CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 CFA 2018 r32 monitoring and rebalancing IFT notes

Monitoring Changes in Investor Circumstances and Constraints LO.c: Recommend and justify revisions to an investor’s investment policy statement and strategic asset allocation, given a c

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IFT Notes for the Level III Exam www.ift.world Page 1

Monitoring and Rebalancing

1 Introduction 2

2 Monitoring 2

2.1 Monitoring Changes in Investor Circumstances and Constraints 2

2.2 Monitoring Market and Economic Changes 3

2.3 Monitoring the Portfolio 3

3 Rebalancing the Portfolio 3

3.1 The Benefits and Costs of Rebalancing 4

3.2 Rebalancing Disciplines 4

3.3 The Perold–Sharpe Analysis of Rebalancing Strategies 6

3.4 Execution Choices in Rebalancing 8

Summary 8

Examples from the Curriculum 12

Example 1 Monitoring a Change in Investment Horizon 12

Example 2 Monitoring Changes in an Investor’s Circumstances and Wealth2 13

Example 3 An Investor with a Concentrated Stock Position 18

Example 4 How Active Managers May Use New Analysis and Information 21

Example 5 The Characteristics of Successful Active Investors 21

Example 6 The Nonfinancial Costs of Portfolio Revision 22

Example 7 An Illustration of the Benefits of Disciplined Rebalancing 23

Example 8 Tolerance Bands for an Asset Allocation 26

Example 9 Strategies for Different Investors 27

This document should be read in conjunction with the corresponding reading in the 2018 Level III CFA® Program curriculum Some of the graphs, charts, tables, examples, and figures are copyright

2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute

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1 Introduction

A portfolio manager works with the client to create an IPS The client’s portfolio is based on the IPS After a portfolio is created the portfolio manager must constantly monitor and rebalance the portfolio because:

1 Client needs and circumstances change

2 Capital market conditions change

3 Fluctuation in market values of assets create divergence from strategic asset allocation

This reading covers monitoring (Section 2) and rebalancing (Section 3)

2 Monitoring

LO.a: Discuss a fiduciary’s responsibilities in monitoring an investment portfolio

A portfolio manager needs to track everything that can affect the client’s portfolio The three main items that need to be monitored are:

 investor circumstances, including wealth and constraints (Section 2.1)

 market and economic changes (Section 2.2)

 the portfolio itself (Section 2.3)

Portfolio managers are fiduciaries, and they therefore have an ethical responsibility to consider the appropriateness and suitability of the portfolio relative to these factors

LO.b: Discuss the monitoring of investor circumstances, market/economic conditions, and portfolio holdings and explain the effects that changes in each of these areas can have on the investor’s portfolio

This LO is covered in sections 2.1, 2.2 and 2.3

2.1 Monitoring Changes in Investor Circumstances and Constraints

LO.c: Recommend and justify revisions to an investor’s investment policy statement and strategic asset allocation, given a change in investor circumstances

A portfolio manager should monitor possible changes in:

 Investor circumstances and wealth: This includes events such as changes in employment,

marital status and the birth of children

 Liquidity requirements: We need to make changes to accommodate cash requirements as a

result of an expected or unexpected events

 Time horizons: We need to reduce risk when an individual moves through the life cycle and

his/her time horizon shortens

Refer to Example 1 from the curriculum

 Tax circumstances: We must construct portfolios that deal with each client’s current tax

situation and take future possible tax circumstances into account

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 Laws and regulations: If laws and regulations change we must make appropriate changes to stay

in compliance

 Unique circumstances: This includes special situations such as socially responsible investing,

concentrated stock holdings etc

A portfolio manager should conduct a review meeting with the client quarterly or on a semi-annual basis

to identify these changes

2.2 Monitoring Market and Economic Changes

A portfolio manager should monitor changes in:

 Asset risk attributes: If the mean return/volatility/correlation of asset classes change profoundly,

then we need to adjust the asset allocation according to the new risk attributes

 Market cycles: We can monitor market cycles and make tactical adjustments to asset allocations or

adjust individual securities holdings to enhance portfolio returns

 Central bank policy: Central bank’s monitory and interest rate decisions affect both the bond and

stock markets

 Yield curve and inflation: Yield curves tend to:

 become steeply upward-sloping during recessions

 flatten during expansions

 become downward sloping before an impending recession

Unexpected inflation affects both fixed income and equity investors

2.3 Monitoring the Portfolio

A portfolio manager should continuously evaluate:

 events and trends affecting prospects of individual holdings and asset classes and their

suitability for attaining client objectives

 changes in asset values that create unintended divergence from client’s strategic asset

allocation

3 Rebalancing the Portfolio

Monitoring and rebalancing a portfolio is similar to flying an airplane The pilot monitors and adjusts, the plane’s course to make sure that the plane ultimately arrives at the predetermined destination

