CFA CFA level 3 study NotéCFA level 3 CFA level 3 CFA level 3 CFA level 3 finquiz curriculum note, study session 16, reading 32

Changes required as a result of a manager’s monitoring responsibilities are as follows: Monitoring: Requires an Alteration of: investor-related circumstances • investment policy statemen

Reading 32 Monitoring and Rebalancing

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Fiduciaries must:

1 act in a position of trust;

2 assess the suitability and appropriateness of a

portfolio relative to:

•the client’s needs and circumstances and

•the investment’s and total portfolio’s basic

characteristics

3 monitor the following items to fulfill their ethical

responsibilities:

•investor circumstances - wealth and constraints;

•market and economic changes; and

•the portfolio itself

Changes required as a result of a manager’s monitoring

responsibilities are as follows:

Monitoring: Requires an Alteration of:

investor-related

circumstances

• investment policy statement;

• strategic asset allocation;

or

• individual portfolio holdings market and

economic changes

• strategic asset allocation;

• tactical asset allocation;

• style or sector exposures; or

• individual portfolio holdings portfolios • strategic asset allocation or

• individual portfolio holdings

2.1 Monitoring Changes in Investor Circumstances

and Constraints Portfolio managers generally review changes in the

needs, circumstances or objectives of:

1 private-wealth clients on a semiannual or quarterly

basis,

2 institutional clients on an annual basis; during the

asset allocation review

NOTE:

More frequent reviews may be required following:

•unexpected changes in client circumstances or

•client requests

2.1.1) Changes in Investor Circumstances and Wealth

1 Changes in wealth and circumstances may affect:

•income, expenditures, risk exposures, and risk

preferences of institutional and private wealth

clients;

• expected retirement income of the latter client category

NOTE:

For examples of situations resulting in changes in client circumstances and wealth, refer to Volume 6, Reading

32, Section 2.1.1

2 Changes in wealth may affect:

• portfolio return requirements and/or

• risk appetite NOTE:

A portfolio manager should only consider permanent changes in wealth when assessing the impact on risk exposures and return requirements

2.1.2) Changing Liquidity Requirements

1 Portfolio managers are responsible for:

• providing liquidity when requested by a client

• monitoring changes in liquidity requirements

2 What triggers changes in the liquidity requirements of private wealth and institutional clients?

Refer to Reading 32, Section 2.1.2

3 Portfolios with potential major withdrawal requirements should minimize the proportion of illiquid investments and should maintain a portion of liquid investments

2.1.3) Changing Time Horizons

1 As a client’s time horizon shortens, managers should consider:

• reducing investment risk

• increasing allocation to bonds

2 Entities with perpetual life portfolios experience few changes in their:

• time horizons,

• risk budgets, and

• appropriate asset allocation; with the passage of time

3 When one time horizon stage elapses and a new commences, investment policy requires changes

4 How do abrupt changes in a client’s time horizon stages affect investment policy and portfolio?

Refer to Reading 32, Section 2.1.3, third paragraph

Reading 32 Monitoring and Rebalancing FinQuiz.com NOTE:

Significant changes in client circumstances may mark

the start of a new time horizon stage

2.1.4) Tax Circumstances

1 Portfolio managers need to:

• assess tax consequences of investment decisions on

portfolios;

• consider each client’s current and future tax

situation when constructing client portfolios;

• consider holding period length and portfolio

turnover rates; and

• assess tax efficiency of investment strategies

oTax efficiency: the proportion of the expected

pretax total return that will be retained after taxes

2 Examples of monitoring a client’s tax circumstances

include:

• deferring income recognition to a low-tax year;

• accelerating expense recognition to a high-tax year;

• realizing term losses at year end to offset

short-term gains;

• changing the allocation to tax-exempt securities;

and

• donating or gifting assets with high unrealized gains

to avoid the imposition of capital gains tax

2.1.5) Changes in Laws and Regulations

1 Managers must evaluate laws and regulations to:

• ensure compliance and

• understand how they affect:

oscope of their advisory responsibilities

odiscretion in client portfolio management

• changes in tax regulations; which are important for

taxable and tax-exempt investors

2 Changes in laws and regulations affect:

• current portfolio holdings

• the range of available investment opportunities; e.g

may introduce new opportunities

3 Changes in tax regulations affect:

• current tax situation and

• equilibrium relationships among assets

2.1.6) Unique Circumstances

1 A private wealth client’s current unique circumstances must be monitored Any potential changes need to be considered

Example:

