Personal Finance:

Another Perspective

Investments 9:
Portfolio Rebalancing and
Reporting

Objectives
A. Understand portfolio rebalancing
B. Understand the importance of portfolio
management and performance evaluation
C. Understand risk-adjusted performance
measures
D. Understand how to perform attribution
analysis

Investment Plan Assignments

Investments 9: Portfolio Rebalancing and Reporting
1. 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.
3

Investment Plan Assignments

Investments 10: Behavioral Finance
1. 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.

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
5

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)

Portfolio Rebalancing (continued)

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

Portfolio Rebalancing (continued)

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

Portfolio Rebalancing (continued)

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

Portfolio Rebalancing (continued)

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
10

Portfolio Rebalancing (continued)

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

11

Questions
Any questions on portfolio rebalancing?

12

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 investors
specific goals

What is performance evaluation?

The process of evaluating a portfolios 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

13

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)

14

Portfolio Management
and Evaluation (continued)
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 cant beat
them, join them, so they buy low-cost passive
funds which meet their benchmarks consistently
and minimize taxes

15

Portfolio Management
and Evaluation (continued)
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

16

Portfolio Management
and Evaluation (continued)
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

17

Portfolio Management
and Evaluation (continued)
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

18

Portfolio Management
and Evaluation (continued)
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

19

Portfolio Management
and Evaluation (continued)
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

20

Portfolio Management
and Evaluation (continued)
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

21

Portfolio Management
and Evaluation (continued)
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

22

Questions
Any questions on the importance of portfolio
management and evaluation?

23

C. Calculate Risk-adjusted Performance

How do you determine whether a portfolio manager is
generating excess returns (i.e., returns above the
managers benchmark)?
Is it only returns?
Should you also be concerned about risk?
It is not just returns that mattersthey must be
adjusted for risk.
There are a number of recognized performance
measures available:
Sharp Index
Treynor Measure
Jensens Measure

24

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

25

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
p
rp = Average return on the portfolio
rf = Average risk free rate
p = Weighted average b for portfolio
It is the portfolio risk premium divided by portfolio
risk as measured by beta

26

Risk Adjusted Performance:

Jensen
Jensens Measure
This is the ratio of your portfolio return less CAPM
determined portfolio return
ap = rp - [ rf + p (rm rf) ]
ap = Alpha for the portfolio
rp = Average return on the portfolio
p = 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

27

Risk Adjusted Performance (continued)

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 Jensens alpha
Of these two, the Treynor measure is more
complete because it adjusts for risk
28

Risk Adjusted Performance (continued)

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

29

Risk Adjusted Performance (continued)

What about style analysis?
Another way of obtaining abnormal returns is
chasing style
Growth versus valuewhats 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
30

Questions
Any questions on risk-adjusted performance
measures?

31

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
Industry

Security Choice
Currency

32

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

33

Portfolio Attribution (continued)

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

34

Portfolio Attribution (continued)

Why is it important to attribute performance to
the portfolios 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 dont perform portfolio

attribution?
You will not know why you are performing as you are
You will not know how to improve

35

Portfolio Attribution (continued)

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
36

Questions
Any questions on portfolio attribution?

37

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?

38

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%
39
Application: When should they rebalance their portfolio and
how should they do it?

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)

40

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 Jensens
alpha.
b. On a risk-adjusted basis, did Fund XYZ outperform the
market?
c. Which risk-adjusted measure should Steve use?

41

Case Study #2 Answers

XYZ Fund
Market
Average return
12.0%
10.0%
Beta
1.2
1.0
Standard 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 )/ p
Portfolio (12-4)/1.2 = 6.7
Market (10-4)/1.0 = 6.0
42

Case Study #2 Answers

XYZ Fund
Average return
12.0%
Beta
1.2
Standard Deviation
26.0%
T-Bill rate
4.0%

Market
10.0%
1.0
24.0%

Jensen = rp [rf + p (rm rf)]

Portfolio alpha = 12 [4 + 1.2 (10-4) = 0.8%
Market alpha = 0
b. Steves XYZ Fund outperformed the market in terms of all
three measures: the Jensens alpha, Treynor measure, and the
Sharpe ratio.
43

Case Study #2 Answers

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 Jensens a alpha
Of these two, the Treynor measure is more
complete because it adjusts better for risk
44

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
Return

Equity
Bonds
Cash

2.0%
1.0%
0.5%

Actual
Weight

70%
20%
10%

Benchmark
Weight

60%
30%
10%

Benchmark
Return

2.5%
1.2%
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?

45

Case Study #3 Answers

Asset Class Actual

Return
Equity
2.0%
Bonds
1.0%
Cash
0.5%

Actual Benchmark Benchmark

Weight Weight
Return
.70
.60
2.5%
.20
.30
1.2%
.10
.10
0.5%

a. Steve and Suzies 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.
46

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

47

Case Study #3 Answers (continued)

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

48

Case Study #3 Answers (continued)

Overall comments:
Steve and Suzies 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 didnt
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.

49