Similarly, a portfolio manager adjusts the portfolio to achieve the desired asset allocation

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Rebalancing covers:

 adjusting actual portfolio to current strategic asset allocation because of price changes in

portfolio holdings

 revisions to investor’s asset class weights because of changes in investor’s objectives and

constraints, or because of changes in capital market expectations

 tactical asset allocation (This topic is addressed in other readings.)

3.1 The Benefits and Costs of Rebalancing

LO.d: Discuss the benefits and costs of rebalancing a portfolio to the investor’s strategic asset allocation

Returns portfolio to optimal allocation Transaction costs offset benefits of rebalancing

Controls drift in overall level of portfolio risk Transaction costs are particularly high for illiquid

investments Controls drift in types of risk exposures Transaction costs include implicit costs and are not

precisely measurable Without rebalancing investor might hold

The advantage of this method is that it is very simple to implement The drawback is that it is unrelated

to market behaviour and the portfolio could be very close (this will lead to unnecessary transaction costs) or very far (this will lead to high market impact costs) from optimal allocations on rebalancing dates

Percentage of portfolio rebalancing

In this method we set rebalancing thresholds or trigger points We will adjust the asset allocation only when the thresholds are crossed For example, consider a three-asset class portfolio of domestic

equities, international equities, and domestic bonds The target asset proportions are 45/15/40 with respective corridors 45% ± 4.5%, 15% ± 1.5%, and 40% ± 4% Suppose the portfolio manager observes

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the actual allocation to be 50/14/36; the upper threshold (49.5%) for domestic equities has been

breached The asset mix would be rebalanced to 45/15/40

Compared to calendar rebalancing, percentage-of-portfolio rebalancing can occur on any calendar date

It also helps a portfolio manager to exercise a tighter control on divergences from target proportions because it is directly related to market performance

Optimal corridor width

LO.f: Discuss the key determinants of the optimal corridor width of an asset class in a of-portfolio rebalancing program

percentage-Exhibit 8 provides a list of factors that affect the optimal corridor width

Factor

Effect on Optimal Width of Corridor (All Else Equal) Intuition

Factors Positively Related to Optimal Corridor Width

Transaction costs The higher the transaction

costs, the wider the optimal corridor

High transaction costs set a high hurdle for rebalancing benefits to overcome

Risk tolerance The higher the risk tolerance,

the wider the optimal corridor

Higher risk tolerance means less sensitivity to divergences from target

A given move away from target is potentially more costly for a high-volatility asset class, as a further divergence becomes more likely

Other rebalancing strategies

Some other rebalancing strategies include:

 Calendar-and-percentage-of-portfolio rebalancing: This a combination of the two approaches discussed above

 Equal probability rebalancing: Here we specify a corridor for each asset class as a common multiple of the standard deviation of the asset class’s returns In this method each asset class is equally likely to trigger rebalancing

 Tactical rebalancing: This is a variation of calendar rebalancing that specifies less frequent rebalancing when markets appear to be trending and more frequent rebalancing when they are

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characterized by reversals

Rebalancing to Target Weights versus Rebalancing to the Allowed Range

LO.g: Compare the benefits of rebalancing an asset class to its target portfolio weight versus rebalancing the asset class to stay within its allowed range

So far we’ve focused on rebalancing to target weights; another strategy is to rebalance to the allowed range which enables portfolio manager to benefit from short-term market opportunities and to better manage weights of relatively illiquid assets

The optimal rebalancing strategy should maximize present value of net benefit

3.3 The Perold–Sharpe Analysis of Rebalancing Strategies

In this analysis we assume that the portfolio consists of only two-asset classes: one risky and the other risk-free We will consider the following strategies

 Buy-and-Hold Strategies

 Constant-Mix Strategies

 Constant-Proportion (CPPI) Strategy

Buy and Hold Strategies

This is a passive strategy of buying an initial asset mix (say 60/40 stocks/Treasury bills) and do nothing subsequently

