Reading 27: Fixed-Income Portfolio ManagementPart I－LOS d matching, justify, label, class, means

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CFA Institute Area 8-11, 13: Asset Valuation
Session 8: Management of Passive and Active Fixed Income Portfolios
Reading 27: Fixed-Income Portfolio ManagementPart I
LOS d: Review and justify the means, such as matching duration and key rate durations, by which an enhanced indexer may seek to align the risk exposures of the portfolio with those of the benchmark bond index.

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Bruce Turner, CFA, is composing a fund to track a benchmark bond index. He decides to use enhanced indexing by matching primary risk factors. This method aligns the risk exposures of the portfolio by investing in:

A) all the bonds in the index in the same proportion as the index and using derivatives to enhance the returns.

B) all the bonds in the index in the same proportion as the index and using leverage to enhance returns.

C) a sample of bonds to match the primary index risk factors with the goal of minimizing construction and maintenance costs.

D) futures contracts and Treasury bills to artificially track the index.

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Answer and Explanation

Choosing a sample of bonds to match the primary risk factors is called enhanced indexing by matching primary risk factors. The goal is to match the risk factors while lowering construction and maintenance costs. The manager can also be selective when choosing the sample and try to select bonds that are the most undervalued.

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In aligning the risk exposures of a bond portfolio to those of a benchmark bond index, the purpose of matching key rate durations is:

A) to make adjustments for convexity.

B) to better match cash flows.

C) to hedge twists of the yield curve.

D) to lower call risk.

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Answer and Explanation

Matching total duration will not necessarily hedge against changes in shape of the yield curve. Matching the durations of a few key rates along the yield curve will better hedge the fund against twists of the yield curve.

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The goal of enhanced indexing by small risk factor mismatches is to:

A) choose a subset of risk factors to match and manage, which may or may not include matching duration.

B) choose a subset of risk factors to match and manage while reducing duration to zero

C) match duration while allowing the manger to tilt the portfolio in favor of other risk factors.

D) match duration with a sample of bonds that are presumably undervalued so as to produce a higher return.

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Answer and Explanation

This is the goal of enhanced indexing by small risk factor mismatches.