Portfolio Rebalancing Methods

Portfolio Rebalancing

• A constant proportion portfolio is a portfolio where adjustments are made to maintain the relative weighting of the portfolio components as their prices change.
• Investors should focus on keeping their chosen asset allocation percentage, and there is no one correct formula for when to rebalance.
• One rule may be to rebalance the portfolio when asset allocations vary by 10% or more.
• However, constant proportion rebalancing requires the purchase of securities that have performed poorly and the sale of those that have performed well, which can be difficult for investors psychologically.

Constant Beta Portfolio

• The base for rebalancing a portfolio using this alternative is the target portfolio Beta.
• Over time, the values of the portfolio components and their Betas will change, causing the portfolio Beta to shift.
• To rebalance, the portfolio Beta can be brought back to the target by:
  • Putting additional money into the stock portfolio and holding cash.
  • Putting additional money into the stock portfolio and buying stocks with a Beta lower than the target Beta.
  • Selling high Beta stocks in the portfolio and holding cash.
  • Selling high Beta stocks and buying low Beta stocks.

Indexing

• This alternative for rebalancing portfolios is more frequently used by institutional investors, such as mutual funds.
• Managing an index-based portfolio eliminates concerns about outperforming the market, as it seeks to behave just like the market averages.
• The investor attempts to maintain some predetermined characteristics of the portfolio, such as a Beta of 1.0.
• The extent to which the portfolio deviates from its intended behavior is called the tracking error.

Portfolio Evaluation

• Proper performance evaluation involves recognizing both the return and the riskiness of the investment.
• Performance evaluation assesses how well a money manager achieves a balance between high returns and acceptable risks.
• Risk-adjusted measures of performance can be used to adjust the return for risk before comparison, such as:
  • Sharpe Measure
  • Treynor Measure
  • Jensen Measure

Sharpe Measure

• The Sharpe Measure relates return to total risk and can be used effectively with a portfolio where unsystematic risk has been diversified away.
• It measures the reward to (total) volatility trade-off and divides the average portfolio excess return over the sample period by the standard deviation of returns over that period.
• Sharpe ratios greater than the ratio for the market portfolio indicate superior performance.

Jensen Measure

• Jensen's alpha represents how much the portfolio manager contributes to portfolio returns.
• Superior managers will generate a significantly positive alpha, while inferior managers will generate a significantly negative alpha.
• Jensen's measure calculates excess returns based on the CAPM.

Comparing Measures of Performance

• Treynor Measure uses beta (systematic risk) as a measure of risk, while Sharpe Ratio uses standard deviation (total risk).
• Sharpe Ratio evaluates the manager on the basis of both rate of return performance and diversification.
• For a completely diversified portfolio, Sharpe Ratio and Treynor give identical rankings because total risk is really systematic variance.