Question

The efficient frontier is composed of the best possible combinations of risk and return for well diversified portfolios. As a result, the investor should always choose the portfolio on the efficient set that maximizes the Sharpe ratio. In a world of positive transaction costs how often should a portfolio manager rebalance their portfolio to make sure it is on the efficient frontier?

Answer 1

An efficient frontier provides the best return possible given a certain level of risk. Stocks are subject to market volatility, and any change in the stock prices will lead to the stock being over-valued or under-valued. Not only at a stock-specific level, but the overall portfolio may also move away from the efficient frontier. This presents the need for rebalancing the portfolio. However, transaction costs are huge. In such a case, a portfolio manager must weight the expected benefit to cost analysis. In this, the manager must access if the expected benefits associated with portfolio rebalancing outweigh the transaction costs that are involved.

Essentially, a portfolio manager must analyze the effect of portfolio rebalancing and consider on what parameters, the portfolio must be rebalanced. He/she must consider the change in the expected value of the portfolio, change in the time horizon associated with rebalancing, change in liquidity requirements, and changes in tax and legal circumstances owing to buying or selling of stocks. Generally, the constant proportion theory says that a portfolio must be rebalanced when asset allocation varies by 10% or more. However, this is not a hard and fast rule. The constant Beta theory believes that if the current beta of the portfolio changes significantly from the target beta, rebalancing must be done to meet the risk-return expectation of the investors. Another method is Indexing theory, which believes that the portfolio must be a rebalanced basis tracking error. This tracking error is the extent to which the portfolio deviates from the index. This index may be based on the efficient frontier. Using these methods, a portfolio manager may rebalance his/her portfolio, thus maximizing the Sharpe's ratio which is the excess portfolio returns over the risk-free rate by the standard deviation (risk) associated with the portfolio. Less frequently, the investor's circumstances may change and he/she may demand a different risk-return profile. This forms another ground for rebalancing.