Trading and Rebalancing focuses on how investment decisions are executed in real markets.
While earlier modules focus on strategy and planning, this module deals with:
- implementing portfolio decisions
- managing transaction costs
- maintaining target asset allocation
Effective execution is important because even the best investment strategy can fail if it is not implemented efficiently.
13.1 Transaction Costs
Transaction costs are the costs associated with buying and selling securities.
These costs can significantly impact portfolio returns, especially for active strategies.
Types of Transaction Costs
Explicit Costs
These are direct and visible costs.
Examples include:
- brokerage fees
- commissions
- taxes
Implicit Costs
These are indirect costs that are not always visible.
Examples include:
- bid ask spread
- market impact
- delay costs
Market Impact
Market impact refers to the effect of large trades on asset prices.
Example
A large buy order may push the price upward, increasing the cost of the trade.
Importance of Managing Transaction Costs
Portfolio managers aim to minimize transaction costs to:
- improve net returns
- increase efficiency
- enhance overall performance
13.2 Portfolio Rebalancing
Rebalancing is the process of adjusting a portfolio to maintain its target asset allocation.
Over time, market movements cause portfolio weights to drift away from desired levels.
Why Rebalancing is Needed
- to maintain risk level
- to align with investment strategy
- to prevent overexposure to certain assets
Types of Rebalancing
Calendar Based Rebalancing
Portfolio is rebalanced at fixed intervals such as:
- monthly
- quarterly
- annually
Threshold Based Rebalancing
Portfolio is rebalanced when asset weights deviate beyond a predefined limit.
Example
If equity allocation deviates by more than 5 percent from target.
Combination Approach
Combines both time based and threshold based methods.
Trade Off in Rebalancing
Frequent rebalancing increases transaction costs.
Infrequent rebalancing increases risk.
Portfolio managers must balance these factors.
13.3 Execution Strategies
Execution strategies focus on how trades are carried out in the market.
The goal is to execute trades efficiently while minimizing costs and market impact.
Key Execution Approaches
Aggressive Execution
- execute trades quickly
- reduce risk of price changes
- higher market impact
Passive Execution
- execute trades slowly
- reduce market impact
- risk of adverse price movement
Algorithmic Trading
Algorithmic trading uses automated systems to execute trades based on predefined rules.
Benefits include:
- reduced human error
- efficient trade execution
- ability to handle large volumes
Best Execution
Best execution refers to achieving the most favorable terms for a trade.
Factors considered include:
- price
- speed
- transaction cost
- market conditions
Portfolio managers must ensure that trades are executed in the best interest of clients.
Importance of Trading and Rebalancing in Level 3
This module is important because it helps candidates:
- understand real world implementation of strategies
- manage transaction costs
- maintain portfolio discipline
- execute trades efficiently
In CFA Level 3, questions often require candidates to recommend execution strategies and rebalancing approaches, making this a highly practical and scoring module.