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When the performance of an investment grade corporate bond portfolio is compared to a relevant bond index, which of the following statements about tracking error is TRUE?

A)	If the return on the bond portfolio is substantially lower than the return on the bond index the tracking error is small.

B)	If the return on the bond portfolio closely matches the return of the bond index the tracking error is small.

C)	Tracking error refers to how closely the return on the bond index matches traders' expectations and is not related to the return on the bond portfolio.

D)	If return on the bond index varies by a much larger amount than the return on the bond portfolio over the same period, the portfolio has low tracking error.

Tracking error is incurred when the return on the bond portfolio deviates from the return on the bond index. Greater deviation means higher tracking error.

Which of the following bond portfolio investment strategies has active management and is aggressive with large mismatches in all risk factors, including duration?

A)	Pure bond index matching.

B)	Active management /larger risk factor mismatches.

C)	Enhanced indexing/matching primary risk factors.

D)	Active management/full-blown active.

Active management/full blown active is the most actively managed type of bond portfolio and also has the highest potential returns and tracking error. On the opposite end of relative management activity is pure bond indexing which attempts to 100% replicate the index, resulting in the lowest tracking error of the alternative enhancement strategies.

Enhanced indexing/minor risk factor mismatches is a bond portfolio management style that:

A)	has substantial deviation from the relevant bond index in the average quality of the bonds.

B)	has the same degree of tracking error as pure bond index matching.

C)	does not deviate from the duration of the relevant bond index.

D)	minimizes transaction costs and management fees.

Enhanced indexing/minor risk factor mismatches does allow for some relative-value analysis by incorporating minor mismatches in sector and quality risk factors. There is no deviation from the duration of the index.

Which of the following bond management styles results in a portfolio that most closely resembles the return performance of a bond index?

A)	Active management/full blown active.

B)	Enhanced indexing/ matching primary risk factors.

C)	Enhanced indexing/minor risk factor mismatches.

D)	Active management/larger risk factor mismatches.

Enhanced indexing/matching primary risk factors does not try to fully replicate the index, as the pure bond approach does. This style uses a large sample of bonds to represent the risk factors present in the index, and, as a result, more closely resembles the index than the others listed.

Which of the following is a difference between enhanced indexing by matching primary risk factors and enhanced indexing that allows minor risk factor mismatches? Enhanced indexing by matching primary risk factors:

A)	is essentially an active management strategy.

B)	allows larger mismatches between the index and portfolio return.

C)	involves fully replicating the index by owning all the bonds in the index.

D)	allows smaller mismatches between the index and portfolio return.

Matching by primary risk factors means that the portfolio will be exposed to the same broad market moving movements as the index. Enhanced indexing with minor risk factor mismatches means that the portfolio will have the same duration as the index, but will have differential movements from the index due to sector, quality, term structure, etc mismatches. Hence, the matching by primary risk factors will tend to yield smaller differences between index and portfolio returns.

Fixed Income Asset Management, Incorporated, (FIAM) has traditionally managed fixed income portfolios for pension and endowment funds employing immunization and cash matching strategies. Recently, FIAM has accepted the responsibility for managing funds for which indexed and enhanced indexed strategies are appropriate. Ms. Debra C. Truxell, CFA, a senior manager at FIAM, has been promoted to Vice President for Index Bond Fund Management to lead the company in this new direction. To staff this effort, Truxell had to recruit several new employees. Since most of the newly hired employees had little experience with indexing strategies, Truxell thought it would be prudent to conduct a series of in-house training seminars.

Cara Moore, an expert in bond indexing strategies, presented the first seminar. She opened the session with a discussion of the risk characteristics that distinguish bond management styles. She stated the key risk factor that distinguishes indexing from active management is that indexing takes no position on duration, but may differ in terms of sector, yield expectations, and quality differences. The differences depend upon how far the portfolio falls along the indexing versus active management continuum.

Moores associate, James Higgins, noted that lower costs, diversification, and stable performance are all advantages of indexing a portfolio to a large, well-diversified bond index. He also said, Simple replication of a bond index such as the Lehman Brothers Aggregate Bond Index is known as pure bond indexing. I recommend pure bond indexing for most passively managed portfolios because it is the most efficient means of reducing tracking error and is the easiest indexing strategy to implement in most circumstances. Truxell supported his statement by saying, The greatest cost benefit of indexing lies in pure bond indexing.

During the second seminar, lead by Pilar Newman, the topic of matching based on various risk factors was addressed. One participant asked "Is it sufficient to match the duration of the indexed portfolio to the duration of the bond index to control for the primary risks of the bond index?" Newman replied, Yes, that is precisely how portfolio managers protect against non-parallel shifts in the yield curve. A second participant asked if modified duration is the appropriate measure of interest rate risk and Newmans partner Martin George replied, While modified duration accurately measures interest rate risk for bullet bonds, it does not accurately measure interest rate risk for bonds with embedded options. Newman added that matching the sector, coupon, and maturity weights of the callable sectors of a bond index results in a better matching of the convexity of the index, which is desirable.

