To improve a buy and hold strategy a constant average duration is imposed for the managed portfolio during the full interest rate cycle. This is done because interest rates follow a mean reversion process. In case interest rates move above their average value, they tend to decline later. In contrast, if the interest rates move below average, then they will rise later.
Initially, consider the level of interest rates fluctuation is at middle range (i0 ) and the average level of index duration is D0. If the interest rates increase from this level, the duration of index will decline. At the same time, if the portfolio manager matches his portfolio duration to index duration, it will result in replication of index performance. When interest rates move to an upper trigger limit iU, subsequently the manager will bring his portfolio duration to the average level of the index duration D0. By maintaining a constant duration D0 for the bond portfolio till the interest rates move back to their average level i0, the portfolio manager will take an active positive exposure that will be rewarded, given the term structure declines later on. In the case of decline in interest rates from level i0 and with a lower trigger limit iL, an opposite argument can be applied.
The success of above strategy will depend on the assumption that the process involved behind the movement in interest rates is mean reverting. This implies that the interest rates should fluctuate in a reasonably well defined and stable range. For example, let us consider a positive shift in the medium term inflation rate. In such case, the fluctuation range of interest rates will also shift accordingly and this will result in trigger levels being adjusted. In case, the portfolio manager does not make these adjustments, he will bet too early on decrease in interest rates and thus, he will under perform with regard to the index. Though interest rates remain mean reverting, the length and amplitude of the cycle will not remain stable always. Going back to the strategy, the trigger levels iU and iL should indicate an imminent reversal in the interest rates trend. If this does not happen and for example, the interest rates keep moving up, then the triggered increase in the active exposure will finally affect the portfolio performance.