The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

BEATING THE BENCHMARK INDEX

Once the index is selected, the next step is to manage the portfolio around that index while trying to outperform it—or generate “alpha.” The starting point in a typical investment strategy is a core view on the economy (GDP growth, inflation expectations, consumer behavior, employment picture, and so on.), which forms the basis of calls on asset prices going forward. For instance, in an environment where employment is rising, inflationary pressures are building, and there is a general surge in asset valuations, the Fed is likely to react by hiking rates, which in turn should give rise to higher rates and a flattening along the entire yield curve. Under these assumptions one could surmise, based on historical relationships, that high-quality asset spreads to Treasuries should widen. Therefore, a portfolio that is structured for this scenario (our “base case”) likely would have a short duration bias relative to the index, have curve flattening exposure, and be underweight spread products.

So far the above approach has taken into account only one dimension of investment decisions, namely return. Before executing the strategy, we would want to assess the risks to the portfolio should the markets behave differently than what is depicted in the base case scenario. Typically, that involves stress-testing the portfolio under alternative (risk) scenarios. In other words, one would shock the curve and spreads in different ways and monitor the performance ...