Reading 42: Monitoring and Rebalancing －LOS d allocation, strategic, benefits, costs

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 15: Monitoring and Rebalancing
Reading 42: Monitoring and Rebalancing
LOS d: Discuss the benefits and costs of rebalancing a portfolio to the investors strategic asset allocation.

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

A) Brokerage fees.

B) Interest expense.

C) Bid-ask spread.

D) Opportunity costs.

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Answer and Explanation

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

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Which of the following statements about trading strategies is TRUE?

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

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

C) Momentum-based strategies outperform buy and hold, as well as disciplined rebalancing, strategies.

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

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Answer and Explanation

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 both buy and hold and momentum-based strategies.

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

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

B) Trading provides liquidity to capital markets.

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

D) Momentum-based strategies out perform constant mix strategies.

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Answer and Explanation

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. Also, momentum-based strategies have been shown to perform poorly relative to a constant mix strategy.

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

A) tax costs.

B) trading costs.

C) deferral costs.

D) brokerage commissions.

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Answer and Explanation

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

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

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

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

C) Zero-correlated assets are in equilibrium and thus will not need to be rebalanced, despite movements in the values of the included assets.

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

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Answer and Explanation

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.