REBALANCING: STRATEGIC CONSIDERATIONS

Learning Outcome

• discuss strategic considerations in rebalancing asset allocations

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The passage discusses strategic implementation choices in asset allocation, focusing on the passive/active management dichotomy. It's essential in understanding how investors navigate the complexities of building and maintaining their portfolios to achieve long-term financial goals. Let's break down the key points and implications of these strategies:

Passive/Active Management of Asset Class Weights

• Tactical Asset Allocation (TAA): This involves short-term deviations from the strategic asset allocation to exploit perceived market opportunities. It's a form of active management aiming to improve the risk-return profile by adjusting the asset mix based on short-term market views.

• Dynamic Asset Allocation (DAA): Differentiated from TAA by its basis on longer-term valuation signals or economic views, DAA adjusts the asset mix for strategic reasons.

• Global Tactical Asset Allocation (GTAA): A broader approach that may involve adjustments across a wide range of asset classes on a global scale.

• Challenges and Costs: Tactical asset allocation involves costs and risks, such as trading costs and potential tax implications, which must be weighed against the expected benefits.

Passive/Active Management of Allocations to Asset Classes

• Passive Management: Here, the investment strategy does not respond to market changes but aims to replicate the returns of a specific index. This approach is characterized by lower costs but also by the limitation of not outperforming the market.

• Active Management: In contrast, active management seeks to outperform the market through strategic selection and timing. This approach can potentially offer higher returns but comes with higher costs and risks.

• Hybrid Approaches: Some strategies incorporate both passive and active elements, offering a balance between cost efficiency and potential for outperformance.

Factors Influencing Passive/Active Choices

• Market Efficiency Beliefs: The decision between passive and active management often hinges on the investor's belief in market efficiency. A strong belief in market efficiency might lean an investor towards passive strategies.

• Tax Considerations and Scalability: For taxable investors, the costs associated with active management might outweigh the benefits. Additionally, the scalability of active strategies can be a critical consideration, especially for large investors like sovereign wealth funds.

• Investment Goals and Constraints: The choice between passive and active management also depends on specific investment goals and constraints, including ESG considerations or the need for specific risk management strategies.

Implementing Passive/Active Strategies

• Costs and Benefits Analysis: Whether adopting a passive or active strategy, investors must carefully analyze the costs (including management and transaction costs) and potential benefits, considering their specific context and objectives.

• Risk Budgeting: This approach involves allocating risk across assets or strategies based on specified criteria, such as volatility or expected risk contributions, and can inform the passive/active decision-making process.

• Manager Selection and Structure: For investors delegating management, choosing the right managers and structuring investments appropriately across the passive/active spectrum is crucial.

Conclusion

The passive/active choice in asset allocation is a strategic decision that impacts the portfolio's risk-return characteristics. By understanding the nuances of each approach and considering the specific context of their investment goals and constraints, investors can make informed decisions that align with their long-term financial objectives. This decision-making process involves weighing the trade-offs between cost, risk, and potential return, underpinned by a thorough analysis of market conditions and investment opportunities.

Rebalancing is the discipline of adjusting portfolio weights to more closely align with the strategic asset allocation. Rebalancing is a key part of the monitoring and feedback step of the portfolio construction, monitoring, and revision process. An investor’s rebalancing policy is generally documented in the IPS.

Even in the absence of changing investor circumstances, a revised economic outlook, or tactical asset allocation views, normal changes in asset prices cause the portfolio asset mix to deviate from target weights. Industry practice defines “rebalancing” as portfolio adjustments triggered by such price changes. Other portfolio adjustments, even systematic ones, are not rebalancing.

Ordinary price changes cause the assets with a high forecast return to grow faster than the portfolio as a whole. Because high-return assets are typically also higher risk, in the absence of rebalancing, overall portfolio risk rises. The mix of risks within the portfolio becomes more concentrated as well. Systematic rebalancing maintains the original strategic risk exposures. The discipline of rebalancing serves to control portfolio risks that have become different from what the investor originally intended.

Consider the example from the internet bubble (1995–2001) in Exhibit 15. The example assumes a 60/40 stock/bond portfolio, in which stocks are represented by the large-cap US growth stocks that characterized the internet bubble. In Panel B, the left-hand scale and upper two lines show month-by-month total portfolio values with and without monthly rebalancing (“wealth rebalanced” and “wealth unrebalanced,” respectively). The right-hand scale and lower two lines show month-by-month portfolio risk as represented by the 5th percentile drawdown (in a VaR model) with and without monthly rebalancing (“risk rebalanced” and “risk unrebalanced,” respectively).

Exhibit 15:

Rebalancing

Panel A. Asset Mix

CFA1816-R-Fa.png

Panel B. Portfolio Value and Risk

CFA1816-R-Fb.png

Note: The data are a 60/40 mix of the S&P 500 Growth Index and the Barclays Capital Aggregate Bond Index.

Panel A shows that, without rebalancing, the asset mix deviates dramatically from the target. Panel B shows that although the portfolios’ values ended similarly (the upper two lines), disciplined rebalancing meant more-stable risks (illustrated by the lower two lines).

This risk perspective is important. Taken to the extreme, never rebalancing allows the high-return (and presumably higher-risk) assets to grow and dominate the portfolio. Portfolio risk rises and concentrates. Taken even further, such a philosophy of never rebalancing may suggest it would have been simpler to have invested only in the highest-expected-return asset class back when the asset mix decision was made. Not rebalancing could negate an intended level of diversification.

Because rebalancing is countercyclical, it is fundamentally a contrarian investment approach.35 Behavioral finance tells us that such contrarianism will be uncomfortable; no one likes to sell the most recently best-performing part of the portfolio to buy the worst. Thus, rebalancing is a discipline of adjusting the portfolio to better align with the strategic asset allocation in both connotations of discipline—the sense of a typical practice and the sense of a strengthening regime.

A Framework for Rebalancing

The actual mechanics of rebalancing are more complex than they first appear. A number of questions arise: How often should the portfolio be rebalanced? What levels of imbalance are worth tolerating? Should the portfolio be rebalanced to the edge of the policy range or to some other point? These non-trivial questions represent the key strategic decisions in rebalancing.

The simplest approach to rebalancing is calendar rebalancing, which involves rebalancing a portfolio to target weights on a periodic basis—for example, monthly, quarterly, semiannually, or annually. The choice of rebalancing frequency may be linked to the schedule of portfolio reviews. Although simple, rebalancing points are arbitrary and have other disadvantages.

Percent-range rebalancing permits tighter control of the asset mix compared with calendar rebalancing. Percent-range approach involves setting rebalancing thresholds or trigger points, stated as a percentage of the portfolio’s value, around target values. For example, if the target allocation to an asset class is 50% of portfolio value, trigger points at 45% and 55% of portfolio value define a 10 percentage point rebalancing range (or corridor) for the value of that asset class. The rebalancing range creates a no-trade region. The portfolio is rebalanced when an asset class’s weight first passes through one of its trigger points. Focusing on percent-range rebalancing, the following questions are relevant:

• How frequently is the portfolio valued?

• What size deviation triggers rebalancing?

• Is the deviation from the target allocation fully or partially corrected?

How frequently is the portfolio valued? The percent-range discipline requires monitoring portfolio values for breaches of a trigger point at an agreed-on frequency; the more frequent the monitoring, the greater the precision in implementation. Such monitoring may be scheduled daily, weekly, monthly, quarterly, or annually. A number of considerations—including governance resources and asset custodian resources—can affect valuation frequency. For many investors, monthly or quarterly evaluation efficiently balances the costs and benefits of rebalancing.

What size deviation triggers rebalancing? Trigger points take into account such factors as traditional practice, transaction costs, asset class volatility, volatility of the balance of the portfolio, correlation of the asset class with the balance of the portfolio, and risk tolerance.36

Before the rise of modern multi-asset portfolios, the stock/bond split broadly characterized the asset allocation and a traditional ±x% rebalancing band was common. These fixed ranges would apply no matter the size or volatility of the allocation target. For example, both a 40% domestic equity allocation and a 15% real asset allocation might have ±5% rebalancing ranges. Alternatively, proportional bands reflect the size of the target weight. For example, a 60% target asset class might have a ±6% band, whereas a 5% allocation would have a ±0.5% band. Proportional bands might also be set to reflect the relative volatility of the asset classes. A final approach is the use of cost–benefit analysis to set ranges.

Is the deviation from the target allocation fully or partially corrected? Once the portfolio is evaluated and an unacceptably large deviation found, the investor must determine rebalancing trade size, as well as the timeline for implementing the rebalancing. In practice, three main approaches are used: rebalance back to target weights, rebalance to range edge, or rebalance halfway between the range-edge trigger point and the target weight.

Strategic Considerations in Rebalancing

The four-part rebalancing framework just described highlights important questions to address in setting rebalancing policy. Strategic considerations generally include the following, all else being equal:

• Higher transaction costs for an asset class imply wider rebalancing ranges.

• More risk-averse investors will have tighter rebalancing ranges.

• Less correlated assets also have tighter rebalancing ranges.

• Beliefs in momentum favor wider rebalancing ranges, whereas mean reversion encourages tighter ranges.

• Illiquid investments complicate rebalancing.

• Derivatives create the possibility of synthetic rebalancing.

