Tolerance Bands for an Asset Allocation
An investment committee is reviewing the following strategic asset allocation:
Domestic equities 50% ± 5% (i.e., 45% to 55% of portfolio value)
International equities 15% ± 1.5%
Domestic bonds 35% ± 3.5%
The market for the domestic bonds is relatively illiquid. The committee views the above corridors as appropriate if each asset class’s risk and transaction cost characteristics remain unchanged. The committee now wants to account for differences among the asset classes in setting the corridors.
Evaluate the implications of the following sets of facts for the stated tolerance bands, given an all-else-equal assumption in each case:
1 Tax rates for international equities increase by 10 percentage points.
2 Transaction costs in international equities increase by 20% relative to domestic equities, but the correlation of international equities with domestic equities and bonds declines. What is the expected effect on the tolerance band for international equities?
3 The volatility of domestic bonds increases. What is the expected effect on their tolerance band? Assume that domestic bonds are relatively illiquid.
Solution to 1:
The tolerance band for international equities should increase if the entity is a taxable investor.
Solution to 2:
Increased transaction costs point to widening the tolerance band for international equities, but declining correlations point to narrowing it. The overall effect is indeterminate.
Solution to 3: Given that the market for domestic bonds is relatively illiquid, the increase in volatility suggests widening the rebalancing band. Containing transaction costs is more important than the expected utility losses from allowing a larger divergence from the strategic asset allocation.
Could someone please explain why? Illiquid calls for wider corridors, alright, but there is higher volatility, so you go for narrower. I would say the effect is indeterminate? (Just like under the second question).
Thank you!