INTEGRATED SIMULATION AND OPTIMIZATION MODELS FOR TRACKING INDEXES OFFIXED-INCOME SECURITIES

Increasing performance pressures on fixed-income managers have led to a search for new and creative ways to add to portfolio returns. The la rgest pension plan sponsors, insurance companies, foundations, and mon ey management firms are using indexed portfolios as their fixed-income assets management strategies since the late 1970s. Tracking a fixed-i ncome index is a difficult task due to transaction costs, portfolio si ze and diversification restrictions, liquidity requirements, bid/ask s preads, etc. This paper develops an integrated simulation and optimiza tion approach for tracking fixed-income indices. The model was impleme nted at Metropolitan Life Insurance Company. We introduce a simulation model for generating scenarios of holding period returns of the secur ities in the index. Then we develop optimization models to select a po rtfolio that tracks the index. The models penalize downside deviations of the portfolio return from the index. The developed framework is us ed to track the Salomon Brothers Mortgage Index. In backtesting over t he period 1989-1991, the models outperformed the index by 50bp. Underp erformance never exceeded more than -5bp in any single month. A small tracking error was also observed during the recent months that the mod el has been in use.