Portfolio Reporting and Rebalancing 26May05

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Personal Finance:
a Gospel Perspective
Investments 9:
Portfolio Reporting
and Rebalancing
1
Objectives
 A. Understand the uses and types of
benchmarks
 B. Understand the importance of portfolio
management and performance evaluation
 C. Understand portfolio rebalancing
 D. Understand how to perform attribution
analysis
 E. Know how to read the WSJ Monthly
Performance Tables
2
Application #1
 Steve and Suzie are both 45, are aggressive investors,
and have an investment 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 portfolio.
Asset Class Actual Wgt. Target Wgt. Difference
Equity
70%
60%
10%
Bonds
20%
30%
-10%
Cash
10%
10%
0%
When should they rebalance their portfolio and how
3
should they do it?
A. Understand the Uses and
Types of Benchmarks
 What are benchmarks?
•
Benchmarks are measuring devices which give
the performance of a specific set of securities for
comparison purposes. Benchmarks may be built
on published indexes or may be customized to
suit a specific investment strategy
 Why are benchmarks important?
•
Benchmarks are the standard from which your
portfolio should be judged. You cannot know
how your are performing without a benchmark
4
Uses of Benchmarks (continued)
 What are the uses of benchmarks?
• 1. Tracks average returns for a specific asset class
• 2. Used to compare performance of mutual fund
managers in similar asset classes and to check
broker’s recommendations
• 3. Use as a base to build portfolios
 Key Questions in choosing or using an Index:
• Is it representative of the performance of assets
desired?
• How broad is the benchmark, i.e. number securities?
• How is it constructed, i.e. price, total return index?
• How is it weighted, i.e.5 market cap, equal weighted?
Uses of Benchmarks (continued)
 How are benchmarks differentiated?
•
Type:
• Stocks:
• Large capitalization (cap), small cap, mid
cap, international, emerging markets, etc.
• Bonds:
• Long-term, short-term, corporate bonds,
government bonds, convertible bonds, etc.
• Other Asset Classes:
• Real estate, REITs, currencies,
commodities, derivatives, gold, hedge
funds, etc.
6
Uses of Benchmarks (continued)
 Geography:
• Global:
• Follows performance of a set of assets from a
specific set of countries including the US, i.e.,
MSCI World, MSCI AC Free. International
includes only countries outside the US
• Regional:
• Follows performance of a set of assets from a
specific region of the world , i.e., MSCI EAFE,
DJ Asia, Latin America
• Country:
• Follows performance of a set of assets from a
specific country , i.e.,
MSCI Argentina,
7
S&P/IFC Chile, Japan TOPIX, etc.
Uses of Benchmarks (continued)
 Asset Size:
•
•
Market Capitalization
 Follows the performance of a set of assets with
a specific market capitalization range, i.e.
large- cap, mid-cap, small-cap, micro-cap, etc.
Industry:
 Follows the performance of a set of assets
from a specific industry, whether global,
regional, or country, i.e. Telecomm, Financial,
Retail, Automotive, Consumer Durable, etc.
8
Uses of Benchmarks (continued)
 Investment Style:
• Value
These follow stocks that are perceived to be
undervalued by the market, i.e. their PE and
P/BV ratios are lower than the market.
 Blend
These follow a portfolio of stocks that include
both value and growth in their portfolio.
• Growth
These follow stocks that are expected to achieve
accelerated growth, whether due to increased
earnings, dominant9market position, or other
Benchmarks Types
Types of Return Benchmarks:
 Price Return:
• Includes only price appreciation or capital gains
 Total Return with Gross Dividends (or gross
dividends reinvested):
• Includes both price appreciation and dividends.
It does not take into account the impact of
withholding taxes on dividends (international)
 Total Return with Net Dividends:
• Includes both price appreciation and dividends.
It also takes into account the impact of
withholding taxes on dividends, hence dividends
10
received internationally will be less than paid
Benchmark Construction
 How are stocks weighted in various benchmarks?
