Investors, who do not believe in Efficient Market Hypothesis (EMH), adopt active management strategies. Such investors incur more search costs (with regard to time as well as money) and transaction costs. However, they believe that the marginal benefit outweighs the marginal costs incurred. Active strategy investors possess superior analytical or judgmental skills, superior information, and the ability or willingness to do what other investors (particularly institutions) are not willing to do.

Forecasting Returns

Active management can be defined as forecast of returns for assets that are available. Through MFM technology, this forecasting part is further reduced to just predicting factor returns. In the case of bond portfolio management, the basic forecasts are related to various issues such as positive or negative parallel shifts of the yield curve, moves toward a more or less steep slope of the yield curve, moves toward a more or less convex yield curve, moves toward wider or narrower sector spreads, moves towards wider or narrower quality spreads etc. Later, based on the portfolio construction technique used, forecast for movements of the complete yield will be translated into factor returns.

Portfolio Construction

Based on the fact whether bond portfolios are explicit forecasts of the factor returns or not, they are classified into two categories. If bond portfolios are explicit forecasts of the factor returns, then a full optimization process can be used. Conversely, if the bond portfolios are not explicit forecasts of the factor returns, then the portfolio is built constraining the risk exposures to remain consistent with the forecast scenario for the yield curve. In such case, use of a risk model will result in minimizing risk given the constraints caused by the forecast.