Bond Portfolio Construction: Chapter Summary

CHAPTER 25
BOND PORTFOLIO CONSTRUCTION
CHAPTER SUMMARY
In this chapter, we will see how to construct (build) portfolios. We begin with a brief review of
the basic principles of the theory of portfolio selection and portfolio risk. Then we explain a key
metric used in constructing, monitoring, and controlling portfolio risk: tracking error. In the last
two sections of the chapter we then explain two approaches to portfolio construction: cell-based
approach and multi-factor model approach.
BRIEF REVIEW OF PORTFOLIO THEORY AND RISK DECOMPOSITION
Portfolio theory as formulated by Harry Markowitz in the early 1950s provides guidance for the
construction of portfolios. The Markowitz framework, also referred to as mean-variance
analysis, states there are three parameters that are important in making portfolio selection
decisions. The first is the mean or expected value of an assets return. The second is the variance
of an assets return and it is this parameter that quantifies the risk of an individual asset. The
covariance, the third input needed for the mean-variance model, is the degree to which the
returns on two assets co-vary or change together.
The correlation between the returns for two assets is equal to the covariance of the two assets
divided by the product of their standard deviations. More specifically, for the simple two asset
case (assets 1 and 2) the portfolio mean (or expected return) and the portfolio variance are
respectively
E(Rp) = w1 E(R1) + w2 E(R2)
var(Rp) = w12 var(R1) + w22 var(R2) + 2w1 w2cov(R1, R2)
where
E(R1 ), E(R2), and E(Rp) are the expected return of asset 1, asset 2, and the portfolio, respectively.
w1 and w2 are the weight (allocation) of assets 1 and 2, respectively, in the portfolio at the
beginning of the period
var(R1), var(R2), and var(Rp) are the variance of asset 1, asset 2, and the portfolio, respectively.
cov(R1, R2) is the covariance between the return for asset 1 and 2
In contrast to the portfolio expected return, the portfolio variance is not merely a weighted
average of the variance of the two assets. Instead, it also depends on the covariance. The
relationship between the covariance and the correlation is as follows:
cov R1, R2
cor R1, R2
SD R1 / SD R2
Copyright 2016 Pearson Education, Inc. 551

where cor(R1, R2) is the correlation between the return of asset 1 and asset 2, and SD(R1) and
SD(R2) are the standard deviation of the return of asset 1 and asset 2, respectively. Rearranging
the above equation, we have:
cov(R1,R2) =cor(R1,R2) SD(R1) SD(R2)
Substituting the right-hand side of the latter covariance equation for the previous variance
equation we get
var(Rp) = w12 var(R1) + w22 var(R2) + 2 w1 w2 cor(R1,R2) SD(R1) SD(R2)
Using this latter variance equation, it is easier to appreciate how the relationship between asset
returns as measured by the correlation impacts the portfolio variance. A correlation of zero
implies that the returns are uncorrelated. Lets look at the following three cases:
Correlation of +1: var(Rp) = w12 var(R1) + w22 var(R2) + 2 w1 w2 SD(R1) SD(R2)
Correlation of 0: var(Rp) = w12 var(R1) + w22 var(R2)
Correlation of 1: var(Rp) = w12 var(R1) + w22 var(R2) 2 w1 w2 SD(R1) SD(R2)
The maximum portfolio variance occurs when there is perfect correlation (i.e., correlation of +1)
between the return of the two assets. The minimum portfolio variance occurs when asset returns
have a correlation of 1.
Financial theory as well as empirical evidence tells us that the portfolio variance can be
decomposed into two general categories: systematic risk and idiosyncratic risk. The systematic
risk is the risk that impacts the return on all assets in the portfolio. Idiosyncratic risk is the risk
that is unique to the return of the assets in the portfolio.
APPLICATION OF PORTFOLIO THEORY TO BOND PORTFOLIO CONSTRUCTION
The Markowitz mean-variance framework has been applied to portfolio construction in two
ways. The first is at the asset class level. The second application is the use of the mean-variance
framework to select securities to construct portfolio.
Moving from the implementation for constructing portfolios within an asset class requires the
estimation of the inputs (mean, variance, and covariance) for all of the securities that are
candidates for inclusion in the portfolio. If there are N securities that can be included in a
portfolio, there are N variances and (N2 N) / 2 covariances to estimate.
One model Markowitz proposed to explain the correlation structure among security returns
assumed that the return on a security depends on an underlying factor, the general prosperity of
the market as expressed by some index. In 1963, William Sharpe estimated the relationship
between the return on the market index (the explanatory variable) and the return on the stock (the
dependent variable). The regression model Sharpe estimated is referred to as the single index
market model or simply the market model. The regression coefficient of the market model that
is estimated is referred to as beta and is a measure of the sensitivity of a stock to general
movements in the market index.

The use of portfolio variance as a risk measure is an issue for two reasons. The first is that it is
assumed that the return distribution for securities is normally distributed. If this holds, the
variance is the appropriate measure of risk. However, empirical and theoretical evidence
suggests that stock returns and bond returns are not normally distribution. The second attack on
portfolio variance is one that follows from a discussion about the objective of portfolio
managers: outperforming a benchmark. The measure used with this objective is a portfolios
tracking error. This measure is the standard deviation or variance of the difference between the
portfolio return and the benchmark return. The key point is that in constructing a portfolio where
there is a benchmark, the relevant risk measure is not the portfolio variance but the portfolio
tracking error.
TRACKING ERROR
When a portfolio managers benchmark is a bond market index, risk is not measured in terms of
the variance or standard deviation of the portfolios return. Instead, risk is measured by the
standard deviation of the return of the portfolio relative to the return of the benchmark index.
This risk measure is called tracking error. Tracking error is also called active risk.
Calculation of Tracking Error
Tracking error is computed as follows:
Step 1: Compute the total return for a portfolio for each period.
Step 2: Obtain the total return for the benchmark index for each period.
Step 3: Obtain the difference between the values found in Step 1 and Step 2. The difference is
referred to as the active return.
Step 4: Compute the standard deviation of the active returns. The resulting value is the tracking
error.
Exhibits 25-1 and 25-2 show the calculation of the tracking error for two hypothetical portfolios,
A and B, assuming some benchmark index. Portfolio As monthly tracking error is 9.30 basis
points with its the monthly returns closely tracking the small returns of the benchmark index. In
contrast, for Portfolio B, the active returns are large with the monthly tracking error also large
at 79.13 basis points.
A tracking error is annualized when observations are monthly as follows:
annual tracking error 5 monthly tracking error 12
A tracking error is annualized when observations are weekly as follows:
annual tracking error 5 monthly tracking error 52

Two Faces of Tracking Error
We call tracking error calculated from observed active returns for a portfolio backward-looking
tracking error. It is also called ex-post tracking error, historical tracking error, and actual
tracking error. A problem with using backward-looking tracking error in bond portfolio
management is that it does not reflect the effect of current decisions by the portfolio manager on
the future active returns and hence the future tracking error that may be realized.
The portfolio manager needs a forward-looking estimate of tracking error to reflect the portfolio
risk going forward. The way this is done in practice is by using the services of a commercial
vendor or dealer firm that has modeled the factors that affect the tracking error associated with
the bond market index that is the portfolio managers benchmark. These models are called
multi-factor risk models. Given a managers current portfolio holdings, the portfolios current
exposure to the various risk factors can be calculated and compared to the benchmarks
exposures to the factors. Using the differential factor exposures and the risks of the factors, a
forward-looking tracking error for the portfolio can be computed. This tracking error is also
referred to as predicted tracking error and ex ante tracking error.
Given a forward-looking tracking error, a range for the future possible portfolio active return can
be calculated assuming that the active returns are normally distributed. For example, assume the
following:
expected return for benchmark = 10%
forward-looking tracking error relative to benchmark = 100 basis points
It should be noted that there is no guarantee that the forward-looking tracking error at the start of,
say, a year would exactly match the backward-looking tracking error calculated at the end of the
year. There are two reasons for this. The first is that as the year progresses and changes are made
to the portfolio, the forward-looking tracking error estimate would change to reflect the new
exposures. The second is that the accuracy of the forward-looking tracking error at the beginning
of the year depends on the extent of the stability of the variances and correlations that
commercial vendors use in their statistical models to estimate forward-looking tracking error.
Tracking Error and Active versus Passive Strategies
A passive strategy relative to the benchmark index occurs when a forward-looking tracking error
is very small. When the forward-looking tracking error is large, the manager is pursuing an
active strategy.
CELL-BASED APPROACH TO BOND PORTFOLIO CONSTRUCTION
Under the cell-based approach to constructing a bond portfolio, the benchmark is divided into
cells, each cell representing a different characteristic of the benchmark. The most common cells
used to break down a benchmark are (1) duration, (2) coupon, (3) maturity, (4) market sectors,
(5) credit quality, (6) call factors, and (7) sinking fund features. The last two factors are
particularly important because the call and sinking fund features of an issue will affect its
performance.

