In: Finance
Compare and contrast the strategies of index matching (or indexing) and of immunisation for managing a bond portfolio. Provide examples for who would use such strategies under what circumstances.
Bond management strategies:
Because of the size of the index the strategy works well with large portfolio due to number of bonds that are required to replicate the index. One must also take into consideration the transaction costs that are associated not only with the original investment but also periodic balancing of portfolio to reflect the changes in the index. The strategy is primarily used by long term investors who want their returns to follow the market. Thus, investors usually have three choices when using an index strategy. They can choose a very narrow index that represents only a small portion of the market (such as the American Stock Exchange Biotech Index). Investors also can purchase a random sample of securities in an index (this is called a sampling approach) or they can purchase a set number of securities in each segment of an index (this is called a stratified approach).
This strategy is mainly used in institutional investment by insurance companies, pension funds & banks in order to match the time horizon of their future liabilities with structured cash flows. This is considered to be one of the soundest strategies & can also be used by the individuals.
For example, just like a pension fund would use an immunization to plan for cash flows upon an individual's retirement, that same individual could build a dedicated portfolio for their own retirement plan.