Asset Allocation: Rebalancing

Rebalancing an investment portfolio to one's target policy allocation is, as asset class returns vary, often necessary to maintain a portfolio's risk characteristics. The following papers examine the intricacies of rebalancing a portfolio. (For individual investors, annual rebalancing within 5% variance bands should provide sufficient risk control, and under certain investment environments a "rebalancing bonus" in absolute return.)

The first paper, from Vanguard Institutional Investors, is geared towards the institutional investor, albeit the insights are applicable to individual investors. The conclusion is especially relevent for taxable accounts.

We include a number of papers examining the rebalancing issue from William Bernstein's Efficient Frontier. One may also find the following study in the FPA Journal to be of interest:

Rebalancing for Tax-Deferred Accounts: Just Do It—Don't Worry How" by Mark W. Riepe, CFA, and Bill Swerbenski, CFA

Portfolio Rebalancing in Theory and Practice

Executive summary

A portfolio’s asset allocation determines the portfolio’s risk and return characteristics. Over time, as different asset classes produce different returns, the portfolio’s asset allocation changes. To recapture the portfolio’s original risk and return characteristics, the portfolio must be rebalanced to its original asset allocation. This paper identifies the factors that influence a rebalancing strategy. We present a conceptual framework for developing rebalancing strategies that can accommodate changes in the financial market environment and in asset class characteristics, as well as account for an institution’s unique risk tolerance and time horizon. Our findings indicate that:

• Determining an effective rebalancing strategy is a function of the portfolio’s assets: their expected returns, their volatility, and the correlation of their returns. For example, a high correlation among the returns of a portfolio’s assets means that they tend to move together, which will tend to reduce the need for rebalancing. In addition, the investment time horizon affects the rebalancing strategy. A portfolio with a short time horizon is less likely to need rebalancing because there is less time for the portfolio to drift from the target asset allocation. In addition, such a portfolio is less likely to recover the trading costs of rebalancing. The effect of a rebalancing strategy on a portfolio depends on return patterns over time. If security prices approximately follow a random-walk pattern, then rebalancing more frequently or within tighter bands reduces a portfolio’s downside risk (absolute as well as relative to the target asset allocation). In a trending or mean-reverting market, the impact of rebalancing may be somewhat different when viewed on an absolute or relative-to-target basis.

• Additional factors to consider when implementing a rebalancing strategy include preference and costs, such as time spent, redemption fees, or trading costs. Each cost incurred will reduce the return of the portfolio. The nature and magnitude of trading costs affect the choice of rebalancing strategies.

• Due to differing risk tolerances, two institutions with identical asset allocations may prefer different rebalancing strategies.

Conclusion

To ensure that a portfolio’s risk and return characteristics remain consistent over time, a portfolio must be rebalanced. The appropriate rebalancing strategy depends on a number of factors such as the market environment and asset-class characteristics. Rebalancing achieves the goal of risk control relative to the target asset allocation in all market environments. Although market return patterns may create opportunities for tactical rebalancing, this active strategy is challenging. Based on reasonable expectations about return patterns, average returns, risk, and correlations, we conclude that for most broadly diversified stock and bond fund portfolios, annual or semiannual monitoring, with rebalancing at 5% thresholds, produces an acceptable balance between risk control and cost minimization. To the extent possible, this rebalancing strategy should be carried out by appropriately redirecting interest income, dividends, new contributions, and withdrawals.

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Efficient Frontier Articles

The Rebalancing Bonus: Theory and Practice September, 1996

When Doesn’t It Pay to Rebalance? January, 1997

Rebalancing: Practical Issues July, 1997

Case Studies in Rebalancing Winter, 2000

Rebalancing Individual National Markets Spring 2000