A manager has the following strategy: add value by actively managing the duration of the fixed income securities in the portfolio. Their return for the year was -0.08%. We need to conclude (yes, no, or cannot determine) if their strategy is consistent with the return. Interest rate management effect can be further subdivided into duration, convexity, and yield-curve shape effects if desired. So is it possible that duration effect is positive, but convexity and yield-curve effect is negative, hence the overall negative return. So can the answer be cannot determine? The answer given is No. Since the manager generated return of -0.08% from interest rate management, they have not been able to add value by actively managing the duration of the portfolio.
Is this an ALM portfolio? If so, then he failed to add value by managing the duration.
It doesn’t matter whether it’s ALM or AO. If they’re supposed to add value by managing duration, then they should be adding value. The negative return says that they’re lousy at duration management.
Shouldn’t this be compared on a net basis for ALM? If liabilities return less than assets, and both are negative, then that’s positive for equity?
On another note, the question lacks comprehension, the negative return could be due to all sorts of reasons.
remember he is an ACTIVE MANAGER … if he says he is going to make money for the client - and then starts to complain – I was doing ALM, my assets did better than my liabilities (or vice versa) - would you trust him with your money…
Depends on what type of investor I am. If it’s a bond fund, then yes. If it’s an ALM, and the client is the liability, then it won’t matter to him what I do with his money, and we both win.
So is it possible that return from duration was positive, yet return from convexity was negative (and larger than the positive return from duration). So overall, we have -0.08% return, but there was value added through duration management?
No, think of convexity as a multiplier of duration return, it cannot more than offset it.
If there is no credit risk involved, then the manager had to be short (long) duration before prices went down (up), for an AO portfolio.
Seems like I was wrong here, now I that got to that reading. Since it’s a portfolio, there cannot be any real connection between both.
With regards to the OP, the question and answer do not mesh. Is it a negative total return, or a negative interest rate managment return? Because the former could be ‘cannot determine’, since there is more than one component other than duration affecting returns.
Curious, where did you get this from?
This is from a past paper, can’t remember which one now. The -0.08% return is from from the interest rate management. I also thought it was “cannot determine”, since duration could be positive, but convexity negative (and larger), so hence overall interest rate management was negative. But the correct answer is given as “No” since overall interest rate management is negative (-0.08%). Can anyone else shed light on why answer is no?
In this case, it should be ‘no’,
I haven’t seen an example where convexity was higher in absolute value, but it is theoretically possible depending on the mix of bonds included.