Portfolio rebalancing is a commonplace practice among investors. Many believe the optimal strategy is to maintain a certain balance of stocks and bonds. Many go deeper still, rebalancing across sectors or even specific securities. However they are subdivided, rebalancing strategies usually rely on a “mechanical” methodology, which
- Nicolas Granger, Campbell R. Harvey, Sandy Rattray and Otto van Hemert define as:
“A mechanical rebalancing strategy, such as a monthly or quarterly reallocation towards fixed portfolio weights, is an active strategy. Winning asset classes are sold and losers are bought.”
The idea is intuitive enough. If one segment of a portfolio charges too far ahead (or gets beaten down), the overall portfolio falls out of the balance designed to produce a long-term return profile. Thus, occasionally selling out some securities and buying others to realign with the original vision is standard practice for many individual investors and asset managers alike.
Yet, there are inherent issues with traditional rebalancing practice, which is often overly mechanistic. Indeed, such mindless rebalancing can actually add to portfolio risk.
Thankfully, there may be a way to eliminate some of this embedded risk: embracing momentum as a tool for lower-risk, more strategic rebalancing.
Rebalancing versus buy and hold
In 2014, researchers at the Man Group published a paper examining the potential risks that can emerge from a mechanistic portfolio strategy. Using the popular 60-40 portfolio (60% stocks, 40% bonds) as their baseline for analysis, they found something interesting:
“While a routinely rebalanced portfolio such as a 60-40 equity-bond mix is commonly employed by many investors, most do not understand that the rebalancing strategy adds risk. Rebalancing is similar to starting with a buy and hold portfolio and adding a short straddle (selling both a call and a put option) on the relative value of the portfolio assets. The option-like payoff to rebalancing induces negative convexity by magnifying drawdowns when there are pronounced divergences in asset returns.”
A follow up study published this month adds further color to the issue, finding that mechanical rebalancing tends to underperform the buy-and-hold strategy during sustained periods of high performance in one of the asset classes:
“A stock-bond portfolio that regularly rebalances tends to underperform a buy-and-hold portfolio at times of continued outperformance of one of the assets. Using a simple two-period model, we explain the main intuition behind this effect: rebalancing means selling (relative) winners, and if winners continue to outperform, that detracts from performance.”
The Man Group researchers further determined mechanical rebalancing strategies underperform buy-and-hold strategies even more severely in the event of a crisis:
“During crises, when markets are often trending, this can lead to substantially larger drawdowns than a buy-and-hold strategy...As stocks typically have more volatile returns than bonds, relative returns tend to be driven by stocks. Hence, of particular interest are episodes with continued negative (absolute and relative) stock performance, such as the 2007-2009 global financial crisis.”
Theoretically, rebalancing is meant to improve expected return as compensation from the extra risk built into the strategy compared to merely adopting a buy-and-hold strategy. This is all reasonable, and not terribly surprising. More interesting is the researchers’ finding that there might be a way to mitigate the risks of rebalancing in order to capture enhanced returns.
Embracing the trend
Analyzing investment performance data from 1960 to 2017, the Man Group researchers found that adding (or “overlaying”) a momentum strategy to a traditional 60-40 portfolio can improve returns and mitigate drawdowns during downturns:
“Allocating 10% to a trend strategy and 90% to a 60-40 monthly-rebalanced portfolio improves the average drawdown by about 5 percentage points, compared to a 100% allocation to a 60-40 monthly rebalanced portfolio. The trend allocation has no adverse impact on the average return over our sample period.”
That is a truly remarkable finding. Intuitively, one would anticipate long-term investment performance would face downward pressure thanks to allocating part of the portfolio to what is essentially a defensive strategy. Yet, the insurance more than pays for itself in this case.
The paper explores further tools of strategic rebalancing, applying various heuristics, such as using thresholds and adjusting rebalancing frequency. Again, these tools proved to be effective in trimming drawdown effects during negative market periods.
Verdict
The Man Group’s latest study of strategic rebalancing is quite fascinating, offering counterintuitive results that might help improve investors’ allocation decisions. In this time of particular economic and market uncertainty, embracing a rebalancing strategy that helps to insure against the nastiest drawdowns may be particularly attractive.
That said, all studies of this kind are inherently backward-looking and rely on imperfect datasets. We certainly will not be abandoning our value investing strategy on the basis of the Man Group’s latest study. Still, it offers real food for thought that deserves the serious consideration of all curious investors.
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