• Market-value weighted (S&P 500, NASDAQ)
• Weight is based on market capitalization
• Stocks are weighted according to their
market capitalization. This assumes market
capitalization (price * shares) is a good
proxy for size
• Price weighted (DJIA, Nikkei, Japan)
• Weight is based on the price of the stock
• Stocks with a higher price are weighted
more in the index. This assumes a higher
priced stock is more valuable than a lower
11
priced stock
Benchmark Construction (continued)
 Equally weighted (Value Line)
• All stocks are weighted the same
• Stocks are equally weighted. This assumes all

stocks are equal and hence gives a higher
weighting to smaller stocks
Float weighted (MSCI Emerging Markets Free)
• Weight is based on market cap and available float
outstanding, i.e. what investors can really purchase
• Stocks are weighted according to available
shares outstanding. This gives greater
preference to companies whose shares can be
purchased (i.e., are not held by a few
12
individuals) and who
do not have foreign
Finding Data on Indexes
 Where do you find these benchmarks or
indexes?
 Internet: Any of the many financial sites
available: CNN Money, YahooFinance, etc.
Generally these free Benchmarks are without
dividends (make sure you check)
 Proprietary Data Providers: Bloomberg, Reuters,
etc. They will also produce special indexes for a
fee ( i.e. MSCI EM Free ex-Malaysia)
 Data Suppliers: Standard and Poors, Morgan
Stanley Capital International, NASDAQ,
Bloomberg, etc.
13
Vanguard Sends Notice of Index Changes
 From a Vanguard e-mail: We believe that the new indexes will
reflect the performance of the funds' targeted market segments
more accurately than any other available indexes. We believe
stock indexes should:
•
•

Be constructed according to objective rules, not subjective judgment.
Weight their holdings to reflect only "floating" shares, meaning those that
are available and freely traded in the open market.
• Feature overlapping buffer zones around the breakpoints between large-,
mid-, and small-capitalization segments.
• Assess a variety of factors to identify a stock as "growth" or "value."
• Rebalance their holdings to reflect market changes in a gradual and
orderly fashion.
From Vanguard Website on 5/6/03:
http://flagship.vanguard.com/VGApp/hnw/web/corpcontent/vanguardviews/js
14
p/VanViewsNCArticle.jsp?chunk=/freshness/News_and_Views/ALL_benchch
Key Benchmarks
 Examples of benchmarks:
• Domestic equities:
• Large cap stocks
• Small-cap stocks
• Micro-cap stocks
• International equities:
• Global
S&P 500 (SPX)
Russell 5000 (RTY)
Wilshire Micro-cap
S&P Global 1200, MSCI
World, DJ World
• International
MSCI EAFE (Europe, Australia
and the Far East)
• Emerging Markets S&P/IFCI and MSCI Emerging
15Markets Free
Key Benchmarks (continued)
 Corporate Bonds
• Short-term
DJ Corporate Bond Index
• Intermediate
Lehman Brothers Intermediate
• High Yield
Salomon Smith Barney High Yield
• Mortgage backed Lehman Brothers MBS Index
• Yankee
Merrill Lynch Yankee Index
 Treasury Securities
• Intermediate
Lehman Intermediate Treasury
• Long-term
Lehman Long-term Treasury
 Real Estate
• REIT
Standard & Poors REIT
16
Questions
 Do we understand the uses and types of
Benchmarks to an investor?
17
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 investor’s
specific goals
 What is performance evaluation?
• The process of evaluating a portfolio’s 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
18
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)
19
Portfolio Management
and Evaluation (continued)
 What is passive management?
• The process of buying a diversified portfolio which
represents a broad market index (or benchmark)
without any attempt to outperform the market
 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 can’t beat
them, join them, so they buy low-cost passive
funds which meet their benchmarks consistently
and minimize taxes
20
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
• 2. Superior stock selection
• Picking sectors, industries, or companies within
a specified benchmark which, as a whole,
outperform the return on the specified
benchmark
21
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, and22higher taxes
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, and23high taxes
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
24
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
25
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
26
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
27
Questions
Any questions on the importance of
portfolio management and evaluation?
28
C. 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 portfolios?
• Changes occur due to:
• Changes in asset class performance
• Changes in investor objectives or risk
• Introduction of new capital
• Introduction of new asset classes
29
Portfolio Rebalancing (continued)
 Why is this rebalancing so critical?
• You must balance competing principles of keeping
both transactions costs and tracking error low
 What is tracking error?
• That 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)
Equal-probability-based
Active risk-based
30
Portfolio Rebalancing (continued)
 What is periodic-based rebalancing?
