Reading 30 Monitoring and Rebalancing Flashcards
The reasons for monitoring and rebalancing
- First, clients’ needs and circumstances change, and portfolio managers must respond to these changes to ensure that the portfolio reflects those changes.
- Second, capital market conditions change.
- Third, fluctuations in the market values of assets create differences between a portfolio’s current asset allocation and its strategic asset allocation.
How often should the review of asset allocation be done?
- In the field of private wealth management, reviews are usually semiannual or quarterly.
- In institutional investing, the asset allocation review is a natural time for reviewing the range of changes in circumstance. Such reviews are often held annually.
Variable prepaid forward
In effect, combines a collar with a loan against the value of the shares.
Rebalancing Benefits
There are also several practical risk management benefits to rebalancing.
- First, if higher-risk assets earn higher returns on average and we let the asset mix drift, higher-risk assets will tend to represent ever-larger proportions of the portfolio over time. Thus the level of portfolio risk will tend to drift upward. Portfolio risk will tend to be greater than that established for the client in the investment policy statement. Rebalancing controls drift in the overall level of portfolio risk.
- Second, as asset mix drifts, the types of risk exposures drift. Rebalancing maintains the client’s desired systematic risk exposures.
- Finally, not rebalancing may mean holding assets that have become overpriced, offering inferior future rewards.
Rebalancing Costs
These costs are of two types—transaction costs and, for taxable investors, tax costs.
Transaction costs consist of more than just explicit costs such as commissions. They include implicit costs, such as those related to the bid–ask spread and market impact. Market impact is the difference between realized price and the price that would have prevailed in the absence of the order. That cost is inherently unobservable.
Calendar Rebalancing
Calendar rebalancing involves rebalancing a portfolio to target weights on a periodic basis, for example, monthly, quarterly, semiannually, or annually. Quarterly rebalancing is one popular choice; the choice of rebalancing frequency is sometimes linked to the schedule of portfolio reviews.
Calendar rebalancing is the simplest rebalancing discipline. It does not involve continuously monitoring portfolio values within the rebalancing period. If the rebalancing frequency is adequate given the portfolio’s volatility, calendar rebalancing can suffice in ensuring that the actual portfolio does not drift far away from target for long periods of time.
A drawback of calendar rebalancing: It is unrelated to market behavior. On any given rebalancing date, the portfolio could be very close to or far away from optimal proportions.
Percentage-of-Portfolio Rebalancing
Percentage-of-portfolio rebalancing (also called percent-range or interval rebalancing) offers an alternative to calendar rebalancing. Percentage-of-portfolio rebalancing involves setting rebalancing thresholds or trigger points stated as a percentage of the portfolio’s value.
Percentage-of-portfolio rebalancing requires monitoring of portfolio values at an agreed-upon frequency in order to identify instances in which a trigger point is breached. To be implemented with greatest precision, monitoring should occur daily.
An obvious and important question is: How are the corridors for asset classes determined?
Investors sometimes set ad hoc corridors. However, ad hoc approaches are open to several criticisms (do not account for differences in transaction costs in rebalancing, for example).
The literature suggests that at least five factors should play a role in setting the corridor for an asset class:
- transaction costs;
- risk tolerance concerning tracking risk versus the strategic asset allocation;
- correlation with other asset classes;
- volatility;
- volatilities of other asset classes.
The more expensive it is to trade an asset class (or the lower its liquidity), the wider its corridor should be, because the marginal benefit in rebalancing must at least equal its marginal cost. The higher the risk tolerance (i.e., the lower the investor’s sensitivity to straying from target proportions), the wider corridors can be.
Correlations also should be expected to play a role. In a two asset-class case, a higher correlation should lead to wider tolerance bands.
A higher volatility should lead to a narrower corridor, all else equal. It hurts more to be a given percent off target for a more highly volatile asset class because it has a greater chance of a further large move away from target.
!!! It is important to remember that if the tolerance band is triggered for one asset class then all asset classes shoudl be rebalanced !!!
Factors Affecting Optimal Corridor Width
1. Transaction costs
The higher the transaction costs, the wider the optimal corridor. (High transaction costs set a high hurdle for rebalancing benefits to overcome).
2. Risk tolerance
The higher the risk tolerance, the wider the optimal corridor. (Higher risk tolerance means less sensitivity to divergences from target).