For a portfolio manager pursuing a passive strategy, the objective is to match the performance of
the benchmark. Following the cell-based approach, the manager selects from all the issues in the
bond index one or more issues in each cell that can be used to represent the entire cell. The total
dollar amount purchased of the issues from each cell will be based on the percentage of the bond
indexs total market value that the cell represents. For a portfolio manager pursuing an active
strategy, the manager will intentionally mismatch the dollar amount purchased for specific cells
where a view is taken.
The number of cells that the indexer uses will depend on the dollar amount of the portfolio. In
practice, when the cell-based approach for bond portfolio construction is used, once a model
portfolio is constructed, the portfolios track error can be estimated. The cell-based approached
ignores how mismatches impact portfolio risk as a result of cross-correlation associated with the
risks of each cell.
Complications in Bond Indexing
There are three forms of bond indexing: pure bond index matching, enhanced indexing matching
primary risk factors, and enhanced indexing allowing for minor risk-factor mismatches. It almost
impossible to implement a pure bond indexing strategy and it is not simple to do so for the other
two bond indexing strategies. These difficulties apply to both the cell-based and multi-factor
model approaches to portfolio construction.
In a pure bond indexing strategy, the portfolio manager must purchase all of the issues in the
bond index according to their weight in the benchmark index. Instead of purchasing all issues in
the bond index, the manager may purchase just a sample of issues using the cell-based approach.
This moves the strategy from being a pure bond indexing strategy to an enhanced bond indexing
strategy with minor mismatches in the primary risk factors. In terms of the cell-based approach,
the primary risk factors are the characteristics or cells.
A portfolio manager faces several other logistical problems in seeking to construct an indexed
portfolio. First, the prices for each issue used by the organization that publishes the index may
not be execution prices available to the indexer. Second, the prices used by organizations
reporting the value of indexes are based on bid prices causing a bias between the performance of
the bond index and the indexed portfolio that is equal to the bid-ask spread.
There are logistical problems unique to certain sectors in the bond market. Because of the
illiquidity of this sector of the bond market, not only may the prices used by the organization that
publishes the index be unreliable, but many of the issues may not even be available. Next,
consider the agency mortgage-backed securities market. There are more than 800,000 agency
pass-through issues. The organizations that publish indexes lump all these issues into a few
hundred generic issues.
Finally, recall that the total return depends on the reinvestment rate available on coupon interest.
If the organization publishing the index regularly overestimates the reinvestment rate, the
indexed portfolio could underperform the bond index by a significant number of basis points a
year.

PORTFOLIO CONSTRUCTION WITH MULTI-FACTOR MODELS
Multi-factor models are statistical models that are used to estimate a securitys expected return
based on the primary drivers affecting the return on securities. The primary drivers of returns are
referred to as risk factors or simply factors. These models are also called multi-factor risk
models or just factor models. Our focus is on how multi-factor models for bonds are used to
identify the sources of a bond portfolios risk and the how to employ them to construct bond
portfolios.
Risk Decomposition
Exhibit 25-3 illustrates how a multi-factor model can be used to identify the risk exposure of
a portfolio relative to a benchmark. This portfolio was constructed using a multi-factor model
combined with an optimization model. The risk exposure for this portfolio is measured in terms
of tracking error. The analysis of the portfolio begins with a comparison of the portfolio to that
of the benchmark.
Although the information contained in Exhibit 25-4 about the allocation based on percentage
market value of sector relative to the benchmark provides a good starting point for our analysis,
the information has limited value because it is not known how the exposures to the sectors are
related to the exposures to the risk factors that drive the portfolios return. Thus, the portfolio
manager must look beyond a nave assessment of portfolio risk relative to the benchmark based
on percentage allocation to sectors. Exhibit 25-5 provides information about the relative
exposure to interest rate risk as measured by duration, spread risk as measured by spread
duration, and call / prepayment risk as measured by vega, as well as the convexity.
More information about the portfolios relative risk exposure to interest rate risk can be obtained
by looking at the contribution to duration for the portfolio and the benchmark. This is shown in
Exhibit 25-6. As can be seen, the major reason for the slightly longer duration of the portfolio
relative to the benchmark is mainly attributable to the duration of the Treasury securities selected
for the portfolio.
Suppose that a portfolio has more exposure to a risk factor than the benchmark. This would mean
if that risk factor moves, the portfolio will have a greater movement than the benchmark. To
address this problem, volatility must be taken into consideration. Exhibit 25-7 shows the monthly
volatility of risk factor categories. Isolated risk in this exhibit displays the tracking
error / volatility of different exposures of the portfolio in isolation.
The risk factor securitized spread is the exposure to changes in the spreads in the agency MBS
market. The risk factor volatility is the risk associated with changes in interest rate volatility.
How can we determine the monthly tracking error for the portfolio given the monthly tracking
error for each risk factor exposure in Exhibit 25-7? Assuming a zero correlation between any
pair of risk factors, the portfolio isolated tracking error attributable to systematic risk is found by

squaring each isolated tracking error for each risk factor, summing them, and then taking the
square root. That is, for the general case where there are K risk factors is
Portfolio isolated systematic TE = [(TE1)2 + (TE2)2 + + (TEK)2]1/2
where TE denotes tracking error and the subscript denotes the risk factor.
The assumption that there is zero correlation between every pair of risk factors is unrealistic. To
address this, correlations or covariances must be brought into the analysis. In the case of tracking
error, lets consider the case where there are only two risk factors, F1 and F2. Then the portfolio
tracking error is equal to
Portfolio TE = [(TEF1)2 + (TEF2)2 + 2 Cov(F1,F2)]1/2
where Cov(F1,F2) is the covariance between risk factor exposures 1 and 2.
Exhibit 25-8 gives a breakdown of the standard deviation of the returns for the portfolio and the
benchmark in terms of systematic risk and idiosyncratic risk. The portfolio has greater systematic
and idiosyncratic risk than the benchmark. For the total risk of the portfolio and the benchmark,
the standard deviation of the portfolio and benchmark can be calculated as follows:
Total risk (volatility of returns) = [(Systematic risk)2 + (Idiosyncratic risk)2]0.5
The portfolio tracking error is
Portfolio tracking error = [(Systematic TE)2 + (Idiosyncratic TE)2]0.5
An extremely important point is that the tracking error (and not the idiosyncratic risk) is what the
manager must consider in portfolio construction and monitoring.
As with equities where a portfolio beta is computed that shows the movement of an equity
portfolio in response to a movement in some equity market index (such as the S&P 500), a beta
can be computed for a bond portfolio. A beta-type measure can be estimated for each risk factor.
For example, consider the risk factor measuring changes in the level of the yield curve which is
the portfolios duration. A duration beta can be calculated as follows:
Duration beta Portfolio duration

Benchmark duration
Exhibit 25-9 provides information about the portfolio risk across the different categories of risk
factors. Shown are the systematic risk and the idiosyncratic risk and the seven components of
systematic risk. The second column shows the isolated tracking error. The contribution to
tracking error for each group of risk factor is shown in the third column. The fourth column gives
a new metric, liquidation effect on tracking error.
A detailed analysis of the systematic and idiosyncratic risk applied at the asset class level rather
than at the individual risk factor level is provided in Exhibit 25-10. The five asset classes are
shown in the first column and in the second column the underweighting or overweighting of each
asset class (referred to as the net market weight) are shown. The last three columns report the
contribution to tracking error for systematic risk, idiosyncratic risk, and total risk. Another
important observation to take away from the analysis reported in Exhibit 25-10 is that corporate
bonds are the major contributor to idiosyncratic risk due to the overweighting of this sector,
carrying relatively higher idiosyncratic risk at the individual security level.

An analysis similar to the decomposition of risk shown in Exhibit 25-9 by asset class instead of
risk factor group is shown in Exhibit 25-11. Notice that the isolated tracking error for both the
Treasury and corporate asset classes exceeds that of the portfolio tracking error. This occurs
because exposures to certain asset classes in the portfolio are acting as hedges to certain other
asset classes (because Treasuries and corporate could also be hedging each other). The hedging
effect can be seen in the fourth column where the liquidation effect on tracking error is shown
for each asset class in Exhibit 25-11.
In the Barclays Capital model, there is a different yield curve used for government products.
With the exception of Treasuries, the other asset classes have exposure to the swap spread factors
on top of the Treasury curve. By decomposing the swap curve into the Treasury curve and swap
spreads, the Barclays Capital model gives portfolio managers the flexibility to analyze their
spread risk over the Treasury or the swap curve depending on their preferences.
There are different measures to look at the exposure to changes in the shape of the yield curve.
The most common is key rate duration. Six key rate durations with respect to the U.S. Treasury
curve, as well as the option-adjusted or effective convexity, are shown in Exhibit 25-12. Key rate
duration is the approximate percentage change in the portfolio value or benchmark value for
a 100 basis point change in the rate for a particular maturity holding all other rates constant. In
terms of mismatch, it is the approximate differential percentage change in the portfolio relative
to the benchmark for a 100 basis point in the rate for a particular maturity holding all other rates
constant. Assuming that the factor volatility represents a typical movement for the factor
(i.e., key interest rate), then the isolated impact of that movement on the return of a portfolio
(versus the benchmark) can be found as follows:
Return impact of a typical movement = (Net key rate duration) Typical rate movement
Exhibit 25-13 shows the exposure of the portfolio to the change in the swap spread. The swap
spread is the difference between the swap rate and the Treasury rate. All securities in the
portfolio except Treasuries expose the portfolio to this risk.
Portfolio Construction Using a Multi-Factor Model and an Optimizer
As with the cell-based approach to portfolio construction, a manager has views on the various
primary factors driving the return on the benchmark and wants to position the portfolio to
capitalize on those expectations. A multi-factor model is used in conjunction with an optimizer
to construct a portfolio. In using an optimizer, the optimal value for all of the variables that the
decision maker seeks is the output for the model. The decision maker specifies the variables
(i.e., decision variables), an objective function, and constraints. Given all of that information, the
optimizer finds the optimal value for all of the decision variables.
The portfolio manager must specify the objective function. This is the measure or quantity that is
to be minimized or maximized. In portfolio construction using multi-factor models, the measure
to be optimized is the portfolios tracking error. The manager wants that measure to be
minimized. The optimization of the objective function is typically done subject to constraints.