In a buy-and-hold strategy, the value of risk-free assets represents a floor for portfolio In our example, if the value of the stock allocation were to fall to zero, we would still have 40% in the risk-free asset

We can therefore derive the following expressions:

Portfolio value = Investment in stocks + Floor value

Cushion = Portfolio value – Floor value

For a buy and hold strategy, the following holds:

 Upside is unlimited, but portfolio value can be no lower than the allocation to bills

 Portfolio value is a linear function of the value of stocks, and portfolio return is a linear function

of the return on stocks

 The value of stocks reflects the cushion above floor value Hence there is a 1:1 relationship between the value of stocks and the cushion

 The implication of using this strategy is that the investor’s risk tolerance is positively related to wealth and stock market returns Risk tolerance is zero if the value of stocks declines to zero

Constant-Mix Strategies

This is a dynamic strategy, which is synonymous with rebalancing to strategic asset allocation The target

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investment in stocks in the constant-mix strategy is:

Target investment in stocks = m × portfolio value

where m is a constant between 0 and 1 that represents the target proportion in stocks

Example of a constant mix strategy: an investor decides that his portfolio will be 60 percent equities and

40 percent bills and rebalances to that proportion regardless of his level of wealth

In constant mix we buy shares when the market is going down and sell when the market is going up

A constant-mix strategy is consistent with a risk tolerance that varies proportionately with wealth An investor with such risk tolerance desires to hold stocks at all levels of wealth

Constant-Proportion Strategy: CPPI

A constant-proportion strategy is a dynamic strategy in which the target equity allocation is a function of the value of the portfolio less a floor value for the portfolio

Target investment in stocks = m × (Portfolio value – Floor value)

Where m is a fixed constant

In this strategy the stock holding is held to a constant proportion of the cushion Hence, an investor buys stocks when prices are risking and sells when prices are falling

This strategy has a higher risk tolerance than buy-and-hold strategy because investor is holding a larger multiple of the cushion in stocks

Linear, Concave, and Convex Investment Strategies

LO.i: Distinguish among linear, concave, and convex rebalancing strategies

Buy and hold is a linear investment strategy because portfolio returns are a linear function of stock returns

Constant-mix is a concave investment strategy Portfolio return increases at a decreasing rate with positive stock returns and decreases at an increasing rate with negative stock returns

CPPI strategy is a convex investment strategy Portfolio return increases at an increasing rate with positive stock returns, and it decreases at a decreasing rate with negative stock returns

Exhibit 9 provides a summary of the strategies

LO.h: Explain the performance consequences in up, down, and flat markets of 1) rebalancing to a constant mix of equities and bills, 2) buying and holding equities, and 3) constant proportion portfolio insurance (CPPI)

Constant Mix Buy and Hold CPPI

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Constant Mix Buy and Hold CPPI Market Condition

Flat (but oscillating) Outperform Neutral Underperform

Investment Implications

Portfolio insurance Selling insurance None Buying insurance

Multiplier 0 < m < 1 m = 1 m > 1

LO.j: Judge the appropriateness of constant mix, buy-and-hold, and CPPI rebalancing strategies when given an investor’s risk tolerance and asset return expectations

The appropriate strategy to choose depends on:

1 Investor’s risk tolerance

2 Types of risk with which investor is concerned

3 Asset class return expectations

3.4 Execution Choices in Rebalancing

(Note: This section is not covered in the LO.)

While rebalancing, execution choices available to a portfolio manager are:

Cash Market Trades: Buying and selling individual security positions

Derivative Trades: Using instruments such as futures contracts and total return swaps

The advantages of using derivatives are:

 lower transaction costs;

 more rapid implementation—in derivative trades one is buying and selling systematic risk exposures rather than individual security positions; and

 leaving active managers’ strategies undisturbed—in contrast to cash market trades, which involve trading individual positions, derivative trades have minimal impact on active managers’ strategies

Summary

LO.a: discuss a fiduciary’s responsibilities in monitoring an investment portfolio;

Portfolio managers are fiduciaries They have an ethical responsibility to consider the appropriateness

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and suitability of the portfolio

Portfolio managers need to track everything that can affect the client’s portfolio The three main items that need to be monitored are:

• investor circumstances, including wealth and constraints

• market and economic changes

• the portfolio itself

LO.b: discuss the monitoring of investor circumstances, market/economic conditions, and portfolio holdings and explain the effects that changes in each of these areas can have on the investor’s portfolio;

