Active versus passive bond investment strategies using manipulation-proof performance measures

¶ … structure' theories by making use of a new method. To achieve this, the case study shapes strategies of bond investment centered on diverse term-structure models to decide the best performing strategy. When making use of a "Manipulation-Proof Performance Measure," the case study attains the finding that in agreement with preceding literature, a pro-active method that is grounded on time-changing term premiums may create the foundation of an effective bond strategy, which outdoes an impartial anticipation inspired passive bond "buy and hold" tactic. Nonetheless, this turns out to be accurate for a previous spell when the literature primarily made this assertion. Later on, the study discovers that the passive "buy and hold" method is considerably superior in comparison to all active bond strategies. Generally, it seems that the impartial expectation model has been the most probable justification of the behavior of the term structure for the duration of more current periods. This is as, financially and statistically, substantial higher performance might not be realized if one utilizes data from the "forward-curve" or the "term-structure" to guide him or her in regulating bond portfolios in reaction to term premium variations (Gonzalez, Skinner, & Agyei-Ampomah, 2013).

Introduction

In the contemporary times, findings have suggested that actively managing portfolios of bond by making use of 'forward curve" data or using the interest rates' "term structure" can bring about a greater and better level of performance. Research studies undertaken by Kessler and Scherer (2009) and Cochrane and Piazzesi (2005) discover that the forward curve is able to give a prediction on the returns attained by the bonds in the future. On the other hand, Ang et al. (2005) as well as Estrella and Mishkin (1997, 1998) discover in their research studies that the gradient of the yield curve is able to offer a forecast of the interest rates in the future.

Results from different research studies have all indicated that active strategies that are centered on, or put together with time varying information in the term structure can create feasible strategies for those who want to invest in bonds (Ilmanen 1995, 1997; Ilmanen & Sayood, 2002; Papageorgiou & Skinner, 2002). However, none of the aforementioned research work has taken into account correctly and precisely, whether active strategies that are centered on information in the term structure as well as the forward curve can in fact perform much better in comparison to a passive "buy and hold" strategy. This is because the research studies did not have accessibility to current advanced "Manipulation-Proof Performance Measure" or MPPM which was put forth by Ingersoll and colleagues in 2007. Rather, the only methods of performance measurement that were accessible to these researchers were all static in their nature and therefore not able to offer any adjustment for the intrinsic forceful nature of strategies centered on time varying term premiums integrated in both the forward and term structure.

Taking into consideration this void in the research, this particular paper will aim to determine as to whether dynamic strategies centered on time varying term premiums can in fact have a better performance compared to a standard buy and hold strategy. A significant aspect in the study or examination of this subject is performance measurement. Active strategies purposely endeavor to change the spread of returns by curtailing shortcomings and enhancing positive potential, and in so doing generate positive skewness in their efforts to improve and increase returns. For the time being, a number of strategies might prosper or be unsuccessful in a dramatic way, bringing about unevenness in the distribution. Any performance measure ought to take into consideration for these additional moments in the distribution of proceeds if at all either skewness and kurtosis or both of them are of concern to the investors. Furthermore, active strategies are dynamic as a result of their nature and therefore static performance measures are incapable of capturing their primary nature.

According to Ingersoll et al. (2007) making use of static performance measures for the assessment and evaluation of dynamic strategies can be deceptive since portfolio managers are able to manipulate their strategies, irrespective of whether it is deliberate or not, in order to attain a better score on an extensive assortment of static performance measures even supposing the manager does not have any private information. In particular, the MPPM overrides and overcomes the limitations of all preceding static performance measures on numerous different factors. It can be separated with time (can be expressed as a function of time, time being the variable) and for that reason not cause to experience any sort of dynamic manipulation. In addition, it is curved in, which implies that an individual or manager cannot manipulate his or her score through leveraging. More so, it is constant with evenness while all at once identifying greater performance that is centered on the manipulation of candid arbitrage prospects. Taking these measurement matters into consideration, the study makes an attempt to measure the performance of a selection of bond strategies that are stirred by data that is meant to be confined in the term structure and in the forward curve through five particularly dissimilar performance measures. First off, there is the traditional mean variance Sharpe ratio and secondly there is the one that alters for utility purposes that represent an inclination for positive skewness in addition to mean variance. The third one makes an adjustment for tail risk and the fourth one makes an adjustment for tail risk, skewness, and kurtosis, in addition to mean variance. The last one makes an adjustment for the forceful nature of active strategies. In particular, this last measure is the MPPM, which inhibits the manipulation of performance scores by regulating the return distribution by means of active trading (O Gonzalez, Skinner, & Agyei-Ampomah, 2013).

