18 Investments 9 - Portfolio Rebalancing and Reporting

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Personal Finance: Another Perspective

Investments 9: Portfolio Rebalancing and

Reporting

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Objectives

A. Understand portfolio rebalancingB. Understand the importance of portfolio

management and performance evaluation C. Understand risk-adjusted performance

measures D. Understand how to perform attribution

analysis

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Investment Plan Assignments

Investments 9: Portfolio Rebalancing and Reporting1. 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.

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Investment Plan Assignments

Investments 10: Behavioral Finance1. 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.

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A. 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

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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)

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Periodic-based rebalancing• Specify a time period, i.e. bi-annually, annually, etc.

After each time period, 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

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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

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• “NMD” (New Money / Donations) Addendum• Since you pay yourself monthly and are very

careful in your selection of assets, you can combine the previous strategies with a “New Money / Donation” strategy

• Rebalance as determined previously. But use new money to purchase the “underweight” assets, so you do not have to sell and incur transactions costs or taxable events

• This way you are not selling assets

• In addition, this strategy helps you to buy “low,” as you are generally purchasing underperforming asset classes


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, i.e., you sell without tax consequences

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Which are the best methods?• Generally, for most investors with fewer investable

assets, the easiest is likely to be most useable

• Generally, a combination of periodic-based or percent-range-based rebalancing is most useful with the NMD addendum

• Review the portfolio annually, but only rebalance when you are +/- 5% to +/-10% (or some range) beyond your targets. Then rebalance back to your targets

• Remember, the goal is to minimize transactions costs, taxes, and tracking error costs

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Questions

• Any questions on portfolio rebalancing?

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B. Understand the Importance of Portfolio Management and Evaluation

What is portfolio management?• The development, 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

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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, management, 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)

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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

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What factors lead to above-benchmark or excess returns?• 1. Superior asset allocation

• Shifting assets between a poor-performing asset class and a better performing asset class, i.e. between large cap to international or small cap

• 2. Superior stock selection

• Picking sectors, industries, or companies within a specified benchmark which, as a whole, outperform the return on the specified benchmark

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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, bonds and other asset classes based on their expectations for returns from each of the asset classes

What are the results?• Done well, superior asset allocation yields higher

returns with lower risk.

• Done poorly, it yields lower returns, higher transactions costs, and higher taxes

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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, 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.

• Done poorly, it yields lower returns, high transactions costs, and high taxes

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What is portfolio evaluation?• The process of monitoring financial asset

performance, comparing asset performance to the relevant benchmarks, and determining how well the fund is meeting its objectives.

• If the assets are underperforming benchmarks, the investor may sell underperforming assets and purchase other assets which would more closely align asset performance with benchmarks

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Why monitor performance?• Unless you monitor performance, 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, and performing versus its benchmark, so you can determine how well you are moving toward your goals

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How do you evaluate performance?• Calculate:

• 1. The period return on each owned asset

• 2. The period index return for each benchmark

• 3. The difference between the asset return and benchmark return

• 4. The weight of each asset or portfolio in the overall portfolio

• 5. The overall portfolio return

• With this information, you can know how each of your funds or assets is performing versus its benchmark, and how well the portfolio is moving toward its objectives

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What is portfolio reporting?• The process of reviewing portfolio performance

with the necessary participants, i.e. your spouse

• If you are managing your portfolio, you should report performance to your spouse at least monthly or quarterly

• If others are helping you manage your portfolio, they should report performance to you and your spouse at least quarterly as well.

• Be careful not to do too much buying and selling, as these incur transactions costs and taxes

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Questions

Any questions on the importance of portfolio management and evaluation?

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C. Calculate Risk-adjusted Performance

How do you determine whether a portfolio manager is generating excess returns (i.e., 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.

There are a number of recognized performance measures available:

• Sharp Index

• Treynor Measure

• Jensen’s Measure

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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

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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

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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

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Which measure is most appropriate? Are there some general guidelines?

• Generally, if the portfolio represents the entire investment for an individual, the Sharpe Index compared to the Sharpe Index for the market is best

• 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, or the Jensen’s alpha

• Of these two, the Treynor measure is more complete because it adjusts for risk

Risk Adjusted Performance (continued)

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Are their limitations of risk adjustment measures?• Yes, very much so. The assumptions underlying

measures limit their usefulness

• Know the key assumptions and be careful!

• When the portfolio is being actively managed, 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


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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

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Questions

• Any questions on risk-adjusted performance measures?

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D. Understand How to Perform Portfolio Attribution (this is optional)

What is portfolio attribution?• The process of separating out portfolio returns into

their related components, 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 Security Choice

• Industry Currency

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Portfolio Attribution (continued)

How do you determine portfolio attribution?• 1. Set up a weighted ‘benchmark’ which includes

all your chosen asset classes

• Use your chosen benchmark for each asset class, and use your target asset allocation weights from your Investment Plan

• 2. Calculate your returns for each of your asset classes

• Calculated returns for each asset class

• Calculate a weighted return for your overall portfolio

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• 4. Compare your portfolio returns in each asset class to the benchmark returns of each index

• Use Teaching Tool 17: Portfolio Attribution Spreadsheet

• 5. Calculate your attribution and make decisions accordingly

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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


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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, 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, 12-36 months

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Questions

Any questions on portfolio attribution?

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Review of Objectives

A. Do you understand the different types and uses of indexes?

B. Do you understand the Importance of Portfolio Management and Performance Evaluation?

C. Do you understand portfolio rebalancing?D. Do you understand risk-adjusted

performance measures? E. Do you understand how to perform

attribution analysis?

