Fear of rebalancing? Put a disciplined policy in place

Many investors wrestle with portfolio-rebalancing decisions, particularly in extreme market environments. In this paper, members of our Investment Strategy Team argue for a well-structured rebalancing policy and share research on calendar-based and range-based strategies.

Views expressed are those of the authors and are subject to change. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. For professional or institutional investors only.

THE PRIMARY GOAL OF REBALANCING is to minimize risk relative to strategic asset allocation targets, which are deliberately set to match an organization’s return, risk, and liability or spending profile. In short, rebalancing avoids overexposure to outperforming asset classes and underexposure to underperforming asset classes, all in the interest of maintaining a pre-defined risk posture.

While that all sounds very reasonable, the reality is that rebalancing can be an emotional decision, particularly in extreme market environments when our instincts may tell us to run from asset classes that are selling off in dramatic fashion. We believe a well-structured rebalancing policy that sets rules for when and how a portfolio is reallocated can help take emotion out of the process. In addition, while past performance is no guarantee, we have seen evidence that investors who have followed disciplined rebalancing policies have been rewarded over the long term for having “bought low” as the market went through a bottoming process rather than trying to time the precise market trough. And, of course, opting not to rebalance is an active decision with risks of its own, including less diversification and more volatility than intended.

In this paper, we share our rebalancing analysis, which focuses on the hypothetical results of three rebalancing strategies — calendar-based (at different frequencies), symmetric-range, and asymmetric-range — as well as the implications of “drifting” (having no rebalancing policy). Our key conclusions include the following:

  • All systematic rebalancing strategies examined displayed a propensity to reduce uncompensated portfolio volatility.
  • The “right” rebalancing policy for each investor is not one-size-fits-all and is likely to vary by risk tolerance and sensitivity to transaction costs and complexity.
  • The rebalancing strategies that have worked best historically are disciplined about buying low/selling high and maintaining an appropriate risk profile.
  • Drifting or ad hoc rebalancing can result in taking on undue risk.
  • Using a symmetric- or asymmetric-range strategy applied over an appropriate calendar period may best capture the desired balance between transaction costs/complexity and policy discipline.

Defining and evaluating rebalancing strategies

Our research assumed a 60% equity/40% fixed income target asset allocation. As the evaluation of rebalancing strategies requires dealing with the time-period dependency of the results, we performed our analysis on a hypothetical portfolio over the entire 1960 – 2019 period, encompassing multiple market environments, as well as rolling periods and discrete decades. We examined risk-adjusted returns across all periods given that symmetric and asymmetric strategies tend to hold more equity exposure on average. We found our key conclusions were consistent over the various time horizons.

We define the three rebalancing strategies as follows:

1. Calendar-based rebalancing resets allocations to the strategic targets on a fixed schedule, regardless of interim market movements. The organization determines the frequency of rebalancing (e.g., monthly, quarterly, annual). The main advantages of this approach are ease of implementation and risk control. However, the systematic nature of calendar-based rebalancing ignores…

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 PhD, CFA, FRM