PORTFOLIO REVISION

Reference Articles : 1. Rebalancing Revisited: The Role of Derivatives David T Brown, Gideon Ozik, Daniel Scholz. Financial Analysts Journal. Charlottesville: Sep/Oct 2007. Vol. 63, Iss. 5; p. 32

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A portfolio is an appropriate mix or collection of investments held by an institution or an individual. The assets in the portfolio could include stocks, bonds, options, warrants, gold certificates, real estate, futures contracts, production facilities, or any other item that is expected to retain its value. Holding a portfolio is a part of an investment and risklimiting strategy called diversification. By owning several assets, certain types of risk (in particular specific risk) can be reduced.

PORTFOLIO MANAGEMENT: Portfolio management involves deciding what assets to include in the portfolio, given the goals of the portfolio owner and changing economic conditions. Selection involves deciding what assets to purchase, how many to purchase, when to purchase them, and what assets to divest. These decisions always involve some sort of performance measurement, most typically expected return on the portfolio, and the risk associated with this return (i.e. the standard deviation of the return). Typically the expected return from portfolios of different asset bundles is compared. NEED FOR PORTFOLIO MANAGEMENT: Portfolio needs periodic maintenance and revision because: The needs of the beneficiary will change The relative merits of the portfolio components will change

To keep the portfolio in accordance with the investment policy statement and investment strategy

TECHNIQUE: An active management policy can be followed in which the composition of the portfolio is dynamic. The portfolio manager periodically changes the portfolio components or the components proportion within the portfolio. A passive management strategy is one in which the portfolio is largely left alone. PORTFOLIO REBALANCING: Rebalancing a portfolio is the process of periodically adjusting it to maintain the original conditions. Following strategies can be employed: 1. Constant mix strategy Is one to which the manager makes adjustments to maintain the relative weighting of the asset classes within the portfolio as their prices change Requires the purchase of securities that have performed poorly and the sale of securities that have performed the best A constant mix strategy sells stock as it rises Example: A portfolio has a market value of $2 million. The investment policy statement requires a target asset allocation of 60 percent stock and 30 percent bonds. Date 1 Jan 1 Apr Portfolio Value $2,000,000 $2,500,000 Actual Allocation 60%/40% 56%/44% Stock $1,200,000 $1,400,000 Bonds $800,000 $1,100,000

What dollar amount of stock should the portfolio manager buy to rebalance this portfolio? What dollar amount of bonds should he sell? Solution: a 60%/40% asset allocation for a $2.5 million portfolio means the portfolio should contain $1.5 million in stock and $1 million in bonds. Thus, the manager should buy $100,000 worth of stock and sell $100,000 worth of bonds. 2. 3. Constant proportion portfolio insurance strategy Relative performance of constant mix and CPPI strategies a. A CPPI strategy buys stock as it rises

REBALANCING WITHIN THE EQUITY PORTFOLIO: The below mentioned models can be employed for rebalancing of portfolio within the equity portfolio 1. Constant proportion: A constant proportion strategy within an equity portfolio requires maintaining the same percentage investment in each stock May be mitigated by avoidance of odd lot transactions

Constant proportion rebalancing requires selling winners and buying losers 2. Constant beta: A constant beta portfolio requires maintaining the same portfolio beta. To increase or reduce the portfolio beta, the portfolio manager can:

Reduce or increase the amount of cash in the portfolio Purchase stocks with higher or lower betas than the target figure Sell high- or low-beta stocks Buy high- or low-beta stocks 3. Change the portfolio components: Changing the portfolio components is another portfolio revision alternative. Events sometimes deviate from what the manager expects: The manager might sell an investment turned sour The manager might purchase a potentially undervalued replacement security

4. Indexing: Indexing is a form of portfolio management that attempts to mirror the performance of a market index. Index funds eliminate concerns about outperforming the market. The tracking error refers to the extent to which a portfolio deviates from its intended behavior COSTS INVOLVED IN PORTFOLIO REVISION: Costs of revising a portfolio can: Be direct dollar costs Result from the consumption of management time Stem from tax liabilities Result from unnecessary trading activity Trading fees: Commissions and Transfer taxes

Market impact: The market impact of placing the trade is the change in market price purely because of executing the trade. Market impact is a real cost of trading. Market impact is especially pronounced for shares with modest daily trading volume Management time: Most portfolio managers handle more than one account. Rebalancing several dozen portfolios is time consuming.

 Tax implications: Individual investors and corporate clients must pay taxes on the realized capital gains associated with the sale of a security. Tax implications are usually not a concern for tax-exempt organizations

