The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

KEY POINTS

• The selection of a benchmark index is a process that can carry as much importance as the optimization of the portfolio itself.

• Above all else, the index should be relevant to the investor.

• The goals of the fund should be considered and, if necessary, a customized index should be created to meet the specific needs of the manager.

• When constructing an index using a rules-based method, it is always important to take into account the replicability of the index, the transparency of the rules created and it should be representative of the market.

• Construction of a custom index can be achieved through mean–variance analysis to meet the needs of almost any investor. Using this method allows the manager to measure performance against the most efficient “passive” allocation of assets, which should eventually lead to better, more informed investment decisions.

• Using optimization techniques is a very potent approach to balance risk versus return in a portfolio versus the benchmark.

• Optimization allows one to change risk parameters, monitor the associated change in excess returns, gauge the interplay between duration, curve positioning and asset allocation, all in a well-defined and consistent framework.

• Notwithstanding the fact that the framework is highly quantitative, there are certainly some steps in the analysis that require a judgment call, such as the choice of certain constraints, the decision about what duration/risk tolerance combination to use, etc. ...