Portfolio Rebalancing
Although it is common to illustrate portfolio construction starting with a position of cash and
building a portfolio of securities, in practice the more common task is to rebalance an existing
portfolio. A multi-factor model along with an optimizer can be used to efficiently rebalance the
portfolio so as to realign the portfolio that has drifting away from the characteristics of the
benchmark over time and / or tilt the portfolio to reflect a managers new views. Rebalancing is
also required when a portfolio manager receives additional funds from a client or portfolio cash
inflows or when a client withdraws funds.
Exhibit 25-14 shows the trades that would have been recommended by the optimizer at the time.
Before the manager executes the package of trades proposed in Exhibit 25-14, there must be an
evaluation of the change in risk exposure.
KEY POINTS
The Markowitz mean-variance model is used to construct portfolios. The inputs required are
the mean (expected return) and variance for each security that is a candidate for inclusion in
the portfolio and the covariance or correlation between each pair of securities.
Although the insights provided by Markowitz mean-variance model are important, there are
several issues that limit its application to the construction of bond portfolios.
Tracking error, or active risk, is the standard deviation of a portfolios return relative to the
benchmark index.
There are two types of tracking errorbackward-looking tracking error, historical tracking
error, and forward-looking tracking error.
Backward-looking tracking error is calculated based on the actual performance of a portfolio
relative to a benchmark index.
Forward-looking tracking error is an estimate of how a portfolio will perform relative to a
benchmark index in the future. Forward-looking tracking error is used in risk control and
portfolio construction. The higher the forward-looking tracking error, the more the manager is
pursuing a strategy in which the portfolio has a different risk profile than the benchmark and
there is, therefore, greater active management.
In the cell-approach to bond portfolio construction, the benchmark is divided into cells which
are the characteristics of the benchmark. The portfolio then picks one or more securities to
either match or mismatch a cell depending on whether the strategy is a passive or active
strategy. In the former, the mismatch is based on the managers view.
There are complications in creating an indexed bond portfolio that are not faced by equity
portfolio managers who want to create an indexed stock portfolio.
Multi-factor models (also called multi-factor risk models or factor models) are statistical
models that are used to estimate a securitys expected return based on the primary drivers
(factors) affecting the return on securities.

The systematic risk factors in multi-factor model include yield curve risk, swap spread risk,
volatility risk, government-related spread risk, corporate spread risk, and securitized spread
risk.
The risk exposure in a factor model is measured in terms of tracking error.
Multi-factor models combined with an optimization model are used to construct a portfolio
that minimizes tracking error subject to the constraints imposed by the manager (client
imposed or self-imposed) and embodying the views of the manager.

ANSWERS TO QUESTIONS FOR CHAPTER 25
(Questions are in bold print followed by answers.)
1. What is the major insight provided by the Markowitz framework in portfolio theory?
The main insight of the Markowitz framework is that when assets are combined to create
a portfolio, the portfolios risk (as measured by the portfolio variance) is not merely some
weighted average of the risks of the individual assets comprising the portfolio. Instead, the
portfolios risk depends on the covariance or correlation of the returns between each pair of
assets comprising the portfolio. The covariance is the degree to which the returns on two assets
co-vary or change together. The correlation is analogous to the covariance between the expected
returns for two assets. Specifically, the correlation between the returns for two assets is equal to
the covariance of the two assets divided by the product of their standard deviations.
2. Answer the below questions.
a. Explain whether you agree or disagree with the following statement: It is the covariance
not the correlation that is important in the mean-variance model for portfolio selection.
One would disagree with the statement because the covariance and correlation can be defined in
terms of one another. Specifically, the correlation between the returns for two assets is equal to the
covariance of the two assets divided by the product of their standard deviations. This is given below:
cov R1, R2
cor R1, R2 .
SD R1 / SD R2
We see from this equation that an increase in the covariance occurs when there is also an
increase in correlation. Thus, it follows that both are important in the mean-variance model for
portfolio selection.
b. Explain whether you agree or disagree with the following statement: In the
mean-variance framework, the variance is lower the higher the correlation between the assets in
the portfolio.
Consider the below equation representing a simple portfolio of two assets (asset 1 and asset 2):
var(Rp) = w12 var(R1) + w22 var(R2) + 2 w1 w2 cor(R1,R2) SD(R1) SD(R2).
From this equation, a higher positive correlation is associated with a higher portfolio variance.
However, suppose the correlation is negative. Then a greater negative correlation is associated
with a lower portfolio variance. Thus, the statement is only true if by higher we mean greater
negative correlation. Because higher implies a greater positive number, one can arguably
disagree with the statement.
3. What are the two ways in which the Markowitz mean-variance framework has been used
by investors?

The Markowitz mean-variance framework has been applied to portfolio construction in two ways.
The first is at the asset class level where investors make an asset allocation decision. This is the
decision as to how to allocate funds amongst the major asset classes (stocks, bonds, cash, real
estate, and alternative assets). This has probably been the major use of the Markowitz framework.
The second application is the use of the mean-variance framework to select securities to
construct portfolio. Although the mean-variance framework has been used in equity portfolio
management for a good number of years, it has seen very limited use in bond portfolio. Moving
from the implementation for constructing portfolios within an asset class requires the estimation
of the inputs (mean, variance, and covariance) for all of the securities that are candidates for
inclusion in the portfolio. These inputs are not easily estimated and there is an entire literature
dealing with the issues associated with estimation risk.
4. What are the difficulties of implementing the Markowitz mean-variance framework in

constructing portfolios?
The implementation for constructing portfolios requires the estimation of the inputs (mean,
variance, and covariance) for all of the securities that are candidates for inclusion in the
portfolio. These inputs are not easily estimated and this presents a variety of difficulties. For
example, the number of inputs that must be calculated is enormous. For example, if there are
N securities that can be included in a portfolio, there are N variances and (N2 N)/2 covariances
to estimate. Hence, for a portfolio of just 50 securities that could be included in a portfolio, there
are 1,224 covariances that must be calculated. For 100 securities, there are 4,950 covariances.
Holding aside estimation risk, the enormity of the estimations that must be made was clear to
Markowitz. It was clear to Markowitz that some kind of model of covariance structure was
needed for the practical implementation of the theory to large portfolios. He did little more than
point out the problem and suggest some possible models of covariance.
The use of portfolio variance as a risk measure presents additional difficulties. First, we have to
make an assumption about the return distribution. If we assume normal distribution of returns,
then the variance is the appropriate measure of risk. However, empirical and theoretical evidence
suggests that stock returns and bond returns are not normally distribution. As a result, extensions
of the Markowitz optimization framework have been suggested that include other risk measures
such skewness and kurtosis. Second, we use of portfolio variance is questioned in regards to the
objective of portfolio managers: outperforming a benchmark. The measure used with this
objective is a portfolios tracking error. This measure is the standard deviation or variance of the
difference between the portfolio return and the benchmark return. The key point is that in
constructing a portfolio where there is a benchmark, the relevant risk measure is not the portfolio
variance but the portfolio tracking error.
Finally, consider the notion of the decomposition of portfolio total risk (i.e., portfolio variance)
into systematic risk and idiosyncratic risk. Studies of the stock market indicate that it does not
take more than 25 or so randomly selected stocks to remove most of the idiosyncratic risk of a
portfolio. That is, a randomly selected portfolio of stocks is mostly exposed to systematic risk.
However, when risk is measured in terms of tracking error, it takes a considerably larger number

