SS16 - Monitoring and Rebalancing

Question 1

What are the considerations the go into **monitoring **a portfolio?

Answer 1

• PM has obligation to continually monitor to ensure portfolio meets the clients needs as these change over time:
  
  • client circumstances
    
    • update IPS
  • capital market conditions and expectations
    
    • change strategic allocation
  • percentage allocations
    
    • rebalancing

Question 2

What are some changes in an **investors circumstances **that would lead to a revision to and IPS?

Answer 2

• marriage
  
  • can affect multiple constraints
  • can affect risk and return objectives
• birth of child
  
  • could add an investment horizon
  • could change investor’s liqudity plans
• desire for funds to be left as a bequest
• receiving an inheritance
• new desire to make significant charitable contributions

Question 3

How can you think about the benefits of portfolio rebalancing in theory?

Answer 3

The benefits of rebalancing can be thought of as being equal to the loss in expected utility that is avoided by rebalancing.

Question 4

What are the primary costs associated with rebalancing?

Answer 4

• transaction costs
• tax liability generated by selling assets that have appreciated in value

Question 5

What is **calendar rebalancing **and what are its benefits/drawbacks?

Answer 5

Calendar rebalancing is rebalancing a portfolio to its strategic allocation at a **predetermined, **regular basis.

​Benefits:

• provides discipline

Drawbacks:

• portfolio allocation could differ significantly from optimal weights between rebalancing dates

Question 6

What is percentage-of-portfolio rebalancing (PPR)?

Answer 6

**Percentage-of-portfolio rebalancing **is rebalancing triggered by changes in relative asset values rather than simply the passage of time.

For an asset class with:

• target allocation T
• maximum percentage change in that allocation P

PM can set tolerance bands, or corridors:

corridor = T +/- (P * T)

Question 7

What are the important determinants of the optimal corridor with for an asset class?

Answer 7

• Using the same max percentage change of all asset classes ignores differences in t-costs and other relevant factors

Manager should consider five factors:

1. ​Transaction costs
2. Risk tolerance
3. Corellation of returns with other asset classes
4. Volatility of asset class returns
5. Volatility of the returns on the other assets in the portfolio

Question 8

What is the relationship between t-costs and corridor width?

Answer 8

Higher the t-costs (means lower liquidity), the greater the deviation from optimal allocation must be for the benefits to outweight the costs. Thus, higher t-costs increase the optimal width of corridor.

Question 9

What is the relationship between risk and corridor width?

Answer 9

The higher the investor’s risk tolernance, the lower the impact from deviations. Thus, higher risk tolerance leads to wider corridor.

Question 10

What is the relationship between correlation with other asset classes and corridor width?

Answer 10

When asset classes move together (all up or all down), the deviations from the target allocation is less. Thus, higher correlation suggest higher corridor width.

Question 11

What is the relationship between volatility of asset class returns and corridor width?

Answer 11

Greater volatility of asset class returns make deviations from target widths more costly. Thus, higher volatility of the asset class suggest narrower corridors.

Question 12

What is the relationship between volatility of returns on other assets in the portfolio and corridor width?

Answer 12

Greater volatility of returns on *other *asset classes can lead to greater deviations from optimal weights. Thus, higher volatility of other assets in the portfolio suggest narrower corridors.

Question 13

Given that you want to rebalance, what are two rebalancing schemes, and what are there benefits/drawbacks?

Answer 13

• return asset allocations to target values
  
  • if asset prices are volatile but not trending, reducing asset class to target could result in higher portfolio returns
• rebalance only to the extent necessary to move an asset class weight back within its corridor
  
  • example: move asset class weights half-way back to target values
  • if asset prices are trending higher, this would be better than returning to target values

Question 14

What are three rebalancing strategies?

Answer 14

1. buy-and-hold
   
   • no rebalancing done after initial allocation.
   • if an asset class increase in value, its weight increases. and vice versa
2. constant mix
   
   • rebalance portfolio to targets either on a periodic basis or when weights move enough from targets
3. constant proportion portfolio insurance (CPPI)
   
   • target weight in an asset class varies directly with the difference between portfolio value and some miniumum value (this is called the cushion)

Question 15

How is CPPI, oen of the three rebalancing strategies, calculated?

Answer 15

The aim of CPPI is to set target weights for an asset class. Example equities:

target equities investment = M(portfolio value - floor value) = M(cushion)

where:

M is a *constant proportion of the cushion *invested in equities

M is greater than 1, and doesn’t change after selected

<todo: clarify></todo:>

Question 16

What are relative performance of the three rebalancing strategies in up or down trending markets?

Answer 16

CPPI will outperform. Results in buy winners and sell losers.

• Increasing market:
  
  • equity values increase, weight in equities and cushion value increases
  • increase in cushion results in additional asset purchases
  • subsequent increases in equities have a greater positive impact on portfolio value
• Decreasing market:
  
  • equity values decrease, weight in equities and cushion value decreases
  • decrease in cushon results in selling equities
  • subsequent decreases in equities have a smaller negative impact on portfolio value

Buy and hold underperforms CPPI.

• no purchases or sales are made, so no amplicication effect is experienced

Constant mix performs worst. Buy losers and sell winners.

• increase in equity requires selling equities to maintain target allocation
• decrease in equity requires buying equities to maintain target allocation

Question 17

What are relative performance of the three rebalancing strategies in nontrending, mean-reverting markets?

Answer 17

CPPI will perform worst. Now produces buy high and sell low.

• rise in equities requires buying more equity. This increases exposure to a subsequent reversal
• decline in equities requires selling more equity. This increases exposure to a subsequent reversal

Buy and hold beats CPPI.

• no purchases or sales are made

Constant mix will perform best. Now produces buy low and sell high.

• increase in equity value will increase percentage allocation to equity and requires selling equity to return to targets
• decrease in equity value will decrease percentage allocation to equity and requires buying equity to return to targets

Question 18

What are linear, concave, and convex rebalancing strategies?

Answer 18

Linear, concave, and convex refers to relationship between:

• portfolio returns
• equity returns

Buy-and-hold

• linear. if equities increase by 5%, a portfolio with 60% equities increases by 0.05 * 0.6 = 0.03. if equities increse by 10%, that portfolio inceases by 0.10 * 0.6 = 0.06.

Constant mix

• concave. think about what happens. When equities increase, we have to sell equities to return to target allocations. As equities increase, the increase in portfolio value will be concave and less than that experienced under buy-and-hold.

CPPI

• convex. Think about what happens. When equities increase, we have to buy equities to maintain the constant proportion of portfolio value allocated to equities. As equities increase, the increase in portfolio value will be convext and more than that experienced under buy-and-hold.

Question 19

How do the three rebalancing strategies differ with regards to investor risk?