• Taxes, which are a cost, discourage rebalancing and encourage asymmetric and wider rebalancing ranges.

Asset class volatility is also a consideration in the size of rebalancing ranges.

A cost–benefit approach to rebalancing sets ranges, taking transaction costs, risk aversion, asset class risks, and asset class correlations into consideration. For example, an asset that is more highly correlated with the rest of the portfolio than another would merit a wider rebalancing range, all else equal, because it would be closer to being a substitute for the balance of the portfolio; thus, larger deviations would have less impact on portfolio risk.

EXAMPLE 10

Different Rebalancing Ranges

1. The table shows a simple four-asset strategic mix along with rebalancing ranges created under different approaches. The width of the rebalancing range under the proportional range approach is 0.20 of the strategic target.

   State a reason that could explain why the international equity range is wider than the domestic equity range using the cost–benefit approach.

   Asset Class	Strategic Target	Fixed Width Ranges	Proportional Ranges (±1,000 bps)	Cost–Benefit Ranges
   Domestic equity	40%	35%–45%	36%–44%	35%–45%
   International equity	25%	20%–30%	22½%–27½%	19%–31%
   Emerging markets	15%	10%–20%	13½%–16½%	12%–18%
   Fixed income	20%	15%–25%	18%–22%	19%–21%

   Solution:

   Higher transaction costs for international equity compared with domestic equity could explain the wider range for international equity compared with domestic equity under the cost–benefit approach. Another potential explanation relates to the possibility that international equity has a higher correlation with the balance of the portfolio (i.e., the portfolio excluding international equity) than does domestic equity (i.e., with the portfolio excluding domestic equity). If that is the case then, all else being equal, a wider band would be justified for international equity.

Investors’ perspectives on capital markets can affect their approach to rebalancing. A belief in momentum and trend following, for example, encourages wider rebalancing ranges. In contrast, a belief in mean reversion encourages stricter adherence to rebalancing, including tighter ranges.

Illiquid assets complicate rebalancing. Relatively illiquid investments, such as hedge funds, private equity, or direct real estate, cannot be readily traded without substantial trading costs and/or delays. Accordingly, illiquid investments are commonly assigned wide rebalancing ranges. However, rebalancing of an illiquid asset may be affected indirectly when a highly correlated liquid asset can be traded or when exposure can be adjusted by means of positions in derivatives. For example, public equity could be reduced to offset an overweight in private equity. Rebalancing by means of highly correlated liquid assets and derivatives, however, involves some imprecision and basis risk.

This insight about liquidity is an instance where thinking ahead about rebalancing can affect the strategic asset allocation. It is one reason that allocations to illiquid assets are often smaller than if trading were possible.

Factor-based asset allocation, liability-relative investing, and goals-based investing, each a valid approach to asset allocation, can give rise to different rebalancing considerations. Factor exposures and liability hedges require monitoring (and rebalancing) the factors weights and surplus duration in addition to asset class weights. Goals-based investing in private wealth management may require both asset class rebalancing and moving funds between different goal sub-portfolios.

Tax considerations also complicate rebalancing. Rebalancing typically realizes capital gains and losses, which are taxable events in many jurisdictions. For private wealth managers, any rebalancing benefit must be compared with the tax cost. Taxes, as a cost, are much larger than other transaction costs, which often leads to wider rebalancing ranges in taxable portfolios than in tax-exempt portfolios. Because loss harvesting generates tax savings and realizing gains triggers taxes, rebalancing ranges in taxable accounts may also be asymmetric. (For example, a 25% target asset class might have an allowable range of 24%–28%, which is −1% to +3%.)

Modern cost–benefit approaches to rebalancing suggest considering derivatives as a rebalancing tool. Derivatives can often be used to rebalance synthetically at much lower transaction costs than the costs of using the underlying stocks and bonds. Using a derivatives overlay also avoids disrupting the underlying separate accounts in a multi-manager implementation of the strategic asset allocation. Tax considerations are also relevant; it may be more cost effective to reduce an exposure using a derivatives overlay than to sell the underlying asset and incur the capital gains tax liability. Lastly, trading a few derivatives may be quicker and easier than hundreds of underlying securities. Of course, using derivatives may require a higher level of risk oversight, but then risk control is the main rationale for rebalancing.

Estimates of the benefits of rebalancing vary. Many portfolios are statistically indistinguishable from each other, suggesting that much rebalancing is unnecessary. In contrast, Willenbrock (2011) demonstrates that even zero-return assets can, in theory, generate positive returns through rebalancing, which is a demonstrable (and surprising) benefit. Whatever the return estimate for the value added from rebalancing, the key takeaway is that rebalancing is chiefly about risk control, not return enhancement.