Individual clients may hold concentrated stock positions Portfolio managers will need to determine how to reduce the riskiness of the position and determine what investment action to take when the position is

liquidated

Example 3 illustrates the issues associated with liquidating

a concentrated stock position in response to changes in client circumstances

2 Institutional clients have unique circumstances that need to be addressed Examples include:

• Social responsible investing (SRI) concerns

• Desire for improvements in corporate governance structures

NOTE:

A change in client’s needs may require a modification

to the IPS (mentioned in Section 2)

2.2 Monitoring Market and Economic Changes

Managers need to monitor the impact of any changes

in financial and economic market conditions on portfolio investments Portfolio managers must adopt a broad view and take all relevant factors into account

For factors that need to be monitored, see sections 2.2.1

to 2.2.4 below:

2.2.1) Changes in Asset Risk Attributes

1 A portfolio’s asset allocation may change due to changes in the underlying:

• mean return,

• volatility, and

• correlations of asset classes

Practice: Example 2 Volume 6, Reading 32

Practice: Example 3 Volume 6, Reading 32

Practice: Example 1

Volume 6, Reading 32

2 Why monitor changes in asset risk attributes?

•To assess whether existing asset allocations continue

to satisfy investment objectives

oIf not, a change in investment objectives or asset

allocation may be required

•New investment opportunities may arise

2.2.2) Market Cycles

Monitoring market cycles and valuation levels help

investors form opinions on short-term risks and rewards

being offered

1 Based on their opinions, investors tactically adjust

asset allocations or adjust individual security holdings

2 Major market swings present extreme opportunities,

good and bad

Example:

During economic growth, securities perform too well

providing the opportunity to sell; while during economic

recessions, stock prices decline significantly providing

the opportunity to invest

2.2.3) Central Bank Policy

Central bank monetary policy:

1 influences stock and bond markets via monetary and

interest rate decisions,

2 immediately impacts money market yields as

opposed to long-term bond yields in the market,

3 affects stock returns, and

4 has a profound effect on bond market volatility

5 Types of monetary policy and influence on stock vs

bond returns:

•Expansionary
Discount rate: low
Higher

returns: stocks

•Restrictive
Discount rate: high
Higher returns:

bonds

Guidance:

Restrictive monetary policy
avoid stocks/embrace

bonds Expansionary monetary policy
embrace stocks/avoid

bonds

2.2.4) The Yield Curve and Inflation

The default-risk free yield curve reflects an investor’s

return requirements at different maturities The curve

reflects:

1 time preferences for current versus future real

consumption,

2 expected inflation, and

3 maturity premium demanded

NOTE:

Yield curve changes trigger changes in bond values, which in turn influences equity values (via competition between the two asset classes)

1 The premium on long-term bonds over short-term bonds is countercyclical

• Premiums are high during recessions and low during expansions

2 Short-term yields are pro-cyclical; correspond with monetary policy

3 The shape of the yield curve depends on the economic cycle stage:

Recession Upward sloping Expansion Flat

Before recessions Downward sloping

(Inverted)

4 Yield curve contains information about future GDP growth

NOTE:

Investors monitor the yields of bonds relative to historical norms to ascertain return prospects

Example:

The yield on 10-year BB+ bonds is 11.27% The average yield of the bond over the past two years was 8.76% Should investors expect a high return?

Yes Due to the higher current yield, prospects for greater returns increase

5 An unusually steep default-free yield curve indicates

a positive outlook for bonds(especially when the cash yield or inflation rate is used as a proxy for the risk-free rate)

6 Investors are affected by inflation in the following ways:

• influences the nominal amount of money required to purchase a basket of goods;

• influences returns and risks in capital markets:

I unexpected increases in inflation result in a decline in real bond yields

II As normal yields rise to offset this loss, bond prices fall

III unexpected changes in inflation affect stock market returns

Reading 32 Monitoring and Rebalancing FinQuiz.com

2.3 Monitoring the Portfolio

This is a continuous process requiring a portfolio manager

to assess:

1 events and trends affecting the prospects of

individual portfolio holdings and asset classes and

a.the ability of existing holdings and asset classes to

remain suitable for achieving investment objectives

2 Changes in asset values creating deviations from the

strategic asset allocation

NOTE:

• 1 leads to a change in either the IPS or individual portfolio holdings

• 2 leads to rebalancing the existing strategic allocation

Portfolio managers need to consider new information on economic conditions, market conditions, and new companies in an effort to add value to client portfolios

Rebalancing involves eliminating the differences

between a portfolio’s actual and strategic asset

allocation in response to changes in underlying security

prices

NOTE:

