16-31 Rebalancing

Question 0

5 determinants of optimal corridor width (of an asset class in percentage-of-portfolio rebalancing)

Answer 0

1. transaction cost
2. risk tolerance
3. correlation of returns with other asset classes in portfolio
4. volatility
5. volatility of returns on other asset classes in portfolio

Know direct vs inverse relationships for each

Question 1

Benefits of rebalancing

Costs

Answer 1

• increases returns in L-T by adding discipline by reducing weights to overvalued assets while increasing weights to undervalued assets
• transaction costs, tax liability from selling appreciated assets

Question 2

Pros and cons of calendar rebalancing and percentage-of-portfolio rebalancing

Answer 2

Calendar

• provides discipline without requirement of frequent rebalancing apart from rebalancing date once a year
• con is that weights can be significantly off due to market movements between rebalancing dates

Percentage

• provides discipline that better tracks intended optimal weights since rebalancing happens whenever weights exceeds predetermined corridor
• portfolio weights and values must be tracked on a daily basis which some firms lack capability

Question 3

3 rebalancing strategies

Explain

Answer 3

buy and hold

• no rebalancing
• floor value is T-bills (if equity goes to zero just left will T-bills)

constant mix

• rebalancing to target weights (warren buffet strategy)
• floor value is zero (as equity falls, sell more an more T-bills to buy equity until nothing left)

constant proportion portfolio insurance (CPPI)

• rebalancing to target weight in equities which vary directly with difference btw Vp and some minimum value.
• target equity investment = M x (Vp - floor) = M x cushion
• M = 1 is buy and hold strategy; M

Question 4

explain performance in trending markets and nontrending, mean-reverting markets

Answer 4

trending markets:
CPPI will outperform bc takes adv of favorable trends faster (alloc to equities or out of equities is faster) thus buying winners and selling losers –> buy and hold (underperforms CPPI because no amplification effect) –> constant mix (sell winners and buy losers so worst performance)

mean reverting volatile markets:
constant mix will outperform bc sell high and buy low right before a market price reversal –> buy and hold –> CPPI (increases alloc to subsequent reveral and downturn in equity prices so does poorly)

Question 5

shape of rebalancing strategies (value of stock market against value of assets)

Answer 5

buy and hold - linear
constant mix - concave
cppi - convex

Question 6

explain appropriateness of each rebalancing strategy given investor’s risk tolerance

Answer 6

buy and hold:

• risk tolerance is zero if value of assets fall below floor value
• otherwise, passively, risk tolerance increases proportionately with wealth

constant mix:

• absolute risk tolerance varies directly with wealth
• relative risk tolerance remains constant regardless of wealth level
• investors using this strategy will hold stocks at all levels of wealth

CPPI:

• risk tolerance similar to buy and hold
• risk tolerance drops to zero when assets fall below floor value
• however, CPPI assumes risk tolerance is more dramatically affected by changes in wealth levels than buy and hold (e.g. as stocks increase, CPPI aggressively pursues more stocks; as stocks fall, CPPI aggressively rids stocks)