Primary navigation:

QFINANCE Quick Links
QFINANCE Topics
QFINANCE Reference
Add the QFINANCE search widget to your website

Home > Asset Management Best Practice > The Case for SMART Rebalancing

Asset Management Best Practice

The Case for SMART Rebalancing

by Arun Muralidhar and Sanjay Muralidhar

Executive Summary

  • Once investment managers establish a long-term strategic allocation or benchmark, fund managers must decide how to manage the fund’s ongoing allocation.

  • Daily market movements can result in constant drifts of actual portfolio allocations from the strategic benchmark.

  • 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.

  • 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.

  • 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.

  • 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.

  • 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.

The Allure of Rebalancing

Rebalancing is attractive because it is simple to understand and to execute, is explicit and transparent, allowing portfolio managers to put in place the exact policy to be followed and be assured that it is being followed, and avoids the appearance of “do-nothing” or “buy-and-hold.” Furthermore, discipline provides a decision regime that can be modeled to quantify the historical risk and return profile. Finally, most analyses suggest that a rebalancing policy is better than doing nothing (or letting the portfolio drift), and that has been good enough for most investors.

The Problem with Static Rebalancing

Despite the low tracking error relative to their benchmarks, static rebalancing policies can be problematic owing to the large absolute and relative drawdowns (or declines in the value of the fund). Therefore, when US and European equity declined dramatically from 2000 to early 2003, rebalancing would have done little to reduce the pain of the portfolio and would have caused the rebalanced portfolio to plummet as well. While static rebalancing is attractive in up markets, the analogy in down markets would be to tying your leg to the anchor of a sinking ship.

The larger questions that this article addresses in the new rebalancing paradigm are:

  • What are the appropriate performance and risk measures in determining the best asset allocation approach? Additional risk measures like the drawdown in the portfolio (maximum decline in the absolute or relative value of the fund), and success ratio (number of months that you outperform the benchmark) are utilized as these better capture the concept of practical portfolio management risk as opposed to standard deviation. After all, a low tracking error relative to a benchmark may be worthless if the fund is bankrupted by a large drawdown in absolute value.

  • Is there a better way to manage asset allocation decisions than static rebalancing?

  • Can other approaches preserve the advantages that rebalancing policies have, namely the ability to have explicit, transparent, and disciplined asset allocation decisions?

Back to Table of contents

Further reading

Book:

  • Muralidhar, Arun. Innovations in Pension Fund Management. Stanford, CA: Stanford University Press, 2001.

Articles:

  • Arnott, Robert D., and Robert M. Lovell, Jr. “Rebalancing: Why? When? How often?” Journal of Investing 2:1 (Spring 1993): 5–10. Online at: dx.doi.org/10.3905/joi.2.1.5
  • Arnott, Robert D., and Lisa M. Plaxco. “Rebalancing a global policy benchmark.” Journal of Portfolio Management 28:2 (Winter 2002): 9–22. Online at: dx.doi.org/10.3905/jpm.2002.319828
  • Bernstein, William J. “Case studies in rebalancing.” Efficient Frontier (Fall 2000). Online at: www.efficientfrontier.com/ef/100/rebal100.htm
  • Buetow, Gerald W., Jr, Ronald Sellers, Donald Trotter, Elaine Hunter, et al. “The benefits of rebalancing.” Journal of Portfolio Management 28:2 (Winter 2002): 23–32. Online at: dx.doi.org/10.3905/jpm.2002.319829
  • Graham, Benjamin, and David Dodd. “Investment link tutorial: Asset allocation.” Just for Funds blog (May 26, 2007).
  • Leland, Hayne E. “Optimal asset rebalancing in the presence of transactions.” Working paper. August 23, 1996. Online at: ssrn.com/abstract=1060
  • Masters, Seth J. “Rules for rebalancing.” Financial Planning (December 2002): 89–93.
  • McCalla, Douglas. “Enhancing the efficient frontier with portfolio rebalancing.” Journal of Pension Plan Investing 1:4 (Spring 1997): 16–32.
  • Muralidhar, Sanjay. “A new paradigm for rebalancing.” The Monitor 22:2 (March/April 2007): 12–16. Online at: tinyurl.com/6caxvkr [PDF].
  • Nersesian, John. “Active portfolio rebalancing: A disciplined approach to keeping clients on track.” The Monitor 21:1 (January/February 2006): 9–15. Online at: www.imca.org/cms_images/file_545.pdf

Website:

Back to top

Share this page

  • Facebook
  • Twitter
  • LinkedIn
  • Bookmark and Share