How to Implement an Active Fixed Income Strategy

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How to Implement an Active Fixed Income Strategy

Fixed income portfolios can be managed either passively or actively. A passive portfolio management strategy is aimed at replicating benchmark portfolio returns while active portfolio management strategies intend to create deliberate risk factor mismatches by overweighting or underweighting securities relative to the benchmark.

These risk factor mismatches are intended to generate excess portfolio returns relative to the chosen benchmarks. The goal of an active fixed income portfolio manager is to identify the type of active management strategy he will pursue.

Categorizing Risk Factor Mismatches

Categorize the risk factor mismatches that are to be exploited in order to increase portfolio returns. Every manager has different sets of skills and should exploit the risk factor mismatches that are more relevant to his experience.

If a manager has superior skill in identifying the intrinsic value of fixed income securities, than he should identify the sectors that need to be overvalued or undervalued. Or if he is better at identifying interest rate movements he should create value through duration mismatching.

Future Market Expectations

Determine the level of future market expectations. According to behavioural finance, market plays a major role in identifying movements in the asset prices. Therefore, the fixed income portfolio manager needs to identify what the market is expecting in the short-term and long-term. Extrapolate market expectations from available market data such as current market prices, market yield and forward rates.

Forecasting the Inputs

Autonomously forecast inputs such as forward rates, prices and yield in order to generate an unbiased comparison between your expectations regarding movements in the risk factors and the market expectations.

If a manager is pursuing active fixed income portfolio management strategies, he believes that he has superior ability in forecasting risk factor movements. Based on these forecasts he should create a mismatch in the portfolio relative to the benchmark.

Relative Value of Securities

Relative valuation techniques allow the manager to identify which securities are undervalued or overvalued. Based on the values determined invest in the securities that are currently undervalued in order to implement a successful active fixed income management strategy. Relative valuation techniques compare the prices of different fixed income securities to determine anomalies in the markets.

When to Pursure Active Management?

A manager should only pursue an active management strategy if he is certain about his superior ability in predicting movements in risk factors. Many portfolio managers falsely believe that they have superior skills compared to an average manager. Managers must take calculated exposures as excessive exposures will increases the benchmark tracking error and can result in highly volatile results.