Reading 42: Monitoring and Rebalancing －LOS g within, versus, target, contrast, benefits

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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 g: Compare and contrast the benefits of rebalancing an asset class to its target portfolio weight versus rebalancing the asset class to stay within its allowed range.

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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 incorrect; Upshaw is correct.

B) Malley is correct; Upshaw is correct.

C) Malley is incorrect; Upshaw is incorrect.

D) Malley is correct; Upshaw is incorrect.

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Answer and Explanation

Malleys statement is incorrect. Rebalancing the portfolio so that target weights are maintained requires more or less constant trading and is likely to force the manager to require (not provide liquidity) which would result in poorly timed trades and higher trading costs. Note that requiring liquidity is selling when others in the market are also selling (resulting in higher bid-ask spreads) while providing liquidity is selling when others are buying, which may minimize trading costs. Upshaws 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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Which of the following statements best characterizes the difference between rebalancing to consistently maintain an asset classs target portfolio weight versus rebalancing to within an allowed range? Rebalancing to consistently maintain an asset classs 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 increase the efficiency of the portfolio.

D) will result in higher trading costs.

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Answer and Explanation

The key issue here is trading costs. Rebalancing a portfolio to consistently maintain an asset classs 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.