How can a multi-factor risk model be used to rebalance a portfolio?

What will be an ideal response?

Although it is common to illustrate portfolio construction starting with a position of cash and building a portfolio of securities, in practice the more common task is to rebalance an existing portfolio. A multi-factor model along with an optimizer can be used to efficiently rebalance the portfolio. This rebalancing using a multi-factor model involves realigning the portfolio that has drifting away from the characteristics of the benchmark over time. For example, the "drift" may involve a change in the duration of the benchmark requiring a change in the duration of the portfolio or it may entail an upgrade or downgrade of some issues in the portfolio. The rebalancing can also involve tilting the portfolio to reflect a manager's new views. Rebalancing is also required when a portfolio manager receives additional funds from a client or portfolio cash inflows or when a client withdraws funds. More details are given below.

Multi-factor models are statistical models that are used to estimate a security's expected return based on the primary drivers affecting the return on securities. The primary drivers of returns are referred to as risk factors or simply factors. These models are also called multi-factor risk models or just factor models.Multi-factor models provide managers with information about the sources of risk in their portfolio. Hence, they are indispensible tools for constructing portfolios so as to realize the desired exposure to the risk factors where a manager has a view. Moreover, these models can be used to monitor and control the risk exposure of the portfolio, which is achievable through rebalancing.

A multi-factor model may prove helpful to help the rebalancing minimize transaction costs by reducing the need to turnover current holdings unnecessarily. The optimizer is able to evaluate the trade-off of replacing one issue held (i.e., a sale) with another issue (i.e., a purchase). The optimizer can identify a package of transactions (i.e., sells and buys) and identify the reduction (or increase) in risk that would result from the execution of those transactions so that the portfolio manager can assess the risk adjustment benefit relative to the cost of executing the transaction.

Exhibit 25-14 shows the trades that would have been recommended for rebalancing. The total market value of the trades was roughly $13 million. Almost half of the sales from the portfolio were for banks and they were replaced with various Treasury notes, a corporate bond, a sovereign bond, and an agency MBS. Before the manager executes the package of trades proposed in Exhibit 25-14, there must be an evaluation of the change in risk exposure. The new systematic tracking error (TE) after rebalancing was 4.2 basis points (the original was 4.6 basis points), idiosyncratic TE is 7.8 basis points (same as before rebalancing), and total TE is 8.8 basis points (9.0 basis points before rebalancing). The decline in the total TE is before there are more than 50 securities in the portfolio after the rebalancing.