- Change over to bonds or to money market instruments can change the
duration of the portfolio and change our exposure to interest rate risk. - Short selling may be prohibited for some investors (e.g. mutual funds).
Even otherwise, it is subject to other risks (backwardation charges). - Rebalancing the portfolio to reduce its beta must be done with some care;
if the portfolio becomes concentrated in a few low beta stocks it becomes
less diversified. This means that rebalancing will have to be done by
selling a broad range of high beta stocks and buying a broad range of low
beta stocks involving higher transaction costs.
For these reasons, the switch to a defensive portfolio would typically involve
simultaneous recourse to several, may be all, the above techniques of beta reduction.
Similarly, a switch to a high beta portfolio may require simultaneous recourse to several
options: switch away from bonds and money market instruments to stocks, borrow and
invest in stocks, rebalance the portfolio in favor of high beta stocks, maintain an
overbought position in the forward market.
This analysis places the money market asset class also in a new light. Since it has very
low beta and duration, this asset class can be used very effectively as an instrument for
changing the duration and beta of the total portfolio in response to changing needs. The
money market portfolio is one of the instruments for shifting temporarily to a defensive
portfolio. It can also play an important role in rebalancing the beta and duration of the
portfolio quickly in response to the change in market values discussed earlier in this
section. Here too the money market portfolio is used temporarily in a balancing role
while a more permanent rebalancing is worked out. The important point, however, is that
the money market portfolios is not seen as just as a repository of idle cash; it is market
portfolio is not seen as just as a repository of idle cash; it is an active element in the
management of the risk of the total portfolio.
Formula Plans
The management of the temporary changes in portfolio beta and duration by adjusting its
composition is known as tactical asset allocation. A number of mechanical rules have
been evolved to simplify this process. These rules seek to replace the subjective
judgment of the investor by ‘formulas’. Their principal advantage is that they are
completely unemotional; they prevent the investor from being swayed by sentiment and
thereby getting into a very risky position.
The two most popular ‘formula plans’ are the Constant Ratio Plan and the Constant
Value Plan. As the name suggests, the constant ratio plan tries to keep a certain constant
percentage of the portfolio in equities. For example, the plan may specify that 60% must
be in equities and allow a 5% band for fluctuations. This means that if equity prices rise
and the equity portfolio rises to 65% of the total, then we must sell equities to bring the
ratio down to 60%. Similarly, if equity prices fall and the ratio drops to 55%, then we