Monitoring and Rebalancing - R40

Question 1

Discuss a fiduciary’s responsibiltiies in monitoring an investment portfolio.

Answer 1

The manager must regularly monitor the client’s circumstances and determine, for example, when to start shifting out of equities and real estate and into bonds and other less risky assets. Remember that changes to any one of the investor’s objectives or constraints can potentially affect the others.

Consider the appropriateness and suitability of the portfolio relative to the:

1. Client’s needs and circumstances
2. Investment’s basic characteristics
3. Basic characteristics of the total portfolio

Question 2

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 investr’s portfolio.

Answer 2

Changes in Investor Circumstances:

• Changes in wealth
• Changing time horizons
• Changing liquidity requirements
• Tax treatment
• Laws and regulations

Market and Economic Conditions

• New asset alternatives
• Changes in asset class risks
• Changes in inflation
• Changes in asset class expected returns
• The stock market and central bank policy

Question 3

Contrast calendar rebalancing to percentage-of-portfolio rebalancing

Answer 3

Calendar rebalancing:

Advantage: Provides discipline w/ the requirement for constant monitoring

Drawback: Portfolio could stray between rebalancing dates

Percentage-of-portfolio rebalancing (PPR) - aka percentage range rebalancing or interval rebalancing

Advantage: Minimizes the degree to which asset classes can violate their allocation corridors.

Drawback: Need/cost to constantly monitor the portfolio

Question 4

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

Answer 4

Transaction costs: The more expensive (more illiquid) it is to trade, the less you should trade. Wider corridor.

Correlations: The more highly correlated the assets, the less frequently the portfolio will require balancing, and the wider the corridor.

Volatility: The greater the volatility of an individual asset class, the tighter the corridor.

Question 5

Explain the performance consequences in up, down, and nontrending markets of:

1. rebalancing to a constant mix of equities and bills
2. buying and holding equities
3. constant proportion portfolio insurance (CPPI)

Answer 5

CM buys stocks as they fall and sells as they rise.

CPPI sells stocks as they fall and buys as they rise.

Question 6

Distinguish among linear, concave, and convex rebalancing strategies.

Answer 6

Linear: Straight-line, m=1.

Concave: Portfolio returns increase at a decreasing rate with positive stock returns and decreases at an increasing rate with negative stock returns. m < 1(CM)

Convex: Purchase of portfolio insurance - dynamically establishes a floor value. m > 1 (CPPI). It increases market volatility.

Concave and convex strategies are mirror immages. If there is more demand for one, it will be more costly. The more popular strategy will subsidize the other.