PORTFOLIO RE - VISION AND RE - BALANCING

PORTFOLIO RE - VISION AND RE - BALANCING

It means the value of the portfolio as well as its composition. The relative proportion of bond and shares may change as shares and bonds fluctuate in response to such changes. Portfolio rebalancing is necessary.

There are three policies of portfolio rebalancing:

1.Buy and hold policy

2.Constant mix policy, and

3.Constant Proportion Portfolio Insurance (CPPI) policy.

These policies have different pay off under varying market conditions. Under all these policies the portfolio consists of investment in shares and bonds.

1. Buy and Hold Policy:

Sometimes this policy is also called ‘do nothing policy’ as under this strategy no balancing is required and therefore investors maintain an exposure to shares and therefore linearly related to the value of stock in general.

Under this strategy investors set a limit (floor)below which he does not wish the value of the portfolio should go. Therefore, he invests an amount equal to floor value in non-fluctuating assets (Bonds).

Since the value of a portfolio is linearly related to the value of stocks, the pay-off diagram is a straight line.

This can be better understood with the help of an example. Suppose a portfolio consisting of Debt/ Bonds for ` 50,000 and ` 50,000 in equity shares currently priced at ` 100 per share. If the price of the share moves from ` 100 to ` 200 the value of the portfolio shall become ` 1,50,000. The pay-off diagram is shown in figure below i.e. a straight line:

This policy is suitable for the investor whose risk tolerance is positively related to portfolio and share

market return but drops to zero of below floor value.

Concluding, it can be said that following are main features of this policy:

(a) The value of the portfolio is positively related and linearly dependent on the value of the share.

(b) The value of the portfolio cannot fall below the floor value i.e. investment in Bonds.

(c) This policy performs better if the initial percentage is higher in share and shares outperform the bond.

Reverse will happen if shares under perform in comparison to bonds or their prices go down.

2. Constant Mix Policy:

Contrary to the above policy this policy is a ‘Do Something Policy’. Under this policy investors maintain an exposure to share at a constant percentage of total portfolio.

This strategy involves periodic rebalancing to required (desired) proportions by purchasing and selling shares as and when their prices go down and up respectively.

In other words this plan specifies that the value of an aggressive portfolio to the value of conservative portfolio will be held constant at a predetermined ratio. However, it is important that this action is taken only if there is change in the prices of shares at a predetermined percentage.

For example if an investor decided his portfolio shall consist of 60% in equity shares and balance

40% in bonds on upward or downward of 10% in share prices he will strike a balance.

In such a situation if the price of share goes down by 10% or more, he will sell the bonds and invest money in equities so that the proportion among the portfolio i.e. 60:40 remains the same.

If the price of share goes up by 10% or more he will sell equity shares and shall in bonds so that the ratio remains the same i.e. 60:40. This strategy is suitable for the investor whose tolerance varies proportionally with the level of wealth and such investor holds equity at all levels.

The pay-off diagram of this policy shall be as follows:

Accordingly, it gives a concave pay off, tends to do well in flat but fluctuating markets.

Continuing above example let us how investor shall rebalance his portfolio (50 : 50) under different

scenarios as follows:

IF PRICES DECREASES

IF PRICES INCREASES

3.Constant Proportion Insurance Policy :

Under this strategy, an investor sets a floor below which he does not wish his asset to fall, called floor, which is invested in some non-fluctuating assets such as Treasury Bills, Bonds etc.

The value of the portfolio under this strategy shall not fall below the specified floor under normal market conditions. This strategy performs well especially in bull markets as the value of shares purchased as cushion increases.

In contrast, bearish market losses are avoided by sale of shares. It should however be noted that this strategy performs very poorly in the market hurt by sharp reversals.

The following equation is used to determine equity allocation:

Target Investment in Shares = Multiplier (Portfolio Value – Floor Value)

Multiplier is a fixed constant whose value shall be more than1.

The pay-off under this strategy can be understood better with the help of an example

Suppose wealth of Mr. A is 10,00,000, a floor value of ` 7,50,000 and a multiplier of 2. Since the initial cushion (difference between Portfolio Value and Floor) is ` 2,50,000, the initial investment in the

share shall be ` 5,00,000 (double of the initial cushion). Accordingly, the initial portfolio mix shall consist of ` 5,00,000 in shares and balance ` 5,00,000 in Bonds.

Situation 1: Suppose stock market rises from 100 to 150. The value of shares of Mr. A’s holding shall rise from ` 5,00,000 to ` 7,50,000 and value of portfolio shall jump to ` 12,50,000 and value of cushion to ` 7,50,000.

Since the CPPI Policy requires the component of shares should go up to 10,00,000. This will necessitate the selling of bonds amounting ` 2,50,000 and reinvesting proceeds in shares.

Situation 2: If stock market falls from 100 to 80, the value of shares of portfolio falls from ` 5,00,000 to` 4,00,000 resulting in reduction of value of portfolio to ` 9,00,000 and cushion to ` 1,50,000.

Since as per CPPI the share component should be 3,00,000 (` 1,50,000 x 2), hence shares of `1,00,000 should be sold and invested in Bonds.Thus from above it is clear that as per CPPI sell the shares as their prices fall and buy them as their prices rise.

This policy is contrary to the Constant Mix Policy and hence pay-off of CPPI shall be convex as shown below:

COMPARATIVE ANALYSIS :