Rebalancing, asset allocation and diversification within asset classes are the holy trinity of enlightened investment strategy. Of the three, rebalancing arguably has lagged as a research subject.
The good news is that the gap is closing. But rebalancing questions still persist and a consensus remains elusive--a vacuum that allows rules of thumb and anecdotal evidence to flourish. No one should assume that the popular advice on behalf of predetermined dates for quarterly and annual rebalancing flows from a rigorous analysis of history. Meanwhile, old habits die hard.
Part of the problem is that in the long run, even a naive rebalancing system may be better than nothing. In contrast, ill-designed asset allocation and diversification strategies will probably do more harm than good. The higher stakes for the latter two may explain the greater interest compared with rebalancing.
In any case, more wealth managers are asking if there's a better way to rebalance. Unfortunately, there are no easy answers. Subjectivity, it seems, is rife in the world of rebalancing research.
And so are viewpoints. For example, a paper published last year in April's Journal of Financial Planning reviewed 21 rebalancing strategies (including ignoring it completely) and concluded that while reallocating assets is "useful," no one approach was singularly superior (hence the title, "Rebalancing for Tax-Deferred Accounts: Just Do It---Don't Worry How"). A subsequent study in last year's November issue of the same publication recommended linking rebalancing rules to the "Fed's prevailing monetary policy" ("Optimal Rebalancing Frequency for Bond/Stock Portfolios").
Further clouding the issue is the performance record of rebalancing over the long haul, as per the Morningstar (Ibbotson) 2007 edition of Stocks, Bonds, Bills and Inflation Yearbook. For example, a portfolio of 70 percent stocks, 30 percent bonds, rebalanced monthly, trailed the stock market (annualized performance of 9.3 percent vs. 10.4 percent) for the 80 years through the end of last year. (Returns are based on the S&P 500 and long-term government bonds). Yet the 70/30 portfolio posted lower volatility (annualized standard deviation) than the equity market over that period (14.5 percent vs. 20.1 percent), according to SBBI. Meanwhile, taking the same initial 70/30 portfolio and never rebalancing delivered a 10.0 percent return and 17.1 percent volatility over those eight decades. Does the quantitative record support or invalidate rebalancing? Or, maybe the record is merely a reminder that more research is needed.
In a bid for clarity, Gobind Daryanani has also crunched the numbers and comes to definite conclusions. In essence, he recommends looking for rebalancing opportunities frequently, but pulling the trigger only when an asset class moves significantly from its target weight. Daryanani is no idle observer of the subject at hand. In addition to studying rebalancing deeply, he designed iRebal (iRebal.com), a software rebalancing tool that evolved out of Daryanani's work in the wealth management industry.
In a sign of the growing interest in rebalancing, financial services firm TD Ameritrade acquired iRebal late last year. The software is available to RIAs working through TD Ameritrade and other institutions. Among iRebal's features: Automating and optimizing the search for rebalancing and tax-loss-harvesting opportunities in portfolios. Designed with financial advisors and institutions in mind, the software can be customized to accommodate a variety of rebalancing preferences.
Daryanani, who continues to oversee iRebal under the TD Ameritrade brand, has his own ideas about what constitutes an optimal rebalancing strategy, as his recent conversation with Wealth Manager reveals.
Why is rebalancing necessary for managing investment portfolios?
Because of reversion to the mean. After things go up a lot, they'll come back down to the average; after a fall, they'll bounce back. Things don't keep going up or down forever.
How should rebalancing be applied for a multi-asset class portfolio with a relatively long time horizon?
In broad terms, asset classes should be rebalanced back to their target weights. And there should be rebalancing bands around those target weights. If the target weight for an asset class moves outside the bands, you should rebalance. In other words, when prices fall enough, rebalance by buying; when prices go up enough, sell. That's the concept. The questions are, How wide should the bands be, and how frequently should you be doing this?
What are the answers?
In fact, the two issues are linked.
For perspective, consider how people have done things. An FPA [Financial Planning Association] survey from a few years ago asked about 100 people and found that most--around 80 percent--were doing either quarterly or annual rebalancing. Why? It's probably because they have quarterly reports and annual meetings with their clients, or something like that. I don't think there's a science behind quarterly or annual rebalancing.
