Some OK me should please explain the meaning of 10% tolerance band for a portfolio with 50% allocation to foxed income.
It means the portfolio can go up to 60% in allocation or down to 40% in allocation before it would be required to rebalance the portfolio in line with the SAA.
Hope this helps.
The question shoulld state whether those bands are absolute in value or percentage of portoflio
Percentage of Portfolio rebalancing. Your bands are +/- %10 of 50%. 45% and 55% are the lower and upper tolerance bands. If the fixed income allocation breeches one of those thresholds then the portfolio needs rebalancing. Keep in mind that whenever you are rebalancing a portfolio you are doing more than one action. If an allocation has fallen in value that means another allocation has risen in value. In order to rebalance the portfolio you need to look at the entire portfolio and not just the allocation that needs rebalancing.
Normal Situation - If the fixed income allocation falls to 40% of the total portfolio, the portfolio would be rebalanced back to the neutral weights, 50% for fixed income. If fixed income is only 40% that means something else in the portfolio appreciated or fixed income fell in value. In order to increase the fixed income allocation back to the neutral weight I need to sell something else that is above its neutral weight.
Tax Sensitive - The above situation is what you will see 9/10 times, but I ran into a CFAI EOC question where the investor was very sensitive to any tax exposure generated from a rebalance. In this case it is ok to only rebalance the portfolio to the tolerance band and not the neutral weight.
Be careful here… it likely means that the tolerance band will be 45% - 55%. If the target allocation is 50% +/- 10%…
it would be 10% of 50%, so +/- 5%.
edit: double post
would you look – you need to read the question
question could be stated as 50% +/- 10% of target allocation -> then it is 45-55%
or it could be 50% +/- 10% absolute -> when 40% - 60% is the band.
so watch out…
it is not as straight as it seems.
touché - i just recall getting burned by this on a mock or a prior AM exam… not sure which one.
Usually it’s a dead giveaway to use percentage of portfolio if you see something like this:
Tolerance band is 10%
50% - Absolute (40% - 60%)
40% - Absolute (30% - 50%)
10% - Absolute (0% - 20%)
If you use absolute bands on the 10% allocation the range of acceptable variance is -100% - 100% of the neutral position allocation. That’s not a good strategy…
Why do you rebalance when the portfolio is at 55%. Is it not still within the tolerance band?
Good point guys. i stand corrected. Could be relative as well !
@Chuckrox8 - rightly pointed out.