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Dan Draper, CFA is a portfolio manager at Madison Securities. Draper is analyzing several portfolios which have just been assigned to him. In each case, there is a clear statement of portfolio objectives and constraints, as welt as an initial strategic asset allocation. However, Draper has found that all of the portfolios have experienced changes in asset values. As a result, the current allocations have drifted away from the initial allocation. Draper is considering various rebalancing strategies that would keep the portfolios in line with their proposed asset allocation targets.
Draper spoke to Peter Sterling, a colleague at Madison, about calendar rebalancing. During their conversation, Sterling made the following comments:
Comment 1: Calendar rebalancing will be most efficient when the rebalancing frequency considers the volatility of the asset classes in the portfolio.
Comment 2: Calendar rebalancing on an annual basis will typically minimize market impact relative to more frequent rebalancing.
Draper believes that a percentage-of-portfolio rebalancing strategy will be preferable to calendar rebalancing, but he is uncertain as to how to set the corridor widths to trigger rebalancing for each asset class. As an example, Draper is evaluating the Rogers Corp. pension plan, whose portfolio is described in Figure 1.
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Client A is 60 years old, and wants to be sure of having at least $800,000 upon his retirement. His risk tolerance drops dramatically whenever his portfolio declines in value. He agrees with the Madison stock market outlook, which is for a long-term bull market with few reversals.
Client B is 35 years old and wants to hold stocks regardless of the value of her portfolio. She also agrees with the Madison stock market outlook.
Client C is 40 years old, and her absolute risk tolerance varies proportionately with the value of her portfolio. She does not agree with the Madison stock market outlook, but expects a choppy stock market, marked by numerous reversals, over the coming months.
Draper believes that the risk tolerance for tracking error relative to the target asset mix and the volatility of any other asset classes in a portfolio are important factors in determining an appropriate rebalancing corridor. Assuming all other factors are equal, the optimal rebalancing corridor will be wider when:
A. the risk tolerance for tracking error is high and the volatility of other asset classes is low.
B. the risk tolerance for tracking error is high and the volatility of other asset classes is high.
C. the risk tolerance for tracking error is low and the volatility of other asset classes is high.
Answer: A
Explanation:
Explanation/Reference:
Explanation:
A higher risk tolerance for tracking error provides more flexibility for the asset allocation relative to the target mix, and therefore a wider rebalancing corridor. If the volatility of other asset classes is high, then large differences from the target asset mix are more likely. Lower volatility reduces the likelihood of large differences, and allows for a wider corridor. (Study Session 16, LOS 46.0)
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