What is 'Trading Effect'

Trading effect is the measure of performance that examines the difference in returns between a bond portfolio and a chosen benchmark. This difference occurs as a result of short-term alterations in the portfolio's composition. The trading effect reveals whether trading activities benefited or hindered a portfolio's return.

BREAKING DOWN 'Trading Effect'

The trading effect serves as a way for investors to quantify a portfolio manager's performance. It answers the simple question of whether the manager (or investor) added value by making adjustments to the portfolio. If the benchmark, such as the Dow Jones Corporate Bond Index, outperforms the actively managed bond portfolio, then the manager subtracted value for the investor. If the bond portfolio earns more than the bond index, then the changes in portfolio composition have increased investor value, indicating a good management strategy.

Numerous and complex factors can influence bond portfolio returns. One reason for a lack bond portfolio performance measures was that prior to the 1970s most bond portfolio managers followed buy-and-hold strategies, so their performance probably did not differ much. In this era, interest rates were relatively stable, so one could gain little from the active management of bond portfolios. The environment in the bond market changed considerably in the late 1970s and especially in the 1980s when interest rates increased dramatically and became more volatile.

This created an incentive to trade bonds, and this trend toward more active management led to substantially more dispersed performance by bond portfolio managers. This dispersion in performance in turn created a demand for techniques that would help investors evaluate the performance of bond portfolio managers.

Measuring Trading Effect

Although the techniques for evaluating stock portfolio performance have been in existence for almost 40 years, comparable techniques for examining bond portfolio performance were initiated more recently when bond market changed considerably because of a dramatic increase in interest rates and volatility. This change created an incentive to trade bonds, and this trend toward active management led to more dispersed performance by bond portfolio managers. This dispersion in performance in turn created a demand for techniques that would help investors evaluate the performance of bond portfolio managers. The evaluation models for bonds typically consider the overall market factors and the impact of individual bond selection. 

This technique for measuring trading effect breaks down the return based on the duration as a comprehensive risk measure. But it not consider differences in the risk of default. Specifically, the technique does not differentiate between an Aaa bond with duration of 8 years and a Baa bond with the same duration. This could clearly affect the performance. A portfolio manager that invested in Baa bonds, for example, could experience a very positive analysis effect simply because the bonds were lower quality than the average quality.

RELATED TERMS
  1. Benchmark Bond

    A benchmark bond is a bond that provides a standard against which ...
  2. Bond

    A bond is a fixed income investment in which an investor loans ...
  3. Corporate Bond

    A corporate bond is a debt security issued by a corporation and ...
  4. Discount Bond

    A discount bond is a bond that is issued for less than its par ...
  5. Total Bond Fund

    A total bond fund is a mutual fund or exchange-traded fund that ...
  6. Bond Buyer 20

    Bond Buyer 20 is a representation of municipal bond trends based ...
Related Articles
  1. Investing

    Investing in Bonds: 5 Mistakes to Avoid in Today's Market

    Investors need to understand the five mistakes involving interest rate risk, credit risk, complex bonds, markups and inflation to avoid in the bond market.
  2. Financial Advisor

    The Effect of Fed Fund Rate Hikes on Your Bond Portfolio

    The extent to which a fed funds rate hike impacts a bond portfolio depends on the portfolio’s duration and its place along the yield curve.
  3. Investing

    Corporate Bonds for Retirement Accounts

    Corporate bonds are usually the preferred choice in retirement accounts. Here are some of the benefits of corporate bonds, and strategies for a portfolio.
  4. Investing

    The Basics Of Bonds

    Bonds play an important part in your portfolio as you age; learning about them makes good financial sense.
  5. Investing

    6 Ways That Investors Use Bonds

    Learn how the stodgy stereotype of bonds can overshadow the basic and advanced uses of what these investments can do for your portfolio.
  6. Investing

    How Rising Interest Rates Impact Bond Portfolios

    A look at the impact that changing interest rates - rising or falling - have on bonds and what investors need to consider.
  7. Investing

    The Best Bet for Retirement Income: Bonds or Bond Funds?

    Retirees seeking income from their investments typically look into bonds. Here's a look at the types of bonds, bond funds and their pros and cons.
  8. Investing

    Why You Should Avoid Fixating on Bond Duration

    Financial advisors and their clients should then focus on a bond fund’s portfolio rather than relying on any single metric like duration.
  9. Investing

    Key Strategies To Avoid Negative Bond Returns

    It is difficult to make money in bonds in a rising rate environment, but there are ways to avoid losses.
  10. Investing

    Evaluating Bond Funds For Performance and Risks

    Discover some of the key factors for determining a bond fund's risk-return profile and its relative performance. Understanding these metrics are important.
Trading Center