• Specify a time period, i.e. quarterly, 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 costs (but
higher tracking error costs)
 Disadvantages
• Independent of market performance
• Performance will depend on relative timing of large
market moves and rebalancings
31
Portfolio Rebalancing (continued)
 What is percent-range-based rebalancing?
• Rebalance the portfolio every time your actual
holdings are +/-5% (or 10%) from your target ratios.
Rebalance whenever any weight is 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
32
generate most rebalances
Portfolio Rebalancing (continued)
• Are there other methods?
• Equal probability rebalancing
• Allow a “no-trade” region around each assets
allocation target so each asset is equally likely to
trigger rebalancing. Rebalance to target ratios
whenever any asset is outside this region
• Active risk rebalancing
• Allow a “no-trade” region around each asset
based on transactions costs, risk aversion,
correlation, and volatility. Rebalance only when
active risk (defined as the standard deviation of
active return) is above a specified threshold.
When this happens, rebalance only back to target
threshold, not back33to target ratios
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 and
percent-range based is useful
• Remember, the goal is to minimize your
transactions costs, your taxes, and your
tracking error costs
34
Questions
• Any questions on portfolio rebalancing?
35
Application #2
You are 40 years old, married, and have a portfolio with three
asset classes. Last quarter your had the following performance.
The equity benchmark is the S&P 500, bonds the Salomon
Brothers Intermediate, and cash is the Lehman Cash Index.
Benchmark weights are your target asset allocation, and actual
weights are different from your target since you have not
rebalanced lately. You like your current asset class weights.
Asset Class Actual
Return
Actual
Weight
Benchmark
Weight
Benchmark
Return
Equity
2.0% .70
.60
2.5%
Bonds
1.0%
.20
.30
1.2%
Cash
0.5%
.10
.10
0.5%
How did you do for the quarter? What was your over or
underperformance? What was your contribution to security
36
selection and to asset allocation?
D. Understand How to Perform
Portfolio Attribution
 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
37
Security Choice
Currency
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
38
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
39
Application #2 Answer
 If you have this return:
•
•
•
•
•
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. Your 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 your performance. In this case you
underperformed your benchmark by -.26% for the
quarter.
40
Application #2 Answer (continued)
b. Your 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
41
Application #2 Answer (continued)
c. Your 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 asset42
class to the total portfolio
Application #2 Answer (continued)
Overall comments:
Your actively managed portfolio under performed the
benchmarks 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 you did well
overweighting (versus your asset allocation targets) the
asset classes that performed well, you didn’t do as well
picking the assets in those asset classes.
It this performance continued for 24-36 months, I would
consider indexing the stock selection decision, i.e. buy
index funds, and keep doing what your are doing with
the asset class decision. 43
Portfolio Attribution (continued)
 Why is it important to attribute performance to
the portfolio’s 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 don’t perform portfolio
attribution?
• You will not know why you are performing as you
are
• You will not know how
44to improve
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
45
Questions
 Any questions on portfolio attribution?
46
E. Know how to read the WSJ Monthly
Performance Tables
• What is the Wall Street Journal?
• It is one of the major business newspapers in the
United States
• What are the Monthly Performance Tables?
• They list the performance of most of the larger
mutual funds which are listed in the United States
• Why do we need this information?
• It is an easy way to check whether your mutual fund
manager is beating your specified benchmark
• If he is not, you can invest in an index fund with
a higher probability that they will meet the
benchmark
47
WSJ Monthly Tables (continued)
What are the precautions
• The numbers presented are for retirement vehicles
only (i.e. tax-deferred or tax-eliminated retirement
vehicles)
• The numbers do not take into account the impact of
federal, state, or local taxes on your returns
• As such, you need to be careful with these
numbers and taxable accounts
• Remember to look at the after-tax returns before
investing for taxable accounts
48
Reading the Wall Street Journal
Monthly Tables
49
Reading a Chart




NAV = Net Asset Value, the cost per share to buy or sell
Inv Obj = Investment objective or asset class
Total Returns = Return before taxes
Exp Rat = Total Expense ratio 50
Stock and Bond Benchmark Indexes
51
Mutual Fund Yardsticks
52
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 how to perform
attribution analysis?
 E. Do you know how to read the WSJ Monthly
Performance Tables?
53
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