Let's do a thought experiment: Two PMs sit next to each other. Both run IG GBP credit against the same benchmark. Both want to rotate from financials into utilities. One builds the trade list cash-neutral, the other duration-neutral. They end up with different trades, different risk profiles, different compliance outcomes. Same idea. Different implementation. Nobody discussed which method to use because of their platform defaults.
Cash-neutral is simple rebalancing: Sell proceeds fund the buys. Market value stays flat. The problem is that the bonds being sold and bought almost never have the same duration. A cash-neutral switch from a 3-year bank bond into a 10-year utility increases duration as a side effect. The PM wanted a sector rotation. They got a sector rotation and a long duration bet.
Duration-neutral is cleaner from a risk perspective. The trade list is sized so the portfolio's overall duration doesn't move. But the cash amounts on each leg rarely match. There's a residual that needs to go somewhere. Money market instrument, futures overlay, or just accepting the cash drag. In a mandate with tight liquidity constraints this becomes its own operational problem.
A few consecutive cash-neutral switches can drift duration by 0.3 years or more. If the mandate has a ±0.5 year band around the benchmark, that drift pushes the portfolio toward the edge without anyone intending it. The duration creep is a by-product of individually reasonable sector calls.
There is a third way of doing it: factor-neutral rebalancing. Hold duration constant, but also spread duration, convexity, or a set of factor exposures. Analytically this is more ambitious. Practically harder, because the rebalancing engine has to solve a multi-constraint optimisation. Most platforms support cash-neutral and duration-neutral. Fewer systems support arbitrary factor constraints, and the computation time on those can be lengthy.
Short-duration credit with a tight band should rebalance duration-neutral. Total return with wide limits might prefer cash-neutral for speed. Liability-matching portfolios should arguably be liability-neutral, which is a different constraint that most rebalancing tools do not support natively.
Related Articles
See THINKFOLIO in Action
Join leading portfolio managers who are using decision infrastructure to navigate complexity and generate alpha.
