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Dynamic Strategies for Asset Distribution

Summary

A portfolio’s components each carry specific risks. In portfolio management, a vital need is to rebalance the portfolio to maintain overall risk at a level deemed acceptable. Dynamic asset distribution is one aspect of this need. Here we explain two of the four classic methods used.

A portfolio containing two or more securities has different elements of risk. This means the initial asset allocation balance is subsequently altered as each security gains or loses value at different rates.

A portfolio containing two or more securities has different elements of risk. This means the initial asset allocation balance is subsequently altered as each security gains or loses value at different rates.

Some time later, the riskier stock may have risen 20%. Now, 20% of the $30 initially invested in the risky stock is $6, so this part of the portfolio has risen to $36. Let us suppose, meanwhile, that the bank stock has not budged: the value of this part of the portfolio is still $70.

Overall, the portfolio is now worth $106 ($36$ + $70). This is fine in terms of profit, but the split between the riskier and less risky components is now less comfortable: the portfolio has become riskier because its performance depends more on the risky stock. In effect, the portion of the portfolio allocated to the risky stock is now $36/$106, or 34%, and the portion in the bank stock has fallen to $70/$106, or 66%. The portfolio allocation has thus moved to 34/66, compared to 30/70 initially.

If this trend continues, the cautious nature of the initial portfolio will come under growing threat. The investor may decide to do nothing and accept this higher risk, or the investor could consider rebalancing the portfolio to return it to a ratio closer to the initial 30/70.

Dynamic asset allocation and rebalancing are among the professional techniques used in building and managing a portfolio. They are vital for managers of institutional funds such as mutual funds, pension funds or hedge funds.

There are essentially four methods that can be applied to a portfolio to manage asset distribution with the aim of rebalancing risk:

  1. Portfolio insurance based on the option delta
  2. Constant proportion portfolio insurance
  3. Buying and holding
  4. Keeping the distribution constant

The first two methods are used more in financial institutions. The first consists in converting the portfolio virtually into a put option, synthetically applying a strategy known to investors who are familiar with options: the purchase of put options to protect securities in the portfolio against price declines. The second method is a simplified version of the first. The reason for these techniques is to set a floor on portfolio value. In contrast to individual investors, who can use exchange-listed put options to mitigate risk, institutional funds, due to their size, lack listed tools to protect themselves: they thus have to create their own, using financial engineering techniques. Individual investors with sufficiently large portfolios can also use methods 1 and 2. This will be the subject of a later article.

The last two methods are universal.

Method 3 is passive and is the simplest one: you initially buy the desired proportion and, whatever happens later, you maintain your positions unchanged.

Let’s look at a portfolio consisting of $60 invested in an ETF (exchange-traded fund). This fund represents a stock exchange index, currently priced at $100. This investment’s risk equals that of the market as a whole. The other part of the portfolio consists of $40 in Treasury bills, a risk-free investment. The initial amalgam is thus 60/40. This portfolio depends entirely on how the index performs. Each dollar rise in the index produces a 60-cent gain in the portfolio. If the index declines, the portfolio cannot go below $40, which is the initial investment in Treasury bills. Method 3 is thus advantageous if the index rises, but could be disastrous if the index falls.

Method 4 is dynamic. Initially, you have a 60/40 amalgam, as in the previous example, but here the investor, regardless of gains or losses, wants to maintain a constant 60/40 proportion between the two types of investments.

If the index falls by 10%, going from $100 to $90, the ETF component declines to $54 from the previous $60, and the portfolio’s total value is now $94. The initial 60/40 amalgam is modified, with the index ETF becoming $54/$94, or 57.45% of the total, and the Treasury bill component becoming 42.55% ($40/$94). The new allocation is thus 57.45/42.55. To get back to the 60/40 split, you have to buy enough of the ETF to go from 57.45% to 60%. In other words, you have to have 60% of $94 invested in the ETF, or $56.40 (0.60 x $94). You thus need to add $2.40 to the ETF holding (the difference between $56.40 and $54). The money needed for the purchase comes from the sale of Treasury bills for an equal amount. The split thus returns to 60/40.

As a general rule, to keep the initial 60/40 amalgam constant, you have to buy more of the ETF if the index goes down, and sell some of it if the index goes up. This method is thus profitable when there are frequent shifts in trend, as in a congestion zone. For example, if the index falls and then returns to the initial position, method 3 will not have made any money, whereas method 4, because of rebalancing, can turn a profit.

Method 3 is better than method 4 if the market is rising constantly.
If the market is falling, method 3 results in lower losses than method 4.

In practice, in method 4, you don’t balance with each market move. You apply a rule: you rebalance the portfolio, for example, only if the index moves by at least 2%.

The author

Charles K. Langford

Charles K. Langford

PhD, Fellow CSI

Charles K. Langford is President of Charles K. Langford, Inc, Portfolio Managers. He teaches portfolio management at School of Management (École des Sciences de la Gestion), University of Québec (Montréal). He is the author of 14 books on portfolio management, derivatives strategies and technical analysis.

Until 2007 he has been vice-president overlay risk management for Visconti Venosta Teaspoon Approach Management, Ltd. Until 1990 he was portfolio manager for Refco Futures (Canada) Ltd.

He has received a Bachelor degree from Université de Montréal, a Master degree and the PhD from McGill University (Montreal); he is Fellow of CSI (Canadian Securities Institute).