clearlycanadian

Jill Frenkel, 62, works for the Smithton Company as the firm's controller. Frenkel is covered by a generous retirement package upon her retirement which is not indexed for inflation, she is in excellent health, and is also covered by the company health plan in retirement. Frenkel's current asset allocation is 70% large cap stocks, 25% intermediate-term, high quality bonds and 5% cash for emergency needs. Given Frenkel's circumstances, she should:

A) Sell stock index futures and buy bond index futures to synthetically create a 20% stock / 80% bond allocation and save on transaction costs.

B) Not rebalance her portfolio at this time.

C) Reduce her allocation to stocks significantly and buy low quality bonds for her portfolio with the proceeds because Jill faces the need for inflation protection in this stage of her lifecycle.

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Given the fact that Jill is in good health, is covered by the health plan and also has a healthy retirement portfolio, she should leave her allocation intact because since the retirement plan is not inflation indexed, she may need the growth potential of equities in the future.

clearlycanadian

Which of the following statements regarding asset rebalancing approaches is least accurate?

A) A "constant mix" asset allocation strategy is also referred to as a "drifting mix."

B) Disciplined rebalancing strategies tend to beat momentum-based strategies over the long term.

C) Market timing strategies tend to perform poorly relative to a constant mix strategy.

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Constant mix is the same thing as disciplined rebalancing.

clearlycanadian

Which of the following statements about trading strategies is CORRECT?

A) A disciplined rebalancing strategy typically underperforms a buy and hold strategy.

B) A buy and hold strategy is best with respect to asset allocation because it has the lowest trading costs.

C) A buy and hold strategy may not satisfy the current asset allocation needs of a client.

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Buy and hold strategies “drift” over time. Because of this, initial asset allocation decisions may not be evident in the resulting portfolio. Disciplined rebalancing performs better than buy and hold strategies in a flat but oscillating market.

clearlycanadian

Which of the following costs are NOT considered component costs of trading prompted by portfolio revisions?

A) Interest expense.

B) Opportunity costs.

C) Brokerage fees.

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Brokerage fees, spreads, trader timing costs, and opportunity costs are component costs of trading.

clearlycanadian

Which of the following statements regarding rebalancing and correlation is CORRECT?

A) Negatively correlated asset classes need rebalancing more frequently than positively correlated asset classes.

B) Perfect positive correlation between asset classes implies the greatest need for rebalancing.

C) The need to rebalance is independent of the correlation between the securities or the asset classes.

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Because the denominator and the numerator (the value of the individual asset class divided by the total value of the portfolio) both change in the same direction when asset classes (and securities) are positively correlated, the portfolio manager needs to rebalance less frequently. However, negatively correlated assets require more rebalancing. In this case the numerator and the denominator might change in opposite directions.

clearlycanadian

Which of the following statements correctly identifies a benefit of active management?

A) Trading provides liquidity to capital markets.

B) Most portfolio managers can add value through active management.

C) Studies have shown more frequent rebalancing to increase portfolio returns.

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After costs, it has been shown that few portfolio managers add value through active management. Studies have shown that more frequent rebalancing can increase portfolio returns, but only before costs. After costs, increasing rebalancing frequency has a detrimental effect on returns.

clearlycanadian

All of the following are costs associated with rebalancing a portfolio EXCEPT:

A) brokerage commissions.

B) tax costs.

C) deferral costs.

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Tax costs are the key costs associated with rebalancing a portfolio and are often underestimated. Investors focus on brokerage commissions and forget trading costs such as market impact, trade execution inefficiencies and opportunity costs.

clearlycanadian

Jennifer Engle, CFA, Chairman of Engle Capital Management wants to implement a defined rebalancing process for all of the portfolios managed by her firm. Engle is aware that calendar rebalancing or percentage-of-portfolio rebalancing are the two primary methods of rebalancing a portfolio. Engle asks Michael Buening, an analyst, to prepare a report on the best rebalancing method for specific criteria. Specifically, Engle wants to know which method would be best under three different criteria: (1) time spent on the rebalancing process, (2) expense of trading, and (3) consistency of portfolio asset allocation. Which of the following correctly lists the best rebalancing method for each of Engle’s criteria?