LO c: recommend and justify revisions to an investor’s investment policy statement and strategic asset allocation, given a change in investor circumstances;

Monitoring Changes in Investor Circumstances and Constraints

A portfolio manager should monitor possible changes in:

 Investor circumstances and wealth: Ex: changes in employment, marital status and the birth of children

 Liquidity requirements: cash requirements as a result of an expected or unexpected events

 Time horizons: reduce risk when an individual moves through the life cycle and his/her time horizon shortens

 Tax circumstances: construct portfolios that deal with each client’s current tax situation and take future possible tax circumstances into account

 Laws and regulations: If laws and regulations change we must make appropriate changes to stay

in compliance

 Unique circumstances: Ex: socially responsible investing, concentrated stock holdings etc

Monitoring Market and Economic Changes

A portfolio manager should monitor changes in:

 Asset risk attributes: If the mean return/volatility/correlation of asset classes change

profoundly, then adjust the asset allocation according to the new risk attributes

 Market cycles: Monitor market cycles and make tactical adjustments to asset allocations or adjust individual securities holdings to enhance portfolio returns

 Central bank policy: Central bank’s monitory and interest rate decisions affect both the bond and stock markets

 Yield curve and inflation: Yield curves tend to:

 become steeply upward-sloping during recessions

 flatten during expansions

 become downward sloping before an impending recession

Unexpected inflation affects both fixed income and equity investors

A portfolio manager should continuously evaluate:

 events and trends affecting prospects of individual holdings and asset classes and their

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suitability for attaining client objectives

 changes in asset values that create unintended divergence from client’s strategic asset

allocation

LO d: discuss the benefits and costs of rebalancing a portfolio to the investor’s strategic asset allocation;

Returns portfolio to optimal allocation Transaction costs offset benefits of rebalancing

Controls drift in overall level of portfolio

 Rebalance the portfolio to target weights on a periodic basis for example quarterly or semi-annually

 Advantage: simple to implement Drawback: does not consider market behaviour

 Portfolio could be close to optimal allocations on rebalancing dates  unnecessary transaction costs

 Portfolio could be very far from optimal allocations on rebalancing dates  high market impact costs

Percentage of portfolio rebalancing

 Set rebalancing thresholds or trigger points; adjust asset allocation only when the thresholds are crossed

 Consider a three-asset class portfolio of domestic equities, international equities, and domestic bonds The target asset proportions are 45/15/40 with respective corridors 45% ± 4.5%, 15% ± 1.5%, and 40% ± 4% Suppose the portfolio manager observes the actual allocation to be 50/14/36; the upper threshold (49.5%) for domestic equities has been breached The asset mix would be

rebalanced to 45/15/40

 Compared to calendar rebalancing, percentage-of-portfolio rebalancing can occur on any calendar date It also helps a portfolio manager to exercise a tighter control on divergences from target proportions because it is directly related to market performance

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LO f: discuss the key determinants of the optimal corridor width of an asset class in a percentage-of portfolio rebalancing program;

Factors Impacting Corridor Width

Factor Effect on Optimal Width of

Corridor (All Else Equal)

Intuition Factors Positively Related to Optimal Corridor Width

Transaction costs The higher the transaction costs,

the wider the optimal corridor

High transaction costs set a high hurdle for rebalancing benefits to overcome

Risk tolerance The higher the risk tolerance, the

wider the optimal corridor

Higher risk tolerance means less sensitivity to divergences from target

Correlation with rest of

Factors Inversely Related to Optimal Corridor Width

Asset class volatility The higher the volatility of a given

asset class, the narrower the optimal corridor

A given move away from target

is potentially more costly for a high-volatility asset class, as a further divergence becomes more likely

Volatility of rest of portfolio The higher this volatility, the

narrower the optimal corridor

Makes large divergences from strategic asset allocation more likely

LO g: compare the benefits of rebalancing an asset class to its target portfolio weight versus rebalancing the asset class to stay within its allowed range;

So far we’ve focused on rebalancing to target weights; another strategy is to rebalance to the allowed range which enables portfolio manager to benefit from short-term market opportunities and to better manage weights of relatively illiquid assets The optimal rebalancing strategy should maximize present value of net benefit

LO h: explain the performance consequences in up, down, and flat markets of 1) rebalancing to a constant mix of equities and bills, 2) buying and holding equities, and 3) constant proportion portfolio insurance (CPPI);

