Decisions relating to portfolio rebalancing, while often considered secondary to deciding on the allocations themselves, can be considered an active investment strategy and have important implications for expected (and realized) portfolio returns and risk. In this article we address common misconceptions about the role and implications of rebalancing, particularly in the context of actively-managed portfolios. A companion article (Ilmanen and Maloney (2015)) examines the rebalancing of strategic asset portfolios.
In this article we refute four prevalent misconceptions related to portfolio rebalancing and seek to clarify the practical implications of each. We find:
- Rebalancing is not generally, as some have suggested, a source of smart beta outperformance. It does alter the distribution of possible return outcomes for a portfolio, but this is more correctly and usefully interpreted as a risk-reduction effect from maintaining better diversification.
- While rebalancing to constant capital allocations maintains long-term risk characteristics better than ‘buy and hold’, dynamic risk targeting does an even better job.
- There is no reliable evidence that risk-targeted portfolios suffer a drag on returns from selling ‘after the horse has bolted.’ Evidence of the risk benefits, on the other hand, is pervasive.
- Levered portfolios require an additional rebalancing process, but this does not cause any special “drag” effects beyond the normal compounding effects of investments at a similar risk level, and some additional transaction costs. Moderately levered portfolios of liquid instruments can be suitable for long-term investors, subject to their risk preferences.
Rebalancing is an essential part of all active investment management. Once the implications have been clearly understood and the most efficient processes implemented, managers and investors can then turn their attention to the underlying strategy, which is the real source of expected returns.