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.

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.

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.

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

Monitoring: Client’s Needs and Circumstances 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.

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.

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.

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.

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.

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 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.

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

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.

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