Rebalancing also covers other actions (see Reading 32,

paragraph preceding section 3.1)

3.1 The Benefits and Costs of Rebalancing

Rebalancing involves a cost vs benefit trade-off

3.1.1) Rebalancing benefits

1 Investor reduces present value of expected utility

losses

• Expected utility loss: cost of straying away from the

optimum strategic asset allocation

2 Controls the level of drift in overall portfolio risk

Explanation: See respective section from curriculum

3 Rebalancing maintains the client’s desired systematic

risk exposures

4 Removes overpriced assets with an inferior returns

prospect

Source: Volume 6, Reading 32 from curriculum

NOTE:

• Disciplined rebalancing reduces risk and

incrementally increases returns over a long-term

investment horizon (See Example 7)

rebalancing to a do-nothing approach

3.1.2) Rebalancing Costs

Rebalancing generates two costs:

1 transaction costs and

2 in the case of taxable investors, tax costs

1 Transaction Costs

1 Offset rebalancing benefits

2 Non-recoverable

3 Rebalancing illiquid investments generates high level

of transaction costs

4 Rebalancing liquid investments generates two types

of transaction costs:

• explicit: commissions ─not difficult to measure

• implicit: bid-ask spreads, market impact and missed trade opportunity costs – require estimation

2 Tax Costs

1 In the event where appreciated asset classes are sold and depreciated asset classes are purchased, rebalancing triggers a tax liability for taxable investors

Explanation: See respective section from curriculum

2 When short-term capital gains tax rate is higher than the long-term rate, rebalancing assets that realize short-term gains only can be costly

NOTE:

When short-term capital gains tax rate is higher than the long-term rate – tax-efficient selling strategy: reduce capital gains taxes by realizing short-term losses, long-term capital losses, long-long-term capital gains and short-term gains, in this order

Practice: Example 7

Volume 6, Reading 32

Practice: Example 4 Volume 6, Reading 32

3.2 Rebalancing Disciplines

Rebalancing disciplines are rebalancing strategies

These include:

1 calendar rebalancing and

2 percentage-of-portfolio rebalancing

COMPARISON 3.2.1) Calendar Rebalancing 3.2.2) Percentage-of-Portfolio Rebalancing

• Rebalances to target weights periodically; e.g

monthly, quarterly, and so forth

• Establishes rebalancing thresholds or trigger points are stated as a percentage of portfolio value

• Example: An investor’s portfolio has two asset classes

with target proportions of 75/25 Rebalancing occurs at

the beginning of the month On each rebalancing

date, asset classes are rebalanced to their target

proportions; 75/25

• Example: The target proportion of an asset class is 40%

of portfolio value and trigger points are 35% and 45% of portfolio value or (40% ± 5%) Portfolio is rebalanced when the actual weight breaches a corridor limit

• Rebalancing frequency may be timed to coincide with

portfolio reviews

• Rebalancing can occur on any calendar date

• Simplest rebalancing approach

• No requirement for continuous monitoring of portfolio

values within the rebalancing period

• Requires frequent monitoring

• Drawback: unrelated to market behavior

I if portfolio’s allocation is close to the optimal

allocation, rebalancing costs may outweigh

benefits

II If portfolio’s allocation is far from optimal, investor

may incur a high level of market impact costs due

to rebalancing

• Directly related to market performance

• Relative to calendar rebalancing, tighter control on divergences from target allocations; especially at lower frequencies of calendar rebalancing

Example:

The target asset allocation for a portfolio with three asset

classes is 40/35/25 The corridors for these asset classes

are 40% ± 1.9%; 35% ± 2.3%; and 25% ± 3.0%, respectively

Market prices have changed as a result of increased

volatility Actual asset allocation is now 40.8/31.9/27.3

Does the portfolio require rebalancing?

Yes The second asset class, with a target weight of 35%, has breached its lower corridor limit, 32.7% (35% - 2.3%) Portfolio will be rebalanced to the 40/35/25 target allocation

Key Determinants of the Optimal Corridor Width in a Percentage-of-Portfolio Rebalancing Program:

Factor Effect on Optimal Width of

Factors Positively Related to Optimal Corridor Width

Transaction costs The higher the transaction costs,

the wider the optimal corridor

Higher transaction costs set a high hurdle for rebalancing costs to overcome

Risk tolerance The higher the risk tolerance, the

wider the optimal corridor

High risk tolerance implies lower sensitivity to divergences from target allocations

