CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 CFA 2018 r32 monitoring and rebalancing IFT notes

Monitoring and Rebalancing IFT Notes Monitoring and Rebalancing Introduction 2 Monitoring 2.1 Monitoring Changes in Investor Circumstances and Constraints 2.2 Monitoring Market and Economic Changes 2.3 Monitoring the Portfolio 3 Rebalancing the Portfolio 3.1 The Benefits and Costs of Rebalancing 3.2 Rebalancing Disciplines 3.3 The Perold–Sharpe Analysis of Rebalancing Strategies 3.4 Execution Choices in Rebalancing Summary Examples from the Curriculum 12 Example Monitoring a Change in Investment Horizon 12 Example Monitoring Changes in an Investor’s Circumstances and Wealth2 13 Example An Investor with a Concentrated Stock Position 18 Example How Active Managers May Use New Analysis and Information 21 Example The Characteristics of Successful Active Investors 21 Example The Nonfinancial Costs of Portfolio Revision 22 Example An Illustration of the Benefits of Disciplined Rebalancing 23 Example Tolerance Bands for an Asset Allocation 26 Example Strategies for Different Investors 27 This document should be read in conjunction with the corresponding reading in the 2018 Level III CFA® Program curriculum Some of the graphs, charts, tables, examples, and figures are copyright 2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute IFT Notes for the Level III Exam www.ift.world Page Monitoring and Rebalancing IFT Notes Introduction A portfolio manager works with the client to create an IPS The client’s portfolio is based on the IPS After a portfolio is created the 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) Monitoring LO.a: Discuss a fiduciary’s responsibilities in monitoring an investment portfolio A portfolio manager needs to track everything that can affect the client’s portfolio The three main items that need to be monitored are:  investor circumstances, including wealth and constraints (Section 2.1)  market and economic changes (Section 2.2)  the portfolio itself (Section 2.3) Portfolio managers are fiduciaries, and they therefore have an ethical responsibility to consider the appropriateness and suitability of the portfolio relative to these factors LO.b: 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 investor’s portfolio This LO is covered in sections 2.1, 2.2 and 2.3 2.1 Monitoring Changes in Investor Circumstances and Constraints LO.c: Recommend and justify revisions to an investor’s investment policy statement and strategic asset allocation, given a change in investor circumstances A portfolio manager should monitor possible changes in:  Investor circumstances and wealth: This includes events such as changes in employment, marital status and the birth of children  Liquidity requirements: We need to make changes to accommodate cash requirements as a result of an expected or unexpected events  Time horizons: We need to reduce risk when an individual moves through the life cycle and his/her time horizon shortens Refer to Example from the curriculum  Tax circumstances: We must construct portfolios that deal with each client’s current tax situation and take future possible tax circumstances into account IFT Notes for the Level III Exam www.ift.world Page Monitoring and Rebalancing   IFT Notes Laws and regulations: If laws and regulations change we must make appropriate changes to stay in compliance Unique circumstances: This includes special situations such as socially responsible investing, concentrated stock holdings etc Refer to Example from the curriculum Refer to Example from the curriculum A portfolio manager should conduct a review meeting with the client quarterly or on a semi-annual basis to identify these changes 2.2 Monitoring Market and Economic Changes A portfolio manager should monitor changes in:  Asset risk attributes: If the mean return/volatility/correlation of asset classes change profoundly, then we need to adjust the asset allocation according to the new risk attributes  Market cycles: We can monitor market cycles and make tactical adjustments to asset allocations or adjust individual securities holdings to enhance portfolio returns  Central bank policy: Central bank’s monitory and interest rate decisions affect both the bond and stock markets  Yield curve and inflation: Yield curves tend to:  become steeply upward-sloping during recessions  flatten during expansions  become downward sloping before an impending recession Unexpected inflation affects both fixed income and equity investors 2.3 Monitoring the Portfolio A 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 Refer to Example from the curriculum Refer to Example from the curriculum Refer to Example from the curriculum Rebalancing the Portfolio Monitoring and rebalancing a portfolio is similar to flying an airplane The pilot monitors and adjusts, the plane’s course to make sure that the plane ultimately arrives at the predetermined destination Similarly, a portfolio manager adjusts the portfolio to achieve the desired asset allocation IFT Notes for the Level III Exam www.ift.world Page Monitoring and Rebalancing IFT Notes 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 (This topic is addressed in other readings.) 3.1 The Benefits and Costs of Rebalancing LO.d: Discuss the benefits and costs of rebalancing a portfolio to the investor’s strategic asset allocation Benefits Costs Returns portfolio to optimal allocation Transaction costs offset benefits of rebalancing Controls drift in overall level of portfolio risk Transaction costs are particularly high for illiquid investments Controls drift in types of risk exposures Transaction costs include implicit costs and are not precisely measurable Without rebalancing investor might hold overpriced securities Capital gains taxes must be considered when we rebalance portfolios Refer to Example from the curriculum 3.2 Rebalancing Disciplines LO.e: Contrast calendar rebalancing to percentage-of-portfolio rebalancing Calendar Rebalancing In this method we rebalance the portfolio to target weights on a periodic basis for example quarterly or semi-annually For example, if the target allocation between stocks and bonds is 60/40 and we are using quarterly rebalancing then, every quarter we would adjust the proportion of stocks and bonds in our portfolio to meet the target allocation The advantage of this method is that it is very simple to implement The drawback is that it is unrelated to market behaviour and the portfolio could be very close (this will lead to unnecessary transaction costs) or very far (this will lead to high market impact costs) from optimal allocations on rebalancing dates Percentage of portfolio rebalancing In this method we set rebalancing thresholds or trigger points We will adjust the asset allocation only when the thresholds are crossed For example, consider a three-asset class