Constant Mix Buy and Hold CPPI Market Condition

Investment Implications

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LO i: distinguish among linear, concave, and convex rebalancing strategies;

 Buy and hold is a linear investment strategy because portfolio returns are a linear function of stock returns

 Constant-mix is a concave investment strategy Portfolio return increases at a decreasing rate with positive stock returns and decreases at an increasing rate with negative stock returns

 CPPI strategy is a convex investment strategy Portfolio return increases at an increasing rate with positive stock returns, and it decreases at a decreasing rate with negative stock returns

LO j: judge the appropriateness of constant mix, buy-and-hold, and CPPI rebalancing strategies when given an investor’s risk tolerance and asset return expectations;

The appropriate strategy to choose depends on:

1 Investor’s risk tolerance

2 Types of risk with which investor is concerned

3 Asset class return expectations

Examples from the Curriculum

Example 1 Monitoring a Change in Investment Horizon

William and Mary deVegh, both 32 years old, met and married when they were university students They each embarked on promising and highly demanding executive careers after leaving college They are hoping to retire at age 55 to travel and otherwise enjoy the fruits of their hard work Now well established at their companies, they also want to start a family and are expecting the birth of their first child in two months They hope the child will follow their tracks and obtain a four-year private university education The deVeghs anticipate supporting their child through college Assume that the deVeghs will each live to age 85

1 Compare and contrast the deVeghs’ investment time horizons prior to and immediately

subsequent to the birth of their first child

2 Interpret the challenges the birth will present to their retirement objectives and discuss

approaches to meeting those challenges, including investing more aggressively

Solution to 1:

Prior to the birth of their child, the deVeghs have a two-stage time horizon The first horizon extends from age 32 up to age 55 This first time horizon could be described as an accumulation period in which the deVeghs save and invest for early retirement The second time horizon is their retirement and is expected to extend from age 55 to age 85 After the birth of their child, they will have a three-stage time horizon The first stage extends from age 32 through age 50, when they expect their child to enter

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university at age 18 During this period, the deVeghs must accumulate funds both for retirement and their child’s university education The second stage extends from age 51 up to age 55 In this period the deVeghs must anticipate disbursing substantial funds for tuition, room and board, and other expenses associated with a private university education The third stage is retirement, expected to extend from age 55 to age 85 as before

Solution to 2:

The birth of the child creates a four-year period of heavy expenses immediately prior to the deVeghs’ intended retirement date Those expenses could put their intended retirement date at risk The most direct way to mitigate this risk is to increase the amount of money saved and to invest savings for the child’s education in a tax-efficient way (tax-advantaged education saving vehicles are available in certain tax jurisdictions) Can the deVeghs mitigate their risk by increasing their risk tolerance? The need for a larger future sum of money does not in itself increase an investor’s ability to take risk, although it may affect the investor’s willingness to do so There is no indication that the child’s birth will be accompanied

by a salary raise or other event increasing the ability to take risk If the deVeghs’ stated risk tolerance prior to the child’s birth accurately reflects their ability to bear risk, investing more aggressively after the child’s birth will not help them meet the challenges the event poses to their retirement objective Back to Notes

Example 2 Monitoring Changes in an Investor’s Circumstances and Wealth2

John Stern, 55 years old and single, is a dentist Stern has accumulated a $2.0 million investment

portfolio with a large concentration in small-capitalization US equities Over the last five years, the portfolio has averaged 20 percent annual total return on investment Stern does not expect to retire before age 70 His current income is more than sufficient to meet his expenses Upon retirement, he plans to sell his dentistry practice and use the proceeds to purchase an annuity to cover his retirement cash flow needs He has no additional long-term goals or needs

In consultation with Stern, his investment advisor, Caroline Roppa, has drawn up an investment policy statement with the following elements (Roppa’s notes justifying each item are included.)

Elements of Stern’s Investment Policy Statement

Risk tolerance: Stern has above-average risk tolerance Roppa’s notes:

 Stern’s present investment portfolio and his desire for large returns indicate a

high willingness to take risk

 His financial situation (large current asset base, ample income to cover expenses, lack of need

for liquidity or cash flow, and long time horizon) indicates a high ability to assume risk

Return objective: The return objective is an average total return of 10 percent or more with a focus on

long-term capital appreciation Roppa’s notes: Stern’s circumstances warrant an above-average return

objective that emphasizes capital appreciation for the following reasons:

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