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

Level III Monitoring and Rebalancing Summary Graphs, charts, tables, examples, and figures are copyright 2016, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Monitoring an Investment Portfolio Portfolio managers are fiduciaries  have an ethical responsibility to consider the appropriateness and suitability of the portfolio Portfolio managers need 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 • market and economic changes • the portfolio itself A portfolio manager should monitor possible changes in:  Investor circumstances and wealth: Ex: changes in employment, marital status and the birth of children  Liquidity requirements: cash requirements as a result of an expected or unexpected events  Time horizons: reduce risk when an individual moves through the life cycle and his/her time horizon shortens  Tax circumstances: construct portfolios that deal with each client’s current tax situation and take future possible tax circumstances into account  Laws and regulations: If laws and regulations change we must make appropriate changes to stay in compliance  Unique circumstances: Ex: socially responsible investing, concentrated stock holdings etc www.ift.world A portfolio manager should monitor changes in:  Asset risk attributes: If the mean return/volatility/correlation of asset classes change profoundly, then adjust the asset allocation according to the new risk attributes  Market cycles: 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 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 www.ift.world Rebalancing 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 Benefits Returns portfolio to optimal allocation Controls drift in overall level of portfolio risk Costs Transaction costs offset benefits of rebalancing 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 www.ift.world Rebalancing Methods Calendar Rebalancing Rebalance the portfolio to target weights on a periodic basis for example quarterly or semi-annually Advantage: simple to implement Drawback: does not consider market behaviour Portfolio could be close to optimal allocations on rebalancing dates  unnecessary transaction costs Portfolio could be very far from optimal allocations on rebalancing dates  high market impact costs Percentage of portfolio rebalancing Set rebalancing thresholds or trigger points; adjust asset allocation only when the thresholds are crossed 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 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 2010 A, 2014 10 A www.ift.world Factors Impacting Corridor Width Effect on Optimal Width of Corridor Factor (All Else Equal) Factors Positively Related to Optimal Corridor Width Transaction costs The higher the transaction costs, the wider the optimal corridor Risk tolerance The higher the risk tolerance, the wider the optimal corridor Correlation with rest of portfolio The higher the correlation, the wider the optimal corridor Factors Inversely Related to Optimal Corridor Width Asset class volatility The higher the volatility of a given asset class, the narrower the optimal corridor Volatility of rest of portfolio The higher this volatility, the narrower the optimal corridor Intuition High transaction costs set a high hurdle for rebalancing benefits to overcome Higher risk tolerance means less sensitivity to divergences from target When asset classes move in synch, further divergence from targets is less likely A given move away from target is potentially more costly for a high-volatility asset class, as a further divergence becomes more likely Makes large divergences from strategic asset allocation more likely 2007 7A, 2009 10 A, 2010 B, 2014 10 B Other Rebalancing Strategies     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 characterized by reversals Rebalance to the allowed range: This 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 Assuming that a portfolio consists of only two-asset classes: one risky and the other risk-free, we will consider the following:  Buy-and-Hold Strategy  Constant-Mix Strategy  Constant-Proportion (CPPI) Strategy www.ift.world Buy and Hold Strategy 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 (m = 1)  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 www.ift.world Constant-Mix Strategy This is a dynamic strategy, which is synonymous with rebalancing to strategic asset allocation The target 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 T-bills and rebalances to that proportion regardless of his level of wealth 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 and is greater than Stock holding is held to a constant proportion of the cushion Hence, an investor buys stocks when prices are rising and sells when prices are falling Higher risk tolerance than buy-and-hold strategy because investor is holding a larger multiple of the cushion in stocks www.ift.world Comparison of 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 Constant Mix Buy and Hold CPPI Underperform Outperform Outperform Neutral Outperform Underperform Down Underperform Investment Implications Payoff curve Concave Multiplier 0