Reading 30 Monitoring and Rebalancing Flashcards
How would the investment results of the recommended rebalancing discipline be affected if markets were nontrending?
Such markets tend to be characterized by reversal and enhance the investment results from rebalancing to the strategic asset allocation, according to Perold–Sharpe analysis.
Constant-Mix Strategies
- Constant mix is a “do-something” (or “dynamic”) strategy in that it reacts to market movements with trades.
- Strong bull and bear markets favor a buy-and-hold strategy.
- On the other hand, the constant-mix strategy tends to offer superior returns compared with buy-and-hold strategies if the equities returns are characterized more by reversals than by trends.
- A constant-mix strategy is consistent with a risk tolerance that varies proportionately with wealth.
Tactical rebalancing
A variation of calendar rebalancing that specifies less frequent rebalancing when markets appear to be trending and more frequent rebalancing when they are characterized by reversals. This approach seeks to add value by tying rebalancing frequency to expected market conditions that most favor rebalancing to a constant mix.
Rebalancing to Target Weights versus Rebalancing to the Allowed Range
- The alternative, applicable to rebalancing approaches that involve corridors, is to rebalance the asset allocation so that all asset class weights are within the allowed range but not necessarily at target weights.
- Compared with rebalancing to target weight, rebalancing to the allowed range results in less close alignment with target proportions but lower transaction costs; it also provides some room for tactical adjustments.
- A number of studies have contrasted rebalancing to target weights to rebalancing to the allowed range based on particular asset classes, time periods, and measures of the benefits of rebalancing. They have reached a variety of conclusions which do not permit one to state that one discipline is unqualifiedly superior to the other.
Buy-and-Hold Strategies
A buy-and-hold strategy is a passive strategy of buying an initial asset mix (e.g., 60/40 stocks/Treasury bills) and doing absolutely nothing subsequently. Whatever the market does, no adjustments are made to portfolio weights. It is a “do-nothing” strategy resulting in a drifting asset mix.
A buy-and-hold strategy would work well for an investor whose risk tolerance is positively related to wealth and stock market returns.
Cash Market Trades
- Cash market* trades generally are more costly, and slower to execute, than equivalent derivative trades. For taxable investors, however, tax considerations may favor cash market trades over derivative market trades.
- First*, there may be no exact derivative market equivalent to a cash market trade on an after-tax basis.
- Second*, in some tax jurisdictions such as the United States, derivative market trades may have unfavorable tax consequences relative to cash market trades. In addition, even if differences in taxation are irrelevant (as in the case of tax-exempt investors), not all asset class exposures can be closely replicated using derivatives, and individual derivative markets may have liquidity limitations.
Derivative Trades
Rebalancing through derivatives markets, for the portion of the portfolio that can be closely replicated through derivative markets, has a number of major advantages:
- lower transaction costs;
- more rapid implementation—in derivative trades one is buying and selling systematic risk exposures rather than individual security positions; and
- leaving active managers’ strategies undisturbed—in contrast to cash market trades, which involve trading individual positions, derivative trades have minimal impact on active managers’ strategies.
The reasons for monitoring and rebalancing
- First, clients’ needs and circumstances change, and portfolio managers must respond to these changes to ensure that the portfolio reflects those changes.
- Second, capital market conditions change.
- Third, fluctuations in the market values of assets create differences between a portfolio’s current asset allocation and its strategic asset allocation.
Factors Affecting Optimal Corridor Width
1. Transaction costs
The higher the transaction costs, the wider the optimal corridor. (High transaction costs set a high hurdle for rebalancing benefits to overcome).
2. Risk tolerance
The higher the risk tolerance, the wider the optimal corridor. (Higher risk tolerance means less sensitivity to divergences from target).
3. Correlation with rest of portfolio
The higher the correlation, the wider the optimal corridor. (When asset classes move in synch, further divergence from targets is less likely).
4. Asset class volatility
The higher the volatility of a given asset class, the narrower the optimal corridor. (A given move away from target is potentially more costly for a high-volatility asset class, as a further divergence becomes more likely).
**5. Volatility of rest of portfolio **
The higher this volatility, the narrower the optimal corridor. (Makes large divergences from strategic asset allocation more likely).