In fact, the literature on rebalancing finds that it doesn't make too much difference for the results if you rebalance quarterly or annually. On the other hand, it helps a bit if it's monthly. But the big improvement comes when you start looking at rebalancing opportunities for portfolios on a weekly or bi-weekly basis. That makes a big difference [for returns]. But there's a limit to frequency's benefits. The daily, weekly and bi-weekly results of my studies show relatively similar results. However, there's a pretty big difference [in performance] between bi-weekly and quarterly, and bi-weekly and annual rebalancing strategies.
How sensitive should the rebalancing band be?
Twenty percent. For example, let's say a portfolio has a 30 percent allocation to U.S. stocks. Any time the allocation drops below 24 percent or above 36 percent, you'd rebalance. That's what I mean by a 20 percent band.
What about higher or lower bands? How do they compare to a 20 percent-band?
If I made the band higher, say 25 percent or 30 percent, you'd miss short-term ups and downs. On the other hand, if you made the band smaller, like 5 percent, you'd only catch small blips, and it's the bigger blips that you want to capture. After analyzing the data, the 20-percent band was pretty consistently giving the best results.
How much market history did you analyze to find that answer?
From 1992 through the end of 2005.
For how many different asset classes?
Five. I looked at U.S. large cap, U.S. small cap, U.S. real estate, commodities and bonds, using total return data for the following indices: S&P 500, Russell 2000, Dow Jones Equity REIT, Dow Jones-AIG Commodity and Bloomberg 7-10 Government.
Assuming those five asset classes, what kind of performance boost should investors expect with a bi-weekly focus on rebalancing compared with quarterly or annual schedules?
From 20 to 50 basis points, depending on the time period and assuming a 10-year horizon.
Are certain market conditions worse for bi-weekly rebalancing relative to a quarterly or annual focus?
In my studies, bi-weekly was always better than annual/quarterly, in up and down markets.
To be clear, when you say that a bi-weekly focus on rebalancing is preferable, you're referring to looking at the portfolio every other week, but not necessarily rebalancing?
Right. I'm not advising that portfolios should be rebalanced bi-weekly. In fact, you may end up rebalancing only once or twice a year. The key issue is that the rebalancing should be done at the right time, and to rebalance at the right time, you should be looking bi-weekly.
If there's a movement in commodities or real estate, for example, and that lasts only a couple of weeks up or down, you'll be able to catch it. But if you're looking only once a year, there's a pretty big chance that you'll miss it. Catching the extra rebalancing benefits requires looking frequently and making the bands wide. If you make the bands too narrow, it doesn't provide that much benefit.
So the sweet spot for rebalancing is running the numbers relatively frequently--bi-weekly--and rebalancing the portfolio when allocations move by 20 percent above or below the target weights.
Yes.
Whereas, preemptively picking, say, December 31 for rebalancing may not produce results because you may miss the best opportunities.
Correct. You just don't know when opportunities will come, and so you have to look frequently. Rebalancing every December 31, for instance, doesn't mean that you'll get no benefit, but you won't get all the benefit you could compared to looking more frequently.
Based on your strategy recommendation for bi-weekly monitoring and 20-percent rebalancing bands, how often is a multi-asset class portfolio likely to be rebalanced?
I recall seeing as many as three or four rebalances in one of the years I studied.
Were there any 12-month periods with no rebalancing using your strategy?
Oh, sure, but on average, based on my studies, the rebalancing actions number about two a year.
How do taxes factor into a rebalancing strategy?
You can't avoid taxes, unless you have a step-up in cost basis. You can defer taxes, but deferrals don't save that much. So one could argue for rebalancing even if there'll be tax consequences. However, most clients don't like to see taxes in the current year. So I would do the following:
Try to rebalance inside IRAs. That means you should use across-account, group-level rebalancing strategies. Also, rebalance less aggressively if taxes exceed a subjective threshold of pain for the client.
JAMES PICERNO (jpicerno@highlinemedia.com) is senior writer at Wealth Manager.
