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.