Executive Summary
Rebalancing is a investing staple of the financial planning world. The execution of a rebalancing strategy helps to ensure that the client's asset allocation does not drift too far out of whack, as without such a process a portfolio holding multiple investments with different returns would eventually lead to a portfolio that increasingly favors the highest return investments due to compounding. Yet in practice, most financial planners often discuss rebalancing not only as a risk-reduction strategy (by ensuring that higher-return higher-volatility assets do not drift to excessive allocations), but also as a return-enhancing strategy. However, in reality, there is nothing inherent about rebalancing that would be anticipated to generate higher returns... unless you get the market timing right.
The inspiration for today's blog post comes from a comment made in response to a prior blog post discussing the market timing aspects of rebalancing strategies. In the commented response, a critic suggested that rebalancing should be viewed as the very opposite of market timing, because it is an a priori strategic planning process, rather than something that is responding to market movements as they occur.
Portfolio Rebalancing - Risk Management Or Return Enhancement?
In response, first of all, I will agree that there is an aspect of rebalancing that I would "purely" call risk management; it's about reallocating the portfolio back to the target allocation, essentially combating the portfolio allocation drift that would otherwise occur over time when you have multiple investments with different returns. However, as my examples from my prior rebalancing blog post show, there is nothing favorable to returns about doing that. In fact, rebalancing adversely affects returns, to the extent that the investor continuously sells the higher return asset to keep it from creeping to an ever-higher allocation.
Yet many, many advisors talk about rebalancing not just as a technique to manage risk and prevent portfolio drift, but as a return enhancer. As my examples illustrate again, though, the return-enhancing aspect of rebalancing is not natural to the process, per se; it only occurs if you get the timing favorably. So at the least, if we're going to insist on viewing rebalancing as purely a risk management function to prevent portfolio drift, that's fine, but it should never be referred to as a "return enhancing" strategy in that context. It would actually be a return-reducing, risk-management technique; not that that's bad, if your goal is to focus on the risk management aspects, but let's at least call a spade a spade.
So where did this idea come from that rebalancing is return-enhancing? As I've shown, the only return-enhancing aspect of the exercise is if you get the timing right on the rebalancing, relative to when assets are "zigging and zagging". As the comment to my prior blog post noted, common techniques of rebalancing include those that rebalance at some fixed time interval (e.g,. once a year), or some percentage deviation from target (e.g., when stocks shift 20% above their intended allocation)... yet how does one choose what time interval, or what percentage deviation? The answer that I see in the research? We try to choose a time interval or percentage deviation that is most likely to give us favorable market timing in the transaction. The percentage deviation research is focused on determining how likely assets are to deviate before mean-reverting, so that you can time the rebalancing trade at the point of maximum deviation. The time interval rebalancing research is generally focused on trying to determine the typical time span before momentum trends reverse, or the overall periodicity of market cycles, again so that our time interval lines up in a manner that is likely to produce favorable timing results.
Improving Returns With Rebalancing Is Sensitive To Market Timing?
So simply put, yes you can apply the rebalancing process on a purely mechanistic basis, but I have yet to see someone make the decision about what time interval or percentage-deviation targets to use for that mechanistic process without implicitly or explicitly doing so because they're trying to get the market timing right. And either way, anyone who has an expectation that rebalancing will produce higher returns, not lower returns, must implicitly be assuming they will get the timing right more often than they get it wrong. If you merely assumed that it was random - that you were just as likely to get example 2 (rebalancing leading to lower returns) as you were example 3 (rebalancing leading to higher returns) in my prior post - then you should assume that rebalancing, on average, will generate as many good trades as bad, no excess return due to timing, and overall result in a net reduction in return due to transaction costs.
Yet again, in practice, I don't hear anyone talk about rebalancing as a return-reducing risk management technique. We talk about it as return-enhancing. But the reality is that it only enhances returns when you get the timing right, and all the research that I've seen into fixed-time-interval and percentage-deviation rebalancing is essentially trying to explicitly or implicitly mine the historical data to figure out what time interval or deviation will produce the most favorable transaction timing.
Granted, I don't think that's necessarily a bad thing. There's some good research out there to show, over lots of different investment environments, what percentage-deviations or time intervals tend to result in transactions that yield favorably timed results. But once again, let's call a spade a spade; if you expect enhanced returns from rebalancing - and if you actually get those enhanced returns - it would appear to be a result of systematically getting the market timing right more often than you got it wrong. In other words, you picked a rebalancing process that gave you good market timing results.
So what do you think? Given that even a purely mechanistic rebalancing process requires some decision, up front, about what the timing will be - and in practice, that timing can increase or decrease returns - is there still an aspect of market timing in rebalancing? And if you don't expect any favorable market timing in your rebalancing transactions, does that mean you set an expectation for your clients that on average, rebalancing will control risk but at a cost of generating no increased returns while also decreasing returns due to transaction costs? Is that a fair characterization of rebalancing?
