Rebalancing to the Strategic Asset Allocation

by Adam Gitsham, CFA
adam.t.gitsham@jpmorgan.com

A disciplined investment strategy requires regular monitoring of the portfolio to ensure that it remains aligned with the investor’s risk and return objectives. Along with reviewing investment performance, it is important to monitor the portfolio’s current asset allocation against the strategic, or target, asset allocation. Drift in asset class weights occurs due to price changes in the portfolio’s holdings and, if left unchecked, can result in the portfolio acquiring a different set of risk and return characteristics than desired. Rebalancing the portfolio involves selling over-weight asset classes and buying under-weight asset classes in order to return the portfolio to the target allocation. This article addresses the key considerations in setting a rebalancing policy.

Benefits of Rebalancing

The strategic asset allocation is developed after careful analysis of the investor’s risk and return objectives and takes into consideration the investor’s time horizon, liquidity requirements, unique factors and capital market expectations. If we assume that the resulting strategic asset allocation is optimal or close to optimal for the investor, any deviation from that asset allocation is considered to be sub-optimal. Rebalancing the portfolio may therefore represent a return to the optimal asset allocation for the investor.¹

Rebalancing is an important tool for controlling risk in the portfolio. If the portfolio is not periodically rebalanced, in the long run the allocation will drift towards higher-return, higher-risk assets. The absolute risk of the portfolio will tend to increase over time, exposing the investor to undesired downside risk. Rebalancing is also important for controlling relative risk. The greater the drift from the target allocation, the greater the potential for relative performance differences and tracking error. As investors generally seek to limit tracking error, periodic rebalancing is an effective tool for controlling this risk.

Rebalancing may also be beneficial as a contrarian investment strategy. That is, rebalancing involves selling appreciated assets and buying depreciated assets. Accordingly, rebalancing should lock in returns over time.

To illustrate the effects of not rebalancing, we simulate a portfolio with a target mix of 60% equity and 40% bonds as of December 31, 2000 and allow these weights to drift over the 10 year period to December 31, 2010. The equity component is invested in the MSCI World Gross Index and the bond component is invested in Barclays Capital Global Aggregate. The benchmark portfolio is rebalanced monthly to maintain the target mix.

Exhibit 1 follows the portfolio’s allocations to equity and fixed income over the time period from the initial 60/40 mix. The equity allocation fell to 44% by March 2003 due to the decline in equity markets before gradually increasing back up to 60% by May 2007. Equity allocation fell sharply again during the financial crisis to 41% in February 2009. By the end of the 10 year period equity allocation is at 51%. The allocation to bonds is the converse of the equity allocation, reaching 59% of the portfolio in February 2009.

Exhibit 1

Source: MSCI and Barclays Capital

Exhibits 2 and 3 reflect the monthly excess return and tracking error of the portfolio respectively. As expected, excess return and volatility of excess return (tracking error) are determined by the magnitudes of both the deviation in asset class weights from target and the asset class returns themselves. The largest excess returns and tracking error occur in the periods when the portfolio’s asset allocation has drifted furthest from the target.

Exhibit 2

Source: MSCI and Barclays Capital

Exhibit 3

Source: MSCI and Barclays Capital

Costs of Rebalancing

Rebalancing the portfolio involves buying and selling assets, which incurs transaction costs. Transaction costs consist of both direct costs, such as trading commissions, as well as indirect costs such as the price impact of trades and the bid-offer spread. In addition, taxable investors face the prospect of additional costs through incurring tax liabilities on realized gains. Rebalancing also incurs additional time and labour costs due to the increased effort and cost of more closely monitoring the portfolio. Rebalancing too frequently can result in excessive costs to the portfolio, offsetting the benefits of rebalancing.

Asset Class Characteristics

When devising a rebalancing strategy, it is important to take into consideration the characteristics of the asset classes that comprise the strategic asset allocation. High correlation of returns between asset classes reduces the need for more frequent rebalancing. When asset class returns are generally moving together, there is less risk of the actual allocation significantly deviating from the target. Asset class volatility, differences in expected returns, and length of time horizon all suggest a more frequent rebalancing policy is required. These characteristics imply a greater risk of deviation from the target allocation.²

Another important asset class characteristic is liquidity. Alternative asset classes such as private equity, hedge funds and real estate are less liquid than traditional asset classes. This may present challenges to rebalancing due to higher transaction costs.

