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Overview of Portfolio Rebalancing
Presented at the 14th Annual Asset Allocation Congress March 6, 2000
Michael D. Smith, CFA Research Director Hewitt Investment Group
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Rebalancing Overview
Why Rebalance?
• Rebalancing is a vital part of investment policy—there can be no asset allocation target without a stated commitment to preserve the target. • A plan may incur unintended risk if no rebalancing policy exists. — This is true particularly for smaller allocations, which can balloon due to outsized returns (e.g., emerging markets). • Rebalancing is passive timing—the process naturally buys low and sells high. — Derivatives-based rebalancing is not delta hedging—it is exactly the opposite. • A clear policy avoids the risks of ad-hoc portfolio revisions • Rebalancing is necessary to achieve the value-added benefits of diversification. • If you do not actively rebalance your portfolio, the market will do it for you eventually.
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Rebalancing Overview
Why Rebalance?—Investment Policy • During the last five years, rebalancing has “cost” plan sponsors relative to a “Let Run” policy. • The strong stock market increased the average equity exposure of a 65%/35% portfolio to 74% during the five years ended 1999. • The time based and exposure based rebalancing rules resulted in similar results during the last five years. • The “Let Run” portfolio outperformed both rebalancing rules by 1.6% per year. • “Let Run” was riskier, but can you “eat” risk adjusted return? • Why rebalance?
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Value of 65%/35% Portfolio
300
"Let Run" Quarterly Rebalancing 5% Proportional Rebalancing
250
Wealth Index
200
150
100 1995 1996 1997 1998
Return 22.8% 21.2% 21.2%
1999
Risk_ 11.0% 9.4% 9.3%
1995 to 1999 Let Run (65%/35%) Quarterly Rebal. 5% Proportional Rebal.
Rebalancing Overview
Why Rebalance?—Investment Policy • You can “eat” risk-adjusted return when it comes to rebalancing! • Allowing the equity exposure of the 65%/35% portfolio to increase over time results in a portfolio that averages 74% equity. • Comparing the “Let Run” with rebalanced portfolios is like comparing portfolios with different equity allocations—and contains the same “information.” • Rather than letting equity exposure “creep,” it is preferable to adopt a higher equity exposure, and rebalance.
Value of 74%/26% Portfolio
300
Let Run Quarterly 5% Proportional
250
Wealth Index
200
150
100 1995 1996 1997 1998
Return 22.8% 23.1% 23.2%
1999
Risk__ 11.0% 10.7% 10.9%
1995 to 1999 Let Run (65%/35%) Quarterly Rebal. 5% Proportional Rebal.
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Rebalancing Overview
Why Rebalance? — “Natural” Rebalancing
Emerging Market Exposure vs. Relative Performance
11% Emerging Markets as percent of Assets 10% 9% 140 8% 120 7% 6% 5% 1993 1994
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180 Emerging/U.S. Relative Performance
160
100
80 1995
Rebalancing Overview
Why Rebalance? — “Natural” Rebalancing
• The market often will “rebalance for you.” — This is not true for total equity since stocks tend to appreciate over time. — However, within the equity allocation, the relative performance of various segments can shift quickly, “rebalancing” your portfolio. • The preceding graph shows the results of allocating 7% of total equity to emerging markets at the end of 1993 (just before one of the greatest years for emerging markets in history!).
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Rebalancing Overview
Why Rebalance? Making Practice from Theory
Diversification Example – No Rebalancing
Asset Stocks Bonds 50/50 Portfolio Year 1 20.00% -10.00% 5.00% Year 2 -10.00% 20.00% 2.86% Cumulative 8.00% 8.00% 8.00%
Diversification Example – With Rebalancing
Asset Stocks Bonds 50/50 Portfolio Year 1 20.00% -10.00% 5.00% Year 2 -10.00% 20.00% 5.00% Cumulative 8.00% 8.00% 10.25%
Note: The composition of the “No Rebalancing” portfolio is 57.1% stocks and 42.9% bonds at the end of year 1.
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When to Rebalance
0.20% 0.15%
0.12% 0.12% 0.08%
Rebalancing Strategies 1973 to 2Q 1999
Return Over "Let Run"
0.10% 0.05%
0.00%
0.00%
-0.01%
-0.02%
-0.05% -0.10% Let Run
Annualized Return 12.20% Standard Deviation 12.94% Average Equity 70.1% # of Rebalancings 0
-0.08%
Annual
12.12% 12.36% 65.7% 26
5% Band
12.19% 12.34% 66.0% 14
10% Band
12.32% 12.30% 66.8% 5
10% Proport. 0.25 Vol Band Asymmetrical
12.18% 12.30% 65.4% 36 12.28% 12.22% 65.2% 16 12.32% 12.26% 65.4% 24
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When to Rebalance
0.20% 0.15% 0.10% 0.05%
0.01%
Rebalancing Strategies 1973 to 2Q 1999
0.14% 0.12% 0.11%
Return Over Equal Risk Portfolio
0.00% -0.05%
-0.07%
0.00%
-0.10%
-0.10%
-0.15% Let Run
Annualized Return Standard Deviation Average Equity # of Rebalancings 12.20% 12.94% 70.1% 0
Annual
12.12% 12.36% 65.7% 26
5% Band
12.19% 12.34% 66.0% 14
10% Band
12.32% 12.30% 66.8% 5
10% Proport. 0.25 Vol Band Asymmetrical
12.18% 12.30% 65.4% 36 12.28% 12.22% 65.2% 16 12.32% 12.26% 65.4% 24
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When to Rebalance
0.20% 0.15%
Rebalancing Strategies 1973 to 2Q 1999
0.13% 0.09%
Return Over Average Equity
0.10% 0.05%
0.00%
0.00% -0.05% -0.10% -0.15% -0.20% -0.18% Let Run Annual 5% Band 10% Band 10% Proport. -0.08% -0.03%
0.01%
0.25 Vol Band
Asymmetrical
Annualized Return Standard Deviation Average Equity # of Rebalancings
12.20% 12.94% 70.1% 0
12.12% 12.36% 65.7% 26
12.19% 12.34% 66.0% 14 10
12.32% 12.30% 66.8% 5
12.18% 12.30% 65.4% 36
12.28% 12.22% 65.2% 16
12.32% 12.26% 65.4% 24
Rebalancing Overview
When to Rebalance
• A “Let Run” strategy, or a policy of no rebalancing, clearly results in a higher risk portfolio with an average equity exposure well above target. — In terms of absolute return, Let Run outperforms some rebalancing strategies due to a higher equity allocation. — However, simply targeting a 70% equity allocation, and maintaining the target, would result in higher returns (18 basis points annualized) than the let run strategy. • By letting the “market” rebalance the portfolio over time, the let run strategy results in asset allocations that are far away from targets at critical times. — Equity exposure fell as low as 52% in 1974, just before stocks recovered strongly. — Equity exposure reached 77% in the quarter before the crash of 1987. • Annual rebalancing has proven to be a poor strategy historically. — Not only did annual rebalancing trail the let run policy (due in large part to lower average equity), but the policy detracted value in risk adjusted returns by both measures.
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