Using Derivatives in Asset Allocation
Changing Asset Allocation with Futures Issue: A portfolio manager in Greece currently manages... Read More
After choosing a strategic asset allocation, portfolios will drift away from those allocations as market conditions change and affect the relative weights of investments within a portfolio. One choice is clearly to ‘do nothing,’ also known as buy and hold. Buy and hold assumes that as higher-risk assets grow faster and take over a portfolio in size, the investor is simultaneously increasing its risk tolerance by letting those high-return securities dominate. Given that this contradicts any initial asset allocation choices, why not only invest in high-risk securities ?
Rebalancing is a discipline as it is a contrarian act in which investors will go against the market by buying low-performing investments and selling high-performing ones. This discipline has been shown to reap the rewards of risk-adjusted returns over longer time horizons. However, it is significantly helped by some degree of market reversion (which is highly common). For example, if a full-steam bull-market takes off and goes nowhere but up (a non-sustainable event), a rebalanced portfolio will underperform a buy-and-hold until some trend reversal shows up.
Two main disciples for rebalancing dominate the investment world. Deciding which is better depends on the context under which the portfolio is managed, as both styles have pros and cons.
Calendar rebalancing is the simplest form and does not require monitoring the portfolio within the target rebalance dates. Percent- range is a more active strategy in which portfolio managers monitor the asset mix regularly and make the desired updates. Rebalancing using a percent-range discipline often involves setting corridors (ranges) or limitations on how far an asset class may move away from its specified range, such as within 5% of its original value.
No one strategy is suitable for every situation in deciding on the style, how often to rebalance, or how tight the ranges should be. Investment managers should consider:
$$ \begin{array}{l|l} \textbf{Factor} & \textbf{Implication} \\ \hline \text{Higher transaction costs} & \text{Wider ranges, less frequent rebalancing} \\ \hline \text{More risk-averse investors} & \text{Tighter ranges, more frequent rebalancing} \\ \hline \text{Less correlated assets} & \text{Tighter ranges, more frequent rebalancing} \\ \hline \text{Belief in momentum} & \text{Wider ranges, less frequent rebalancing} \\ \hline \text{Belief in mean-reversion} & \text{Tighter ranges, more frequent rebalancing} \\ \hline \text{Illiquid investments} & \text{Complicate the rebalancing process} \\ \hline \text{Derivatives} & \text{Allow for possible synthetic rebalancing} \\ \hline \text{Taxes} & { \text{Discourage rebalancing,} \\ \text{asymmetric rebalancing, and broader ranges.} } \end{array} $$
Candidates should familiarize themselves with the table to understand the reasoning behind the effects and their implications on rebalancing. A key takeaway should be that rebalancing has more to do with risk control than return-seeking.
Question
Which of the following is most likely a conclusion for an investor with a high-risk tolerance?
Rebalance using:
- tighter ranges, more frequent rebalancing.
- tighter ranges, less frequent rebalancing.
- wider ranges, less frequent rebalancing.
Solution
The correct answer is C:
Investors with a high-risk tolerance are more comfortable with large swings in portfolio value. This means that given the inherent transaction costs and frequent favorable tax treatment of long-term gains vs. short-term gains—this is, however, country-specific—the portfolio manager should avoid those drawbacks by rebalancing less often. This could include wider ranges for percent-range style or simply checking in less often for calendar rebalancing strategies.
A is incorrect. It suggests that the investor would rebalance their portfolio more frequently and within tighter ranges, which would reduce the portfolio’s overall risk. This is not consistent with the behavior of an investor with a high-risk tolerance.
B is incorrect. It suggests the investor would rebalance their portfolio less frequently but within tighter ranges. This would also reduce the overall risk of the portfolio, which again is not consistent with the behavior of an investor with a high-risk tolerance.
Reading 4: Overview of Asset Allocation
Los 4 (j) Discuss strategic considerations in rebalancing asset allocations