Podcast Beta
Questions and Answers
What is a constant proportion portfolio, and what is its main objective?
A constant proportion portfolio is one that maintains the relative weighting of its components as their prices change, with the objective of keeping the chosen asset allocation percentage.
Why is constant proportion rebalancing psychologically difficult for investors?
It requires purchasing securities that have performed poorly and selling those that have performed well.
What is the alternative rebalancing method besides constant proportion portfolio?
Constant Beta portfolio.
What happens to the portfolio Beta over time in a Constant Beta portfolio?
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What is the purpose of rebalancing a portfolio?
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What is a common rule of thumb for when to rebalance a portfolio?
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How can a portfolio Beta be reduced in a Constant Beta portfolio?
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What is the Beta of cash in a portfolio?
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What should cash be in an investment portfolio?
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What is one way to rebalance a portfolio and reduce Beta?
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What type of investors frequently use indexing to rebalance their portfolios?
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What is the goal of an index-based portfolio manager?
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What is tracking error in portfolio management?
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What is the importance of performance evaluation in investment?
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Why is it important to consider both return and riskiness in performance evaluation?
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What is the question that performance evaluation tries to answer?
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What is the formula to compute the average excess return for Stock XYZ?
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Why is a comparison with other managers of similar investment style misleading?
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What is the Sharpe measure for Stock XYZ?
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What is the Treynor measure for Stock XYZ?
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What is the purpose of using risk-adjusted measures of performance?
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What is the formula for Jensen's measure (JM)?
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What are the three types of risk-adjusted measures of performance mentioned?
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What does a positive alpha in Jensen's measure indicate?
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What does the Sharpe Index measure?
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What does a negative alpha in Jensen's measure indicate?
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What is the formula for the Sharpe measure?
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What does a Sharpe ratio greater than the market portfolio indicate?
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What are the Sharpe measures for the market and managers D, E, and F?
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What does the Sharpe measure show?
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What does a positive alpha of a portfolio indicate according to the Jensen measure?
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How do you rank portfolios based on the Jensen measure?
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What is the difference between the Sharpe Ratio and Treynor measures?
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Why do the Sharpe Ratio and Treynor measures give identical rankings for a completely diversified portfolio?
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How does diversification affect the ranking of portfolios using the Sharpe Ratio and Treynor measures?
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What is the impact of a change in the risk-free rate on the Jensen measure of a portfolio?
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What does a Jensen measure of 37% indicate about portfolio A?
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Why are the Jensen measures of the portfolios different under different market conditions?
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Study Notes
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.
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Description
Learn about different portfolio rebalancing methods, including constant proportion portfolio and constant beta portfolio, to maintain optimal asset allocation.
