Reading 42: Monitoring and Rebalancing －LOS c justify, investor, strategic, investment, allocation

cfaedu

CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 15: Monitoring and Rebalancing
Reading 42: Monitoring and Rebalancing
LOS c: Recommend and justify revisions to an investors investment policy statement and strategic asset allocation, given a change in investor circumstances.

cfaedu

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 percent large cap stocks, 25 percent intermediate-term, high quality bonds and 5 percent cash for emergency needs. Given Frenkel's circumstances, she should:

A) Not rebalance her portfolio at this time.

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

C) Eliminate her cash reserve entirely.

D) 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.

---

Answer and Explanation

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.

cfaedu

Jim Cantore is a 45 year old client with a $1.5 million portfolio that is heavily weighted toward equities. Cantore will continue working for the next 20 years and has a substantial retirement portfolio through his current employer.

Cantore's three children are now nearing college age and will all attend premiere universities in the U.S. which each cost $50,000 per year to attend. All college expense will be paid out of Cantore's portfolio. Cantore should:

Cantore's three children are now nearing college age and will all attend premiere universities in the U.S. which each cost $50,000 per year to attend. All college expense will be paid out of Cantore's portfolio. Cantore should:

A) Not rebalance his portfolio because his children should all pay their own way through school.

B) Rebalance his portfolio toward large-cap common stocks and international securities because education costs are highly correlated with the returns to these securities.

C) Rebalance his portfolio toward high quality, intermediate-term debt instruments to service the expected liquidity needs of his portfolio.

D) Rebalance his portfolio toward high quality, long-term debt instruments in anticipation of a shift in his risk tolerance and a need for a more stable portfolio upon retirement.

---

Answer and Explanation

The liquidity needs of sending his children to school should take precedence over his retirement needs, which are already well funded.

cfaedu

Mimi Smith, a client of Osborne Capital, Inc., believes that her portfolio should be rebalanced. She supports her claim by stating that she just won the lottery and wants to retire 10 years earlier than before. Does she have a valid claim?

A) No. Not enough information is given to determine.

B) Yes. Her time horizon has changed.

C) No, It would require excessive trading.

D) Yes. Her wealth and time horizon have changed.

---

Answer and Explanation

Changes in wealth, time horizon, and liquidity requirements all dictate the need to rebalance. Taxes, laws, and regulations, as well as unique circumstances, also play into this decision. These changes would outweigh the negatives of additional commissions.

cfaedu

Which of the following statements regarding asset rebalancing approaches is FALSE?

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

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

C) Excessive cash balances in a portfolio tend to significantly decrease overall portfolio returns.

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

---

Answer and Explanation

Constant mix is the same thing as disciplined rebalancing.

cfaedu

Which of the following statements regarding disciplined rebalancing is TRUE? Disciplined rebalancing (e.g., maintaining an asset mix at 60 percent stocks and 40 percent bonds):

A) allows for the possibility of a drifting mix.

B) prevents substantial gains from market timing.

C) performs worse than ad hoc changes in asset mix.

D) eliminates periodic departures from the policy mix.

---

Answer and Explanation

Disciplined rebalancing prevents drifting of the asset mix with market variability, and disciplined rebalancing seems to outperform the ad hoc rebalancing of the asset mix. Evidence suggests that market timing fails to add value.

Disciplined rebalancing prevents drifting of the asset mix with market variability, and disciplined rebalancing seems to outperform the ad hoc rebalancing of the asset mix. Evidence suggests that market timing fails to add value.

cfaedu

Which of the following represents the most effective way to reduce the costs of using a tactical asset allocation strategy?

A) Increase the size of cash balances.

B) Use package trading.

C) Eliminate unexecuted trades by forcing execution.

D) Rebalance using futures contracts.

---

Answer and Explanation

Because futures are so inexpensive, using them significantly reduces transaction costs and can increase the benefits of a tactical strategy. Excessive cash balances have been shown to decrease overall portfolio returns, and using package trades and eliminating unexecuted trades may both reduce costs, but may not be viable alternative alternatives for some investment strategies.

cfaedu

Which of the following statements regarding rebalancing strategies is FALSE?

A) Using futures contracts can significantly enhance the benefits of tactical asset allocation.

B) Excessive cash balances tend to significantly decrease overall portfolio returns.

C) Market timing strategies will tend to outperform constant mix strategies.

D) Drifting mix strategies tend to perform poorly compared to disciplined rebalancing strategies.

---

Answer and Explanation

Market timing strategies have been shown to perform poorly relative to constant mix strategies. The other statements are true.

deqiang

thanks.