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

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Abstract

This study compares the performance of different rebalancing strategies under realistic market conditions by reporting statistical significance levels. Our analysis is based on historical data from the United States, the United Kingdom, and Germany and comprises three different classes of rebalancing (periodic, threshold, and range rebalancing). Despite cross-country differences, our history-based simulation results show that all rebalancing strategies outperform a buy-and-hold strategy in terms of Sharpe ratios, Sortino ratios, and Omega measures. The differences in risk-adjusted performance are not only statistically significant, but also economically relevant. However, the choice of a particular rebalancing strategy is of only minor economic importance.

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Notes

  1. 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).

  2. 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).

  3. 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.

  4. 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.

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Acknowledgments

We appreciate helpful comments from Wolfgang Bessler, Martijn Cremers, Javier Estrada, Alexander Kempf, Aymen Karoui, Lawrence Kryzanowski, Philipp Kurmann, Christoph Meinerding, Rainer Schlittgen, Markus Schmid (the editor), Florian Sonnenburg, and Heinz Zimmermann as well as from participants at the 2011 joint conference of the German Classification Society (GfKl) and the German Association for Pattern Recognition (DAGM) in Frankfurt am Main, the 2012 Midwest Finance Association (MFA) Conference in New Orleans, the 2012 European Financial Management (EFMA) Symposium on Asset Management in Hamburg, the 2012 Finanzmarktkolloquium on Asset Management in Cologne, the 2013 Financial Management Association (FMA Europe) Conference in Luxembourg, the 2013 European Financial Management (EFMA) Conference in Reading, and the 2013 Financial Management Association (FMA) Conference in Chicago.

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  1. alpha portfolio advisors GmbH, Bad Soden am Taunus, Germany

    Hubert Dichtl

  2. University of Hamburg, Hamburg, Germany

    Wolfgang Drobetz & Martin Wambach

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  1. Hubert Dichtl
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  2. Wolfgang Drobetz
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Correspondence to Wolfgang Drobetz.

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Dichtl, H., Drobetz, W. & Wambach, M. Where is the value added of rebalancing? A systematic comparison of alternative rebalancing strategies. Financ Mark Portf Manag 28, 209–231 (2014). https://doi.org/10.1007/s11408-014-0231-3

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