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Case Study #1

Data Steve and Suzie, both 45, are aggressive investors, and

have a portfolio of over $250,000. 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.

Asset Class Actual Weight Target Weight Difference

Equity 70% 60% 10%

Bonds 20% 30% -10%

Cash 10% 10% 0%

Application: When should they rebalance their portfolio and how should they do it?

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Case Study #1 Answers

The decision of when to rebalance should be part of their investment plan. They need to determine the best time for them to rebalance, and the most cost effective means. The key is to minimize transactions costs and turnover, while at the same time maintaining adequate diversification and return.• One thought is the new money donation (NMD)

strategy where they use new money and donate appreciated assets to rebalance. Since this change is due to appreciation of equities, if they will donate the appreciated equity assets, i.e. donations in kind to a charity, they can take the money they would have spent on their charity donations, and purchase more bonds. (See Teaching Tool 8 – Tithing Share Transfer Example)

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Case Study #2

Data Steve is reviewing the performance of his largest asset, the

XYZ mutual fund (which is actively managed), for the most recent sample period. The T-bill rate during the period was 4%. Fund XYZ Market• Average return 12% 10%• Beta 1.2 1.0• Standard Deviation 26% 24%

Calculations and Application a. Calculate the following performance measures for Steve

for the fund and the market: Sharpe, Treynor, and Jensen’s alpha.

b. On a risk-adjusted basis, did Fund XYZ outperform the market?

c. Which risk-adjusted measure should Steve use?

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XYZ Fund MarketAverage return 12.0% 10.0%Beta 1.2 1.0Standard Deviation 26.0% 24.0%T-Bill rate 4.0%

a. Performance measures

Sharpe = (rp – rf )/ sd• Portfolio (12-4)/26 = .31• Market (10-4)/24 = .25

Treynor = (rp – rf )/ ßp

• Portfolio (12-4)/1.2 = 6.7

• Market (10-4)/1.0 = 6.0

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XYZ Fund MarketAverage return 12.0% 10.0%Beta 1.2 1.0Standard Deviation 26.0% 24.0%T-Bill rate 4.0%

Jensen = rp – [rf + ßp (rm – rf)]• Portfolio alpha = 12 – [4 + 1.2 (10-4) = 0.8%• Market alpha = 0

b. Steve’s XYZ Fund outperformed the market in terms of all three measures: the Jensen’s alpha, Treynor measure, and the Sharpe ratio.


c. Which measure is most appropriate?

• Generally, if the portfolio represents the entire investment for an individual, the Sharpe Index compared to the Sharpe Index for the market is best. This is not the case here.

• 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, or the Jensen’s a alpha

• Of these two, the Treynor measure is more complete because it adjusts better for risk

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Case Study #3 (optional)

Data: Steve and Suzie are 45 years old, married, and have a portfolio with three asset classes. Last quarter they had the following performance. The equity benchmark is the S&P 500, bonds the SB Intermediate, and cash is the Lehman Cash Index. Benchmark weights are their target asset allocation, and actual weights are different from their target get since they have not rebalanced lately. They like their current asset class weights.

Asset Class Actual Actual Benchmark Benchmark Return Weight Weight ReturnEquity 2.0% 70% 60% 2.5%Bonds 1.0% 20% 30% 1.2%Cash 0.5% 10% 10% 0.5%

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?

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• Asset Class Actual Actual Benchmark Benchmark

• Return Weight Weight Return

• Equity 2.0% .70 .60 2.5%

• Bonds 1.0% .20 .30 1.2%

• Cash 0.5% .10 .10 0.5%

a. Steve and Suzie’s quarterly return was (2.0%*.7) + (1.0*.2) + (.5*.1) or 1.65%. The index return was (2.5*.6) + (1.2*.3) + (.5*.1) or 1.91%. The difference between these two returns is their performance. In this case they underperformed their benchmark by -.26% for the quarter.

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Case Study #3 Answers (continued)

b. Their contribution of security selection to relative performance was -.39%. This is calculated as:

(1) (2) (1*2)

Market Diff. Ret. Man. Port. Wgt. Contribution

Equity -0.5% .70 -0.35%

Bonds -0.2% .20 -0.04%

Cash 0.0% .10 0.00%

Contribution of Security Selection -0.39%(1) Managed fund return less index return (2.0%-2.5%)

(2) Actual weight of the managed portfolio

(1*2) Contribution of asset class security selection to the portfolio

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c. Their contribution from asset allocation was .13%. This is calculated as:

(3) (4) (3*4)

Market Excess Weight Index-BM Contribution

Equity 10% .59% 0.059%

Bonds -10% -.71% 0.071%

Cash 0% -1.41% 0.000%

Contribution of Asset Allocation 0.130%(3) Weight of actively managed fund less benchmark weight (- is underweight)

(4) Asset class return less total portfolio return (equity is 2.50-1.91 or .59%, bond is 1.20-1.91=-.71)

(3*4) Contribution of the asset class to the total portfolio

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• Overall comments:

Steve and Suzie’s actively managed portfolio under performed the benchmark by .26% or 26 basis points (1.65%-1.91%). This underperformance was a combination of a -.39% contribution to security selection and a .13% contribution from asset allocation. While they did well overweighting (versus their asset allocation targets) the asset classes that performed well, they didn’t do as well picking the assets in those asset classes.

• If this performance continued for 24-36 months, they should consider indexing the stock selection decision, i.e. buy index funds, and keep doing what they are doing with the asset class decision.

Economy & Finance

18 Investments 9 - Portfolio Rebalancing and Reporting