of stocks to remove idiosyncratic risk. Typically, this is not the case when dealing with bonds
where the benchmark is one of the standard bond market indexes.
5. What was the purpose for William Sharpes development of the single index market model?
It was clear to Markowitz that some kind of model of covariance structure was needed for the
practical implementation of the theory to large portfolios. He did little more than point out the
problem and suggest some possible models of covariance. One model Markowitz proposed to
explain the correlation structure among security returns assumed that the return on a security
depends on an underlying factor, the general prosperity of the market as expressed by some
index. We might say that the purpose of Sharpes development of the single index market model
was in response to Markowitzs proposal. Thus, in response, Sharpe developed a model in 1963
where he tested the suggestion made by Markowitz through an examination of how stock returns
tend to go up and down together with a general stock market index. Specifically, Sharpe
estimated the relationship between the return on the market index (the explanatory variable) and
the return on the stock (the dependent variable). The regression model Sharpe estimated is
referred to as the single index market model or simply the market model. The regression
coefficient of the market model that is estimated is referred to as beta and is a measure of the
sensitivity of a stock to general movements in the market index.
6. Why is the tracking error more important than portfolio variance of returns when a
portfolio managers performance is measured versus a benchmark?
A key point is that in constructing a portfolio where there is a benchmark, the relevant risk
measure is not the portfolio variance but the portfolio tracking error. When performance is
measured against a benchmark, tracking error is more important than portfolio variance
because on tracking error measures how closely a portfolio follows the index to which it is
benchmarked. The most common measure is the root-mean-square of the difference between the
portfolio and index returns.
Many portfolios are managed to a benchmark, normally an index. Some portfolios are expected
to replicate, before trading and other costs, the returns of an index exactly (an index fund), while
others are expected to 'actively manage' the portfolio by deviating slightly from the index in
order to generate active returns or to lower transaction costs. Tracking error (also called active
risk) is a measure of the deviation from the benchmark; the aforementioned index fund would
have a tracking error close to zero, while an actively managed portfolio would normally have a
higher tracking error. Dividing portfolio active return by portfolio tracking error gives the
information ratio, which is a risk adjusted performance metric.
7. What is tracking error?
the standard deviation of the portfolios return. Instead, risk is measured by the standard
deviation of the return of the portfolio relative to the return of the benchmark index. This risk
measure is called tracking error. Tracking error is also called active risk.
Tracking error is computed as follows. First, compute the total return for a portfolio for each

period. Second, obtain the total return for the benchmark index for each period. Third, obtain the
difference between the return values for portfolio and index for each period. The difference for
each period is referred to as the active return for that period. Finally, compute the standard
deviation of the active returns. The resulting value is the tracking error.
One should not that the tracking error measurement is in terms of the observation period. If
monthly returns are used, the tracking error is a monthly tracking error. If weekly returns are used,
the tracking error is a weekly tracking error. Tracking error is annualized as follows. When
observations are monthly: annual tracking error = monthly tracking error 12 . When
observations are weekly: annual tracking error = monthly tracking error 52 .
8. Explain why backward-looking tracking error has limitations for estimating a portfolios
future tracking error.
A portfolios backward-looking tracking error is computed based on actual active returns and
reflect the portfolio managers decisions during the observation period with respect to the factors
that affect tracking error. Consequently, one limitation with using backward-looking tracking
error in bond portfolio management is that it does not reflect the effect of current decisions by
the portfolio manager on the future active returns and hence the future tracking error that may be
realized. Another limitation is that the backward-looking tracking error will have little predictive
value and can be misleading regarding portfolio risks going forward.
9. Why might one expect that for a manager pursuing an active management strategy that
the backward-looking tracking error at the beginning of the year will deviate from the
forward-looking tracking error at the beginning of the year?
The portfolio manager needs a forward-looking estimate of tracking error to reflect the portfolio
risk going forward. The way this is done in practice is by using the services of a commercial
vendor or dealer firm that has modeled the factors that affect the tracking error associated with
the bond market index that is the portfolio managers benchmark. Given a managers current
portfolio holdings, the portfolios current exposure to the various risk factors can be calculated
and compared to the benchmarks exposures to the factors. Using the differential factor
exposures and the risks of the factors, a forward-looking tracking error for the portfolio can be
computed. Given a forward-looking tracking error, a range for the future possible portfolio active
return can be calculated assuming that the active returns are normally distributed.
There is no guarantee that the forward-looking tracking error at the start of, say, a year would
exactly match the backward-looking tracking error calculated at the end of the year. There are
two reasons for this. The first is that as the year progresses and changes are made to the portfolio,
the forward-looking tracking error estimate would change to reflect the new exposures. The
second is that the accuracy of the forward-looking tracking error at the beginning of the year
depends on the extent of the stability in the variances and correlations that commercial vendors
use in their statistical models to estimate forward-looking tracking error.
These problems notwithstanding, the average of forward-looking tracking error estimates

obtained at different times during the year can be reasonably close to the backward looking

tracking error estimate obtained at the end of the year. The forward-looking tracking error is
useful in risk control and portfolio construction. The manager can immediately see the likely
effect on tracking error of any intended change in the portfolio. Thus scenario analysis can be
performed by a portfolio manager to assess proposed portfolio strategies and eliminate those that
would result in tracking error beyond a specified tolerance for risk.
10. Answer the below questions.
(a) Compute the tracking error from the following information:
Portfolio As Lehman Aggregate

Month 2001 Return (%) Bond Index Return (%)
January 2.15 1.65
February 0.89 0.10
March 1.15 0.52
April 0.47 0.60
May 1.71 0.65
June 0.10 0.33
July 1.04 2.31
August 2.70 1.10
September 0.66 1.23
October 2.15 2.02
November 1.38 0.61
December 0.59 1.20
The tracking error is the standard deviation of the active returns where an active return is the
portfolio As return minus the benchmarks return for each month. The below table has each
active return in the Active Return column.
[Note that when subtracting a negative index return from a portfolio return, the negative return is
actually added to the portfolio return to get the active return. For example, for February, we have
0.89% 0.10% = 0.89% + 0.10% = 0.99%).]
To compute the standard deviation of these active returns, we subtract the average (or mean)
active return from each active return, and then square each difference. Each difference squared
value is given in the table above in the Differences Squared column. We then divided this sum
by 12 1 = 11. We then multiply by 100 to convert to basis points. One basis point equals
0.0001 or 0.01%. We can then annualize the monthly basis points by multiplying by the square
root of 12.
At the bottom of the above table we list details including the mean active return, variance,
standard deviation or tracking error (in terms of both percentage and basis points), and the
annualized tracking error (in terms of basis points).

Portfolio Lehman Aggregate Active Differences
Month 2001 As Return Bond Index Return Return Squared
January 2.15% 1.65% 0.50% 0.0707(%2)
February 0.89% 0.10% 0.99% 0.5713(%2)
March 1.15% 0.52% 0.63% 0.1567(%2)
April 0.47% 0.60% 0.13% 0.0109(%2)
May 1.71% 0.65% 1.06% 0.6820(%2)
June 0.10% 0.33% 0.23% 0.2155(%2)
July 1.04% 2.31% 1.27% 2.2625(%2)
August 2.70% 1.10% 1.60% 1.8655(%2)
September 0.66% 1.23% 0.57% 0.6467(%2)
October 2.15% 2.02% 0.13% 0.0109(%2)
November 1.38% 0.61% 0.77% 1.0084(%2)
December 0.59% 1.20% 0.61% 0.1413(%2)
Sum of Portfolio Returns = 2.81%
Mean Active Return = 0.2342%
Variance (sum of differences squared / 11) = 0.6947(%2)
Standard Deviation = Tracking Error = 0.8335%
Tracking error in basis points = 83.35
Tracking error in basis points annualized = 288.74
(b) Is the tracking error computed in part (a) a backward-looking or forward-looking

tracking error?
The tracking error computed in part (a) is backward-looking because it is calculated based on the
actual active returns observed for a portfolio is prior periods. Calculations computed for a portfolio
based on a portfolios actual active returns reflect the portfolio managers decisions during the
observation period with respect to the factors that affect tracking error.
(c) Compare the tracking error found in part (a) to the tracking error found for Portfolios
A and B in Exhibits 25-1 and 25-2. What can you say about the investment management
strategy pursued by this portfolio manager?
The tracking error found for our problem is greater especially compared to Portfolio A. A greater
tracking error means greater deviation from the benchmark. This is seen if we compare active
return values from our table with the greater active return values found in the exhibits. For our
problem, it appears the manager may be employing a high-risk strategy to enhance the indexed
portfolios return. This strategy is commonly referred to as enhanced indexing or indexing
plus.

