Trading Effect Definition

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Trading Effect Definition

What Is Trading Effect?

The trade impact assesses a portfolio manager’s effectiveness by comparing portfolio returns to a predetermined benchmark.

Key Takeaways

  • The trade impact assesses a portfolio manager’s effectiveness by comparing portfolio returns to a predetermined benchmark.
  • The trading impact provides an answer to the basic issue of whether the portfolio manager or investor adds value to the portfolio by actively managing it.
  • The trading impact may also be used to assess if active (trade) investment is preferable than passive investing.

Understanding Trading Effect

The trade impact is the difference in performance between the portfolio of an active investor and a set benchmark. Active investing is a hands-on method that needs someone to serve as the portfolio manager. The goal of active investing is to determine if the selected composition of the investor’s portfolio, including any changes made over the observation time, performed better or worse than the benchmark. The trading impact may also be used to establish if active (trade) investment is superior to more passive (buy-and-hold) investing techniques.

The benchmark adopted must be relevant to the portfolio being assessed and generally recognized and utilized. For example, the S&P 500 index would be an ideal benchmark to assess an investor’s portfolio that is mostly made of large-cap shares in the United States.

The trading impact allows investors to quantify the performance of a portfolio manager. It addresses the straightforward issue of whether the manager (or investor) created value by making portfolio modifications.

If the benchmark, such as the Dow Jones Corporate Bond Index, beats the actively managed bond portfolio, the portfolio manager has deducted value from the investor’s account. If the bond portfolio outperforms the bond index, the changes in portfolio composition have enhanced investor value, suggesting a successful management approach.

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Trading Effect and Bond Portfolios

Bond portfolio results may be influenced by a variety of complicated variables. One reason for the absence of bond portfolio performance measurements was that most bond portfolio managers used buy-and-hold strategies prior to the 1970s, therefore their performance probably did not vary significantly. Because interest rates were largely constant at the time, active management of bond portfolios provided little benefit. The bond market environment altered substantially in the late 1970s and early 1980s, when interest rates rose rapidly and became more unpredictable.

Although strategies for analyzing stock portfolio performance have been around for decades, analogous approaches for reviewing bond portfolio performance have only lately been developed, as bond market volatility has grown considerably.

This shift generated an incentive to trade bonds, and the tendency toward active management resulted in more erratic performance by bond portfolio managers. As a result of this disparity in performance, there was a need for methodologies to assist investors in evaluating the performance of bond portfolio managers.

Bond assessment algorithms often take into account both broad market conditions and the influence of individual bond selection. This trading impact measurement approach breaks down the return based on the bond’s tenure as a complete risk measure, but it does not account for changes in default risk.

The approach, in particular, does not distinguish between a AAA bond with an eight-year length and a BBB bond with the same period, which might obviously impair performance. A portfolio manager who invests in BBB bonds, for example, may see a significant trading benefit merely because the bonds are of lesser grade.

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