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Portfolio Revision Meaning
Portfolio revision is one of the pillars of the overall process of portfolio management. It entails assessing the change in portfolio composition over a period of time and taking steps, if required, to get it back in line with the investment objective and risk tolerance framework with which the portfolio was initially constructed. Portfolio revision also helps investors in keeping their investments relevant to changing times and trends. The primary intention behind portfolio revision is to achieve an optimal amount of returns for a given level of risk.
Importance of Portfolio Revision
Portfolio revision is important in order to keep up with changes in the business and economic cycle as well as market movement. Some other factors also enhance its importance:
- Changing the amount invested due to a pressing need for withdrawal or increased investable income.
- Change in risk-tolerance due to change in investment objectives or life-cycle.
In order to ensure that even after having to take actions based on the two points above an investor continues to get rewarded for his investments, portfolio revision becomes an essential activity under the overall umbrella of portfolio management.
Portfolio Revision strategies
Alike portfolio construction, portfolio revision techniques can be one of the following two:
Active Portfolio Revision
As the name of the strategy suggests, an investor or professional portfolio manager is quite hands on with making changes to the portfolio. The underlying philosophy behind active portfolio revision is that in-depth securities research and analysis can reveal investments which can beat market returns as markets are inefficient. Subscribers of this strategy don’t find the idea of market returns appealing and react to changes in market situations in order to gain an advantage over others.
However, in order to try to generate greater than market returns and the relatively frequent churning of portfolios, this strategy is costly due to the cost associated with research as well as higher trading costs that a passive strategy.
Passive Portfolio Revision
In passive portfolio revision, the primary aim is to keep earning market returns by executing a buy-and-hold strategy for the most part. This is not to say that changes are not made to the portfolio at all throughout the investment horizon, just the portfolio changes are less in number compared to the active strategy and portfolio managers do not react to every change in the direction of markets.
The believers in passive portfolio revision subscribe to Efficient Market Hypothesis which holds that financial markets are efficient as all available information about a security is available throughout the market and is priced into the security. Due to this belief, this technique finds it futile to try to beat market returns, and thus, tries to equal them.
Portfolio changes in this strategy usually take place at a pre-determined duration and due to a little requirement of research and a smaller number of changes, the costs associated with this strategy are low.
There are rules associated with the portfolio revision strategy, specifically that which is passive in approach, which decides the changes that will need to be made to a portfolio. These rules are known as formula plans.
For the purpose of understanding Formula Plans, let’s assume that there are two broad divisions of a portfolio – aggressive, which is equity-oriented, and conservative or defensive, which includes government and high-grade corporate bonds.
Formula Plans, which are a set of rules determining changes to a portfolio, can be of three types:
Constant Dollar Value Plan
The constant dollar value plan works with the aim of keeping the dollar-denominated equities portion of the portfolio constant. This implies that if the value of the equities portion rises beyond the set dollar value due to favorable market movement, some stocks from that aggressive segment of the portfolio will be sold in order to maintain the constant dollar value pre-determined for it.
This also works the other way around in that if the value of the aggressive segment decline because stock prices have fallen, more stocks need to be purchased in order to maintain the constant dollar value.
In order to execute this plan, what needs to be decided is the frequency of this change because that will determine the costs associated with this strategy. Investors need to allow some leeway to the constant dollar value plan in order to ensure that their transaction costs do not east into their profits, especially in a volatile market where the constant dollar value can be breached frequently.
The most prominent aspect of this plan is the ease of execution. Taking into consideration the pre-determined action points and periods, an investor is always certain about his fixed exposure to equities, thus alleviating the worry of exposing himself to increased risk.
Constant Ratio Plan
The constant ratio plan is based on the idea that the aggressive and conservative portions of the portfolio are set according to a ratio. For instance, a ratio of 1:1 between the two segments means that half of the portfolio will be invested in stocks while the other half would be invested in defensive securities like bonds. On the other hand, a ratio of 1.5:1 between aggressive and defensive segments respectively means that 60% of the portfolio will comprise of stocks while 40% will be invested in bonds.
While in both the Constant Dollar Value Plan and the Constant Ratio Plan, the equities portion is rebalanced at pre-determined periods based on whether stocks have risen or fallen, in the sense of pre-determined ratios, the Constant Ratio Plan goes beyond the Constant Dollar Value Plan by fixing a relationship between the two portions.
Variable Ratio Plan
The variable ratio plan builds on where the constant ratio plans stop by providing higher flexibility than the latter does. The plan allows the ratio between the aggressive and defensive portions of a portfolio to change either based on market movement or on some pre-set factors.
For instance, a variable ratio plan can allow for a higher ratio of the aggressive portion vis-à-vis the conservative portion when equities are doing well in order to benefit from the bull-run. The plan can also allow for a higher ratio in favor of the defensive portion as an investor grows old and his life cycle demands a more conservative approach to investments.
It is important for investors to note that these techniques provide a broad framework for portfolio revision or rebalancing and cannot determine the success of a strategy on their own. That involves securities selection in light of investment objective, horizon, and risk profile of the investor.1,2