Fixed Income Analysis, Second Edition

CHAPTER 18

MANAGING FUNDS AGAINST A BOND MARKET INDEX

I. INTRODUCTION

The benchmark for a manager can be either a bond market index or liabilities. In this chapter, we provide an overview of strategies for managing funds against a bond market index. We restrict our discussion to domestic bond markets, specifically the U.S. bond market, in the illustrations in this chapter. In Chapter 20, we cover global bond investing. In Chapter 19, we discuss strategies for managing funds when the benchmark is one or more liabilities.

II. DEGREES OF ACTIVE MANAGEMENT

In the previous chapter we discussed the risk factors associated with a bond portfolio and a bond market index. One can classify bond portfolio strategies in terms of the degree to which a manager constructs a portfolio with a risk profile that differs from the risk profile of the benchmark index. Kenneth Volpert of the Vanguard Group has classified bond portfolio strategies as follows:²⁸⁶

1. pure bond index matching

2. enhanced indexing/matching risk factors

3. enhanced indexing/minor risk factor mismatches

4. active management/larger risk factor mismatches

5. unrestricted active management

We discuss each of these strategies below.

A. Pure Bond Index Strategy

In terms of risk and return, the strategy with the least risk of underperforming the index is a pure bond index matching strategy.

1. Reasons for Indexing There are several reasons that support a bond indexing strategy. First, empirical evidence suggests that historically ...