Monitoring and Rebalancing Fiduciaries must: act in a position of trust; assess the suitability and appropriateness of a portfolio relative to: MONITORING clients; • expected retirement income of the latter client category NOTE: • the client’s needs and circumstances and • the investment’s and total portfolio’s basic characteristics monitor the following items to fulfill their ethical responsibilities: • investor circumstances - wealth and constraints; • market and economic changes; and • the portfolio itself Changes required as a result of a manager’s monitoring responsibilities are as follows: Monitoring: investor-related circumstances market and economic changes portfolios 2.1 Requires an Alteration of: For examples of situations resulting in changes in client circumstances and wealth, refer to Volume 6, Reading 32, Section 2.1.1 Changes in wealth may affect: • portfolio return requirements and/or • risk appetite NOTE: A portfolio manager should only consider permanent changes in wealth when assessing the impact on risk exposures and return requirements 2.1.2) Changing Liquidity Requirements • investment policy statement; • strategic asset allocation; or • individual portfolio holdings Portfolio managers are responsible for: • • • • strategic asset allocation; tactical asset allocation; style or sector exposures; or individual portfolio holdings What triggers changes in the liquidity requirements of private wealth and institutional clients? • strategic asset allocation or • individual portfolio holdings Portfolios with potential major withdrawal requirements should minimize the proportion of illiquid investments and should maintain a portion of liquid investments Monitoring Changes in Investor Circumstances and Constraints • providing liquidity when requested by a client • monitoring changes in liquidity requirements Refer to Reading 32, Section 2.1.2 2.1.3) Changing Time Horizons Portfolio managers generally review changes in the needs, circumstances or objectives of: private-wealth clients on a semiannual or quarterly basis, institutional clients on an annual basis; during the asset allocation review As a client’s time horizon shortens, managers should consider: • reducing investment risk • increasing allocation to bonds Entities with perpetual life portfolios experience few changes in their: NOTE: More frequent reviews may be required following: • unexpected changes in client circumstances or • client requests 2.1.1) Changes in Investor Circumstances and Wealth Changes in wealth and circumstances may affect: • income, expenditures, risk exposures, and risk preferences of institutional and private wealth • time horizons, • risk budgets, and • appropriate asset allocation; with the passage of time When one time horizon stage elapses and a new commences, investment policy requires changes How abrupt changes in a client’s time horizon stages affect investment policy and portfolio? Refer to Reading 32, Section 2.1.3, third paragraph –––––––––––––––––––––––––––––––––––––– Copyright © FinQuiz.com All rights reserved –––––––––––––––––––––––––––––––––––––– FinQuiz Notes Reading 32 Reading 32 Monitoring and Rebalancing FinQuiz.com 2.1.6) Unique Circumstances NOTE: Significant changes in client circumstances may mark the start of a new time horizon stage Practice: Example Volume 6, Reading 32 2.1.4) Tax Circumstances A private wealth client’s current unique circumstances must be monitored Any potential changes need to be considered Example: Individual clients may hold concentrated stock positions Portfolio managers will need to determine how to reduce the riskiness of the position and determine what investment action to take when the position is liquidated Portfolio managers need to: • assess tax consequences of investment decisions on portfolios; • consider each client’s current and future tax situation when constructing client portfolios; • consider holding period length and portfolio turnover rates; and • assess tax efficiency of investment strategies o Tax efficiency: the proportion of the expected pretax total return that will be retained after taxes Examples of monitoring a client’s tax circumstances include: • deferring income recognition to a low-tax year; • accelerating expense recognition to a high-tax year; • realizing short-term losses at year end to offset shortterm gains; • changing the allocation to tax-exempt securities; and • donating or gifting assets with high unrealized gains to avoid the imposition of capital gains tax 2.1.5) Changes in Laws and Regulations Practice: Example Volume 6, Reading 32 Example illustrates the issues associated with liquidating a concentrated stock position in response to changes in client circumstances Institutional clients have unique circumstances that need to be addressed Examples include: • Social responsible investing (SRI) concerns • Desire for improvements in corporate governance structures NOTE: A change in client’s needs may require a modification to the IPS (mentioned in Section 2) Practice: Example Volume 6, Reading 32 Managers must evaluate laws and regulations to: • ensure compliance and • understand how they affect: o scope of their advisory responsibilities o discretion in client portfolio management • changes in tax regulations; which are important for taxable and tax-exempt investors 2.2 Monitoring Market and Economic Changes Managers need to monitor the impact of any changes in financial and economic market conditions on portfolio investments Portfolio managers must adopt a broad view and take all relevant factors into account Changes in laws and regulations affect: • current portfolio holdings • the range of available investment opportunities; e.g may introduce new opportunities Changes in tax regulations affect: • current tax situation and • equilibrium relationships among assets For factors that need to be monitored, see sections 2.2.1 to 2.2.4 below: 2.2.1) Changes in Asset Risk Attributes A portfolio’s asset allocation may change due to changes in the underlying: • mean return, • volatility, and • correlations of asset classes Reading 32 Monitoring and Rebalancing Why monitor changes in asset risk attributes? • To assess whether existing asset allocations continue to satisfy investment objectives o If not, a change in investment objectives or asset allocation may be required • New investment opportunities may arise 2.2.2) Market Cycles Monitoring market cycles and valuation levels help investors form opinions on short-term risks and rewards being offered Based on their opinions, investors tactically adjust asset allocations or adjust individual security holdings Major market swings present extreme opportunities, good and bad FinQuiz.com NOTE: Yield curve changes trigger changes in bond values, which in turn influences equity values (via competition between the two asset classes) The premium on long-term bonds over short-term bonds is countercyclical • Premiums are high during recessions and low during expansions Short-term yields are pro-cyclical; correspond with monetary policy The shape of the yield curve depends on the economic cycle stage: Stage Example: During economic growth, securities perform too well providing the opportunity to sell; while during economic recessions, stock prices decline significantly providing the opportunity to invest 2.2.3) Central Bank Policy influences stock and bond markets via monetary and interest rate decisions, immediately impacts money market yields as opposed to long-term bond yields in the market, affects stock returns, and has a profound effect on bond market volatility Types of monetary policy and influence on stock vs bond returns: Expansionary monetary policy Upward sloping Expansion Flat Before recessions Downward sloping (Inverted) NOTE: Investors monitor the yields of bonds relative to historical norms to ascertain return prospects Example: The yield on 10-year BB+ bonds is 11.27% The average yield of the bond over the past two years was 8.76% Should investors expect a high return? Higher Higher returns: Guidance: Restrictive monetary policy Recession Yield curve contains information about future GDP growth Central bank monetary policy: • Expansionary Discount rate: low returns: stocks • Restrictive Discount rate: high bonds Shape avoid stocks/embrace bonds embrace stocks/avoid bonds 2.2.4) The Yield Curve and Inflation The default-risk free yield curve reflects an investor’s return requirements at different maturities The curve reflects: time preferences for current versus future real consumption, expected inflation, and maturity premium demanded Yes Due to the higher current yield, prospects for greater returns increase An unusually steep default-free yield curve indicates a positive outlook for bonds(especially when the cash yield or inflation rate is used as a proxy for the risk-free rate) Investors are affected by inflation in the following ways: • influences the nominal amount of money required to purchase a basket of goods; • influences returns and risks in capital markets: I unexpected increases in inflation result in a decline in real bond yields II As normal yields rise to offset this loss, bond prices fall III unexpected changes in inflation affect stock market returns Reading 32 2.3 Monitoring and Rebalancing NOTE: Monitoring the Portfolio This is a continuous process requiring a portfolio manager to assess: events and trends affecting the prospects of individual portfolio holdings and asset classes and a the ability of existing holdings and asset classes to remain suitable for achieving investment objectives Changes in asset values creating deviations from the strategic asset allocation FinQuiz.com • leads to a change in either the IPS or individual portfolio holdings • leads to rebalancing the existing strategic allocation Portfolio managers need to consider new information on economic conditions, market conditions, and new companies in an effort to add value to client portfolios Practice: Example