There are quite a few theories addressing rebalancing. Some suggest monthly, quarterly or annual rebalancing. Others suggest rebalancing based on how far off the asset class has drifted from the target. In the later, rebalancing can be triggered by setting up a rule to rebalance when the positions weight drifts by more than a tolerance value, which can be 10%, 20%, 25%, 50%, etc.
On a journey to determine which rebalancing option is better, we constructed a sample moderate portfolio and tested different options over the most recent 20-year period. This allowed us to review the portfolio during the bull markets as well as the bear markets in 2000-2002 and 2007-2008 periods.
In short, our conclusion is in line with what many research papers have concluded. There is no evidence that frequent rebalancing, including even annual rebalancing, adds value to the portfolio performance.
After testing quarterly, annually, and with target weight rules, we found that rebalancing proves the most effective when one or more of the positions weights drift by more than 50% of the tolerance value, providing an increased annualized rate of return by 0.30% over a 20-year period and 0.46% over a 10-year period*. In other words, in the last 20 years, a hypothetical investment of $100,000 grew to $402,153 in the portfolio that was rebalanced annually, versus $426,950 in the portfolio that was rebalanced when one of more positions drifted by more than 50% from the target allocation. We’ll call that the “Trigger Rebalanced Portfolio”.
The Trigger Rebalanced Portfolio has been rebalanced only 6 times in the last 20 years, saving a good amount in transaction costs compared to the annually rebalanced portfolio, which has been rebalanced 20 times.
It is important to note that the target allocation in the sample moderate portfolio has been set to include 70% equities and 30% bonds.
In our test, the Trigger Rebalanced Portfolio with the trigger set for 50%, drifted to an allocation as high as 81% in equities and 19% in bonds and as low as 62.53% in equities and 37.47% in bonds. To implement this strategy, the investor must be comfortable with the dynamically changing allocation and therefore a risk level in the portfolio.
For example, from Jan 1, 2008 to Dec 31, 2008, the Trigger Rebalanced Portfolio declined 23.5%, and the annually rebalanced portfolio 25.04%. If the allocation were to drift to 80% in equities at “the wrong time”, the portfolio could have declined 29.25%. This is absolutely not an attempt to predict the future, rather just a reminder that allowing the portfolio to drift may increase risk.
From the longer-term perspective, over the 20-year period, risk as measured by standard deviation was almost the same.
The Trigger Rebalanced Portfolio had a standard deviation of 11.0%, only .1% higher than the Annually Rebalanced Portfolio at 10.9%.
Over the last 10 years, the risk has been higher. The Trigger Rebalanced Portfolio had 10.5% standard deviation, and the annually rebalanced portfolio 9.8%.
To summarize, the portfolio with the target allocation of 30% to bonds, may drift up to 50% in either direction, or allocate anywhere between 20% and 45% to bonds, and after that point the rebalance is triggered. Timing of the rebalances in our sample portfolio, may have attributed to improved results.
Coincidently, the drawdown in the 2007-2008 and 2000-2002 crisis was reduced by 1-2% as the rebalances had been triggered to lower equity positions close to the peak of the bull market and the reverse effect had been achieved when the equity prices were low, and the rebalances were triggered to sell a portion of the bond portfolio and buy more equities before the recovery.
Transaction cost savings are not accounted for in the calculation and can provide additional value.
While there are firms that recommend rebalancing frequently, we shouldn’t let the feeling of needing to do “something” get in the way of simply allowing the portfolio to capture market returns. There is no evidence that frequent rebalancing adds value.
Our findings are also in line with the facts found in the research paper published in October 2008 by DFA titled “Rebalancing and Returns” authored by Marlena Lee, Co-Head of Research: “A rebalancing strategy that tolerates a greater amount of drift will typically have higher expected returns and be exposed to greater risk compared to rebalancing strategies that allow less drift.” Marlena Lee analyzed 82 years of data, her conclusion: “Over the entire 82-year sample, it is clear that the rebalanced portfolio had no significant advantage over the portfolios rebalanced less frequently. It would be premature to declare the existence of positive rebalancing return benefits using 10 to 20 years of data because the period is too short and the data is too volatile to distinguish higher expected returns from luck.”
“…there is no easy one-size-fits-all rebalancing solution. Rebalancing decisions should be driven by the need to maintain an allocation with a risk and return profile appropriate for each investor. The optimal rebalancing strategy will differ for each investor, depending on their unique sensitivities to deviations from the target allocation, transaction frequency, and tax costs.”
At OCWM we will review portfolios quarterly and rebalance only when target weight in the asset classes have drifted sufficiently to justify the transaction cost, potential tax consequences and to not impact probability of future returns and risk level established in the Investment Policy Statement for each client.
On a journey to determine which rebalancing option is better, we constructed a sample moderate portfolio and tested different options over the most recent 20-year period. This allowed us to review the portfolio during the bull markets as well as the bear markets in 2000-2002 and 2007-2008 periods.
