performance of a scrupulous index The manager only holds the securities that are in the index So. Whenever the piece of music of the index changes, so will the holdings in the fund. Lower fees: To manage the funds it requires fewer possessions. The savings made through this could be passed to the investors if the funds are of a particular category. Then investors can shop for the fund with the lowest fee. Consistent presentation the managers know what to expect, as the fund held by them is a representative of the broader market it reduces the opportunity of underperforming Duration: When the benchmark of indexing bonds is expected to fall the managers can increase the extent of the portfolio and vice versa. that the managers will move identically to the market movement.

There may be situations where the mangers may outperform the index at the same risk level Participation: The indexed funds include in them only the bonds of the benchmarked index. It neglects other sectors which might be growing This limits the chance of the managers to make profit from the market Objectives of the investor The selected index may be doing good, but may not be converging with the objectives of the investor (b) Stratified Sampling It is a statistical tool Here, the population is divided into subpopulations (cells) and random samples are taken of each cell Each cell represents different characteristics of the index, and is well thought-out to be homogeneous within The cells are formed taking into consideration features like duration, coupon rate, prime of life. Credit rating and the like the percentages of the universe falling within each cell are computed. To represent the cell the manager then selects at random one or more bond issues the each cell composes the total market weight of issues on the selected indexs piece of music of that characteristic. (c) Tracking Error The difference between the price of an indexed collection and the price of the standard is called tracking error the difference in the presentation of the portfolio and the benchmark result in an startling profit or loss. The significant amount of tracking error occurs with the cellular method. When the amount invested is small in respect and the number of cells to be repeated is large because of the need to buy odd loss of issues in order to truthfully represent the required cells They are purchased at higher prices than round lots If the number of cells is reduced, to limit the compulsory number of odd lots would then potentially increase tracking error because of the mismatch with the benchmark index.

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