Volume 6, Reading 32 REBALANCING THE PORTFOLIO Rebalancing involves eliminating the differences between a portfolio’s actual and strategic asset allocation in response to changes in underlying security prices Example 7, Reading 32, contrasts a disciplined rebalancing to a do-nothing approach 3.1.2) Rebalancing Costs Rebalancing generates two costs: NOTE: Rebalancing also covers other actions (see Reading 32, paragraph preceding section 3.1) transaction costs and in the case of taxable investors, tax costs Transaction Costs 3.1 The Benefits and Costs of Rebalancing Rebalancing involves a cost vs benefit trade-off 3.1.1) Rebalancing benefits Investor reduces present value of expected utility losses • Expected utility loss: cost of straying away from the optimum strategic asset allocation Controls the level of drift in overall portfolio risk Explanation: See respective section from curriculum Rebalancing maintains the client’s desired systematic risk exposures Removes overpriced assets with an inferior returns prospect Source: Volume 6, Reading 32 from curriculum NOTE: • Disciplined rebalancing reduces risk and incrementally increases returns over a long-term investment horizon (See Example 7) Practice: Example Volume 6, Reading 32 Offset rebalancing benefits Non-recoverable Rebalancing illiquid investments generates high level of transaction costs Rebalancing liquid investments generates two types of transaction costs: • explicit: commissions ─not difficult to measure • implicit: bid-ask spreads, market impact and missed trade opportunity costs – require estimation Tax Costs In the event where appreciated asset classes are sold and depreciated asset classes are purchased, rebalancing triggers a tax liability for taxable investors Explanation: See respective section from curriculum When short-term capital gains tax rate is higher than the long-term rate, rebalancing assets that realize short-term gains only can be costly NOTE: When short-term capital gains tax rate is higher than the long-term rate – tax-efficient selling strategy: reduce capital gains taxes by realizing short-term losses, longterm capital losses, long-term capital gains and shortterm gains, in this order Reading 32 3.2 Monitoring and Rebalancing FinQuiz.com Rebalancing Disciplines Rebalancing disciplines are rebalancing strategies These include: calendar rebalancing and percentage-of-portfolio rebalancing COMPARISON 3.2.1) Calendar Rebalancing 3.2.2) Percentage-of-Portfolio Rebalancing • Rebalances to target weights periodically; e.g monthly, quarterly, and so forth • Establishes rebalancing thresholds or trigger points are stated as a percentage of portfolio value • Example: An investor’s portfolio has two asset classes with target proportions of 75/25 Rebalancing occurs at the beginning of the month On each rebalancing date, asset classes are rebalanced to their target proportions; 75/25 • Example: The target proportion of an asset class is 40% of portfolio value and trigger points are 35% and 45% of portfolio value or (40% ± 5%) Portfolio is rebalanced when the actual weight breaches a corridor limit • Rebalancing frequency may be timed to coincide with portfolio reviews • Rebalancing can occur on any calendar date • Simplest rebalancing approach • No requirement for continuous monitoring of portfolio values within the rebalancing period • Requires frequent monitoring • Drawback: unrelated to market behavior I if portfolio’s allocation is close to the optimal allocation, rebalancing costs may outweigh benefits II If portfolio’s allocation is far from optimal, investor may incur a high level of market impact costs due to rebalancing • Directly related to market performance • Relative to calendar rebalancing, tighter control on divergences from target allocations; especially at lower frequencies of calendar rebalancing Example: The target asset allocation for a portfolio with three asset classes is 40/35/25 The corridors for these asset classes are 40% ± 1.9%; 35% ± 2.3%; and 25% ± 3.0%, respectively Market prices have changed as a result of increased volatility Actual asset allocation is now 40.8/31.9/27.3 Does the portfolio require rebalancing? Yes The second asset class, with a target weight of 35%, has breached its lower corridor limit, 32.7% (35% - 2.3%) Portfolio will be rebalanced to the 40/35/25 target allocation Key Determinants of the Optimal Corridor Width in a Percentage-of-Portfolio Rebalancing Program: Factor Effect on Optimal Width of Corridor Intuition Factors Positively Related to Optimal Corridor Width Transaction costs The higher the transaction costs, the wider the optimal corridor Higher transaction costs set a high hurdle for rebalancing costs to overcome Risk tolerance The higher the risk tolerance, the wider the optimal corridor High risk tolerance implies lower sensitivity to divergences from target allocations Correlation with rest of portfolio The higher the correlation, the wider the optimal corridor When asset classes