3. 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).
4. 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).
5. Volatility of rest of portfolio
The higher this volatility, the narrower the optimal corridor. (Makes large divergences from strategic asset allocation more likely).
Calendar-and-percentage-of-portfolio rebalancing
In this approach, the manager monitors the portfolio at regular frequencies, such as quarterly. The manager then decides to rebalance based on a percentage-of-portfolio principle (has a trigger point been exceeded?).
Equal probability rebalancing
In this discipline, the manager specifies a corridor for each asset class as a common multiple of the standard deviation of the asset class’s returns. Rebalancing to the target proportions occurs when any asset class weight moves outside its corridor. In this discipline each asset class is equally likely to trigger rebalancing if the normal distribution describes asset class returns. However, equal probability rebalancing does not account for differences in transaction costs or asset correlations.
Tactical rebalancing
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. This approach seeks to add value by tying rebalancing frequency to expected market conditions that most favor rebalancing to a constant mix.
Rebalancing to Target Weights versus Rebalancing to the Allowed Range
- The alternative, applicable to rebalancing approaches that involve corridors, is to rebalance the asset allocation so that all asset class weights are within the allowed range but not necessarily at target weights.
- Compared with rebalancing to target weight, rebalancing to the allowed range results in less close alignment with target proportions but lower transaction costs; it also provides some room for tactical adjustments.
- A number of studies have contrasted rebalancing to target weights to rebalancing to the allowed range based on particular asset classes, time periods, and measures of the benefits of rebalancing. They have reached a variety of conclusions which do not permit one to state that one discipline is unqualifiedly superior to the other.
Setting Optimal Thresholds
The optimal portfolio rebalancing strategy should maximize the present value of the net benefit of rebalancing to the investor. Equivalently, the optimal strategy minimizes the present value of the sum of two costs: expected utility losses (from divergences from the optimum) and transaction costs (from rebalancing trades). Despite the apparent simplicity of the above formulations, finding the optimal strategy in a completely general context remains a complex challenge:
- If the costs of rebalancing are hard to measure, the benefits of rebalancing are even harder to quantify.
- The return characteristics of different asset classes differ from each other, and at the same time interrelationships (correlations) exist among the asset classes that a rebalancing strategy may need to reflect.
- The optimal rebalancing decisions at different points in time are linked; one decision affects another.
- Accurately reflecting transaction costs may be difficult; for example, transaction costs can be nonlinear in the size of a rebalancing trade.
- The optimal strategy is likely to change through time as prices evolve and new information becomes available.
- Rebalancing has tax implications for taxable investors.
Buy-and-Hold Strategies
A buy-and-hold strategy is a passive strategy of buying an initial asset mix (e.g., 60/40 stocks/Treasury bills) and doing absolutely nothing subsequently. Whatever the market does, no adjustments are made to portfolio weights. It is a “do-nothing” strategy resulting in a drifting asset mix.
A buy-and-hold strategy would work well for an investor whose risk tolerance is positively related to wealth and stock market returns.
Constant-Mix Strategies
- Constant mix is a “do-something” (or “dynamic”) strategy in that it reacts to market movements with trades.
- Strong bull and bear markets favor a buy-and-hold strategy.
- On the other hand, the constant-mix strategy tends to offer superior returns compared with buy-and-hold strategies if the equities returns are characterized more by reversals than by trends.
- A constant-mix strategy is consistent with a risk tolerance that varies proportionately with wealth.
Linear, Concave, and Convex Investment Strategies
- A buy-and-hold strategy has been called a linear investment strategy because portfolio returns are a linear function of stock returns.
- The share purchases and sales involved in constant-mix and CPPI strategies introduce nonlinearities in the relationship.
- For constant-mix strategies, the relationship between portfolio returns and stock returns is concave; that is, portfolio return increases at a decreasing rate with positive stock returns and decreases at an increasing rate with negative stock returns.
- In contrast, a CPPI strategy is convex. Portfolio return increases at an increasing rate with positive stock returns, and it decreases at a decreasing rate with negative stock returns.
- Convex strategies represent the purchase of portfolio insurance, concave strategies the sale of portfolio insurance. That is, convex strategies dynamically establish a floor value while concave strategies provide or sell the liquidity to convex strategies.
