Fixed-income securities are an important asset class that adds considerable diversification benefits to a portfolio.
The passive strategy known as stratified sampling allows investors to achieve benchmark returns while controlling risk and transaction costs.
This approach can be utilized in a tactical asset-allocation strategy, as it allows for relatively quick changes in portfolio allocations.
Stratified sampling allows for active bets to be integrated into the portfolio by tilting weights in response to forecasted returns.
The use of back-testing will ensure that actual outcomes align with expectations by adequately controlling benchmark risks.
An allocation of investment to fixed-income assets is an important component of any diversified investment strategy. The fixed-income asset class comprises a variety of debt instruments that include government bonds, corporate bonds, municipal bonds, mortgage-backed securities, inflation-indexed debt, and convertible bonds, among others. With such a large number of securities available from which to construct a portfolio, this article reviews the stratified sampling method of replicating the returns of a benchmark portfolio in fixed-income securities. This method is of use to investors who are undertaking both active and passive portfolio management approaches.
Figure 1 shows the daily total returns of the S&P 500 and the MSCI World equity indices as well as fixed-income indices covering a broad-based global benchmark, global high yield, and world corporate debt between February 2002 and February 2012. The impact of the financial crisis is clearly evident in the figure. Interestingly, an investment made in February 2002 in either of the fixed-income indices would be worth more today than either of the equity benchmarks. In terms of risk, the standard deviation of monthly returns is considerably higher for the two equity indices—around 16%. The global broad-based index and the world corporate index have values of 6–7%. An important benefit of including fixed income in a portfolio is the diversification benefit. The correlation coefficients between the five indices are given in Table 1. The global high-yield index is more highly correlated with the equity indices than the other fixed-income indices. Either way, it is clear that fixed income should be included in a diversified portfolio.
|MSCI World Equity||S&P 500||BOFA/ML Global Broad FI||BOFA/ML Global High Yield FI||Citibank World Corporate FI|
|MSCI World Equity||1.000||0.973||0.264||0.755||0.466|
|BOFA/ML Global Broad FI||0.264||0.166||1.000||0.346||0.877|
|BOFA/ML Global High Yield FI||0.755||0.705||0.346||1.000||0.622|
|Citibank World Corporate FI||0.466||0.357||0.877||0.622||1.000|
BOFA/ML: Bank of America Merrill Lynch; FI: fixed income
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