Reading 42: Monitoring and Rebalancing －LOS h buying, holding, insurance

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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 h: Explain the performance consequences, in up, down, and nontrending markets, of (1) rebalancing to a constant mix of equities and bills, (2) buying and holding equities, and (3) constant-proportion portfolio insurance (CPPI).

deqiang

thanks.

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Which investors appear to be the best fit for:

Portfolio B?

Portfolio C?

A) Lerner Johnson

B) Johnson Lerner

C) Johnson Kent

D) Kent Lerner

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Answer and Explanation

Portfolio C has the most invested in equity and alternative investments such as the hedge fund and the least invested in bonds thus it is most suited to someone who can tolerate more risk such as Kent who is only 26 years old. Since Lerner is the oldest at 70 years old and still owns the copper mine he would not benefit from the private equity or real estate investments in portfolio B. Also, private equity could have a long lock up period which would not be appropriate for an older person. Since portfolio B has a higher concentration of long term bonds than portfolio A, portfolio B is more interest rate sensitive making it less appropriate than portfolio A for Lerner. Johnson on the other hand is younger than Lerner and can therefore tolerate the longer lock up period of the private equity in portfolio B and greater interest rate sensitivity of the higher concentration of long term bonds in portfolio B.

Portfolio C has the most invested in equity and alternative investments such as the hedge fund and the least invested in bonds thus it is most suited to someone who can tolerate more risk such as Kent who is only 26 years old. Since Lerner is the oldest at 70 years old and still owns the copper mine he would not benefit from the private equity or real estate investments in portfolio B. Also, private equity could have a long lock up period which would not be appropriate for an older person. Since portfolio B has a higher concentration of long term bonds than portfolio A, portfolio B is more interest rate sensitive making it less appropriate than portfolio A for Lerner. Johnson on the other hand is younger than Lerner and can therefore tolerate the longer lock up period of the private equity in portfolio B and greater interest rate sensitivity of the higher concentration of long term bonds in portfolio B.

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After Nack rebalances Portfolio A the first time, its bond holdings should:

A) rise by $1,600.

B) rise by $11,350.

C) decline by $1,550.

D) decline by $7,650.

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Answer and Explanation

To calculate the targeted stock holding, multiply the stock multiplier by (total assets portfolio floor).
Total assets = $93,000.
Portfolio floor = $70,000.
Stock multiplier = 2.

The new stock holdings = 2 × ($93,000 - $70,000) = $46,000.
Current stock holdings are $57,350, so we must sell $11,350 in stocks to hit the target, which means that the bond holdings will rise by $11,350.

To calculate the targeted stock holding, multiply the stock multiplier by (total assets portfolio floor).
Total assets = $93,000.
Portfolio floor = $70,000.
Stock multiplier = 2.

The new stock holdings = 2 × ($93,000 - $70,000) = $46,000.
Current stock holdings are $57,350, so we must sell $11,350 in stocks to hit the target, which means that the bond holdings will rise by $11,350.

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Wallace is a:

A) passive trader.

B) value-motivated trader.

C) liquidity-motivated trader.

D) information-motivated trader.

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Answer and Explanation

Traders who make moves for the purchase of reallocating assets or dealing with liquidity issues are called passive or liquidity-oriented traders. Liquidity-oriented traders are more concerned with time than price, because they are willing to pay for liquidity when they need it. Wallace is price-sensitive rather than time-sensitive, which classifies him as a passive trader.

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The owner of Portfolio B appears least concerned about:

A) income.

B) liquidity.

C) volatility.

D) market downturns.

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Answer and Explanation

The portfolio does contain a fair amount of income-producing bonds, and the diversification of the portfolio could suggest some interest in limiting volatility and the effect of market downturns. But the presence of real estate and private equity in the portfolio suggest the owner is not concerned about liquidity.

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After rebalancing Portfolio A the second time, if Nacks goal is to maximize return potential while limiting potential loss of principal, her best rebalancing strategy is:

A) buy and hold.

B) constant mix.

C) constant proportion.

D) program trading.

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Answer and Explanation

A constant-mix strategy outperforms in a flat but oscillating market but underperforms in a trending market. A constant-proportion strategy outperforms in a trending market but underperforms in a flat but oscillating market. Buy and hold limits downside by keeping funds in cash or bonds, while it performs well in an upward-trending market and is roughly flat in an oscillating market. If Nack doesnt have any insight on where the market is going and wants to limit loss of principal, buy and hold is the best option of those offered, especially considering that her analysts are projecting either a flat or upward market, but not a downward market. Program trading is not a rebalancing strategy.

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When Nack rebalances Portfolio A the second time, the portfolios stock allocation is most likely to fall by:

A) 3.11%.

B) 6.45%.

C) 1.57%.

D) 3.33%.

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Answer and Explanation

At the time of the second rebalancing, the portfolios stock weighting is 68.11%. Constant-mix rebalancing assumes the purchase or sale of stock sufficient to return the portfolio to its original weighting, in this case 65%.

68.11% − 65% = 3.11%

68.11% − 65% = 3.11%

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Assume that $10 million of stocks and cash is being managed according to a constant mix strategy. Assume further that the desired stock-to-total portfolio value ratio for the strategy is 0.75. Which of the following is closest to the amount of stock that must be bought or sold if the value of the stock component of the portfolio increases by $500,000?

A) $500,000 must purchased.

B) $125,000 must be purchased.

C) $125,000 must be sold.

D) $500,000 must be sold.

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Answer and Explanation

The initial portfolio consists of $2.5 million in cash plus $7.5 million in stock. The initial stock-to-total value ratio can be expressed as 7.5/(2.5 + 7.5) = 0.75. After the increase in the value of the stock component of the portfolio, the stock-to-total value ratio is 8.0/(2.5 + 8.0) = 0.7619. The amount of stock that must be sold to lower this ratio to 0.75 is determined as follows:

(8.0 − X)/(10.5) = 0.75, or X = $125,000

(8.0 − X)/(10.5) = 0.75, or X = $125,000

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Which of the following statements about constant mix rebalancing is FALSE?

A) As stock prices rise, the stock to total assets ratio, increases so stocks should be sold.

B) As stock prices fall, the stock to total assets ratio decreases, so stocks must be purchased.

C) The clients' level of risk aversion determines the slope coefficient.

D) As stock prices rise, the stock to total assets ratio increases, so stocks should be purchased.

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Answer and Explanation

To maintain the constant mix, when stock prices rise, stocks must be sold.

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Which of the following statements about asset allocation strategies is TRUE?

A) Constant mix outperforms buy and hold when stock market reversals occur.

B) Constant mix outperforms buy and hold when stock market reversals do not occur.

C) Constant mix is a convex strategy.

D) Buy and hold is a concave strategy.

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Answer and Explanation

Constant mix is a concave strategy while buy and hold is a linear strategy.

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

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) The slope of the exposure diagram (y-axis = desired stock position, x-axis = asset value) for a constant mix strategy increases as investor risk tolerance increases.

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

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

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Answer and Explanation

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

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

A) Constant proportion portfolio insurance (CPPI).

B) Concave strategy.

C) Buy and hold.

D) Constant mix.

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Answer and Explanation

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 about constant proportion rebalancing strategies is FALSE?

A) It is a concave strategy.

B) The strategy is protected on the downside.

C) The strategy does well in a bull market.

D) The strategy performs worse than a constant mix strategy in a flat, oscillating market.

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Answer and Explanation

Constant proportion is a convex strategy.

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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) Cannot be determined.

D) Constant mix.

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Answer and Explanation

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