Monitoring and Rebalancing

Question 1

What are the benefits of rebalancing?

Answer 1

The primary benefit is maintaining the investor’s desired exposure to systematic risk factors. If allowed to drift, the riskier assets tend to take over the portfolio. Rebalancing also provides discipline. Successful performance can make the client want to react to temporary market conditions rather than follow a long-term, disciplined approached.

Question 2

What are the cost of rebalancing?

Answer 2

Tax liability

Transaction costs, including market conditions under which the trade is made.

Question 3

Define calendar rebalancing and list its benefits and drawbacks.

Answer 3

Rebalancing the portfolio to its strategic allocation on a predetermined, regular basis. The benefit is that it provides discipline without the requirement for constant monitoring. The drawback is that the portfolio cout ld stray considerably between rebalancing dates.

Question 4

Define percentage-of-portfolio rebalancing (PPR) and list its benefits and drawbacks.

Answer 4

Rebalancing is triggered by changes in value rather than calendar dates. The manager sets the tolerance bands or corridors that are considered optimal for each asset class. By not waiting for specific rebalancing dates, PPR provides the benefit of minimizing the degree to which asset classes can violate their allocation corridors. The primary cost to PPR is associated with the need to constantly monitor the portfolio. This requires the time and expense of continually assessing the values of the asset classes and making necessary trades.

Question 5

What are the key determinants of the optimal corridor width of an asset in a percentage-of-portfolio rebalancing program.

Answer 5

The following conditions will increase the optimal width of the corridor for that asset.

1. High Transaction costs (low liquidity)
2. High Risk tolerance
3. High Correlation of returns with other assets
4. Low Volatility of asset class returns
5. Low Volatility of the returns on the other assets in the portfolio

(Greater volatility makes deviations from target weights potentially more costly because deviations from optimal weights can lead to even greater deviations when asset returns are highly volatile.)

Question 6

Rank the performance consequence of the buy-and hold, constant mix, and the constant-proportion portfolio insurance (CPPI) in a trending market.

Answer 6

1. CPPI
2. Buy-and-hold
3. Constant-mix

Question 7

What is the Constant-Proportion Insurance Strategy?

Answer 7

“A Constant-Proportion Strategy: CPPI
A constant-proportion strategy is a dynamic strategy in which the target equity allo- cation is a function of the value of the portfolio less a floor value for the portfolio. The following equation is used to determine equity allocation:
Target investment in stocks = m × (Portfolio value – Floor value)
where m is a fixed constant. Constant-proportion strategies are so called because stock holdings are held to a constant proportion of the cushion. A characteristic of constant-proportion strategies is that they are consistent with a zero tolerance for risk (and hence no holdings in stocks) when the cushion is zero.”“When m exceeds 1, the constant-proportion strategy is called constant-proportion portfolio insurance (CPPI).”

Question 8

Rank the performance consequence of the buy-and hold, constant mix, and the constant-proportion portfolio insurance (CPPI) in a flat but oscillating market.

Answer 8

1. Constant Mix
2. Buy-and-hold
3. CPPI

Question 9

What is the assumed risk tolerance for the buy-and hold, constant-mix, and CPPI strategy.

Answer 9

Buy-and-hold assumes that risk tolerance is directly related to wealth. The investor’s tolerance for risk is zero if the value of the investor’s assets fall below the floor value.

Constant-mix assumes that relative risk tolerance is constant but absolute risk tolerance varies directly with wealth. Investors who use this strategy will hold stocks at all levels of wealth.

CPPI actively assumes that risk tolerance is directly related to wealth.The investor’s tolerance for risk is zero if the value of the investor’s assets fall below the floor value. Risk tolerance is more dramatically affected by changes in wealth levels than buy-and-hold.

Question 10

Distinguish among linear, concave, and convex rebalancing strategies.

Answer 10

Linear - Buy-and-Hold exposure diagram’s slope is equal to one. It does not rebalance regardless of the portfolio wealth level.

Convex - CPPI exposure diagram’s slope is greater than one. Any procedure that buys when stocks rise or sells when stocks fall is a convex a strategy. The more investors that follow convex strategies, the more volatile the markets will become.

Concave - Constant Mix exposure diagram’s slope is less than one. Any procedure that buys when stocks fall or sells when stocks rise is a concave strategy. If more investors follow concave strategies, the markets will become too stable.