Monday, May 9, 2011

At Suggestion of the Advisory Board, the AIM Fixed Income Fund Will Conduct Pro Forma Stress Testing

Dan Tranchita
Jay Schwister
This past week the AIM Funds annual report meetings produced some excellent suggestions from the alumni, faculty, and investment professionals who attended. During the AIM Fixed Income Fund meeting it was suggested by members of the Advisory Board [which include Jay Schwister and Dan Tranchita (Baird Advisors)] that the students conduct not only ex post, but pro forma bond fund 'stress testing.'


The other members of the Fixed Income Advisory Board include Pat Brown of Citigroup and Tim Fotsch of Wells Capital Management. Jay Schwister and Dan Tranchita explained to the students the importance of knowing in advance the impact on a bond portfolio of changing interest rates, credit spreads, and yield curve twists. Jay Schwister said, "While I appreciate the fact that the AIM students understand how their portfolio performance was impacted by events during the past twelve months, I'm more concerned that they understand the impact on their future returns if interest rates rise by 100 bps or if credit spreads widen 50 bps. It is essential that a fixed income investor know the extent of risk exposure they have within their portfolio." 


Dr. David Krause, AIM program director, said, "This suggestion was well received by the students. Currently, the AIM Fixed Income Fund has targeted a 100 bps tracking error limit and, as Jay and the others pointed out, it is important for the student-managers to understand how various positions will impact their risk budget. For instance, if the ETFs they purchase have an average tracking error of 30 bps versus the benchmark, then 30% of their risk budget is already used up without any duration or credit risk being utilized."


Dr. Krause continued, "The AIM Fixed Income Fund meeting on Wednesday was the best we've had since the inception of the AIM Funds in 2005. Jay Schwister and Dan Tranchita were joined by Sean Gissal (Marquette Endowment Fund, CIO), Pat Brown (Citigroup), and Tim Fotsch (Wells Capital Management). The AIM students were very appreciative of the investment professionals' comments and efforts to help them understand the process of managing a fixed income portfolio."


"Interestingly, this weekend an article was posted on Morningstar.com titled, How to Stress-Test a Portfolio's Interest-Rate Sensitivity, Dr. Krause said. "This article will be discussed with the students in the AIM Class of 2012 and students enrolled in my Fixed Income course when the fall semester begins. We'll work on building a model to conduct pro forma stress testing of the AIM Fixed Income Fund."  


Dr. Krause concluded, "Another good article on understanding a bond portfolio's duration as it relates to interest rate risk was published last fall on Morningstar.com at: http://news.morningstar.com/articlenet/article.aspx?id=333205. We'll continue to work on building a sensitivity model that allows the students to understand the impact of different scenarios, such as changing interest rates and inflation levels. We'd like to thank the investment professionals that take time to visit our campus and the AIM program....it is greatly appreciated."

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