Level III
Monitoring and Rebalancing
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Reproduced and republished with permission from CFA Institute. All rights reserved.


1. Introduction
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Portfolio manager works with the client to create the IPS
The client portfolio is based on the IPS
Portfolio manager must constantly monitor and rebalance the
portfolio because:
1. Client needs and circumstances change
2. Capital market conditions change
3. Fluctuation in market values of assets create divergence from strategic
asset allocation

•

This reading covers monitoring (Section 2) and rebalancing
(Section 3)
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2. Monitoring

• Fiduciaries have an ethical responsibility to consider the
appropriateness and suitability of the portfolio relative to:
Client’s needs and circumstances



Monitor changes in
circumstances and constraints

Investment’s basic characteristics



Monitor market and economic
changes

Portfolio’s basic characteristics



Monitor the portfolio

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2.1 Monitoring Changes in Investor Circumstances and
Constraints
• Portfolio manager should monitor possible changes in…

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Investor circumstances and wealth (Example 2)
Liquidity requirements
Time horizons (Example 1)
Tax circumstances
Laws and regulations
Unique circumstances (Example 3)

• Conduct review meeting with the client quarterly or on a semiannual basis
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2.2 Monitoring Market and Economic Changes
• Portfolio manager should monitor changes in…
 Asset risk attributes
 Market cycles
 Central bank policy
 Yield curve and inflation
 Other
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2.3 Monitoring the Portfolio
• Portfolio manager should continuously evaluate
 Events and trends affecting prospects of individual holdings and asset
classes and their suitability for attaining client objectives
 Changes in asset values that create unintended divergence from client’s
strategic asset allocation

• Example 4: How active managers may use new analysis and
information
• Example 5: Characteristics of successful active investors
• Example 6: Nonfinancial cost of portfolio revision
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3. Rebalancing the Portfolio
• Monitoring and rebalancing a portfolio is similar to flying an
airplane
• Rebalancing covers
 Adjusting actual portfolio to current strategic asset allocation because of
price changes in portfolio holdings
 Revisions to investor’s asset class weights because of changes in
investor’s objectives and constraints, or because of changes in capital
market expectations
 Tactical asset allocation (addressed in other readings)

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3.1 The Benefits and Costs of Rebalancing
Benefits
• Returns portfolio to optimal allocation
• Controls drift in overall level of
portfolio risk
• Controls drift in types of risk
exposures
• Without rebalancing investor might
hold overpriced securities
• Example 7

Costs
• Transaction costs offset benefits of
rebalancing
• Transaction costs are particularly high
for illiquid investments
• Transaction costs include implicit costs
and are not precisely measurable
• Capital gains taxes must be considered
when we rebalance portfolios

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3.2 Rebalancing Disciplines
• Calendar Rebalancing
 Rebalance portfolio to target weights on a periodic basis
 Advantage: simplicity
 Disadvantage: unrelated to market behavior

• Percentage-of-Portfolio Rebalancing
 Set rebalancing thresholds or trigger points
 40% +/- 5% : 35% - 45% is the corridor or tolerance band
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Transaction costs
Risk tolerance concerning tracking risk versus strategic asset allocation
Correlation with other asset classes
Volatility of asset class and volatilities of other asset classes in portfolio
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3.2 Rebalancing Disciplines (Cont…)
• Other rebalancing strategies
 Calendar-and-percentage-of-portfolio rebalancing
 Equal probability rebalancing
 Tactical rebalancing

• So far we’ve focused on rebalancing to target weights; another strategy is to
rebalance to the allowed range which enables portfolio manager to benefit
from short-term market opportunities and to better manage weights of
relatively illiquid assets
• Optimal rebalancing strategy should maximize present value of net benefit
(easier said than done!)
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3.3 The Perold-Sharpe Analysis of Rebalancing
• Strategies presented here assume a two-asset class setting, one
risky and the other risk-free
• We will consider the following strategies
 Buy-and-Hold Strategies
 Constant-Mix Strategies
 Constant-Proportion (CPPI) Strategy

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Buy and Hold Strategies
Passive strategy of buying an initial asset mix (say 60/40
stocks/Treasury bills) and do nothing subsequently

Portfolio value = Investment in stocks + Floor value
Cushion = Portfolio value – Floor value

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Constant-Mix Strategies
Dynamic strategy, synonymous with rebalancing to strategic asset allocation
Target investment in stocks = m x Portfolio value

In constant mix we buy

shares when the market is
going down and sell when
the market is going up!

Constant-mix strategy is consistent with a risk tolerance that varies
proportionately with wealth. An investor with such risk tolerance desires to
hold stocks at all levels of wealth.
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Constant-Proportion Strategy: CPPI
Target equity allocation is a dynamic strategy where…
Target investment in stocks = m x (Portfolio value – Floor value)
Stock holding are held to a constant proportion of the cushion
Buy stocks when prices are rising and sell when prices are falling
Higher risk tolerance than buy-and-hold strategy because investor is holding a larger multiple
of the cushion in stocks
Zero risk tolerance when cushion = 0

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Linear, Concave and Convex Investment Strategies
• Buy and hold is a linear investment strategy
because portfolio returns are a linear function
of stock returns

• Share purchases and sales in constant mix and
CPPI strategies introduce nonlinearities in the
relationship
• Constant-mix  Concave

• CPPI  Convex
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Appropriate strategy depends on:
1) Investor’s risk tolerance
2) Types of risk with which investor is concerned
3) Asset class return expectations
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3.4 Execution Choices in Rebalancing (not a LOS)
• Cash Market Trades

• Derivative Trades

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Conclusion
• Examples

• Summary
• Practice Problems
• Learning Objectives

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