11. Assume the following:
benchmark index = Salomon Smith Barney BIG Bond Index

expected return for benchmark index = 7%
forward-looking tracking error relative to Lehman Aggregate Bond Index = 200 basis points
Assuming that returns are normally distributed, complete the following table:
Number of Standard Range for Portfolio Corresponding Range
Deviations Active Return for Portfolio Return Probability
1
2
3
With an expected return of 7% and a standard deviation of 200 basis points or 2%, then a normal
distribution implies there is about a 67% probability that values will be found between one
standard deviation of either side of the mean. Thus, for a standard deviation of 1, the range on
either side of the mean for portfolio active return is 1 standard deviation times 2% = 2%. The 2%
deviation will be on both the left and right side of the 7% mean value. Thus, with a portfolio mean
return of 7%, the corresponding range for portfolio return will be from 5% (7% 2% = 5%) left of
the mean value to 9% (7% + 2% = 9%) right of the mean value
Similarly, for a standard deviation of 2, the range on either side of the mean is 2 standard
deviation times 2% = 4%. With a portfolio mean active return of 7%, the corresponding range
for portfolio return will be from 7% 4% = 3% to 7% + 4% = 11%. A normal distribution
implies there a 96% probability that values will be found between two standard deviation of
either side the mean.
Likewise, for a standard deviation of three, the range on either side of the mean is 3 standard
deviation times 2% = 6%. With a portfolio mean active return of 7%, the corresponding range for
portfolio return will be 7% 6% = 1% and 7% + 6% = 13%. A normal distribution implies there a
99% probability that values will be found between two standard deviation of either side the mean.
The above values can all be found in the below table.
Number of Standard Range for Portfolio Corresponding Range

Deviations Active Return for Portfolio Return Probability
1 2% 5%9% 67%
2 4% 3%11% 95%
3 6% 1%13% 99%
12. At a meeting between a portfolio manager and a prospective client, the portfolio manager
stated that her firms bond investment strategy is a conservative one. The portfolio manager
told the prospective client that she constructs a portfolio with a forward-looking tracking
error that is typically between 250 and 300 basis points of a client-specified bond index.
Explain why you agree or disagree with the portfolio managers statement that the portfolio
strategy is a conservative one.

If the chosen benchmark is the desired norm, then greater deviation from the norm implies more
risk taking, i.e., less conservative than claimed by the portfolio manager. Regardless, it appears
the manager is pursuing an active strategy that involves risk taking. More details are given
below.
First, one would expect a higher tracking error over a longer horizon. Lets assume the
forward-looking tracking error given in our problem (between 250 and 300 basis points of
a bond index) is an annual tracking error. Even for this longer horizon, 250 to 300 basis points
represent a large tracking error (especially compared to a zero tracking error which would be
obtained if one just mimicked the benchmark). However, the tracking error is also unique to the
benchmark used. If an improper benchmark is used then the tracking error measure may not be
too meaningful.
Second, the strategy is not passive. When a portfolio is constructed to have a forward-looking
tracking error of zero, the manager has effectively designed the portfolio to replicate the
performance of the benchmark. If the forward-looking tracking error is maintained for the entire
investment period, the active return should be close to zero. Such a strategyone with
a forward-looking tracking error of zero or very smallindicates that the manager is pursuing
a passive strategy relative to the benchmark index.
Third, when the forward-looking tracking error is large the manager is pursuing an active
strategy. The larger the deviation from the chose benchmark, the larger the tracking error and
thus greater risk taking can be inferred. Forward-looking tracking error indicates the degree of
active portfolio management being pursued by a manager. Therefore, it is necessary to
understand what factors (referred to as risk factors) affect the performance of a managers
benchmark index. The degree to which the manager constructs a portfolio that has exposure to
the risk factors that is different from the risk factors that affect the benchmark determines the
forward-looking tracking error.
13. What is meant by tracking error due to systematic risk factors?
By tracking error due to systematic risk factors, we mean tracking error caused by factors that
affect the return of securities in the benchmark in varying degrees. More details are given below.
the standard deviation of the portfolios return. Instead, risk is measured by the standard
deviation of the return of the portfolio relative to the return of the benchmark index. This risk
measure is called tracking error. Tracking error is also called active risk.
Forward-looking tracking error indicates the degree of active portfolio management being
pursued by a manager. Therefore, it is necessary to understand what factors (including
systematic risk factors) affect the performance of a managers benchmark index. The degree to
which the manager constructs a portfolio that has exposure to the risk factors that is different
from the risk factors that affect the benchmark determines the forward-looking tracking error.

The risk factors affecting the Lehman Brothers Aggregate Bond Index have been investigated by
various researchers. The risk factors can be classified into two types: systematic risk factors and
nonsystematic risk factors. Systematic risk factors are forces that affect all securities in
a certain category in the benchmark index. Nonsystematic factor risk is the risk that is not
attributable to the systematic risk factors.
When we speak of tracking error due to systematic risk factors, we have two factors in mind
because systematic risk factors can be divided into two categories: term structure risk factors and
non-term structure risk factors. Term structure risk factors are risks associated with changes in
the shape of the term structure (level and shape changes). Non-term structure risk factors include
the following: sector risk, quality risk, optionality risk, coupon risk, MBS sector risk, MBS
volatility risk, and MBS prepayment risk.
14. You are reviewing a report by a portfolio manager that indicates that a funds predicted
(forward-looking) tracking error is 94.87 basis points. Furthermore, it is reported that the
predicted tracking error due to systematic risk is 90 basis points and the predicted tracking
error due to non-systematic risk is 30 basis points. Why doesnt the sum of these two
tracking error components total up to 94.87 basis points?
The predicted tracking error is 94.87 basis points. The two major risk categories are systematic
and non-systematic risks. For our portfolio, they are respectively 90 basis points and 30 basis
points. Now this might seem confusing because adding these two risks we do not get to the
predicted tracking error of 94.87 basis points for the portfolio. The reason is that these risk
measures are standard deviations and therefore they are not additive. However, the variances are
additive. The implicit assumption in this calculation is that there is no correlation or covariance
between any of the two components of the risk factors. Consequently, the variance of the two
major risk components is:
Predicted tracking error for systematic risks2 = variance for systematic risks = 902 = 8,100
Predicted tracking error for nonsystematic risks2 = variance for nonsystematic risks = 302 = 900
The total variance is 8,100 + 900 = 9,000. The square root of the total variance is 94.86833 basis
points, which rounded off to 94.87 basis points is equal to the predicted tracking error for the
portfolio.
15. What are the drawbacks of the cell-based approach for bond portfolio construction?
Let us first describe the cell-based approach. Under the cell-based approach, the
benchmark is divided into cells, each cell representing a different characteristic of the
benchmark. The most common cells used to break down a benchmark are (1) duration, (2)
coupon, (3) maturity, (4) market sectors, (5) credit quality, (6) call factors, and (7) sinking
fund features.
The number of cells that the indexer uses will depend on the dollar amount of the portfolio. In
a portfolio of less than $100 million, for example, using a large number of cells entails

a problem. The drawback faced by the manager is it would require purchasing odd lots of
issues. This increases the cost of buying the issues to represent a cell and thus would increase the
portfolios tracking error. Reducing the number of cells to overcome this problem would increase
the portfolios tracking error in an undesirable way. If the tracking error is unsatisfactory, the
manager must alter the portfolio so that the tracking error is within the acceptable range specified
by the manager or the client. This is often not a simple process because modifying the portfolio
can result in unintended bets (or views) by changing the allocation to cells. This adds another
drawback to the equation.
Moreover, the cell-based approach faces an additional drawback as it ignores how

mismatches impact portfolio risk as a result of cross-correlation associated with the risks of each
cell. For example, it is possible that there may be large mismatches between two of the cells
(characteristics) but the correlation of the risks associated with the cells may result in a very
small increase in the portfolios tracking error.
Fortunately, these drawbacks of the cell-based approach can be dealt with using the more
quantitative approach, the multi-factor model approach.
16. Why is it difficult to build a portfolio in pursuing a pure bond indexing strategy?
Although it is not simple to build a portfolio for enhanced indexing strategies, it is even more
difficult to implement a pure bond indexing strategy. These grave difficulties apply to both the
cell-based and multi-factor model approaches to portfolio construction. Below we attempt to
describe why.
In a pure bond indexing strategy, the portfolio manager must purchase all of the issues in the
bond index according to their weight in the benchmark index. However, substantial tracking
error will result from the transaction costs (and other fees) associated with purchasing all the
issues and reinvesting cash flow (maturing principal and coupon interest). A broad-based market
index could include more than 6,000 issues, so large transaction costs make this strategy
impractical. In addition, some issues in the bond index may not be available at the prices used in
constructing the index.
Instead of purchasing all issues in the bond index, the manager may purchase just a sample of
issues using the cell-based approach. This moves the strategy from being a pure bond indexing
strategy to an enhanced bond indexing strategy with minor mismatches in the primary risk
factors. Although this approach reduces tracking error resulting from high transaction costs, it
increases tracking error resulting from the mismatch of the indexed portfolio and the bond index.
In practice, managers who state that they pursue a pure bond indexing strategy typically are
forced to follow an enhanced bond indexing strategy with minor mismatches in the primary risk
factors.
A portfolio manager faces several other logistical problems in seeking to construct an indexed
portfolio. First, the prices for each issue used by the organization that publishes the index may
not be execution prices available to the indexer. In fact, they may be materially different from the
prices offered by some dealers. In addition, the prices used by organizations reporting the value