move in synch, further divergence is less likely Reading 32 Monitoring and Rebalancing FinQuiz.com 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 percentage move away from the target is potentially more costly for a highly volatile asset class, as further divergence becomes more likely Volatility of rest of portfolio The higher the volatility, the narrower the optimal corridor Makes large divergences from strategic asset allocation more likely Source: Volume 6, Exhibit 8, Reading 32 NOTE: • Illiquid assets should have wider corridors • Ad hoc approaches to setting corridors not consider the differences in rebalancing transaction costs across asset classes Tip: For a multi-asset portfolio consider the concerned asset class as one class and the balance of the portfolio as the other class Practice: Example Volume 6, Reading 32 For an illustration of whether tolerance bands for asset classes are appropriate, practice Example 8, Reading 32 3.2.3) Other Rebalancing Strategies are trending • Specifies more frequent rebalancing when markets are characterized by reversals 3.2.4) Rebalancing to Target Weights versus Rebalancing to the Allowed Range Relative to rebalancing to target weights, rebalancing to an allowed range has the following advantages: • incurs lower transaction costs and • provides room for tactical adjustments Example: A U.S investor gives 25% target weight to emerging market stocks and the weight moves above the upper corridor limit Forecasting a transitory decrease in the U.S dollar, the investor will want to partially rebalance the exposure to take advantage of the short-term exchange rate change Calendar-and-percentage-of-portfolio rebalancing: • The strategy is executed in the following manner: i Monitor the portfolio at specified intervals (e.g quarterly) ii Rebalance the portfolio using a percentage-ofportfolio principle; i.e based on corridors • Advantage: Avoids incurring rebalancing costs associated with a calendar rebalancing approach (when the portfolio is near optimum) Equal probability rebalancing: • Corridors are specified for each asset class as a common multiple of the standard deviation of the asset class’s returns • Rebalancing is triggered when any asset class weight moves outside its corridor • Each asset class has an equal probability of triggering rebalancing if returns are normally distributed • Drawback: does not account for differences in transaction costs or asset correlations Tactical rebalancing: • Specifies less frequent rebalancing when markets Additional advantage (latter approach): allows managers to better manage the weights to illiquid assets Disadvantage: rebalancing to an allowed range does not perfectly align actual asset allocation with target proportions 3.2.5) Setting Optimal Thresholds Finding the optimal rebalancing strategy implies: • maximizing the net present value of net rebalancing benefits • keeping the present value of expected utility losses and transaction costs to a minimum Challenges faced when finding the optimal rebalancing strategy are as follows: • Rebalancing costs and benefits are difficult to measure • Return characteristics of asset classes may differ from each other, but may be interrelated; the strategy needs to reflect this • Optimal rebalancing decisions may be linked to and affect future rebalancing decisions • Transaction costs may be difficult to incorporate; Reading Monitoring and Rebalancing e.g costs may not be linearly related to the size of the trade • Optimal strategy changes with the passage of time and with new information • Rebalancing has tax consequences 3.3 The Perold-Sharpe Analysis of Rebalancing Strategies • Contrasts constant mix strategies with other strategies • Assumes a simple-two asset class scenario o only one asset class is risky 3.3.1) Buy-and-Hold Strategies Passive, do-nothing approach Does not adjust portfolio weights following market movements Floor = amount invested in Treasury bills; i.e risk-free Strategy implies risk tolerance is positively related to wealth and stock returns • When total value of stocks is zero, risk tolerance is zero Special case of a constant proportion strategy (CPPI – see below) Outperforms constant-mix strategies (see below) when markets are trending Neutral when markets are characterized by reversals (or flat and oscillating) Portfolio value = Investment in stocks + Floor value • Portfolio value is linearly related to investment in stocks • Portfolio return is linearly related to the return on stocks o Portfolio return = Percent in stock × Return on stocks • Unlimited upside potential • Downside potential limited to the floor • Cushion = Investment in stocks = Portfolio value – Floor value • Cushion and value of stocks have a 1:1 relationship (above floor) • m = 1; i.e target stock proportion = actual stock proportion FinQuiz.com 3.3.2) Constant Mix Strategies Dynamic – reacts to market movements (see Point below) Target investment in stocks = m× Portfolio value, where, 0