Portfolio Monitoring and Rebalancing

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?• What are the differences between the

rebalancing methods?

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

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.


• 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.


• 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.


• 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


• Other changes:• Time horizon• Tax circumstances• Laws and regulations• Unique circumstances – concentrated

stock positions, socially responsible investing, etc.

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.


• 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.


• 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.


• 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.


• 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.

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?

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

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.

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.

Rebalancing Discipline

• A rebalancing discipline is a strategy for rebalancing.

• Most managers adopt either a calendar rebalancing or percentage-of-portfolio rebalancing.

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.

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%) .


• 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.


• 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

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.

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

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.

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.

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.

Readings

• RM 5

Documents

Portfolio Monitoring and Rebalancing