Objective

The main objective of this case study is the subject matter of how to measure performance

Methodology

The source of the data employed in this case study is Ebscohost and the keywords used are bond strategies, term structure theory, performance measurement and MPPM. Another search of the keywords was also done on Bloomberg. This research study purposes to examine, in an empirical manner, a basic buy and hold long-term bond strategy and make a comparison of how it performs against three other dissimilar bond strategies that are a forward curve, a term structure and an immunization strategy. The intent here is to determine whether the statistically significant information within the forward curve and the term structure can create the context of a superior investment strategy. In this case study, we opted to examine and study the performance of 9-year bond portfolios since nine years seem to be a probable contender for a distinctive, long-term, chosen environment investment horizon. In undertaking this examination, the study proposes to gather the closing bid price of every day together with the date issue, date of maturity, day count convention, the coupon rate, and the ISIN number of all 452 Treasury bonds that can be accessed in Bloomberg from 1 May, 2007. Centered on the aforementioned aspects, the researcher will make the attempt to make a calculation of the yield to maturity, the accumulated interest for every day of trading and Macaulay duration (O Gonzalez, Skinner, & Agyei-Ampomah, 2013).

As the study proxy for the interest rate that is accessible for investment in the short run, the researcher will gather the 3-month LIBOR rates from Bloomberg. Since the researcher is certain of the day count conventions, it is possible to calculate the implicit LIBOR rate of per day of trading ( Gonzalez, Skinner, & Agyei-Ampomah, 2013). In order to be certain that the bond strategies are studied in an integrated context, all of the bond strategies started on the similar date as the same bonds when capitalized in the bond market. To be considered, every bond has to have 9 years of constant daily bid prices from the date of the original portfolio. To decrease any characteristic risk, the researcher will choose a total of 6 bonds from the bonds that are appropriate as of the day the portfolio was formed. At every date of formation, 4 portfolios are formed with each of them being consistent to each of the strategies. In this manner, the asset assortment choice of each of the four strategies is placed constant in order for the researcher to isolate the influence of the timing decision ( Gonzalez, Skinner, & Agyei-Ampomah, 2013). The selection of studies consists of articles with bonds to their portfolios. One bond is required to have a maturity that is near 9 years while a second bond ought to have a Macaulay duration that is near 9 years. Two other bonds must have a Macaulay duration superior than, however still near 9 years, and the ultimate two ought to have a Macaulay period that is a reduced number but still near 9 years ( Gonzalez, Skinner, & Agyei-Ampomah, 2013).

The immunization strategy is similar to the buy and hold strategy with the only difference that the study does not employ equivalent weights for the investing back on coupons or for the creation of the primary bond portfolio. In detail, these weights are selected to ensure that the primary bond portfolio has a Macaulay time period that is equivalent to 9 years. The portfolios for active strategies are fashioned from the similar bonds as the buy and hold bond strategy and immunization strategy. Similar to the buy and hold bond strategy, these portfolios are similarly weighted. Nevertheless, when making use of active strategies, if term premiums differ it will be important to decide when the investor ought to adjust from holding bonds to financial instruments of the money market and the other way round ( Gonzalez, Skinner, & Agyei-Ampomah, 2013).

The study will apply two disparities of the time varying term premium approach. To start with, there is the slope premium strategy, which makes the assumption that, an increase in the slope of the term structure encompasses beneficial information regarding the probability of greater impending inflation and/or real economic activity, and as a result, rises in the gradient of the term structure are associated to rises in interest rates in the long run (Estrella and Mishkin, 1997). As a result, if the gradient of the term structure rises, one ought to trade the bonds and invest the capital in instruments of the money market. Secondly, there is the forward curve strategy, which emphasizes that the forward curve forecasts the projected yield on long-term bonds. When the projected surplus yield on long-term bonds is positive, one ought to hold bonds. On the other hand, when the projected return is negative, one ought to sell bonds and invest the capital in instruments of the money market (Cochrane and Piazzesi 2005).

Considering the interest rate process is stochastic, a sightless application of the probit decision rule will bring about too many trades. As an alternative, one ought to try to find guarantee that interests rates are on a mean-reverting tendency. As a result, the researcher will make the decision to shift from bonds to Libor money market instruments when, for the duration of any ten trading day period, the probit model forecasts an increase in interest rates in the long run on seven or more out of those ten days of trading. After that, the researcher then goes back to bonds at the time when the probit model forecasts a decline in interest rates in the long run on seven or more days out of the ten days of trading ( Gonzalez, Skinner, & Agyei-Ampomah, 2013).

The passive buy and hold bond strategy has the great benefit of not needing any sort of transaction costs for revenue. This implies that there no expenses linked with trading the whole bond portfolio and investing the money back in the money market and vice versa. All active strategies, for instance the slope premium strategy necessitate a comprehensive turnover once the decision is made for moving from the bonds and shift to the money market. As a result, we would give the preconceived notion for the results in favor of the active strategies if we did not make an adjustment for the influence of these extra costs ( Gonzalez, Skinner, & Agyei-Ampomah, 2013).

Conclusion

Generally, it seems that the impartial expectation model is the most probable justification of the term structure behavior for the duration of more current periods. This is since, financially and statistically, substantial higher performance cannot be realized if one utilizes data from the "forward-curve" or the "term structure" to guide him or her in altering bond portfolios in reaction to term premium changes (Gonzalez, Skinner, & Agyei-Ampomah, 2013).