Rebalancing plays an important role in portfolio management. It ensures the overall portfolio risk and takes advantage of buying-low and selling-high opportunities in the market. Rebalancing basically brings back the portfolio to original asset allocation. The objective of a rebalancing strategy is to minimize the risk relative to target asset allocation instead of maximizing returns. Although rebalancing also increases the returns relative to non-rebalancing over the long term.
An asset allocation means dividing the investment amount among different asset classes such as stocks, bonds, cash etc. The process of determining the proportion of each asset class depends on investor’s investment time horizon, investment goals and risk tolerance. For instance, an investor’s portfolio consists of three assets such as stocks, bonds and cash then the investor’s asset allocation could be anything – (70%,20%,10%),(50%,40%,10%),(20%,70%,10%) depending on investor’s characteristics. Asset allocation is the major determinant of risk and return for a given portfolio. However, the portfolio drifts from target asset allocation over the time period as assets produce different returns, and hence risk-return characteristics deviate from investor’s goals and preferences. Therefore, asset managers rebalance the portfolio to maintain the target asset allocation.
There are various strategies used by different asset managers to rebalance the portfolio:
A “time-only” strategy which rebalances the portfolio at different frequencies: monthly, quarterly, annually, biennially, and decennially and so on, regardless of how much the portfolio drifted from its target asset allocation.
A “threshold-only” strategy which rebalances the portfolio when portfolio drifted from its target asset allocation by a predetermined threshold such as 5% or 10%, regardless of the frequency. The tighter threshold results in more frequently portfolio rebalancing.
A “time-and-threshold” strategy which rebalances the portfolio at different frequencies but only when the portfolio drifted from its target asset allocation by a predetermined threshold. On the scheduled rebalancing date, if portfolio deviation is less than the threshold level, the portfolio won’t be rebalanced.
The question is does rebalancing work? The answer is Yes! There are numerous studies on portfolio rebalancing such as Charles Rotblut and the Vanguard Group proved that rebalancing reduced the volatility and at the same time enhanced the returns. We also tested whether rebalancing really work and in addition, looked for optimal rebalancing strategy too.
I considered the long historical time period 1920 through 2016 and different asset classes with different asset allocations. I found that there is little difference between portfolio rebalancing at different frequencies and threshold however there is significant difference between rebalanced portfolio and non-rebalanced portfolio. The rebalanced portfolio outperformed non-rebalanced portfolio. I analyzed different rebalancing strategies to find optimal rebalancing strategy but there is no optimal frequency or threshold to rebalance the portfolio. All strategies produce more or less same risk and return. The rebalanced portfolio displayed marginally high return but much low volatility which results in higher Sharpe ratio as compared to non-rebalanced portfolio. Even the maximum drawdown, which reflects downside risk of a portfolio, was also observed to be lower than non-rebalanced portfolio.
Rebalancing does play an important role in portfolio management but it’s difficult to come up with optimal rebalancing strategy. Rebalancing the portfolio is equally important as diversifying the portfolio in practice.