Dynamic Strategies: Constant Proportion

Posted By: Advisor Analyzer Team

As the old saying goes, there is more than one way to skin a cat. Similarly, there is more than one way to invest and maintain one’s investment portfolio. Anyone involved in the markets know that investment management is not a onetime event, but a dynamic process. An investor may buy and subsequently sell an investment when it does not perform as expected. Some may rebalance to maintain their initial allocation, and others may exercise a buy hold strategy. While it is difficult to determine which is best, we are able to distinguish the pro's and con's of each strategy.

Constant-Proportion Strategy

The constant proportion strategy maintains consistent exposure to equities by a cushion multiple that is predetermined by the investor. The floor level is set by the investor, and is the minimum level acceptable for the portfolio value to fall. The residual value of that floor is invested in conservative non-fluctuating asset (usually treasury bills, money market funds). Under normal market conditions, the portfolio will not fall below this specified floor.

 

Once the floor value has been established, the investor selects a multiplier. The initial investment allocation to equities equals the multiplier times the “cushion”. The cushion value here is the difference between the value of the assets to be invested and the value of the floor. Allocation to Equities = Multiplier X (Asset Value - Floor Value) As equity values rise the investor purchases more of the security, increasing the equity allocation. Conversely, when equity values fall, the constant-proportion strategy requires the investor to sell his position. When following this strategy using the above provided formula, the equity allocation stays at a constant multiple of the cushion (assets-floor).

Payoffs:

Payoffs: The constant-proportion strategy provides good downside protection and potentially unlimited upside participation.

Performs Best/Worst When:

The strategy performs best in up markets. The strategy does well in advancing markets because the investor increases the equity exposure as prices rise. However, the strategy performs poorly in a sideways moving (oscillating) market, and does worst when there are sharp market reversals. With a sharp reversal, the investor has increased the equity position and a greater portion of funds experience a price decline.

Ideal Investor for Strategy:

The strategy is best suited for investors with zero risk tolerance below the stated floor but increasing risk tolerance as equity values move further away from the floor. Similar to the constant mix strategy, the constant proportion strategy requires a predetermined rule for rebalancing.

Cost of Implementing Strategy:

Transaction costs are incurred when rebalancing. It is usually the case that transaction costs are avoided until a portion of the portfolio value has changed by a percentage specified by the client. Taxes can be a material consideration as well for investors practicing this strategy in taxable accounts.

Conclusion

There are many more portfolio strategies available to investors, but the Buy Hold, Constant Mix, Constant Proportion strategies are most often used by financial professionals today. Investors that properly utilize the correct strategy for a given market environment can claim superior portfolio performance over their investing peers who practice a wrong strategy. However, no single strategy can claim absolute superiority to another at all times, since each strategy has its unique merits and shortcomings in skinning the financial cat.