of indexes are based on bid prices. Dealer ask prices, however, are the ones that the manager
would have to transact at when constructing or rebalancing the indexed portfolio. Thus, there
will be a bias between the performance of the bond index and the indexed portfolio that is equal
to the bid-ask spread.
Furthermore, there are logistical problems unique to certain sectors in the bond market. Consider
first the corporate bond market. There are typically about 3,500 issues in the corporate bond
sector of a broad-based index. Because of the illiquidity of this sector of the bond market, not
only may the prices used by the organization that publishes the index be unreliable, but many of
the issues may not even be available. Next, consider the agency mortgage-backed securities
market. There are more than 800,000 agency pass-through issues. The organizations that publish
indexes lump all these issues into a few hundred generic issues. The portfolio manager is then
faced with the difficult task of finding pass-through securities with the same riskreturn profiles
of these hypothetical issues.
Finally, recall that the total return depends on the reinvestment rate available on coupon interest.
If the organization publishing the index regularly overestimates the reinvestment rate, the
indexed portfolio could underperform the bond index by a significant number of basis points
a year.
17. How can a multi-factor risk model be used to monitor and control portfolio risk?
A multi-factor risk model can be used to monitor and control portfolio risk through
a forward-looking estimate of tracking error. The portfolio manager needs this forward-looking
estimate of tracking error to reflect the portfolio risk going forward. The way this is done in
practice is by using the services of a commercial vendor or dealer firm that has modeled the
factors that affect the tracking error associated with the bond market index (i.e., the portfolio
managers benchmark). These models are called multi-factor risk models. Given a managers
current portfolio holdings, the portfolios current exposure to the various risk factors can be
calculated and compared to the benchmarks exposures to the factors. Using the differential
factor exposures and the risks of the factors, a forward-looking tracking error for the portfolio
can be computed. This tracking error is also referred to as predicted tracking error and ex ante
tracking error.
Given a forward-looking tracking error, a range for the future possible portfolio active return can
be calculated assuming that the active returns are normally distributed. For example, assume the
following:
expected return for benchmark 10%
forward-looking tracking error relative to benchmark 100 basis points
From the properties of a normal distribution, we know the following:
Number of Standard Range for Portfolio Corresponding Range for

Deviations Active Return Portfolio Return Probability
1 1% 9%11% 67%
2 2% 8%12% 95%

3 3% 7%13% 99%
It should be noted that there is no guarantee that the forward-looking tracking error at the start of
a period would exactly match the backward-looking tracking error calculated at the end of the
year. Regardless the average of forward-looking tracking error estimates obtained at different
times during the year will be reasonably close to the backward-looking tracking error estimate
obtained at the end of the year.
The forward-looking tracking error is useful in risk control and portfolio construction. The
manager can immediately see the likely effect on tracking error of any intended change in the
portfolio. Thus, scenario analysis can be performed by a portfolio manager to assess proposed
portfolio strategies and eliminate those that would result in tracking error beyond a specified
tolerance for risk.
18. How can a multi-factor risk model be used to rebalance a portfolio?
Although it is common to illustrate portfolio construction starting with a position of cash and
building a portfolio of securities, in practice the more common task is to rebalance an
existing portfolio. A multi-factor model along with an optimizer can be used to efficiently
rebalance the portfolio. This rebalancing using a multi-factor model involves realigning the
portfolio that has drifting away from the characteristics of the benchmark over time . For
example, the drift may involve a change in the duration of the benchmark requiring a
change in the duration of the portfolio or it may entail an upgrade or downgrade of some
issues in the portfolio. The rebalancing can also involve tilting the portfolio to reflect a
managers new views. Rebalancing is also required when a portfolio manager receives
additional funds from a client or portfolio cash inflows or when a client withdraws funds.
More details are given below.
Multi-factor models are statistical models that are used to estimate a securitys expected return
based on the primary drivers affecting the return on securities. The primary drivers of returns are
referred to as risk factors or simply factors. These models are also called multi-factor risk models
or just factor models. Multi-factor models provide managers with information about the sources
of risk in their portfolio. Hence, they are indispensible tools for constructing portfolios so as to
realize the desired exposure to the risk factors where a manager has a view. Moreover, these
models can be used to monitor and control the risk exposure of the portfolio, which is achievable
through rebalancing.
A multi-factor model may prove helpful to help the rebalancing minimize transaction costs by
reducing the need to turnover current holdings unnecessarily. The optimizer is able to evaluate
the trade-off of replacing one issue held (i.e., a sale) with another issue (i.e., a purchase). The
optimizer can identify a package of transactions (i.e., sells and buys) and identify the reduction
(or increase) in risk that would result from the execution of those transactions so that the
portfolio manager can assess the risk adjustment benefit relative to the cost of executing the
transaction.

Exhibit 25-14 shows the trades that would have been recommended for rebalancing. The total
market value of the trades was roughly $13 million. Almost half of the sales from the portfolio
were for banks and they were replaced with various Treasury notes, a corporate bond, a
sovereign bond, and an agency MBS. Before the manager executes the package of trades
proposed in Exhibit 25-14, there must be an evaluation of the change in risk exposure. The new
systematic tracking error (TE) after rebalancing was 4.2 basis points (the original was 4.6 basis
points), idiosyncratic TE is 7.8 basis points (same as before rebalancing), and total TE is 8.8
basis points (9.0 basis points before rebalancing). The decline in the total TE is before there are
more than 50 securities in the portfolio after the rebalancing.
Exhibit 25-14 Trades for Portfolio Rebalancing

Buys
Identifier Description Position Amount Market Value
912828LK US TREASURY NOTES 3,133,909 3,235,179
912828LS US TREASURY NOTES 2,814,967 2,924,353
489170AB KENNAMETAL INC 1,959,720 2,087,886
94986EAA WELLS FARGO CAPITAL XIII 1,286,097 1,360,888
912810QD US TREASURY BONDS 1,118,189 1,111,380
465138ZR ISRAEL STATE OF 920,297 1,097,735
912810QB US TREASURY BONDS 1,017,169 991,185
GNG03410 GNMA II Single Family 15yr 117,277 119,672
Total 12,928,278
Sells
912828NV US TREASURY NOTES 2,662,260 2,586,183
16132NAV CHARTER ONE BANK FSB 2,203,358 2,332,312
05946NAD BANCO BRADESCO SA 1,564,870 1,828,328
827065AA SILICON VALLEY BANK 1,692,776 1,770,613
912828NL US TREASURY NOTES 1,603,631 1,612,239
912810QC US TREASURY BONDS 1,462,336 1,468,727
912810QE US TREASURY BONDS 1,298,352 1,329,875
Total 12,928,278

19. In a factor model, what is meant by isolated tracking error?
An isolated tracking error refers to the method of calculating the partial tracking error due to
a single group of risk factors in isolation; no other forms of risk are considered. Illustrations
giving more details are given below.
Let us first illustrate an isolated tracking error by considering the risk factor securitized spread
in Exhibit 25-7. This risk factor is the exposure to changes in the spreads in the agency MBS
market. The value of 2.5 means that if the portfolio only differs from the benchmark with respect
to its exposure to changes in the spread in the agency MBS sector, then this mismatch relative to
the benchmark would result in a monthly isolated tracking error of 2.5 basis points.
Second, we consider Exhibit 25-7 where can notice that there is a risk exposure category labeled
volatility. This risk factor is the risk associated with changes in interest rate volatility and is
critical for quantifying the exposure of a portfolio or benchmark to securities with embedded
options such as callable bonds and agency MBS because they are impacted by changes in
volatility.
Hence, the value of 1.3 is the exposure of the portfolio to the risk factor volatility. The value of
1.3 means that if the portfolio only differs from the benchmark with respect to its exposure to
changes in volatility, then this mismatch relative to the benchmark would result in
a monthly isolated tracking error of 1.3 basis points.
We can compute a portfolio isolated systematic tracking error by assuming a zero correlation
between any pair of risk factors. Given this assumption, the portfolio isolated tracking error
attributable to systematic risk is found by squaring each isolated tracking error for each risk
factor, summing them, and then taking the square root. That is, for the general case where there
are K risk factors is
Portfolio isolated systematic TE = [(TE1)2 + (TE2)2 + + (TEK)2]1/2
where TE denotes tracking error and the subscript denotes the risk factor.
Consider the 50-security portfolio in Exhibit 25-13 where the monthly isolated TE for each risk
factor is shown in Exhibit 25-7. Here the portfolio isolated systematic TE is 6.24 basis points per
month as shown below:
Portfolio isolated systematic TE = [(3.9)2 + (2.6)2 + (1.3)2 + (0.8)2 + (2.8)2 + (2.5)2]1/2 = 6.24
The assumption that there is zero correlation between every pair of risk factors is unrealistic.
Obviously, to address this, correlations or covariances must be brought into the analysis. The
calculation of the portfolio risk then involves the use of the variance-covariance matrix for the
risk factors. Recall that in mean-variance analysis, the portfolio variance (risk) captures the
diversification effect by taking into consideration the covariances. In the case of tracking error,
lets consider the case where there are only two risk factors, F1 and F2. Then the portfolio
tracking error is equal to