SYNTHETIC REBALANCING USING DERIVATIVES Portfolio allocations drift away from the desired (i.e., target) allocations as asset classes experience differing returns. This drift creates undesirable tracking error. Rebalancing moves the asset-class holdings back close to their desired allocations but incurs transaction costs. Portfolio rebalancing trades off tracking error against the transaction costs associated with avoiding tracking error. We need to achieve optimal rebalancing strategies that minimize the expected transaction costs required to achieve a given level of tracking error. Reductions in expected transaction costs can be obtained by using derivatives to synthetically rebalance a portfolio. The shape of the optimal no-trade region depends on trading costs, asset volatility, and the correlations between asset-class returns. We desire to achieve lower expected transaction costs to obtain the same level of tracking error. Strategies for efficient cash-market rebalancing require rebalancing the portfolio back to a notrade region and setting the no-trade region to induce efficient rebalancing trades. Once the derivative position limit has been met, any further drift of the asset class that is over weighted (underweighted) relative to the target allocation is rebalanced in the cash market. REBALANCING TO THE TARGET VS. REBALANCING TO THE BOUNDARY: The estimates of tracking error and expected transaction cost depend on the input assumptions. The proportional savings in expected transaction costs; however, from strategies that trade to the boundaries versus rebalancing to the targets does not vary much with the return assumptions. SYNTHETIC REBALANCING: Synthetic rebalancing trades reduce exposure to asset classes that are over weighted relative to their target allocations by using short positions in derivatives and add exposure to underweighted asset classes by using long positions in derivatives. Synthetic rebalancing is attractive because derivatives are generally traded at considerably lower cost than cash-market positions. An effective synthetic rebalancing strategy must be carefully designed, however, because the transaction-cost and tracking-error implications of a synthetic rebalancing trade depend on the cost of trading the derivatives and how long the derivative positions are maintained. For example, when futures are shorted to reduce exposure, transaction costs are incurred in assembling the futures positions and each time the futures positions are rolled as the contracts approach expiration. The length of time derivative positions are held also affects the tracking error associated with a rebalancing strategy because of the derivatives-cash market benchmark basis.

Synthetic rebalancing trades occur when the allocations to the asset classes deviate from their target allocations by 1 percent. The derivatives exposure limit is the difference between the cash and derivatives boundaries. The notional value of a derivative position cannot exceed 4 percent of the portfolio value in this case. The mechanics of a synthetic rebalancing program are shown by starting with allocations at the portfolio target allocations and then showing the trades that are made as the portfolio allocations drift from their target allocations. The effective allocation is the sum of the cash allocation and futures positions. Thus, the portfolio is synthetically rebalanced back to the rebalancing boundaries. The derivative positions taken to synthetically rebalance the portfolio are taken off when the performances reverse. When equity outperforms fixed income, the effective allocations are maintained by taking off the long fixed-income and short equity derivative positions. Thus, the expected length of time the derivative position is held increases with the derivative position limit. When more than two asset classes are involved, the derivative position limits are smaller for asset classes in which the appropriate derivative contract has either high roll costs or high derivatives-cash market basis volatility. Three parameters are required to characterize each derivative contract and to simulate synthetic rebalancing strategies: (1) The costs of trading derivatives, (2) The costs of maintaining derivative positions, and (3) The basis volatility associated with the synthetic trade. These three parameters also fully characterize all potential derivative alternatives. For futures contracts, the cost of trading is the bid-ask spread, including any market impact and commissions. The cost of maintaining a futures contract, the roll cost, is the bid-ask spread, market impact, and commissions for calendar rolls, which are usually considered lower than the costs of initiating a position. Roll costs for futures are lower because they are generally transacted at a time when the market is more liquid than it is at initiation. The quote convention is frequently "bid to bid" on the roll (which reduces bid-ask spread costs by half), and the manager has discretion over when to roll the positions, which presumably mitigates market impact costs. The expected transaction-cost savings from using synthetic rebalancing are substantial. The expected transaction cost of synthetic rebalancing is less than 50 percent of the cost of cashmarket rebalancing for low-tracking-error targets and 90 percent of the cost of cash-market rebalancing for high-tracking-error targets.The chosen tracking-error target depends on the investor's tracking-error tolerance and the expected transaction costs associated with obtaining that tracking error. The availability of synthetic rebalancing programs tends to shift investors toward tight tracking-error tolerances. CASH FLOWS AND REBALANCING

When a portfolio experiences cash inflows or outflows, efficient synthetic rebalancing strategies have an additional dimension: a maximum allocation to cash. Thus, rebalancing policies are characterized by (1) The maximum allowable allocation to cash, (2) Upper and lower synthetic boundaries, and (3) Upper and lower cash boundaries. The optimization procedure searches over boundaries to determine the set of boundaries that results in the lowest expected transaction costs for a given level of tracking error. The efficient approach is to rebalance by holding at least some of the cash inflows and overlaying the cash position with derivatives. Also note that for most asset classes, the lower boundary is wider than the upper boundary. The purpose is to allow the portfolio to hold cash. The upper derivatives boundary on cash caps the amount of cash that is allowed to remain without a derivative overlay at 0.55 percent of the portfolio. The lower derivatives boundary on cash is constrained to be zero to preclude leverage. CONCLUSION 1. Synthetic rebalancing programs can minimize the expected transaction costs associated with portfolio rebalancing. 2. With synthetic rebalancing, the expected transaction costs for a given tracking-error target are considerably lower than can be attained by even the most well-conceived strategies that rebalance by using only cash-market assets. 3. When the desired tracking-error target is small, synthetic rebalancing can achieve the same level of tracking error for less than half the cost of cash-market-only rebalancing. As the tracking-error target increases, the expected transaction-cost savings from synthetic rebalancing decline. 4. Synthetic rebalancing is particularly attractive when the desired tracking error is small, because derivative positions are expected to be maintained for longer periods of time when the tracking-error tolerance is large. 5. A synthetic rebalancing strategy must incorporate features that limit the length of time the derivative positions are held. 6. When a portfolio receives cash inflows or is required to make periodic cash payments, the efficient rebalancing strategy allows the portfolio to hold some cash. When cash flows arrive, gaining the desired exposure by overlaying at least some of the cash with derivative positions is more efficient than investing the entire cash flow directly into the underweighted asset classes. Investing the cash flow into cash assets generally moves the asset allocations inside the no-trade region. The overlay strategy avoids trading cashmarket asset classes inside the no-trade region, which is inefficient. The numerical optimization procedure determines the most efficient allowable cash position and notrade region. SUBMITTED BY: