Where is the value added of rebalancing? A systematic comparison of alternative rebalancing strategies

Sharpe (2010) argues that the performance of rebalancing relative to buy-and-hold can be highly period-dependent. Irrespective of having superior knowledge about the return-generating process, investors should follow a rebalancing strategy only if they are less concerned than the average investor about inferior returns in very bad or very good markets. Following an adaptive asset allocation policy, investors should routinely compare their asset allocations with current market proportions to make sure that any differences are consistent with differences between their own circumstances and those of the average investor. Sharpe’s proposed strategy is macro-consistent in the sense that all investors can follow it. Kimball et al. (2011) develop an overlapping generations model to illustrate how optimizing agents rebalance in equilibrium. The aggregate risk tolerance effect is a driving force in their model. Shocks to the valuation of risky assets affect investors’ wealth differently, depending on their initial asset allocation. As a result, such shifts affect the distribution of wealth and change aggregate risk tolerance (violating Merton’s (1971) model market-clearing behavior) as well as the demand for risky assets (departing from the standard model’s rebalancing advice).

The long-term strategy of the NGPFG is characterized by quarterly trading frequency, an implemented no-trade region of \({\pm }3~\%\) around the target weights, and a reallocation back to the target weights if the relative proportion of stocks falls outside the no-trade region for 1 day during the corresponding quarter (Norwegian Ministry of Finance 2012). This strategy is comparable to the implemented “3 % quarterly threshold rebalancing” (strategy 6 in Table 1).

The transaction costs of 15  bps per roundtrip solely relate to the assets’ reallocation, which in turn depends on the underlying rebalancing algorithm. Additional costs do incur with respect to administration and management of the portfolio. Exchange traded funds (ETFs) are a cost-effective way of implementing rule-based portfolio strategies such as rebalancing. According to the market leaders iShares, Lyxor Asset Management, and db X-trackers, the total expense ratio (TER) of the most liquid ETFs ranges between 15 and 20 bps for government bonds and between 15 and 52 bps for equities. These costs are independent of the rebalancing frequency and are charged regardless of the applied portfolio strategy. Therefore, we exclude the TER from our analysis as it does not affect the issue of whether rebalancing provides value added.

An exception is monthly rebalancing in the United States. In this case, the buy-and-hold strategy has a slightly higher mean annual return in comparison to the monthly (but not to the quarterly or to the yearly) rebalancing strategy.