Personal Finance

:
Another Perspective

Investments 9:
Portfolio Rebalancing and
Reporting

1

Objectives
 A. Understand portfolio rebalancing
 B. Understand the importance of portfolio
management and performance evaluation
 C. Understand risk-adjusted performance
measures
 D. Understand how to perform attribution
analysis

2

Investment Plan Assignments
Investments 9: Portfolio Rebalancing and Reporting
1. Determine the type of rebalancing you will likely use and
how often you will rebalance, and include it in your
investment plan under section IV.B.2 of your Investment
Plan.
2. Think through the new money/donations addendum, and how
you will utilize it to minimize taxes and transactions costs in
rebalancing
3. Determine how often you will monitor and report on your
portfolio, and include it in IV.A.1.
4. Determine how you will communicate portfolio results and
include it in section IV.C.
3

Investment Plan Assignments
Investments 10: Behavioral Finance
1. There are no assignments for your Investment Plan
from this section. Listen and try to determine
ways Behavioral Finance can help you to be a
better investor.

4

Understand Portfolio Rebalancing  What is portfolio rebalancing? • The process of bringing portfolios back into given target asset allocation ratios  What causes the need to rebalance? • Changes occur due to: • Changes in asset class performance • Changes in investor objectives or risk • Introduction of new capital • Introduction of new asset classes 5 .A.

Portfolio Rebalancing (continued)  Why is this rebalancing so critical? • There are competing principles: • Minimize transactions costs and taxes • Minimize tracking error at your risk tolerance level  What is tracking error? • It is the return that is lost from your portfolio being different from your target weight  What are the different ways of rebalancing? • Periodic-based (or calendar-based) • Percent-range-based (or volatility-based) 6 .

Portfolio Rebalancing (continued)  Periodic-based rebalancing • Specify a time period. bi-annually. i. annually.e. rebalance the portfolio back to your original asset allocation targets • Advantages • Most simple of the methods • Longer periods have lower transactions and tax costs (but higher tracking error costs) • Disadvantages • Independent of market performance • Performance will depend on relative timing of large market moves and rebalancing 7 . etc. After each time period.

Portfolio Rebalancing (continued)  Percent-range-based rebalancing • Rebalance the portfolio every time actual holdings are +/-5% (or +/-10%) from target ratios. Rebalance whenever you are outside this range • Advantages • Easy to implement • Wider ranges will reduce transactions costs (at the expense of higher tracking error) • Asset performance will trigger rebalancing • Disadvantages • Setting an effective range is difficult • Assets with higher target ranges and volatility will generate most rebalances 8 .

But use new money to purchase the “underweight” assets.” as you are generally purchasing underperforming asset classes 9 . you can combine the previous strategies with a “New Money / Donation” strategy • Rebalance as determined previously. this strategy helps you to buy “low. so you do not have to sell and incur transactions costs or taxable events • This way you are not selling assets • In addition.Portfolio Rebalancing (continued) • “NMD” (New Money / Donations) Addendum • Since you pay yourself monthly and are very careful in your selection of assets.

. i.Portfolio Rebalancing (continued)  NMD Addendum (continued) • Rebalance using appreciated assets for your charitable contributions (see Learning Tool 8) • Use the money you would have spent for contributions to purchase underweight assets • This way you eliminate your capital gains taxes for the contributed assets. and you get the full benefit of the deduction for your taxes. you sell without tax consequences 10 .e.

5% to +/-10% (or some range) beyond your targets. for most investors with fewer investable assets. Then rebalance back to your targets • Remember. but only rebalance when you are +/. a combination of periodic-based or percent-range-based rebalancing is most useful with the NMD addendum • Review the portfolio annually. and tracking error costs 11 .Portfolio Rebalancing (continued)  Which are the best methods? • Generally. taxes. the easiest is likely to be most useable • Generally. the goal is to minimize transactions costs.

Questions • Any questions on portfolio rebalancing? 12 .

construction. and management of a portfolio of financial assets to attain an investor’s specific goals  What is performance evaluation? • The process of evaluating a portfolio’s performance with the goal of understanding the key sources of return  Why are these two topics so important? • Both are complicated subjects and both are critical to investing 13 .B. Understand the Importance of Portfolio Management and Evaluation  What is portfolio management? • The development.

and other fees • However. you must do this consistently year-after-year. and not just from luck • Why is “active” management such a hot topic? • Management fees for mutual funds which can consistently outperform their benchmarks are 5-25 times higher than those on passive management (19 basis points versus 250 basis points) 14 . management.Portfolio Management and Evaluation (continued)  What is “active” portfolio management? • The process of using publicly available data to actively manage a portfolio in an effort to: • Beat the benchmark after all transactions costs. taxes.

