Executive Summary
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Once investment managers establish a long-term strategic allocation or benchmark, fund managers must decide how to manage the fund’s ongoing allocation.
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Daily market movements can result in constant drifts of actual portfolio allocations from the strategic benchmark.
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Traditionally, experts advised “static rebalancing” wherein simple rules bring the allocations back to the benchmark if some allocation limit is breached or some calendar date is reached.
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Static rebalancing strategies are risky, as the investors take an implicit bet to be either long or short an asset without really focusing on the view on the markets.
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While static rebalancing is often better than drift, this article describes how SMART (Systematic Management of Assets using a Rules-based Technique) can be a better tool for investors.
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By using market factors and managing allocations proactively within rebalancing ranges (i.e., no change in overall policy), investors can improve performance and risk management.
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SMART rebalancing is essential for good governance.
Background
Every fund manager has to deal with a vexing issue—namely, how to manage the rebalancing process as the returns from this activity impact the total portfolio performance. There is a wealth of information on these strategies, and many papers have been written on this topic.1 Nersesian (2006) does an excellent job of introducing a process to help determine the ideal rebalancing policy and examine the considerations in selecting the appropriate approach. Most rebalancing policies (periodic, range, or threshold) first focus on minimizing the tracking error or absolute standard deviation of the portfolio as the key measure of risk (either directly or by targeting the highest Sharpe ratio), and then attempt to manage the trade-off relative to the transactions costs that more frequent rebalancing generates.2
Many portfolio managers manage their asset allocation decisions by adopting a rebalancing policy which typically involves returning the asset allocation to the target allocation or strategic asset allocation (SAA) at calendar intervals (monthly, quarterly, or annually). Alternatively, portfolio managers may use a “range-based” approach whereby the trigger points or ranges are typically 3–5% from the target, based on the volatility of asset classes. Variations of this approach rebalance to somewhere within these allocation ranges or use periodic cash flows to move the asset allocation of the various assets closer to what a rebalancing action would attempt to do. Often these approaches are a move toward a practical maintenance of the strategic weights, trading off between managing transactions costs and tracking error relative to the benchmark. These approaches can be called “static rebalancing” because the limits are set. However, the portfolio still drifts within the bands, as most policies are silent about what actions staff should take within the bands. This is demonstrated in Figure 1.
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