Time Spent on Process

Expense of Trading

Consistency of Allocation

A) Calendar rebalancing Percentage-of-portfolio Calendar rebalancing

B) Calendar rebalancing Unknown Percentage-of-portfolio

C) Unknown Calendar rebalancing Percentage-of-portfolio

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The primary benefit to calendar rebalancing is that it provides the discipline of rebalancing without the constant need to monitor the portfolio. The result is that calendar rebalancing is the less time intensive rebalancing method.

Trading expense related to rebalancing is a result of where asset thresholds are set under the percentage-of-portfolio method, and also the volatility of the portfolio. For a portfolio with low volatility and wide thresholds, calendar rebalancing would result in more frequent trading, while a volatile portfolio with tight thresholds would lead to more frequent trades under the percentage-of-portfolio method. Therefore, the best method if trading expenses were the primary criteria is unknown.

The primary benefit of percentage-of-portfolio rebalancing is that it minimizes the degree to which asset classes can violate their allocation corridors, resulting in the most consistent asset allocation. With calendar rebalancing, the portfolio allocation could vary widely in between rebalancing dates.

clearlycanadian

Michael Severino and Jeffery Chalmers are portfolio managers for Parthenon Asset Advisors. Severino and Chalmers both believe that having defined criteria for rebalancing a portfolio provides discipline in their portfolio management process, but they have different opinions on how to go about it. Severino states, “With calendar rebalancing, a portfolio could spend the majority of its existence looking extremely different from the target asset allocation, but trades made to rebalance the portfolio may only have a minor impact on how the portfolio is allocated.” Chalmers replies, “If we use percentage-of-portfolio rebalancing, there may never be a trade placed to rebalance our client portfolios.”

With regard to their statements about rebalancing methods:

A) Severino is incorrect; Chalmers is correct.

B) Severino is correct; Chalmers is correct.

C) Severino is incorrect; Chalmers is incorrect.

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Both Severino and Chalmers make correct statements. With calendar rebalancing, the rebalancing process is related to the passage of time rather than the value of the portfolio. In theory, a portfolio that is rebalanced using the calendar rebalancing method could stray considerably from the target asset allocation before the rebalancing date, but move closer to target on the rebalancing date, resulting in minor trades in the portfolio. In the case of percentage-of-portfolio rebalancing, a tolerance band is set for each asset class in the portfolio, and the portfolio is rebalanced when it moves outside of the tolerance band. Under the percentage-of-portfolio method, if the asset classes never stray outside of the tolerance levels, the portfolio will never have to be rebalanced.

clearlycanadian

Tyrone Wilkins and Deborah Ortiz are portfolio managers for Meabon Asset Management. Both Wilkins and Ortiz believe that rebalancing is an important part of portfolio management, but are unsure which rebalancing method would be best for their respective clients. Wilkins wants to maintain his client’s exposure to systematic risk factors, but does not want to spend his time constantly monitoring his client’s portfolio. Ortiz is most concerned that two or more asset classes in the portfolio could stray too far from the portfolio’s target allocation. Given their concerns, which rebalancing method would be best for Wilkins and Ortiz respectively?

Rebalancing Method for Wilkins

Rebalancing Method for Ortiz

A) Calendar Percentage-of-Portfolio

B) Percentage-of-Portfolio Monte Carlo Portfolio

C) Percentage-of-Portfolio Calendar

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The two primary methods of rebalancing are calendar rebalancing and percentage-of-portfolio rebalancing – Monte Carlo is not a rebalancing method. With calendar rebalancing, the portfolio is rebalancing on a predetermined date. Since calendar rebalancing provides discipline without the need for constant monitoring, calendar rebalancing would be appropriate for Wilkins. Percentage-of-portfolio rebalancing is triggered by changes in value rather than calendar dates. Since Ortiz is most concerned about asset classes straying from a target allocation, Ortiz could use percentage of portfolio rebalancing to set a target corridor for each asset class and rebalance the portfolio when the portfolio’s asset allocation moves outside of the corridor.