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Balancing rebalancing

Is rebalancing good for investors? In rebalancing, investors adjust exposure to assets regularly back to target asset allocation. Many investment experts say it is a good practice.

Let’s first see what the numbers tell us. The January edition of our Monthly Insights publication reported our analysis on portfolio rebalancing, using FTSE All Shares (UK stocks) and FTSE All Gilts (UK bonds) index data over the last 10 years. We tried different rebalancing frequencies on different portfolios with different stock/bond target allocation. For simplicity we ignored trading costs, which could reduce portfolio returns.

The first table shows the portfolio value at the end of 2021 (each portfolio starts with a value of 100 at the end of 2011). Rebalancing improves the total return over 10 years, though only marginally. This is partly due to UK gilts falling over the last 18 months or so (the rebalancing keeps buying a falling asset).

But that is only part of the story. We also looked at the resulting portfolio volatility after rebalancing, and calculated the risk adjusted return (annual return divided by volatility) for all the portfolios, with and without rebalancing. See the table below.

Notice how rebalancing improves the overall risk adjusted return of many of the portfolios. So even though the improvement in long term returns looks marginal and can be offset by trading costs, the reduction in portfolio volatility should not be ignored. Overall, we would expect rebalancing a portfolio to generate higher long-term risk-adjusted returns, an argument that David Stevenson highlighted in his recent article in Citywire (where he also quoted our analysis).

When we rebalance by adjusting down (up) the asset exposure against the target allocation by selling (buying) the assets, we automatically “sell high, buy low”. That works based on an important assumption: financial assets tend to mean revert to their fair values. Based on the famous quote from the father of value investing, Benjamin Graham, such mean reversion occurs as financial markets move from a short-term voting machine (voting for a company’s popularity) to a weighing machine that looks for long term value in the assets.

If markets can sometimes favour popular, trendy companies, some assets may continue to be overvalued (or undervalued) for quite a while. We have seen that with US growth stocks, especially in technology companies over the last five years or so. Regular rebalancing may create short term pain and underperformance for investors.

Why is volatility reduced?

One possible explanation is that if the value of an asset keeps going up, there will be more uncomfortable players in the market who are worried about its valuation. This nervousness can translate into higher volatility. Because of this increased volatility, reducing exposure to such assets through rebalancing will reduce overall volatility of the portfolio. Therefore, rebalancing for long-term investors still make sense.

Two other questions follow. First, how frequently should one rebalance? Secondly, how about rebalancing due to changes in the benchmark index compositions?

How often to rebalance?

We looked at the first question briefly in our Monthly Insights. Sadly, there is no simple answer. We know that economically one should not (and cannot) rebalance too frequently, as the trading costs involved are prohibitive. Most investors rebalance at the end of a quarter, every six months or every year. As a result, some short-term traders, especially those using algorithmic trading, will use these calendar rebalancing dates to trade. If stock A has gone up (down) a lot and it is coming to the end of a quarter, some traders will expect many investment managers to sell (buy) the stock when they rebalance. They will act early and short sell (or buy) the stock to push down (bid up) the price shortly before rebalancing. Many investment managers rebalance at market close, which gives additional advantage for these traders on less liquid assets like small cap stocks.

The above issue also affects the situation raised in the second question, especially for index tracking funds and exchange traded funds. A recent article in Investment Week reported the “cost” due to poor execution of rebalancing in US ETFs. One may disagree with the amount found in the research, but it highlights why sticking to fixed, known dates in rebalancing may not be ideal. To address this issue, some institutional investors rebalance whenever the difference of the current exposure of an asset varies too much with the target allocation. That difference can be an absolute percentage or be determined based on historical volatility of the asset. But these advanced solutions are more complicated to implement, especially for individual investors and their advisers.

Overall, one needs to blend science and art in a balanced manner in rebalancing. But that should not prevent us from rebalancing. So, have you rebalanced your portfolios or your clients’ portfolios yet?

James Chu CFA

Head of Investment Solutions


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