Rebalancing Costs
These costs are of two types—transaction costs and, for taxable investors, tax costs.
Transaction costs consist of more than just explicit costs such as commissions. They include implicit costs, such as those related to the bid–ask spread and market impact. Market impact is the difference between realized price and the price that would have prevailed in the absence of the order. That cost is inherently unobservable.
Identify the relative investor risk tolerance characteristics of each of the following investing strategies: (1) buy-and-hold, (2) constant-mix, (3) constant-proportion portfolio insurance (CPPI)
1) Buy-and-hold: the investors tolerance for risk is zero of the value of investors assets falls below the floor value (zero equity allocation) but increases as stocks increase in value.
2) Constant-mix: Investor`s relative risk tolerance remains constant regardless of their wealth level. They will hold stocks at all levels of wealth.
3) CPPI: Investor risk tolerance is similar to that of the buy-and-hold methodology. Investor risk tolerance drops to zero when assets drop berlow the floor value.
Best rebalancing strategies that have convex payoff diagram?
Because convex strategies sell stocks as prices fall and buy as prices rise, they perform poorly in flat, by oscilating market - selling in weakness only to see the market renound, and buying on strength only to see the market fall.
*the constant mix strategy has a concave payoff diagram
Setting Optimal Thresholds
The optimal portfolio rebalancing strategy should maximize the present value of the net benefit of rebalancing to the investor. Equivalently, the optimal strategy minimizes the present value of the sum of two costs: expected utility losses (from divergences from the optimum) and transaction costs (from rebalancing trades). Despite the apparent simplicity of the above formulations, finding the optimal strategy in a completely general context remains a complex challenge:
- If the costs of rebalancing are hard to measure, the benefits of rebalancing are even harder to quantify.
- The return characteristics of different asset classes differ from each other, and at the same time interrelationships (correlations) exist among the asset classes that a rebalancing strategy may need to reflect.
- The optimal rebalancing decisions at different points in time are linked; one decision affects another.
- Accurately reflecting transaction costs may be difficult; for example, transaction costs can be nonlinear in the size of a rebalancing trade.
- The optimal strategy is likely to change through time as prices evolve and new information becomes available.
- Rebalancing has tax implications for taxable investors.
Critique a percentage-of-portfolio discipline that involves establishing a corridor of target percentage allocation ± 5% for each asset class in the foundation’s portfolio.
The suggested approach has several disadvantages:
- A fixed ±5% corridor takes no account of differences in transaction costs among the asset classes. For example, private equity has much higher transaction costs than inflation-protected bonds and should have a wider corridor, all else equal.
- The corridors do not take account of differences in volatility. Rebalancing is most likely to be triggered by the highest volatility asset class.
- The corridors do not take account of asset class correlations.
When Buy-and-Hold is better than CPPI?
Whereas the level of volatility results in market, characterized more by reversals than by trends the CPPI requires a manager to sell shares s after weakness and buy shares after strenght; those transactions are unprofitable if drops are followed by rebounds and increases are retraced. Transaction costs, such as theu may be, will also work against the investor. Under this volatility scenario, buy-and-hold should outperform CPPI.
However, if the level of volatility does not result in reversals dominating the upward trend, CPPI could be expected to outperform buy-and-hold.
Linear, Concave, and Convex Investment Strategies
- A buy-and-hold strategy has been called a linear investment strategy because portfolio returns are a linear function of stock returns.
- The share purchases and sales involved in constant-mix and CPPI strategies introduce nonlinearities in the relationship.
- For constant-mix strategies, the relationship between portfolio returns and stock returns is concave; that is, portfolio return increases at a decreasing rate with positive stock returns and decreases at an increasing rate with negative stock returns.
- In contrast, a CPPI strategy is convex. Portfolio return increases at an increasing rate with positive stock returns, and it decreases at a decreasing rate with negative stock returns.
- Convex strategies represent the purchase of portfolio insurance, concave strategies the sale of portfolio insurance. That is, convex strategies dynamically establish a floor value while concave strategies provide or sell the liquidity to convex strategies.