Portfolio Management and Evaluation (continued)  What is “passive” portfolio management? • The process of buying a diversified portfolio which represents a broad market index (or benchmark) without any attempt to outperform the market or pick stocks  Why is “passive” management such a hot topic? • Most active managers fail to outperform their benchmarks. especially after costs and taxes • Investors have realized that if you can’t beat them. join them. so they buy low-cost passive funds which meet their benchmarks consistently and minimize taxes 15 .

or companies within a specified benchmark which. Superior stock selection • Picking sectors.e. Superior asset allocation • Shifting assets between a poor-performing asset class and a better performing asset class.Portfolio Management and Evaluation (continued)  What factors lead to above-benchmark or excess returns? • 1. i. outperform the return on the specified benchmark 16 . as a whole. between large cap to international or small cap • 2. industries.

higher transactions costs.Portfolio Management and Evaluation (continued)  What is superior asset allocation? • The process where the investor gains a higher return than the benchmark from adjusting the investment portfolio for movements in the market • The investor shifts among stocks. it yields lower returns. and higher taxes 17 . superior asset allocation yields higher returns with lower risk. • Done poorly. bonds and other asset classes based on their expectations for returns from each of the asset classes  What are the results? • Done well.

it yields lower returns. sectors or industries • The investor shifts among the various securities of the index in an attempt to buy the securities with the highest growth potential  What are the results? • Done well. superior selection yields higher returns with lower risk.Portfolio Management and Evaluation (continued)  What is superior stock selection? • The process where the investor builds an investment portfolio which earns returns in excess of the benchmark through buying or selling undervalued stocks. and high taxes 18 . high transactions costs. • Done poorly.

comparing asset performance to the relevant benchmarks.Portfolio Management and Evaluation (continued)  What is portfolio evaluation? • The process of monitoring financial asset performance. the investor may sell underperforming assets and purchase other assets which would more closely align asset performance with benchmarks 19 . • If the assets are underperforming benchmarks. and determining how well the fund is meeting its objectives.

you will not know how you are doing in working toward accomplishing your objectives • You need to know how every asset you own is performing. so you can determine how well you are moving toward your goals 20 .Portfolio Management and Evaluation (continued)  Why monitor performance? • Unless you monitor performance. and performing versus its benchmark.

The difference between the asset return and benchmark return • 4. The period return on each owned asset • 2. you can know how each of your funds or assets is performing versus its benchmark.Portfolio Management and Evaluation (continued)  How do you evaluate performance? • Calculate: • 1. The period index return for each benchmark • 3. The weight of each asset or portfolio in the overall portfolio • 5. and how well the portfolio is moving toward its objectives 21 . The overall portfolio return • With this information.

e. as these incur transactions costs and taxes 22 . they should report performance to you and your spouse at least quarterly as well. you should report performance to your spouse at least monthly or quarterly • If others are helping you manage your portfolio. • Be careful not to do too much buying and selling. i. your spouse • If you are managing your portfolio.Portfolio Management and Evaluation (continued)  What is portfolio reporting? • The process of reviewing portfolio performance with the necessary participants.

Questions  Any questions on the importance of portfolio management and evaluation? 23 .

e.. Calculate Risk-adjusted Performance  How do you determine whether a portfolio manager is generating excess returns (i.  There are a number of recognized performance measures available: • Sharp Index • Treynor Measure • Jensen’s Measure 24 .C. returns above the manager’s benchmark)? • Is it only returns?  Should you also be concerned about risk? • It is not just returns that matters—they must be adjusted for risk.

Risk Adjusted Performance: Sharpe  Sharpe Index • A ratio of your “excess return” divided by your portfolio standard deviation rp – rf sp • rp = Average return on the portfolio • sp = Standard deviation of portfolio return • The Sharpe Index is the portfolio risk premium divided by portfolio risk as measured by standard deviation 25 .

Risk Adjusted Performance: Treynor  Treynor Measure • This is similar to Sharpe but it uses the portfolio beta instead of the portfolio standard deviation rp – rf ßp rp = Average return on the portfolio rf = Average risk free rate ßp = Weighted average b for portfolio • It is the portfolio risk premium divided by portfolio risk as measured by beta 26 .

