Buy and hold or active trading: These are the opposite ends of the portfolio-rebalancing spectrum. On one end, “buy and hold” implies never selling a stock once it has been purchased. On the other, “active trading” can imply anything from regular rebalancing to whimsical day-trading – but most real-life investors fall somewhere in between these two extremes. Indeed, even the strictest of buy and hold advocates generally understand that portfolio holdings need to be rebalanced now and then – but why, when, and how often? This is the subject of AQR’s December 2015 white paper: Portfolio Rebalancing Part 1 of 2: Strategic Asset Allocation.
Allocating by Capital or Risk?
Most investors’ strategic portfolio considerations are based on target capital (or dollar) allocations – similar to market cap-weighted indices. The alternative, risk parity – wherein allocations are made to target risk across asset classes – will be dealt with in Part 2 of AQR’s Portfolio Rebalancing articles.
In Part 1, authors Antti Ilmanen and Thomas Maloney, both from AQR’s Portfolio Solutions Group, point out that capital-based rebalancing tends to work against investors in trending markets. That’s because rebalancing has the effect of selling winners to buy losers, and if those winners keep on winning while the losers keep on losing, this hurts portfolio performance.
The idea of rebalancing to maintain capital allocations is based on the idea that investments will mean revert — but if markets are trending strongly, this mean reversion doesn’t take place. However, from a risk perspective, frequent rebalancing tends to maintain consistent levels across investments better than buy and hold, where the risk posed by winners becomes greater as their allocation sizes grow.
How to Rebalance
AQR’s Ilmanen and Maloney say there are two main decisions to be made when deciding how to rebalance:
- When? (How often? On a fixed schedule or by a trigger-based system?)
- How much? (Fully rebalance back to the benchmark, or only partially?)
Before making these decisions, investors should consider the following determinants:
- Their tolerance of short-term variations in portfolio risk characteristics;
- Expected costs, which may include transaction costs, operational costs, and tax implications; and
- Expectations of trending or mean-reverting investment performance going forward.
Ilmanen and Maloney warn of the “pitfalls of discretionary rebalancing,” suggesting investors should implement systems to avoid emotional decision-making. Investors may prefer using discretion to reflect tactical market views, but the authors believe doing this successfully is “more difficult than hind-sighted narratives” suggest. Any tactical views should be applied with “humility and caution,” say the authors, and in combination with a predefined, rules-based rebalancing system.
In support of the authors’ claims, AQR’s paper includes a “simple empirical analysis” examining several rebalancing approaches and 43 years of monthly return data dating back to 1972. The base strategic portfolio allocations for the analysis are listed below:
- 30% U.S. equities (MSCI US Index)
- 20% Non-U.S. equities (MSCI World ex US Index)
- 20% U.S. government bonds (Barclays US Treasury Intermediate Index)
- 20% Non-U.S. government bonds (Barclays Global ex US Treasury Hedged Index)
- 10% Commodities (GSCI Index)
The white paper then analyzes the return and risk characteristics portfolios with different rebalancing schemes would have produced:
- Buy and hold
- Biennial rebalancing
- Annual rebalancing
- Monthly rebalancing
- +/- 30% trigger rebalancing
- +/- 20% trigger rebalancing
- +/- 10% trigger rebalancing
Data for net total return, volatility, net Sharpe ratio, max drawdown, annual turnover, average number of rebalances per year, average trade size, annual trade costs, and more are broken out to show each rebalancing scheme’s impact of schedule and impact of degree. The image below depicts the hypothetical Sharpe ratios for several rebalancing methods across three time spans: 1972-2014, 1972-1993, and 1993-1994:
To Rebalance or Not
Rebalancing is not a surefire winner. The impact of rebalancing on returns always depends on investment outcomes — if investments are trending, rebalancing will have a negative impact. If they are mean-reverting, then it should have a positive impact. The impact on risk, in contrast to returns, is more predictable.
For more information, download a pdf copy of the white paper.
Past performance does not necessarily predict future results.
Jason Seagraves contributed to this article.