Correlation with rest of portfolio The higher the correlation, the

wider the optimal corridor

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

Reading 32 Monitoring and Rebalancing FinQuiz.com

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 percentage move away from the target is potentially more costly for a highly volatile asset class, as further divergence becomes more likely

Volatility of rest of portfolio The higher the volatility, the

narrower the optimal corridor

Makes large divergences from strategic asset allocation more likely

Source: Volume 6, Exhibit 8, Reading 32

NOTE:

• Illiquid assets should have wider corridors

• Ad hoc approaches to setting corridors do not

consider the differences in rebalancing transaction

costs across asset classes

Tip: For a multi-asset portfolio consider the concerned

asset class as one class and the balance of the portfolio

as the other class

For an illustration of whether tolerance bands for asset

classes are appropriate, practice Example 8, Reading

32

3.2.3) Other Rebalancing Strategies

1 Calendar-and-percentage-of-portfolio rebalancing:

• The strategy is executed in the following manner:

i Monitor the portfolio at specified intervals (e.g

quarterly)

ii Rebalance the portfolio using a

percentage-of-portfolio principle; i.e based on corridors

• Advantage: Avoids incurring rebalancing costs

associated with a calendar rebalancing approach

(when the portfolio is near optimum)

2 Equal probability rebalancing:

• Corridors are specified for each asset class as a

common multiple of the standard deviation of the

asset class’s returns

• Rebalancing is triggered when any asset class

weight moves outside its corridor

• Each asset class has an equal probability of

triggering rebalancing if returns are normally

distributed

• Drawback: does not account for differences in

transaction costs or asset correlations

3 Tactical rebalancing:

• Specifies less frequent rebalancing when markets

are trending

• Specifies more frequent rebalancing when markets are characterized by reversals

3.2.4) Rebalancing to Target Weights versus Rebalancing to the Allowed Range

1 Relative to rebalancing to target weights, rebalancing to an allowed range has the following advantages:

• incurs lower transaction costs and

• provides room for tactical adjustments

Example:

A U.S investor gives 25% target weight to emerging market stocks and the weight moves above the upper corridor limit Forecasting a transitory decrease in the U.S dollar, the investor will want to partially rebalance the exposure to take advantage of the short-term exchange rate change

2 Additional advantage (latter approach): allows managers to better manage the weights to illiquid assets

3 Disadvantage: rebalancing to an allowed range does not perfectly align actual asset allocation with target proportions

3.2.5) Setting Optimal Thresholds

1 Finding the optimal rebalancing strategy implies:

• maximizing the net present value of net rebalancing benefits

• keeping the present value of expected utility losses and transaction costs to a minimum

2 Challenges faced when finding the optimal rebalancing strategy are as follows:

• Rebalancing costs and benefits are difficult to measure

• Return characteristics of asset classes may differ from each other, but may be interrelated; the strategy needs to reflect this

• Optimal rebalancing decisions may be linked to and affect future rebalancing decisions

• Transaction costs may be difficult to incorporate; Practice: Example 8

Volume 6, Reading 32

e.g costs may not be linearly related to the size of

the trade

•Optimal strategy changes with the passage of time

and with new information

•Rebalancing has tax consequences

3.3 The Perold-Sharpe Analysis of Rebalancing

Strategies

•Contrasts constant mix strategies with other

strategies

•Assumes a simple-two asset class scenario

oonly one asset class is risky

3.3.1) Buy-and-Hold Strategies

1 Passive, do-nothing approach

2 Does not adjust portfolio weights following market

movements

3 Floor = amount invested in Treasury bills; i.e risk-free

4 Strategy implies risk tolerance is positively related to

wealth and stock returns

•When total value of stocks is zero, risk tolerance is

zero

5 Special case of a constant proportion strategy (CPPI –

see below)

6 Outperforms constant-mix strategies (see below)

when markets are trending

7 Neutral when markets are characterized by reversals

(or flat and oscillating)

Portfolio value = Investment in stocks + Floor value

•Portfolio value is linearly related to investment in

stocks

•Portfolio return is linearly related to the return on

stocks

oPortfolio return = Percent in stock × Return on

stocks

•Unlimited upside potential

•Downside potential limited to the floor

•Cushion = Investment in stocks = Portfolio value –

Floor value

•Cushion and value of stocks have a 1:1 relationship

(above floor)

•m = 1; i.e target stock proportion = actual stock

proportion

Example:

Portfolio is allocated to stocks and treasury bills in the

proportion 70/30, respectively Stocks earn a return of

20% What is the new portfolio allocation?