Risk Adjusted Performance: Jensen  Jensen’s Measure • This is the ratio of your portfolio return less CAPM determined portfolio return • ap = rp .[ rf + ßp (rm – rf) ] ap = Alpha for the portfolio rp = Average return on the portfolio ßp = Weighted average Beta rf = Average risk free rate rm = Average return on market index port. • It is portfolio performance less expected portfolio performance from CAPM 27 .

the Sharpe Index compared to the Sharpe Index for the market is best • If many alternatives are possible. or the Jensen’s alpha • Of these two. or if this is only part of the overall portfolio. if the portfolio represents the entire investment for an individual. the Treynor measure is more complete because it adjusts for risk 28 .Risk Adjusted Performance (continued)  Which measure is most appropriate? Are there some general guidelines? • Generally. use the Treynor measure versus the Treynor measure for the market.

The assumptions underlying measures limit their usefulness • Know the key assumptions and be careful! • When the portfolio is being actively managed.Risk Adjusted Performance (continued)  Are their limitations of risk adjustment measures? • Yes. basic stability requirements are not met • Be careful when portfolios are actively managed • Practitioners often use benchmark portfolio comparisons and comparisons to other managers to measure performance • This is largely because they are easier 29 . very much so.

Risk Adjusted Performance (continued)  What about style analysis? • Another way of obtaining abnormal returns is chasing style • Growth versus value—what’s hot? • You can decompose returns by attributing allocation to style • Style tilts and rotation are important active portfolio strategies • Style analysis has become increasingly popular in the industry 30 .

Questions • Any questions on risk-adjusted performance measures? 31 .

generally attributable to asset allocation and securities selection  What is the importance of these components? • These components are related to elements of portfolio performance. to see what you do well  What are examples of some of these components? • Broad asset allocation • Industry Security Choice Currency 32 . Understand How to Perform Portfolio Attribution (this is optional)  What is portfolio attribution? • The process of separating out portfolio returns into their related components.D.

Set up a weighted ‘benchmark’ which includes all your chosen asset classes • Use your chosen benchmark for each asset class. Calculate your returns for each of your asset classes • Calculated returns for each asset class • Calculate a weighted return for your overall portfolio 33 .Portfolio Attribution (continued)  How do you determine portfolio attribution? • 1. and use your target asset allocation weights from your Investment Plan • 2.

Compare your portfolio returns in each asset class to the benchmark returns of each index • Use Teaching Tool 17: Portfolio Attribution Spreadsheet • 5.Portfolio Attribution (continued) • 4. Calculate your attribution and make decisions accordingly 34 .

Portfolio Attribution (continued)  Why is it important to attribute performance to the portfolio’s components? • It can explain the difference in return based on component weights or selection • It can summarize the performance differences into appropriate categories • It can help you know how you are doing  What happens if you don’t perform portfolio attribution? • You will not know why you are performing as you are • You will not know how to improve 35 .

Portfolio Attribution (continued)  What do you do if your actively managed funds continue to underperform? • Watch them carefully. Underperformance for a month or quarter is understandable. but over 12-36 months it should be positive • If not. 12-36 months 36 . find another fund or index the asset class performance  How long does it take to determine whether an active manager is good or not? • Generally.

Questions  Any questions on portfolio attribution? 37 .

Review of Objectives  A. Do you understand the Importance of Portfolio Management and Performance Evaluation?  C. Do you understand how to perform attribution analysis? 38 . Do you understand portfolio rebalancing?  D. Do you understand risk-adjusted performance measures?  E. Do you understand the different types and uses of indexes?  B.

and have a portfolio of over $250. both 45. are aggressive investors. Their target asset allocation is 60% equities and 40% bonds and cash which they have invested in 10 mutual funds. Their actual asset class weights are different from their targets due to the out-performance of the equity part of their portfolios.Case Study #1 Data  Steve and Suzie.000. Asset Class Actual Weight Target Weight Difference Equity 70% 60% 10% Bonds 20% 30% -10% Cash 10% 10% 0% 39 Application: When should they rebalance their portfolio and how should they do it? .

• One thought is the new money donation (NMD) strategy where they use new money and donate appreciated assets to rebalance. if they will donate the appreciated equity assets. they can take the money they would have spent on their charity donations. They need to determine the best time for them to rebalance. The key is to minimize transactions costs and turnover. Since this change is due to appreciation of equities.Case Study #1 Answers  The decision of when to rebalance should be part of their investment plan. and purchase more bonds. donations in kind to a charity.e. while at the same time maintaining adequate diversification and return. and the most cost effective means. i. (See Teaching Tool 8 – Tithing Share Transfer Example) 40 .

The T-bill rate during the period was 4%. and Jensen’s alpha. Which risk-adjusted measure should Steve use? 41 . On a risk-adjusted basis. the XYZ mutual fund (which is actively managed). for the most recent sample period.  b. Treynor.2 1. did Fund XYZ outperform the market?  c.Case Study #2 Data  Steve is reviewing the performance of his largest asset. Fund XYZ Market • Average return 12% 10% • Beta 1.0 • Standard Deviation 26% 24% Calculations and Application  a. Calculate the following performance measures for Steve for the fund and the market: Sharpe.