Portfolio TE = [(TEF1)2 + (TEF2)2 + 2 Cov(F1,F2)]1/2
where Cov(F1,F2) is the covariance between risk factor exposures 1 and 2.
20. Following is a portfolio consisting of 50 bonds with a market value of $100 million as of
April 29, 2011:
003723AA ABN AMRO BANK NV 1,449,636 1,422,596

00104BAC AES EASTERN ENERGY 1,682,044 1,206,446
02051PAC ALON REFINING KROTZ 592,304 630,655
02360XAL AMERENENERGY GENERATING 707,484 737,343
101137AD BOSTON SCIENTIFC 1,551,232 1,656,030
12527GAA CF INDUSTRIES INC 1,328,707 1,499,778
165167BS CHESAPEAKE ENERGY CORP 797,314 880,013
125896BG CMS ENERGY 1,286,476 1,337,697
251591AY DEVELOPERS DIVERS REALTY 646,714 644,344
FGB08000 FHLM Gold Guar Single F. 30yr 2,683,702 3,040,911
FGB07001 FHLM Gold Guar Single F. 30yr 690,235 780,262
FGB06402 FHLM Gold Guar Single F. 30yr 885,600 1,004,579
FNA07098 FNMA Conventional Long T. 30yr 884,357 1,014,899
FNA08000 FNMA Conventional Long T. 30yr 1,643,844 1,883,297
FNA05003 FNMA Conventional Long T. 30yr 641,485 684,085

FNA05010 FNMA Conventional Long T. 30yr 794,384 843,855
Continued from Previous Page

GNB04411 GNMA II Single Family 30yr 2,391,899 2,509,580
381427AA GOLDMAN SACHS CAPITAL II 3,123,435 2,761,546
45905CAA INTERNATL BANK RECON DEV-GLOBA 1,151,247 1,200,080
45950KBJ INTL FINANCE CORPORATION 1,227,607 1,198,808
46513E5Y ISRAEL STATE OF-GLOBAL 1,797,220 1,911,761
500769BR KREDIT FUER WIEDERAUFBAU-GLOBA 3,461,061 1,012,672
500769CH KREDIT FUER WIEDERAUFBAU-GLOBA 3,430,115 941,429
582834AM MEAD CORP 727,352 787,191
58551TAA MELLON CAPITAL IV 3,326,734 3,102,915
651715AF NEWPAGE CORP 6,414,006 1,603,501
665772CE NORTHERN STATES PWR MINN 889,932 907,113
723787AG PIONEER NATURAL RESOURCES 945,542 1,045,275
749685AQ RPM INTERNATIONAL INC 591,159 642,823
797440BM SAN DIEGO GAS & ELECTRIC 957,058 856,840
784635AM SPX CORPORATION 708,877 766,621
91311QAD UNITED UTILITES PLC 844,170 848,272
915436AF UPM-KYMMENE CORP 655,540 648,265
912810PW US TREASURY BONDS 797,859 804,588
912810QA US TREASURY BONDS 8,725,929 7,505,533
912810QK US TREASURY BONDS 4,408,259 4,048,097
912828PA US TREASURY NOTES 3,507,446 3,378,751
912828PF US TREASURY NOTES 21,453,185 20,596,365
962166AV WEYERHAEUSER CO 750,667 871,588

The benchmark for the manager who has constructed this portfolio is a composite index
consisting one-third each of the Barclays Capital U.S. Treasury index, Barclays Capital U.S.
Credit Index, and Barclays Capital U.S. MBS index.
Asset Class Portfolio Benchmark

Total 100.0 100.0
Treasury 36.3 33.3
Government Related 6.3 6.8
Corporate Industrials 11.0 13.9
Corporate Utilities 5.9 2.9
Corporate Financials 7.9 9.7
MBS Agency 32.6 33.3
Analytics Portfolio Benchmark Difference

Duration 6.87 5.37 1.50
Spread Duration 6.77 5.27 1.50
Convexity 0.47 0.00 0.47
Vega 0.01 0.03 0.02
Spread 355 55 300.00
Duration Contribution Portfolio Benchmark Difference

Total 6.87 5.37 1.50
Treasury 3.62 1.78 1.84
Government Related 0.92 0.41 0.51
Corporate 1.10 1.74 0.63
Securitized 1.23 1.45 0.22
Risk Factor Categories Risk

Yield curve risk 40.8
Swap spread risk 2.5
Volatility risk 2.8
Govt-related spread risk 5.3
Corporate spread risk 30.6
Securitized spread risk 5.8
Risk Factor Categories Risk

Total 33.2
Yield curve risk 23.4
Swap spread risk 0.2
Volatility risk 0.5

Govt-related spread risk 0.0
Corporate spread risk 10.0
Securitized spread risk 0.8
Volatility Portfolio Benchmark Tracking Error

Systematic 141.90 117.4 37.9
Idiosyncratic 19.30 4.8 18.7
Total 143.20 117.5 42.3
Portfolio Beta 1.18
Contribution to Liquidation TEV Elasticity

Risk Factor Group Isolated TEV
TEV Effect on TEV (%)
Total 42.3 42.3 42.3 1.0
Systematic Risk 37.9 33.2 22.4 0.8
Curve 40.8 23.4 4.3 0.5
Swap Spreads 2.5 0.2 0.1 0.0
Volatility 2.8 0.5 0.4 0.0
Spread Government Related 5.3 0.0 0.3 0.0
Spread Corporate 30.6 10.0 0.8 0.2
Spread Securitized 5.8 0.8 1.1 0.0
Idiosyncratic Risk 18.7 9.1 4.2 0.2
Describe in detail the risk characteristics of this portfolio. Be sure to discuss where it seems
like the manager is taking views on the market?
The benchmark for the manager who has constructed this portfolio is a composite index
consisting of one-third each of the Barclays Capital U.S. Treasury index, Barclays Capital U.S.
Credit Index, and Barclays Capital U.S. MBS index. First, in regards to the Barclays Capital
U.S. Treasury index, this index measures the performance of U.S. Treasury securities. Second, in
regards to the Barclays Capital U.S. Credit Index, this index includes both corporate and
non-corporate sectors where the corporate sectors are industrial, utility, and finance that include
both U.S. and non-U.S. corporations. The non-corporate sectors are sovereign, supranational,
foreign agency, and foreign local government. The index is calculated monthly on price-only and
total-return basis. All returns are market value-weighted inclusive of accrued interest. Third, in
regards to the Barclays Capital U.S. MBS index, this index measures the performance of
investment grade fixed-rate mortgage-backed pass-through securities of GNMA, FNMA, and
FHLMC.
The analysis of the portfolio begins with a comparison of the portfolio to that of the benchmark.
Identification of the mismatches indicates where the manager has taken a view (unintentional or
not). The asset class table compares the portfolio and the benchmark in terms of the allocation
to the major sectors of the benchmark. From the asset allocation (as shown in the table below

that puts in the differences) that the portfolio manager is taking a positive view on the treasury
and corporate utility sectors by overweighting them and this is achieved by underweighting the
other sectors.
Although the information contained in the asset table (about the allocation based on percentage
market value of sector relative to the benchmark) provides a good starting point for our analysis,
the information has limited value because it is not known how the exposures to the sectors are
related to the exposures to the risk factors that drive the portfolios return. Here are three
examples. First, consider the Treasury sector. It is possible that the specific Treasury securities
contained in the portfolio have a lesser contribution to portfolio duration than the contribution to
index duration of the Treasuries in the benchmark despite the overweighting of Treasuries in the
portfolio. As a second example of why the manager must look beyond the percentage allocation
to a sector, consider the corporate bonds in the financial sector. Corporate financials will have
a contribution to spread duration in both the portfolio and the benchmark. It is possible to have
an underweight of this sector in the portfolio and yet have a contribution to spread duration that
is greater than that of the benchmark. Finally, a portfolios convexity relative to the benchmark
will impact relative performance. It is possible to underweight the portfolios exposure to agency
MBS so as to create a portfolio with large negative convexity while the benchmark has much
lower negative convexity.
It is for this reason that the portfolio manager must look beyond a nave assessment of portfolio
risk relative to the benchmark based on percentage allocation to sectors. The analytics table
provides information about the relative exposure to interest rate risk as measured by duration,
spread risk as measured by spread duration, and call / prepayment risk as measured by vega, as
well as the convexity. From these analytics we observe the following:
(1) The duration of the portfolio exceeds that of the benchmark so that portfolio has more
exposure to changes in the level of interest rates.
(2) Due to the underweighting in Treasuries, spread duration is higher.
(3) The higher portfolio convexity compared to the benchmark means less exposure to call
and prepayment risk which can be attributable to the less exposure to agency MBS.
(4) Exposure to call / prepayment risk as measure by vega is small and about the same for the
portfolio and the benchmark.
More information about the portfolios relative risk exposure to interest rate risk can be seen by
looking at the contribution to duration for the portfolio and the benchmark. As can be seen, the
major reason for the longer duration of the portfolio relative to the benchmark is attributable to
the duration of the Treasury securities selected for the portfolio.
The analysis thus far is missing a vital element. To understand why, suppose that a portfolio has
more exposure to a risk factor than the benchmark. This would mean if that risk factor moves,
the portfolio will have a greater movement than the benchmark. But the question is: To what
extent does that risk factor move? Another way of asking this is: How volatile is the risk factor?
For example, from the analysis of the analytics, we know that the portfolio has greater exposure
than the benchmark to changes in the level of interest rates (i.e., a higher duration) but less

