CFA 2018 r32 monitoring and rebalancing

Level III Monitoring and Rebalancing www.ift.world Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved 1 Introduction • • • Portfolio manager works with the client to create the IPS The client portfolio is based on the IPS Portfolio manager must constantly monitor and rebalance the portfolio because: Client needs and circumstances change Capital market conditions change Fluctuation in market values of assets create divergence from strategic asset allocation • This reading covers monitoring (Section 2) and rebalancing (Section 3) www.ift.world 2 Monitoring • Fiduciaries have an ethical responsibility to consider the appropriateness and suitability of the portfolio relative to: Client’s needs and circumstances  Monitor changes in circumstances and constraints Investment’s basic characteristics  Monitor market and economic changes Portfolio’s basic characteristics  Monitor the portfolio www.ift.world 2.1 Monitoring Changes in Investor Circumstances and Constraints • Portfolio manager should monitor possible changes in…       Investor circumstances and wealth (Example 2) Liquidity requirements Time horizons (Example 1) Tax circumstances Laws and regulations Unique circumstances (Example 3) • Conduct review meeting with the client quarterly or on a semiannual basis www.ift.world 2.2 Monitoring Market and Economic Changes • Portfolio manager should monitor changes in…  Asset risk attributes  Market cycles  Central bank policy  Yield curve and inflation  Other www.ift.world 2.3 Monitoring the Portfolio • Portfolio manager should continuously evaluate  Events and trends affecting prospects of individual holdings and asset classes and their suitability for attaining client objectives  Changes in asset values that create unintended divergence from client’s strategic asset allocation • Example 4: How active managers may use new analysis and information • Example 5: Characteristics of successful active investors • Example 6: Nonfinancial cost of portfolio revision www.ift.world Rebalancing the Portfolio • Monitoring and rebalancing a portfolio is similar to flying an airplane • Rebalancing covers  Adjusting actual portfolio to current strategic asset allocation because of price changes in portfolio holdings  Revisions to investor’s asset class weights because of changes in investor’s objectives and constraints, or because of changes in capital market expectations  Tactical asset allocation (addressed in other readings) www.ift.world 3.1 The Benefits and Costs of Rebalancing Benefits • Returns portfolio to optimal allocation • Controls drift in overall level of portfolio risk • Controls drift in types of risk exposures • Without rebalancing investor might hold overpriced securities • Example Costs • Transaction costs offset benefits of rebalancing • Transaction costs are particularly high for illiquid investments • Transaction costs include implicit costs and are not precisely measurable • Capital gains taxes must be considered when we rebalance portfolios www.ift.world 3.2 Rebalancing Disciplines • Calendar Rebalancing  Rebalance portfolio to target weights on a periodic basis  Advantage: simplicity  Disadvantage: unrelated to market behavior • Percentage-of-Portfolio Rebalancing  Set rebalancing thresholds or trigger points  40% +/- 5% : 35% - 45% is the corridor or tolerance band • • • • Transaction costs Risk tolerance concerning tracking risk versus strategic asset allocation Correlation with other asset classes Volatility of asset class and volatilities of other asset classes in portfolio www.ift.world www.ift.world 10 www.ift.world 11 www.ift.world 12 www.ift.world 13 3.2 Rebalancing Disciplines (Cont…) • Other rebalancing strategies  Calendar-and-percentage-of-portfolio rebalancing  Equal probability rebalancing  Tactical rebalancing • So far we’ve focused on rebalancing to target weights; another strategy is to rebalance to the allowed range which enables portfolio manager to benefit from short-term market opportunities and to better manage weights of relatively illiquid assets • Optimal rebalancing strategy should maximize present value of net benefit (easier said than done!) www.ift.world 14 3.3 The Perold-Sharpe Analysis of Rebalancing • Strategies presented here assume a two-asset class setting, one risky and the other risk-free • We will consider the following strategies  Buy-and-Hold Strategies  Constant-Mix Strategies  Constant-Proportion (CPPI) Strategy www.ift.world 15 Buy and Hold Strategies Passive strategy of buying an initial asset mix (say 60/40 stocks/Treasury bills) and nothing subsequently Portfolio value = Investment in stocks + Floor value Cushion = Portfolio value – Floor value www.ift.world 16 Constant-Mix Strategies Dynamic strategy, synonymous with rebalancing to strategic asset allocation Target investment in stocks = m x Portfolio value In constant mix we buy shares when the market is going down and sell when the market is going up! Constant-mix strategy is consistent with a risk tolerance that varies proportionately with wealth An investor with such risk tolerance desires to hold stocks at all levels of wealth www.ift.world 17 Constant-Proportion Strategy: CPPI Target equity allocation is a dynamic strategy where… Target investment in stocks = m x (Portfolio value – Floor value) Stock holding are held to a constant proportion of the cushion Buy stocks when prices are rising and sell when prices are falling Higher risk tolerance than buy-and-hold strategy because investor is holding a larger multiple of the cushion in stocks Zero risk tolerance when cushion = www.ift.world 18 Linear, Concave and Convex Investment Strategies • Buy and hold is a linear investment strategy because portfolio returns are a linear function of stock returns • Share purchases and sales in constant mix and CPPI strategies introduce nonlinearities in the relationship • Constant-mix  Concave • CPPI  Convex www.ift.world 19 Appropriate strategy depends on: 1) Investor’s risk tolerance 2) Types of risk with which investor is concerned 3) Asset class return expectations www.ift.world 20 www.ift.world 21 www.ift.world 22 3.4 Execution Choices in Rebalancing (not a LOS) • Cash Market Trades • Derivative Trades www.ift.world 23 Conclusion • Examples • Summary • Practice Problems • Learning Objectives www.ift.world 24 ... This reading covers monitoring (Section 2) and rebalancing (Section 3) www.ift.world 2 Monitoring • Fiduciaries have an ethical responsibility to consider the appropriateness and suitability of... analysis and information • Example 5: Characteristics of successful active investors • Example 6: Nonfinancial cost of portfolio revision www.ift.world Rebalancing the Portfolio • Monitoring and rebalancing. .. Other rebalancing strategies  Calendar -and- percentage-of-portfolio rebalancing  Equal probability rebalancing  Tactical rebalancing • So far we’ve focused on rebalancing to target weights; another