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Rebecca Riley and Daniel Gray are portfolio managers for Silver Wolf Asset Management. The firm believes that rebalancing a portfolio is important for maintaining an investor’s exposure to systematic risk factors and follows a percentage-of-portfolio approach to rebalancing. Riley and Gray each recently brought a new client to the firm and are starting to establish guidelines for investing their portfolios. Riley states, “My client has a low tolerance for risk, so I am setting wide tolerance corridors for rebalancing. If the market takes a downturn, the client will not want his fixed income assets sold to purchase more equities.” Discussing his client, Gray says, “My client’s portfolio consists largely of small-cap domestic equities, emerging market equities, and high yield bonds. Since the asset classes in his portfolio are relatively volatile, I am also setting wide tolerance corridors, or else I would be rebalancing his portfolio practically all the time.”

With regard to their statements about the effects of factors on the width of the tolerance corridors:

A) Riley’s statement is incorrect; Gray’s statement is correct.

B) Riley’s statement is incorrect; Gray’s statement is incorrect.

C) Riley’s statement is correct; Gray’s statement is correct.

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Both Riley’s statement and Gray’s statement are incorrect. Based on the criteria they have stated – they should be setting tight tolerance corridors for rebalancing purposes. Riley said that her client has a low risk tolerance. With a low risk tolerance, tolerance corridors should be smaller in order to detect corridor violations and take action to avoid an even worse violation. If the portfolio is allowed to drift, riskier assets in the portfolio will tend to take over. With volatile asset classes, Gray’s client should also have small tolerance corridors. When an asset class is volatile and/or the rest of the assets are volatile, the tolerance corridor should be small to give the portfolio manager the ability to detect any violation in the allocation and react quickly to avoid an even worse violation.

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Stuart Steinberg, a portfolio manager for Weber Capital Advisors, uses a percentage-of-portfolio rebalancing approach when rebalancing his client portfolios, but is unsure how to set the optimal corridor width for each asset class. Steinberg is evaluating the following factors for a particular asset class.

Factor 1:	The asset class has a tendency to be extremely volatile.
Factor 2:	The asset class has a low trading volume and a high bid-ask spread.
Factor 3:	When comparing the asset class to the rest of the portfolio, the volatility for the rest of the portfolio is high.

Which of the factors would lead Steinberg to set a large corridor for the asset class?

A) Factors 1 and 2 only.

B) Factors 2 and 3 only.

C) Factor 2 only.

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When an asset class is volatile and/or the rest of the assets are volatile, the tolerance corridor should be small to give the portfolio manager the ability to detect any violation in the allocation in the asset class and react quickly enough to avoid an even worse violation. However, in this example the low trading volume and high bid-ask spread implies a large corridor. When an asset class is illiquid and transactions costs are high, the corridor should be wider to try to avoid frequent trading.

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Which of the following statements best characterizes the difference between rebalancing to consistently maintain an asset class’s target portfolio weight versus rebalancing to within an allowed range? Rebalancing to consistently maintain an asset class’s target portfolio weight:

A) will always have lower tracking error.

B) require more monitoring of the portfolio than rebalancing within an allowed range.

C) will result in higher trading costs.

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The key issue here is trading costs. Rebalancing a portfolio to consistently maintain an asset class’s target portfolio weight requires more or less constant trading and the inability for the manager to time the trades. Both of these factors mean that rebalancing to a target portfolio weight results in higher trading costs. Note that the higher trading costs could increase the tracking error of the portfolio versus one that has allowable trading bands. Also, even though trading costs would be reduced by having an allowable range for each asset class, the manager would still need to constantly monitor the portfolio to see if the asset classes are still within the allowable bands, so there is no discernable difference in the amount of monitoring on the part of the portfolio manager.

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Anita Malley and James Upshaw are portfolio managers for Washington Square Asset Management. Malley and Upshaw are debating the merits of rebalancing an asset within a portfolio to its target portfolio weight versus creating a tolerance band for each asset. Malley states, “Rebalancing a portfolio so that target weights are maintained may force the manager to provide liquidity to the market, resulting in poorly timed trades and higher trading costs.” Upshaw states, “It does not matter if we rebalance to maintain target portfolio weights or create tolerance bands; if we use either method, the portfolio will require constant monitoring.”

With regard to their statements:

A) Malley is correct; Upshaw is incorrect.

B) Malley is incorrect; Upshaw is correct.

C) Malley is correct; Upshaw is correct.

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Malley’s statement is incorrect. Rebalancing the portfolio so that target weights are maintained (constant mix strategy) requires more or less constant trading and is likely to force the manager to provide liquidity which could result in poorly timed trades but generally supplying liquidity results in lower trading costs. Note that requiring liquidity is selling when others in the market are also selling or buying when others are buying (resulting in higher bid-ask spreads) while providing liquidity is selling when others are buying or buying when others are selling, which may minimize trading costs. Upshaw’s statement is correct – both rebalancing to maintain target portfolio weights or creating tolerance bands would require constant monitoring of the portfolio, although the tolerance band method is likely to result in less frequent trading

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In a flat but oscillating market, which asset allocation strategy outperforms?

A) Buy and hold.

B) Constant proportion portfolio insurance (CPPI).

C) Constant mix.

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In a flat but oscillating market, constant mix outperforms a comparable buy and hold strategy, which, in turn, outperforms a CPPI strategy.

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In a trending market, which asset allocation strategy outperforms?

A) Constant proportion portfolio insurance (CPPI).

B) Constant mix.

C) Buy and hold.

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In a trending market, CPPI outperforms a comparable buy and hold, which, in turn, outperforms a constant mix strategy.

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Which of the following statements about asset allocation strategies is CORRECT? Constant mix:

A) outperforms buy and hold when stock market reversals do not occur.

B) is a convex strategy.

C) outperforms buy and hold when stock market reversals occur.

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Constant mix is a concave strategy.

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Which of the following statements regarding the risk consequences of asset allocation strategies is least accurate?

A) With a buy and hold strategy, the investor's tolerance for risk is zero if the value of the investor's assets falls below the floor value.

B) Constant proportion portfolio insurance (CPPI) actively assumes risk tolerance is directly related to wealth.

C) Constant mix actively assumes risk tolerance is directly related to wealth.

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CPPI, not constant mix, assumes risk tolerance is directly related to wealth. A constant mix strategy assumes that risk tolerance is constant regardless of wealth levels.

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Which of the following strategies is also referred to as insured asset allocation?

A) Constant mix.

B) Constant proportion portfolio insurance (CPPI).

C) Concave strategy.

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CPPI is the term used by Perold and Sharpe. It is referred to as insured asset allocation and momentum based by Maginn and Tuttle. CPPI is a momentum based strategy that aggressively increases exposure to risky assets in a rising market.

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Which of the following statements regarding a constant mix portfolio strategy is least accurate?

A) The slope of the exposure diagram (y-axis = desired stock position, x-axis = asset value) for a constant mix strategy is between zero and one.

B) Under a constant mix strategy, stocks are purchased as the stock market falls.

C) Under a constant mix strategy, stocks are purchased as the stock market rises.

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With a constant mix strategy, stocks must be sold as the market rises in order to maintain the ratio of stock to total assets.