2 = 6.0 Standard Deviation 26.2 1.0 42 .0 = 6.0% a.31 • Market (10-4)/24 = .0% 10.Case Study #2 Answers XYZ Fund Market Average return 12.0% T-Bill rate 4.0% 24. Performance measures Sharpe = (rp – rf )/ sd • Portfolio (12-4)/26 = .0% Beta 1.7 • Market (10-4)/1.25 Treynor = (rp – rf )/ ßp • Portfolio (12-4)/1.

8% • Market alpha = 0  b.2 (10-4) = 0.0% T-Bill rate 4. 43 .0% Jensen = rp – [rf + ßp (rm – rf)] • Portfolio alpha = 12 – [4 + 1. Treynor measure.0% Market 10.0 24.0% 1. and the Sharpe ratio.0% Beta 1.2 Standard Deviation 26. Steve’s XYZ Fund outperformed the market in terms of all three measures: the Jensen’s alpha.Case Study #2 Answers XYZ Fund Average return 12.

if the portfolio represents the entire investment for an individual.Case Study #2 Answers  c. Which measure is most appropriate? • Generally. or the Jensen’s a alpha • Of these two. • If many alternatives are possible. or if this is only part of the overall portfolio. use the Treynor measure versus the Treynor measure for the market. the Treynor measure is more complete because it adjusts better for risk 44 . This is not the case here. the Sharpe Index compared to the Sharpe Index for the market is best.

5% Calculations and Application: What was their over or underperformance? What was their contribution to security selection and to asset allocation? How did they do for the quarter? 45 .5% 1. and actual weights are different from their target get since they have not rebalanced lately. and cash is the Lehman Cash Index. Last quarter they had the following performance.Case Study #3 (optional) Data: Steve and Suzie are 45 years old. Asset Class Actual Return Equity Bonds Cash 2. The equity benchmark is the S&P 500.2% 0.0% 1. They like their current asset class weights. married. and have a portfolio with three asset classes. bonds the SB Intermediate.5% Actual Weight 70% 20% 10% Benchmark Weight 60% 30% 10% Benchmark Return 2. Benchmark weights are their target asset allocation.0% 0.

30 1.0*. The index return was (2.70 .2*.65%.0% Cash 0.5% . In this case they underperformed their benchmark by -.5*.7) + (1.26% for the quarter.1) or 1.6) + (1.0%*.1) or 1.Case Study #3 Answers • • • • • Asset Class Actual Return Equity 2.2) + (.2% .20 .5*. Steve and Suzie’s quarterly return was (2.5% Actual Benchmark Benchmark Weight Weight Return . The difference between these two returns is their performance.10 .91%.0% Bonds 1. 46 .10 0.5% a.3) + (.5*.60 2.

Port.5%) (2) Actual weight of the managed portfolio (1*2) Contribution of asset class security selection to the portfolio 47 .0% .35% Bonds -0.39%.70 -0.0%-2.39% (1) Managed fund return less index return (2. Their contribution of security selection to relative performance was -.5% . Man.20 -0. Contribution Equity -0.2% .04% Cash 0.00% Contribution of Security Selection -0. Ret.Case Study #3 Answers (continued) b. Wgt.10 0. This is calculated as: (1) (2) (1*2) Market Diff.

20-1.91=-.59% 0.is underweight) (4) Asset class return less total portfolio return (equity is 2.071% Cash 0% -1.50-1.71% 0.91 or .000% Contribution of Asset Allocation 0.13%. bond is 1.Case Study #3 Answers (continued) c.059% Bonds -10% -.59%. Their contribution from asset allocation was .41% 0. This is calculated as: (3) (4) (3*4) Market Excess Weight Index-BM Contribution Equity 10% .71) (3*4) Contribution of the asset class to the total portfolio 48 .130% (3) Weight of actively managed fund less benchmark weight (.

13% contribution from asset allocation.65%-1. 49 .39% contribution to security selection and a . they should consider indexing the stock selection decision.26% or 26 basis points (1. While they did well overweighting (versus their asset allocation targets) the asset classes that performed well. This underperformance was a combination of a -. and keep doing what they are doing with the asset class decision.e. • If this performance continued for 24-36 months. buy index funds. i.Case Study #3 Answers (continued) • Overall comments: Steve and Suzie’s actively managed portfolio under performed the benchmark by .91%). they didn’t do as well picking the assets in those asset classes.