In short, our conclusion is in line with what many research papers have concluded. There is no evidence that frequent rebalancing, including even annual rebalancing, adds value to the portfolio performance.
After testing quarterly, annually, and with target weight rules, we found that rebalancing proves the most effective when one or more of the positions weights drift by more than 50% of the tolerance value, providing an increased annualized rate of return by 0.30% over a 20-year period and 0.46% over a 10-year period*. In other words, in the last 20 years, a hypothetical investment of $100,000 grew to $402,153 in the portfolio that was rebalanced annually, versus $426,950 in the portfolio that was rebalanced when one of more positions drifted by more than 50% from the target allocation. We’ll call that the “Trigger Rebalanced Portfolio”.
The Trigger Rebalanced Portfolio has been rebalanced only 6 times in the last 20 years, saving a good amount in transaction costs compared to the annually rebalanced portfolio, which has been rebalanced 20 times.
It is important to note that the target allocation in the sample moderate portfolio has been set to include 70% equities and 30% bonds.
In our test, the Trigger Rebalanced Portfolio with the trigger set for 50%, drifted to an allocation as high as 81% in equities and 19% in bonds and as low as 62.53% in equities and 37.47% in bonds. To implement this strategy, the investor must be comfortable with the dynamically changing allocation and therefore a risk level in the portfolio.
For example, from Jan 1, 2008 to Dec 31, 2008, the Trigger Rebalanced Portfolio declined 23.5%, and the annually rebalanced portfolio 25.04%. If the allocation were to drift to 80% in equities at “the wrong time”, the portfolio could have declined 29.25%. This is absolutely not an attempt to predict the future, rather just a reminder that allowing the portfolio to drift may increase risk.
From the longer-term perspective, over the 20-year period, risk as measured by standard deviation was almost the same.
The Trigger Rebalanced Portfolio had a standard deviation of 11.0%, only .1% higher than the Annually Rebalanced Portfolio at 10.9%.
Over the last 10 years, the risk has been higher. The Trigger Rebalanced Portfolio had 10.5% standard deviation, and the annually rebalanced portfolio 9.8%.
To summarize, the portfolio with the target allocation of 30% to bonds, may drift up to 50% in either direction, or allocate anywhere between 20% and 45% to bonds, and after that point the rebalance is triggered. Timing of the rebalances in our sample portfolio, may have attributed to improved results.
Coincidently, the drawdown in the 2007-2008 and 2000-2002 crisis was reduced by 1-2% as the rebalances had been triggered to lower equity positions close to the peak of the bull market and the reverse effect had been achieved when the equity prices were low, and the rebalances were triggered to sell a portion of the bond portfolio and buy more equities before the recovery.
Transaction cost savings are not accounted for in the calculation and can provide additional value.
While there are firms that recommend rebalancing frequently, we shouldn’t let the feeling of needing to do “something” get in the way of simply allowing the portfolio to capture market returns. There is no evidence that frequent rebalancing adds value.
Our findings are also in line with the facts found in the research paper published in October 2008 by DFA titled “Rebalancing and Returns” authored by Marlena Lee, Co-Head of Research: “A rebalancing strategy that tolerates a greater amount of drift will typically have higher expected returns and be exposed to greater risk compared to rebalancing strategies that allow less drift.” Marlena Lee analyzed 82 years of data, her conclusion: “Over the entire 82-year sample, it is clear that the rebalanced portfolio had no significant advantage over the portfolios rebalanced less frequently. It would be premature to declare the existence of positive rebalancing return benefits using 10 to 20 years of data because the period is too short and the data is too volatile to distinguish higher expected returns from luck.”
“…there is no easy one-size-fits-all rebalancing solution. Rebalancing decisions should be driven by the need to maintain an allocation with a risk and return profile appropriate for each investor. The optimal rebalancing strategy will differ for each investor, depending on their unique sensitivities to deviations from the target allocation, transaction frequency, and tax costs.”
At OCWM we will review portfolios quarterly and rebalance only when target weight in the asset classes have drifted sufficiently to justify the transaction cost, potential tax consequences and to not impact probability of future returns and risk level established in the Investment Policy Statement for each client.
*7/9/1999-7/8/2019 and 7/9/2009- 7/8/2019
The Trigger Rebalancing is not “absolute” rebalancing where the tolerance is calculated at the portfolio level. For example, a 40% position with 10% tolerance would be rebalanced when it reaches 30% or 50%. This approach is impractical because the smaller weight positions in the portfolio never get rebalanced.
The Trigger Rebalancing is not “absolute” rebalancing where the tolerance is calculated at the portfolio level. For example, a 40% position with 10% tolerance would be rebalanced when it reaches 30% or 50%. This approach is impractical because the smaller weight positions in the portfolio never get rebalanced.
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