Nicholas Morgan, a long-time FIAM employee, is interested in implementing call exposure positioning. He understands that when bonds move from being priced to call to being priced to maturity, returns can be enhanced by increasing the portfolios relative exposure to call risk. He notes bonds that are priced to maturity tend to underperform when rates fall and bonds that are priced to call tend to underperform when rates rise. Morgan tells Truxells staff that they need to factor this in when implementing a call exposure enhancement strategy.

A)	Moore is correct regarding the primary factor that distinguishes indexing from active management; Truxell is correct regarding the cost savings from pure bond indexing.

B)	Moore is correct regarding the primary factor that distinguishes indexing from active management; Truxell is incorrect regarding the cost savings from pure bond indexing.

C)	Moore is incorrect regarding the primary factor that distinguishes indexing from active management; Truxell is incorrect regarding the cost savings from pure bond indexing.

D)	Moore is incorrect regarding the primary factor that distinguishes indexing from active management; Truxell is correct regarding the cost savings from pure bond indexing.

Moore is correct. A full-blown active management strategy takes an aggressive approach to risk factor mismatches, including duration. Enhanced indexing maintains the same duration as the index. It is not until one moves up the risk spectrum into active strategies that a position regarding duration is taken.

Truxell is incorrect in her assessment of the cost savings from pure bond indexing. Full replication is extremely costly. In general, it is more difficult to fully replicate a bond index than a stock index.

A)	correct both with respect to the advantages of indexing and in his conclusions regarding pure bond indexing.

B)	incorrect both with respect to the advantages of indexing and in his conclusions regarding pure bond indexing.

C)	incorrect with respect to the advantages of indexing, but correct in his conclusions regarding pure bond indexing.

D)	correct with respect to the advantages of indexing but incorrect in his conclusions regarding pure bond indexing.

Higgins is correct regarding the advantages of indexing. Diversification, lower costs, and stable performance relative to a non-indexed portfolio are all advantages of indexing. However, pure bond indexing is expensive and difficult to implement in a fixed-income portfolio due to the illiquidity of many of the bonds in the index. Therefore, Higgins is incorrect in the conclusions he draws regarding pure bond indexing (or full replication).

A)	As a matter of fact this type of matching is the best way to assure that the tracking error attributable to a yield shift is minimized.

B)	It is not sufficient. Sector cell weighting is the recommended strategy to control for primary risk factors.

C)	Matching the primary risk factors of the index such as duration, cash flow, sectors, quality, and callability is the most effective method".

D)	The duration matching technique described is consistently effective for Treasury index portfolios only.

A)	overweighting 1-5 year Treasuries and underweighting 1-5 year corporates.

B)	underweighting long-term Treasuries and overweighting long-term corporates.

C)	overweighting long-term Treasuries and underweighting long-term corporates.

D)	underweighting 1-5 year Treasuries and overweighting 1-5 year corporates.

A)	George is correct; Newman is incorrect regarding matching the convexity of the index.

B)	George is correct; Newman is also correct regarding matching the convexity of the index.

C)	George is incorrect; Newman is correct regarding matching the convexity of the index.

D)	George is incorrect; Newman is also incorrect regarding matching the convexity of the index.

George is correct, modified duration does not effectively measure the interest rate risk of bonds with embedded options - we must use effective duration for that task. Newman is also correct regarding her statement about convexity. Matching the sector, coupon, and maturity weights of the callable sectors results in a better match of the convexity of the index.

A)	correct in assuming that returns may be enhanced when a callable bond moves from being priced to call to being priced to maturity, however, he does not understand the relationship between interest movements and the performance of callable bonds.

B)	incorrect in assuming that returns may be enhanced when a callable bond moves from being priced to call to being priced to maturity. He also does not understand the relationship between interest movements and the performance of callable bonds.

C)	correct in assuming that returns may be enhanced when a callable bond moves from being priced to call to being priced to maturity, and he understands the relationship between interest rate movements and the performance of callable bonds, which will allow him to profit from rate changes.

D)	incorrect in assuming that returns may be enhanced when a callable bond moves from being priced to call to being priced to maturity. However, he does understand the relationship between interest rate movements and the performance of callable bonds, which will allow him to profit from rate changes.

Morgan is correct in assuming that returns can be enhanced by increasing a portfolios relative exposure to call risk when a callable bond moves from being priced to call to being priced to maturity. However, he is backwards when it comes to over and underperformance of callable bonds when interest rates change. Bonds that are priced to call underperform when rates decline and bonds that are priced to maturity underperform when rates increase. The reason is that callable bonds cap out when rates fall and dont fall as much as noncallable bonds when rates rise due to negative convexity.