Why less correlated assets and believe momentum will lead to wider optimal corridor for rebalancing but not narrow?
When asset A is positively correlated to asset B, a drop of price of asset A will imply a drop of asset B and thus no balancing is needed in order to maintain the strategic asset allocation? for momentum that one…anyone can give me some insight?
Actually, the more correlated the asset is to the rest of the portfolio, the wider the optimal corridor.
Part 1: Correlation between the asset and the rest of the portfolio
The higher the correlation between the assets, then that means the weight/mix of the portfolio should be relatively stable and not deviate too far from the SAA (you can think of this as auto-rebalancing feature where you do not have to incur additional transaction cost). So, no MANUAL rebalancing is needed by the portfolio manager. In this case, we can afford to set the optimal corrider wider. You may ask why not make it narrower? If you do make it narrower, you may accidentally trigger a MANUAL rebalancing when there is a small deviation from the SAA, even though we do not expect the deviation to become larger. (thus increasing the cost of rebalancing).
Note: My usage of the term MANUAL rebalancing is simply to mean that the portfolio manager will have to instruct the dealer to buy/sell the asset classes to restore the SAA and thus incur transaction cost.
Part 2: Momentum
If you believe that the asset is in a positive momentum, then you do not want to rebalance so often. Let’s take an equity as an example
If the equity price is rising (positive momentum), you will want to hold or buy more equity to gain further. To allow it to rise further, you must set the corrider wider. If you set a tight corridor, the portfolio will be rebalanced (i.e. the equity will be sold to be restored to SAA) before you could gain fully from the equity exposure (i.e. selling when market is rising)
If the equity price is declining and you think it will continue to slide lower (negative momentum), you will want to reduce your exposure to equity. So, you will want to set the corridor wider. If you set a narrow corridor, you will easily trigger the rebalancing, and you will be buying more equity when the equity market is still declining.
Keep in mind the objective of rebalancing is to balance out the benefit of rebalancing vs the cost of rebalancing.
Benefit of rebalancing - keep the portfolio close to the SAA so the chances of meeting client’s return and risk objectives is higher.
Cost of rebalancing - transaction cost, taxes, etc…
Wat abt when its mean-Reverting .?? didnt got y to keep corridor narrow…
and for volatility to keep in narrow is coz to control risk ryt,.?
If you think the asset return is mean reverting, then set tighter corridors so you can sell before the price declines and buy before the price rises.
Yes, the higher the asset volatility, the narrower the corridor to keep the allocation from deviating too far away from SAA.