exposure to changes in spreads (i.e., a higher spread duration). But which exposure (i.e., risk
factor) has greater volatility?
To address this, volatility must be taken into consideration. The contribution to duration table
shows the (monthly) volatility of risk factor categories. Lets look at each one of these volatilities
and what they mean. The (isolated) risk in this table displays the tracking error / volatility of
different exposures of the portfolio in isolation. Consider first the yield curve risk of 40.8
reported in this table. Yield curve risk is the risk exposure to changes in the interest rates. We
know from the analytic table that the portfolio duration is greater than the benchmark (6.87
versus 5.37), but how does that translate into what it will cost the manager in terms of additional
risk. That is where the 40.8 is useful. Suppose that the portfolio only differs from the benchmark
with respect to its exposure to changes in the yield curve. Then the 40.8 means that this
mismatch relative to the benchmark creates a risk equal to 40.8 basis points per month of
volatility. That is, if rates were the portfolios only net exposure, this number would be the
tracking error volatility (TEV) of that portfolio versus the benchmark.
The volatility table gives a breakdown of the standard deviation of the returns for the portfolio
and the benchmark in terms of systematic risk and idiosyncratic risk. The portfolio has greater
systematic and idiosyncratic risk than the benchmark. For the total risk of the portfolio and the
benchmark, because the systematic and idiosyncratic risks are constructed so as to be
independent, the standard deviation of the portfolio and benchmark can be calculated as follows:
Total risk (volatility of returns) = [(Systematic risk)2 + (Idiosyncratic risk)2]0.5
The total risk for the portfolio and the benchmark using the values in the volatility table is
143.2 and 117.5, respectively.
Notice that for the benchmark, the percentage of the total risk (117.5) that is explained by the
systematic risk factors (117.4) is 99.91%. For the portfolio it is 99.09% (141.9 / 143.2). It would
therefore seem that the idiosyncratic risk is not important. This, however, is not true when
dealing with the tracking error of the portfolio (volatility of the net position, portfolio vs. the
benchmark). The systematic and idiosyncratic tracking error (per month) is 37.9 basis points and
18.7 basis points per month, respectively. The portfolio tracking error is
Portfolio tracking error = [(Systematic TE)2 + (Idiosyncratic TE)2]0.5
Therefore, the portfolio tracking error is 42.3 basis points per month. Consequently, although
idiosyncratic risk is minimal for the portfolio on a standalone basis, when risk is assessed relative
to a benchmark, there is tracking error risk of 42.3 basis points per month. (The systematic risk is
responsible for 18.7 / 42.3 or 44.21% of the total risk.)
This is an extremely important point: It is the tracking error not the idiosyncratic risk (as
measured by the standard deviation of the idiosyncratic returns) that the manager must consider
in portfolio construction and monitoring. In our illustration, the portfolio tracking error is small,
only 42.3 basis points.

As with equities where a portfolio beta is computed that shows the movement of an equity
portfolio in response to a movement in some equity market index (such as the S&P 500), a beta
can be computed for a bond portfolio. As shown in volatility table, the portfolio beta is 1.18.
Because the benchmark is the Composite Index, a beta of 1.18 means that if that index increases
by 10%, the portfolio will increase, on average, by 11.8%.
A beta-type measure can be estimated for each risk factor. For example, consider the risk factor
measuring changes in the level of the yield curve which is the portfolios duration. A duration
beta can be calculated as follows:
Duration beta Portfolio duration

Benchmark duration
For our portfolio and benchmark, because the duration is 6.87 and 5.37, respectively
(see contribution to duration table), the duration beta is 1.18.
Although the information contained in the volatility table gives us a starting point for
understanding the portfolios risk relative to the benchmark, further insight can be gained by
looking at how the portfolio risk (as measured by tracking error) is allocated across the different
(1) categories of risk factors and (2) asset classes (i.e., sectors of the benchmark).
This risk factor group table provides information about the portfolio risk across the different
categories of risk factors. Shown are the systematic risk and the idiosyncratic risk and six
components of systematic risk. The contribution to TEV column shows the isolated tracking
error. The contribution to tracking error for each group of risk factor is shown in the liquidation
effect on TEV column. As can be seen, the major risk exposures of the 50-bond portfolio are
yield curve risk, corporate spread risk, and systematic risk. The Liquidation Effect on TEV
column gives a new metric, liquidation effect on tracking error. Barclays Capital defines this
metric to be the impact to the portfolios tracking error by hedging (i.e., eliminating) the
exposure to the respective risk group. For example, consider the systematic risk. The liquidation
effect on tracking error shown in the exhibit is 22.4 and is interpreted as follows: if the portfolio
manager hedges the systematic risk, then the portfolios tracking error will decline by 22.4 basis
points per month. Because the portfolios tracking error is 42.3 basis points per month, this
means that hedging the systematic risk reduces the monthly tracking error for the portfolio to
37.9 basis points per month.

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CHAPTER 25

BOND PORTFOLIO CONSTRUCTION

BRIEF REVIEW OF PORTFOLIO THEORY AND RISK DECOMPOSITION

Copyright 2016 Pearson Education, Inc. 551

APPLICATION OF PORTFOLIO THEORY TO BOND PORTFOLIO CONSTRUCTION

Copyright 2016 Pearson Education, Inc. 552

Calculation of Tracking Error

Tracking error is computed as follows:

A tracking error is annualized when observations are monthly as follows:

annual tracking error 5 monthly tracking error 12

A tracking error is annualized when observations are weekly as follows:

annual tracking error 5 monthly tracking error 52

Copyright 2016 Pearson Education, Inc. 553

Tracking Error and Active versus Passive Strategies

CELL-BASED APPROACH TO BOND PORTFOLIO CONSTRUCTION

Copyright 2016 Pearson Education, Inc. 554

Complications in Bond Indexing

Copyright 2016 Pearson Education, Inc. 555

Copyright 2016 Pearson Education, Inc. 556

Duration beta Portfolio duration

Copyright 2016 Pearson Education, Inc. 557

Portfolio Construction Using a Multi-Factor Model and an Optimizer

Copyright 2016 Pearson Education, Inc. 558

Copyright 2016 Pearson Education, Inc. 559

Copyright 2016 Pearson Education, Inc. 560

2. Answer the below questions.

Copyright 2016 Pearson Education, Inc. 561

4. What are the difficulties of implementing the Markowitz mean-variance framework in

Copyright 2016 Pearson Education, Inc. 562

7. What is tracking error?

Copyright 2016 Pearson Education, Inc. 563

These problems notwithstanding, the average of forward-looking tracking error estimates

Copyright 2016 Pearson Education, Inc. 564

10. Answer the below questions.

(a) Compute the tracking error from the following information:

Portfolio As Lehman Aggregate

Copyright 2016 Pearson Education, Inc. 565

(b) Is the tracking error computed in part (a) a backward-looking or forward-looking

Copyright 2016 Pearson Education, Inc. 566

benchmark index = Salomon Smith Barney BIG Bond Index

The above values can all be found in the below table.

Number of Standard Range for Portfolio Corresponding Range

Copyright 2016 Pearson Education, Inc. 567

13. What is meant by tracking error due to systematic risk factors?

Copyright 2016 Pearson Education, Inc. 568

Copyright 2016 Pearson Education, Inc. 569

Moreover, the cell-based approach faces an additional drawback as it ignores how

Copyright 2016 Pearson Education, Inc. 570

Number of Standard Range for Portfolio Corresponding Range for

Copyright 2016 Pearson Education, Inc. 571

18. How can a multi-factor risk model be used to rebalance a portfolio?

Copyright 2016 Pearson Education, Inc. 572

Exhibit 25-14 Trades for Portfolio Rebalancing

Copyright 2016 Pearson Education, Inc. 573

Portfolio isolated systematic TE = [(TE1)2 + (TE2)2 + + (TEK)2]1/2

Copyright 2016 Pearson Education, Inc. 574

where Cov(F1,F2) is the covariance between risk factor exposures 1 and 2.

Identifier Description Position Amount Market Value

003723AA ABN AMRO BANK NV 1,449,636 1,422,596

Copyright 2016 Pearson Education, Inc. 575

Identifier Description Position Amount Market Value

FNA05011 FNMA Conventional Long T. 30yr 1,105,717 1,173,465

Copyright 2016 Pearson Education, Inc. 576