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

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 ac

Level III

Monitoring and Rebalancing

Summary

Monitoring an Investment Portfolio

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

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



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 suitability for attaining client objectives

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

Rebalancing

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

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 Capital gains taxes must be considered when we rebalance

Calendar Rebalancing

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

Rebalancing Methods

Factor

Effect on Optimal Width of Corridor

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 portfolio The higher the correlation, the wider

the optimal corridor

When asset classes move in synch, further divergence from targets is less likely

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

Factors Impacting Corridor Width

Other Rebalancing Strategies

 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 characterized by reversals

 Rebalance to the allowed range: This 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

Assuming that a portfolio consists of only two-asset classes: one risky and the other risk-free, we will consider

the following:

 Buy-and-Hold Strategy

 Constant-Mix Strategy

 Constant-Proportion (CPPI) Strategy

Buy and Hold Strategy

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 (m = 1)

 The implication of using this strategy is that the investor’s risk tolerance is positively related to wealth and

Constant-Mix Strategy

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

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 T-bills and rebalances to that proportion regardless of his level of wealth

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 and is greater than 1

Stock holding is held to a constant proportion of the cushion Hence, an investor buys stocks when prices are rising and sells when prices are falling

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

Market Condition

Up Underperform Outperform Outperform

Flat (but oscillating) Outperform Neutral Underperform

Down Underperform Outperform Outperform

Investment Implications

Payoff curve Concave Linear Convex

Comparison of Strategies

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