CFA level 3 volume VI trading and rebalancing, performance evaluation, and GIPS finquiz smart summary, study session 16, reading 32

2018 Study Session # 16, Reading # 32 “MONITORING AND REBALANCING” MONITORING Fiduciary must: Act in a position of trust Assess portfolio suitability relative to client’s needs & circumstances Monitor investor related circumstances, market & economic changes & portfolios 2.1 Monitoring Changes in Investor Circumstances and Constraints ∆ in the needs, circumstances or objectives of private wealth clients (institutional clients) are reviewed on a semiannual or quarterly basis (annual basis) More frequent reviews may be required on client’s request or unexpected ∆ in client circumstances 2.1.1 Changes in Investor Circumstances and Wealth May affect income, expenditure, risk, return & retirement income 2.1.2 Changing Liquidity Requirements Portfolio managers: Provide liquidity when requested by a client Monitor changes in liquidity requirement 2.1.3 Changing Time Horizons the time horizon, investment, allocation to bonds Perpetual life portfolios ⇒ few changes in time horizon, risk budgets & asset allocation 2.1.4 Tax Circumstances Portfolio manager should: Assess tax consequences of investment decisions Consider client’s current & future tax situation Assess tax efficiency 2.1.5 Changes in Laws and Regulations Managers must evaluate laws & regulations to ensure compliance ∆ in law affects current portfolio as well as range of available investments Copyright © FinQuiz.com All rights reserved 2018 Study Session # 16, Reading # 32 2.2 Monitoring Market and Economic Changes 2.2.1 Changes in Asset Risk Attributes A portfolio’s asset allocation may change due to ∆ in mean return, volatility & correlation of assets 2.2.2 Market Cycles Major market swings provide extreme +ve or –ve opportunities Investors tactically adjust asset allocations or individual security holdings based on their opinions 2.2.3 Central Bank Policy Expansionary monetary policy ⇒ discount rates, stock return Restrictive monitory policy ⇒ discount rates, bond return 2.2.4 The Yield Curve and Inflation Default RF yield curve reflects: Expected inflation Maturity premium Time preference for real consumption Maturity premiums are countercyclical Sharpe of the Y.C depends on the economic cycle stages Y.C provides information about future GDP growth 2.3 Monitoring the Portfolio Continuous process requiring a manager to assess: Events & trends affecting asset classes & individual holdings ∆in asset values creating deviation from the SAA Copyright © FinQuiz.com All rights reserved 2018 Study Session # 16, Reading # 32 REBALANCING THE PORTFOLIO 3.1 The Benefits and Costs of Rebalancing 3.1.1 Rebalancing Benefits 3.1.2 Rebalancing Costs In PV of expected utility losses Controls the level of drift in overall portfolio risk Maintains desired systematic risk exposure Removes overpriced assets with an inferior returns prospect Transaction costs (offset rebalancing benefits) Tax costs if investor is taxable 3.2 Rebalancing Disciplines 3.2.1 Calendar Rebalancing 3.2.2 Percentage-of-Portfolio Rebalancing Periodic rebalancing to target weights (e.g monthly) Rebalancing frequency may be timed to match with portfolio reviews Simplest approach No continuous monitoring required Drawback: If allocation is close to optimal allocation rebalancing cost > benefits If allocation is far from the optimal, level of market impact costs Rebalancing thresholds or trigger points stated as % of portfolio value Require frequent monitoring Directly related to market performance Tighter control on divergence from target allocation Key Determinants of the Optimal Corridor Width in a Percentage- of-Portfolio Rebalancing Program: Factor Effect on Optimal Width of Corridor 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 the volatility, the narrower the optimal corridor Intuition Higher transaction costs set a high hurdle for rebalancing costs to overcome High risk tolerance implies lower sensitivity to divergences from target allocations When asset classes move in synch, further divergence is less likely A given percentage move away from the target Costly for a highly volatile asset class, as further divergence becomes more likely Makes large divergences from strategic asset allocation more likely Reference: Volume 6, Exhibit 8, Reading 30 Copyright © FinQuiz.com All rights reserved 2018 Study Session # 16, Reading # 32 3.2.3 Other Rebalancing Strategies Calendar-And-Percentage-Of-Portfolio Rebalancing Monitor the portfolio at specified intervals Rebalance the portfolio under % principle Avoid incurring rebalancing cost when the portfolio is nearly optimal Equal Probability Rebalancing Corridors are specified for each asset class Rebalancing is triggered when any asset class weight moves outside its corridor Equal probability of triggering rebalancing Ignores difference in transaction costs or asset correlations Tactical Rebalancing In trending markets less frequent rebalancing More frequent rebalancing when markets are characterized by reversals 3.2.4 Rebalancing to Target Weights versus Rebalancing to the Allowed Range Rebalancing to an allowed range has the following advantages over rebalancing to target weights: Transaction costs Tactical adjustments are possible Better manage the weights of an illiquid assets Disadvantage: Not perfectly align actual asset allocation with target proportions 3.2.5 Setting optimal Thresholds Optimal rebalancing strategy implies: Maximize rebalancing benefits Transaction costs Challenges: Rebalancing costs & benefits are difficult to measure Tax consequences Optimal strategy changes with the passage of time Copyright © FinQuiz.com All rights reserved 2018 Study Session # 16, Reading # 32 3.3 The Perold-Sharpe Analysis of Rebalancing Strategies 3.3.1 Buy-and-Hold Strategies 3.3.2 Constant-Mix Strategies Passive do-nothing strategy Floor = amount invested in T-bills Risk tolerance is +ly related to wealth & stock returns Special case of CPPI In trending market, this strategy outperforms constant mix strategy This strategy remains neutral in flat & oscillating market Portfolio value = investment in stocks +floor value Limited downside (floor) & unlimited upside potential Target stock proportion = actual stock proportion (m=1) 3.3.3 A Constant-Proportion Strategy: CPPI Dynamic strategy Buy(sell) shares as stock prices ( ) Target investment in stock = m ×(portfolio value- floor value) If m>1, strategy is known as CPPI Investment in RF assets is dynamic Perform well in trending markets & poor in markets characterized by reversals Reacts to market movements Target investment in stocks = m × portfolio value where 0