Portfolio Rebalancing Methods
38 Questions
0 Views

Choose a study mode

Play Quiz
Study Flashcards
Spaced Repetition
Chat to lesson

Podcast

Play an AI-generated podcast conversation about this lesson

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?

<p>The portfolio Beta shifts as the values of portfolio components and their Betas change.</p> Signup and view all the answers

What is the purpose of rebalancing a portfolio?

<p>To maintain the chosen asset allocation percentage.</p> Signup and view all the answers

What is a common rule of thumb for when to rebalance a portfolio?

<p>When asset allocations vary by 10% or more.</p> Signup and view all the answers

How can a portfolio Beta be reduced in a Constant Beta portfolio?

<p>By putting additional money into the stock portfolio and holding cash, which dilutes the stocks and reduces the portfolio Beta.</p> Signup and view all the answers

What is the Beta of cash in a portfolio?

<p>Zero.</p> Signup and view all the answers

What should cash be in an investment portfolio?

<p>a temporary component</p> Signup and view all the answers

What is one way to rebalance a portfolio and reduce Beta?

<p>Sell high Beta stocks and buy low Beta stocks</p> Signup and view all the answers

What type of investors frequently use indexing to rebalance their portfolios?

<p>Institutional investors, such as mutual funds</p> Signup and view all the answers

What is the goal of an index-based portfolio manager?

<p>To behave like the market averages</p> Signup and view all the answers

What is tracking error in portfolio management?

<p>The extent to which a portfolio deviates from its intended behavior</p> Signup and view all the answers

What is the importance of performance evaluation in investment?

<p>To assess the balance between high returns and acceptable risks</p> Signup and view all the answers

Why is it important to consider both return and riskiness in performance evaluation?

<p>To recognize the balance between high returns and acceptable risks</p> Signup and view all the answers

What is the question that performance evaluation tries to answer?

<p>Can anyone consistently earn an 'excess' return, thereby 'beating' the market?</p> Signup and view all the answers

What is the formula to compute the average excess return for Stock XYZ?

<p>R = (1.86% - 5.09% - 1.99% + 1.72%) / 4</p> Signup and view all the answers

Why is a comparison with other managers of similar investment style misleading?

<p>Because some managers may concentrate on particular subgroups, making portfolio characteristics not truly comparable.</p> Signup and view all the answers

What is the Sharpe measure for Stock XYZ?

<p>-0.29</p> Signup and view all the answers

What is the Treynor measure for Stock XYZ?

<p>-0.73</p> Signup and view all the answers

What is the purpose of using risk-adjusted measures of performance?

<p>To adjust the return for risk before comparing performance.</p> Signup and view all the answers

What is the formula for Jensen's measure (JM)?

<p>aj = [Rjt –(RFRt)] – [bj(Rmt-RFRt)]</p> Signup and view all the answers

What are the three types of risk-adjusted measures of performance mentioned?

<p>Sharpe Measure, Treynor Measure, and Jensen Measure.</p> Signup and view all the answers

What does a positive alpha in Jensen's measure indicate?

<p>Superior management</p> Signup and view all the answers

What does the Sharpe Index measure?

<p>The reward to (total) volatility trade-off.</p> Signup and view all the answers

What does a negative alpha in Jensen's measure indicate?

<p>Inferior management</p> Signup and view all the answers

What is the formula for the Sharpe measure?

<p>S = (Rportfolio - RFR)/sportfolio</p> Signup and view all the answers

What does a Sharpe ratio greater than the market portfolio indicate?

<p>Superior performance.</p> Signup and view all the answers

What are the Sharpe measures for the market and managers D, E, and F?

<p>Market: (14%-8%)/20% = 0.3, Manager D: (13%-8%)/18% = 0.28, Manager E: (17%-8%)/22% = 0.41, Manager F: (16%-8%)/23% = 0.35</p> Signup and view all the answers

What does the Sharpe measure show?

<p>The risk premium earned over the risk-free rate per unit of total risk.</p> Signup and view all the answers

What does a positive alpha of a portfolio indicate according to the Jensen measure?

<p>A portfolio manager is better-than-average.</p> Signup and view all the answers

How do you rank portfolios based on the Jensen measure?

<p>By comparing the Jensen measure values of each portfolio.</p> Signup and view all the answers

What is the difference between the Sharpe Ratio and Treynor measures?

<p>The Sharpe Ratio uses total risk (standard deviation) while Treynor uses beta (systematic risk).</p> Signup and view all the answers

Why do the Sharpe Ratio and Treynor measures give identical rankings for a completely diversified portfolio?

<p>Because total risk is equal to systematic risk in a completely diversified portfolio.</p> Signup and view all the answers

How does diversification affect the ranking of portfolios using the Sharpe Ratio and Treynor measures?

<p>Diversification can lead to differences in rankings between the two measures.</p> Signup and view all the answers

What is the impact of a change in the risk-free rate on the Jensen measure of a portfolio?

<p>A change in the risk-free rate affects the Jensen measure, which may change the ranking of portfolios.</p> Signup and view all the answers

What does a Jensen measure of 37% indicate about portfolio A?

<p>Portfolio A has outperformed the market by 37%.</p> Signup and view all the answers

Why are the Jensen measures of the portfolios different under different market conditions?

<p>The Jensen measure is sensitive to changes in the market return and risk-free rate.</p> Signup and view all the answers

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.

Studying That Suits You

Use AI to generate personalized quizzes and flashcards to suit your learning preferences.

Quiz Team

Description

Learn about different portfolio rebalancing methods, including constant proportion portfolio and constant beta portfolio, to maintain optimal asset allocation.

More Like This

Use Quizgecko on...
Browser
Open
Browser
Browser