The value of stocks increases to 84 (1.2 × 70) from 70

New portfolio value = 114 (84 + 30) New allocation is

74/26

3.3.2) Constant Mix Strategies

1 Dynamic – reacts to market movements (see Point 4 below)

2 Target investment in stocks = m× Portfolio value,

where,

0 < m < 1 m: target stock proportion

3 Floor value = 0

4 Reduces (increases) actual stock proportions to m

when stock values are trending up (down)

5 Effectively maintains a portfolio’s systematic risk characteristics over time

6 Strategy implies risk tolerance varies proportionally with wealth

NOTE:

The constant mix strategy implies a constant relative risk

tolerance or aversion See footnote 18, Reading 32

7 Underperforms CPPI and buy-and-hold strategies during strong bull and bear markets; when markets are trending

8 Outperforms CPPI and buy-and-hold strategies when equity returns are characterized by reversals

9 Contrarian strategies: provide liquidity

Explanation: See Volume 6, Reading 32

3.3.3) A Constant-Proportion Strategy: CPPI

1 Dynamic strategy (see Point 2 below)

2 Buys (sells) shares as stock values rise (decline)

3 Target investment in stock = m × (Portfolio value –

Floor value);

• where m is a fixed constant

• if m > 1, strategy is known as constant-proportion portfolio insurance (CPPI)

4 When the cushion is zero, strategy is consistent with a zero risk tolerance

5 When the cushion is positive, risk tolerance is higher than a buy-and-hold strategy

6 Aggressively increases (decreases) allocation to stocks when stocks are trending up (down)

Example:

When stocks are trending up, investment in stocks increases by more than 1:1 with the increase in the value

of stocks

7 Investment in risk-free assets (floor) is dynamic and:

• Maybe minimal when stocks are trending up

• rapidly increases, but restricted to the floor value, when stocks are trending down

8 Performs well in trending markets

9 Performs poorly when markets are characterized by reversals

10.Requires rebalancing rules to manage rebalancing costs

Reading Monitoring and Rebalancing FinQuiz.com

11.Momentum-oriented: consume liquidity of markets

3.3.4) Linear, Concave, and Convex Investment

Strategies

1 Buy-and-hold strategies are linear

2 Constant-mix and CPPI strategies are non-linear

3 Constant-mix strategies
relationship between

portfolio & stock returns
concave

• Concave strategies represent the sale of portfolio

insurance

4 CPPI strategies
relationship between portfolio &

stock returns
convex

• Convex strategies represent the purchase of

portfolio insurance

5 Buy-and-hold strategies do not sale or purchase

portfolio insurance

6 Convex strategies dynamically establish a floor value

NOTE:

Concave strategies provide liquidity to convex

strategies

Q: Why are buy-and-hold, CPPI, and constant-mix

strategies known as linear; convex; and concave

strategies, respectively?Refer to Reading 32, Section

3.3.4

NOTE:

relative return performances of the three strategies in

various markets

3.3.5) Summary of Strategies

The appropriateness of rebalancing strategies depends

on the investor’s risk tolerance and asset-class return

expectations

3.4 Execution Choices in Rebalancing Executing a rebalancing transaction depends upon:

1 specific assets held in the portfolio,

2 the availability of cash markets,

3 the availability of derivative markets, and

4 in case of taxable investors, tax consequences Major rebalancing choices include:

1 cash market trades (see section 3.4.1)

2 derivative trades (see section 3.4.2)

3.4.1) Cash Market Trades

Trades rebalance by buying and selling individual assets and represent the most direct means of portfolio rebalancing

Benefits:

1 Relative to derivative market trades, tax considerations are more favorable Why?

Source: Reading 32

2 Not all asset class exposures can be replicated using derivative strategies

3 Derivative markets may have liquidity limitations Drawbacks:

1 More costly;

2 slower to execute; and

3 may impair active manager trades if care is not taken

3.4.2) Derivative Trades

1 Portfolios are rebalanced using derivative instruments, e.g futures

2 Trades attempt to ensure that the total exposure to asset classes closely mimics the effects of

rebalancing

Benefits:

1 Lower transaction costs;

2 rapid execution; and

3 minimal impact on active manager strategies

Drawbacks:

1 Asset class exposure may be difficult to replicate and

2 individual markets may have liquidity limitations

For a brief overview, refer to Reading 32, Section 4

Practice: End of Chapter Practice

Problems for Reading 32 & FinQuiz

Item-Set Id# 14096

Practice: Example 9

Volume 6, Reading 32