Rebalancing Strategies

A ‘No Rebalancing’ strategy involves a buy-and-hold approach in which, once implemented, the asset allocation is allowed to drift and is never rebalanced. This strategy is not appropriate for an investor who desires to actively control the risk of the portfolio. A ‘Continuous Rebalancing’ strategy involves constantly buying and selling securities to rebalance the portfolio in an effort to eliminate tracking error. The cumulative impact of transaction costs in this approach would be detrimental to the portfolio’s performance. Between these two ends of the rebalancing spectrum, investors generally choose between calendar rebalancing, percentage of portfolio rebalancing or a combination of these two approaches.

Calendar rebalancing entails rebalancing the portfolio to the strategic allocation at set periodic intervals, such as monthly, quarterly or annually. The choice of rebalancing interval is primarily dependent on the investor’s tolerance for tracking error, but should also take into consideration asset class characteristics and market volatility. The argument against this approach is that the rebalancing interval is set arbitrarily and may not be related to current market conditions. The portfolio could drift significantly from the target allocation before it is rebalanced, resulting in increased tracking error. Alternatively, the portfolio may be rebalanced unnecessarily if the asset class weights have drifted only slightly away from target by the rebalancing date.

Percentage of portfolio rebalancing involves defining tolerance corridors around the target allocations for each asset class. The portfolio is only rebalanced when a tolerance corridor is breached. For example, if the strategic asset allocation for equity is 60%, a tolerance range of 5% on either side may be set such that the portfolio will be rebalanced if the equity allocation falls below 55% or exceeds 65%. The advantage of this strategy over calendar rebalancing is that it is more closely related to market conditions and can form a more effective control on risk, particularly when markets are volatile.

In order to implement percentage of portfolio rebalancing, appropriate corridors for each asset class in the allocation need to be specified. Five factors are important when assigning corridors to asset classes.³ Tolerance for risk, transaction costs, and the correlation of the asset class with the rest of the portfolio are positively related to corridor width. Volatility of the asset class and volatility of the rest of the portfolio are negatively related to corridor width.

Percentage of portfolio and calendar rebalancing can be combined to produce a hybrid strategy in which the portfolio’s asset allocation is rebalanced at periodic intervals and only if the asset class corridors have been breached. Alternatively the portfolio may be rebalanced at any time if a corridor is breached as well as at set periodic intervals.

Another adaptation of the percentage of portfolio approach is to rebalance the portfolio to within the specified corridors, but not necessarily all the way to the target allocation. This approach has the benefit of reducing transaction costs, and may allow a degree of tactical asset allocation within the rebalancing strategy.

Investors also use strategies aimed at minimizing rebalancing costs, such as directing income and net cash contributions towards the purchase of under-weight asset classes rather than having to sell over-weight asset classes.

Rebalancing and the Market Environment

Research has shown that the effect of rebalancing on the portfolio’s level of return and absolute risk is dependent on the market environment but effective at controlling tracking error irrespective of the market environment.⁴

In a trending market, where a stronger performing asset class in one period continues to outperform in the next period, rebalancing lowers the rate of return of the portfolio compared to a no rebalancing strategy. The investor continuously sells the stronger performing asset class and buys the weaker performing asset class. Rebalancing may also increase the level of absolute risk of the portfolio at the same time as reducing tracking error. In a downward trending market, rebalancing involves selling bonds and purchasing equities, resulting in an increase in the absolute risk of the portfolio.

In a mean-reverting market, where a stronger performing asset class in one period becomes a weaker performing asset class in the next period, rebalancing may enhance the return of the portfolio due to the contrarian nature of the strategy. Asset classes that have appreciated in value are sold and those that have depreciated in value are purchased. Clearly the timing of rebalancing is an important factor in determining any return enhancement.

In the long run, it has been shown that rebalancing tends to increase portfolio return, while reducing both absolute risk and tracking error.⁵

Conclusion

To ensure the portfolio remains aligned with the risk and return objectives of the investor, the portfolio must be periodically rebalanced to the strategic asset allocation. A trade off exists between the benefits of rebalancing, primarily the control of tracking error in the portfolio, and the costs associated with rebalancing. Investors should implement a rebalancing strategy that both takes into consideration the characteristics of the asset classes included in the strategic asset allocation and employs strategies that minimize the costs of rebalancing.

To view the next article, Multiple Asset Class Return Comparison, click here.