Trading Effect: What It Means, How It Works

What Is Trading Effect?

The trading effect measures a portfolio manager's effectiveness by comparing their portfolio returns to that of a chosen benchmark.

Understanding Trading Effect

The trading effect is the difference in performance between an active investor's portfolio and a chosen benchmark. Active investing takes a hands-on approach and requires that someone act in the role of the portfolio manager. With active investing, the aim is to see if the chosen composition of the investor's portfolio, including any alterations that were made during the observed period, performed better or worse than the benchmark. The trading effect can also be used to determine whether active investing (trading) is better than more passive buy-and-hold investing strategies.

The chosen benchmark has to have relevancy to the portfolio being measured and must be widely recognized and used. For example, the S&P 500 index would be an appropriate benchmark to measure an investor's portfolio that is predominantly comprised of U.S. large-cap equities.

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 portfolio 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.

Trading Effect and Bond Portfolios

Numerous and complex factors can influence bond portfolio returns. One reason for a lack of 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 that 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 1980s when interest rates increased dramatically and became more volatile.

This change created an incentive to trade bonds, and this trend toward active management led to more dispersed performances 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 the trading effect breaks down the return based on the bond's duration as a comprehensive risk measure, but it does not consider differences in the risk of default.

Specifically, the technique does not differentiate between an AAA bond with a duration of eight years and a BBB bond with the same duration, which could clearly affect the performance. A portfolio manager that invested in BBB bonds, for example, could experience a very positive trading effect simply because the bonds were of lower quality.