portfolio monitoring and rebalancing
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Portfolio Monitoring and Rebalancing. 03/04/09. Monitoring and Rebalancing. Why do we need to monitor a portfolio? What should we monitor? What are the costs and benefits of rebalancing a portfolio? What methods can we use to rebalance? - PowerPoint PPT PresentationTRANSCRIPT
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Portfolio Monitoring and Rebalancing
03/04/09
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Monitoring and Rebalancing
• Why do we need to monitor a portfolio?• What should we monitor?• What are the costs and benefits of
rebalancing a portfolio?• What methods can we use to
rebalance?• What are the differences between the
rebalancing methods?
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The Need for Monitoring a Portfolio
• Portfolios need to be monitored because any or all of the following factors may change:• Client’s needs and circumstances• Capital market conditions• Portfolio asset weights
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Monitoring: Client’s Needs and Circumstances
• Periodic meetings with the client can be used to assess if the client’s needs and circumstances have changed.
• Changes should be used to revise the IPS.
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Monitoring: Client’s Needs and Circumstances
• Changes in investor circumstances and wealth:• Any major events in a client’s life may
require the IPS to be reworked.
• For institutional clients, changes to mandates or required returns may required the same.
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Monitoring: Client’s Needs and Circumstances
• Changes in investor circumstances and wealth:• For individuals, increases in wealth
typically make clients more risk tolerant.
• Permanent increases in wealth requires the reassessment of the client’s risk tolerance and return requirements.
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Monitoring: Client’s Needs and Circumstances
• Changes in liquidity requirement:• This can be caused by factors such as
unemployment, divorce, house purchase, etc. for individuals
• For institutions, changes in pension plan benefits, capital project funding, etc. can lead to different liquidity requirements.
• The manager needs to ensure that a sufficient portion of the portfolio is in assets such as money-market instruments to satisfy withdrawals
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Monitoring: Client’s Needs and Circumstances
• Other changes:• Time horizon• Tax circumstances• Laws and regulations• Unique circumstances – concentrated
stock positions, socially responsible investing, etc.
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Monitoring: Market and Economic Changes
• The economy moves through phases of expansion and contraction, each with unique characteristics.
• Financial markets, which are linked to economic expectations, reflect the resulting changing relationships among asset classes and individual securities.
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Monitoring: Market and Economic Changes
• Changes in asset risk attributes:• The historical relationship between asset
mean returns, standard deviations and correlations may change meaningfully.
• These changes may require changes to allocations.
• It may provide active managers profitable opportunities if the market’s view is pessimistic.
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Monitoring: Market and Economic Changes
• Market cycles:• Market cycles allow for short-term views
on asset classes and securities.
• Historically, cyclical tops and bottoms are examples of the opportunity to take advantage of mean reversion of asset classes.• For broader asset classes, we can compare
earnings yields to bond yields.
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Monitoring: Market and Economic Changes
• Central bank policy:• Immediate impact of Fed policy in bond
markets is on short-term yields (not long-term).
• Higher interest rates usually hurt stock returns and lower interest rates usually enhance stock returns.
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Monitoring: Market and Economic Changes
• Yield curve:• The yield curve tends to be steep (and
upward sloping) during recessions, flatter during expansions and inverted prior to recessions.
• Unusually steep curves tend to presage bond rallies.
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Monitoring: Portfolio
• A portfolio is never exactly optimal even after one day.
• Do the costs of adjustment outweigh any expected benefits from eliminating small differences between the current portfolio and the best possible one?
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Rebalancing
• Rebalancing can include:• Adjusting the actual portfolio to the
current strategic asset allocation because of price changes in portfolio holdings
• Revisions to the client’s target asset class weights
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Rebalancing: Practical Benefits
• Higher-risk assets will tend to represent a larger proportion of the portfolio over time.
• Over time, the types of risk exposures will change.
• Over time, the portfolio may include over-priced assets.
• Historically, disciplined rebalancing has shown to increase returns and reduce risk for the portfolio.
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Rebalancing: Costs
• Transaction costs are sometimes difficult to measure.
• They include commissions and illiquidity costs.
• Tax costs can also be significant especially when rebalancing requires the sale of appreciated assets.
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Rebalancing Discipline
• A rebalancing discipline is a strategy for rebalancing.
• Most managers adopt either a calendar rebalancing or percentage-of-portfolio rebalancing.
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Rebalancing Discipline: Calendar
• Calendar rebalancing is the simplest approach to rebalancing a portfolio.
• Rebalancing can be done monthly, quarterly or annually, where quarterly is the most popular.
• One drawback of this method is that it is unrelated to market behavior.
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Rebalancing Discipline: Percentage-of-Portfolio
• Percentage-of-Portfolio rebalancing involves setting rebalancing trigger points stated as a percentage of the portfolio’s value.
• If the target asset class weight is 40% and the trigger points are 35% and 45%, then the 35% to 45% range is considered the corridor or tolerance band (40% + 5%) .
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Rebalancing Discipline: Percentage-of-Portfolio
• Rebalancing using the Percentage-of-Portfolio method is directly related to market performance.
• Ideally, daily monitoring is required.
• Rebalancing trades can occur on any date therefore allowing for tighter control on divergences from target proportions.
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Rebalancing Discipline: Percentage-of-Portfolio
• Corridors can be set in an ad hoc manner.
• However, research suggests that corridors for each asset class should be set based on:• Transaction costs
• The greater the costs, the wider the corridor• Correlation (with other asset classes)
• Generally, higher correlations should lead to wider corridors
• Volatility• The greater the volatility, the narrower the corridor
• Risk Tolerance• The higher the risk tolerance, the wider the corridor
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Rebalancing Discipline: Strategies Compared
• When rebalancing a portfolio to its strategic asset allocation weights, we are implicitly carrying out a constant-mix strategy.
• We can compare this strategy to a buy-and-hold strategy and a constant-proportion portfolio insurance (CPPI) strategy.
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Rebalancing Discipline: Buy-and-Hold
• A buy-and-hold strategy is one where an initial asset mix is purchased and nothing is done subsequently.
• The floor value in this strategy is the value of the risk-free assets:
Portfolio value = Risky asset value + Floor value
Investment in stock = cushion =portfolio value – floor value
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Rebalancing Discipline: Constant-Mix
• A constant-mix strategy is one where the portfolio is rebalanced to the strategic asset allocation weights.
• The target investment in the risky asset is:
Target investment in risky asset = m * Portfolio value
where m represents the target proportion in the risky asset.
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Rebalancing Discipline: Constant-Mix
• A constant-mix strategy does better than a buy-and-hold strategy if risky asset returns are characterized more by reversals than trends.
• A buy-and-hold strategy works better during strong bull and bear markets.
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Rebalancing Discipline: CPPI
• A constant-proportion strategy adjusts risky asset investment based on the relationship between portfolio value and floor value:
Target investment in risky asset = m * (Portfolio value-floor value)
where m is a fixed constant.
• The CPPI strategy works best when the markets are momentum-oriented and is therefore exactly the opposite of a constant-mix strategy.
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Readings
• RM 5