portfolio of domestic equities, international equities, and domestic bonds The target asset proportions are 45/15/40 with respective corridors 45% ± 4.5%, 15% ± 1.5%, and 40% ± 4% Suppose the portfolio manager observes IFT Notes for the Level III Exam www.ift.world Page Monitoring and Rebalancing IFT Notes the actual allocation to be 50/14/36; the upper threshold (49.5%) for domestic equities has been breached The asset mix would be rebalanced to 45/15/40 Compared to calendar rebalancing, percentage-of-portfolio rebalancing can occur on any calendar date It also helps a portfolio manager to exercise a tighter control on divergences from target proportions because it is directly related to market performance Optimal corridor width LO.f: Discuss the key determinants of the optimal corridor width of an asset class in a percentageof-portfolio rebalancing program Exhibit provides a list of factors that affect the optimal corridor width Factor Effect on Optimal Width of Corridor (All Else Equal) Intuition Factors Positively Related to Optimal Corridor Width Transaction costs The higher the transaction costs, the wider the optimal corridor High transaction costs set a high hurdle for rebalancing benefits to overcome Risk tolerance The higher the risk tolerance, the wider the optimal corridor Higher risk tolerance means less sensitivity to divergences from target 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 Factors Inversely Related to Optimal Corridor Width 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 Volatility of rest of portfolio The higher this volatility, the narrower the optimal corridor Makes large divergences from strategic asset allocation more likely Refer to Example from the curriculum Other rebalancing strategies Some other rebalancing strategies include:  Calendar-and-percentage-of-portfolio rebalancing: This a combination of the two approaches discussed above  Equal probability rebalancing: Here we specify a corridor for each asset class as a common multiple of the standard deviation of the asset class’s returns In this method each asset class is equally likely to trigger rebalancing  Tactical rebalancing: This is a variation of calendar rebalancing that specifies less frequent rebalancing when markets appear to be trending and more frequent rebalancing when they are IFT Notes for the Level III Exam www.ift.world Page Monitoring and Rebalancing IFT Notes characterized by reversals Rebalancing to Target Weights versus Rebalancing to the Allowed Range LO.g: Compare the benefits of rebalancing an asset class to its target portfolio weight versus rebalancing the asset class to stay within its allowed range 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 The optimal rebalancing strategy should maximize present value of net benefit 3.3 The Perold–Sharpe Analysis of Rebalancing Strategies In this analysis we assume that the portfolio consists of only two-asset classes: one risky and the other risk-free We will consider the following strategies  Buy-and-Hold Strategies  Constant-Mix Strategies  Constant-Proportion (CPPI) Strategy Buy and Hold Strategies This is a passive strategy of buying an initial asset mix (say 60/40 stocks/Treasury bills) and nothing subsequently In a buy-and-hold strategy, the value of risk-free assets represents a floor for portfolio In our example, if the value of the stock allocation were to fall to zero, we would still have 40% in the risk-free asset We can therefore derive the following expressions: Portfolio value = Investment in stocks + Floor value Cushion = Portfolio value – Floor value For a buy and hold strategy, the following holds:  Upside is unlimited, but portfolio value can be no lower than the allocation to bills  Portfolio value is a linear function of the value of stocks, and portfolio return is a linear function of the return on stocks  The value of stocks reflects the cushion above floor value Hence there is a 1:1 relationship between the value of stocks and the cushion  The implication of using this strategy is that the investor’s risk tolerance is positively related to wealth and stock market returns Risk tolerance is zero if the value of stocks declines to zero Constant-Mix Strategies This is a dynamic strategy, which is synonymous with rebalancing to strategic asset allocation The target IFT Notes for the Level III Exam www.ift.world Page Monitoring and Rebalancing IFT Notes investment in stocks in the constant-mix strategy is: Target investment in stocks = m × portfolio value where m is a constant between and that represents the target proportion in stocks Example of a constant mix strategy: an investor decides that his portfolio will be 60 percent equities and 40 percent bills and rebalances to that proportion regardless of his level of wealth In constant mix we buy shares when the market is going down and sell when the market is going up A 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 Constant-Proportion Strategy: CPPI A constant-proportion strategy is a dynamic strategy in which the target equity allocation is a function of the value of the portfolio less a floor value for the portfolio Target investment in stocks = m × (Portfolio value – Floor value) Where m is a fixed constant In this strategy the stock holding is held to a constant proportion of the cushion Hence, an investor buys stocks when prices are risking and sells when prices are falling This strategy has a higher risk tolerance than buy-and-hold strategy because investor is holding a larger multiple of the cushion in stocks Linear, Concave, and Convex Investment Strategies LO.i: Distinguish among linear, concave, and convex rebalancing strategies Buy and hold is a linear investment strategy because portfolio returns are a linear function of stock returns Constant-mix is a concave investment strategy Portfolio return increases at a decreasing rate with positive stock returns and decreases at an increasing rate with negative stock returns CPPI strategy is a convex investment strategy Portfolio return increases at an increasing rate with positive stock returns, and it decreases at a decreasing rate with negative stock returns Exhibit provides a summary of the strategies LO.h: Explain the performance consequences in up, down, and flat markets of 1) rebalancing to a constant mix of equities and bills, 2) buying and holding equities, and 3) constant proportion portfolio insurance (CPPI) Constant Mix IFT Notes for the Level III Exam Buy and Hold CPPI www.ift.world Page Monitoring and Rebalancing Constant Mix Buy and Hold CPPI Up Underperform Outperform Outperform Flat (but oscillating) Outperform Neutral Underperform Down Underperform Outperform Outperform IFT Notes Market Condition Investment Implications Payoff curve Concave Linear Convex Portfolio insurance Selling insurance None Buying insurance Multiplier 0