Making It Happen
The key to this approach is that while it does involve a little more work than implementing (or recommending) a rebalancing policy, it has similar advantages.
Simplicity. Once the rules are articulated (and typically these are either explained by fundamental arguments, well-researched trends or common intuition) they can be easily followed and implemented. This simplicity also allows investors to track a few key factors consistently and act on them with confidence.
Explicitness and transparency. By definition, this approach requires a clear definition of the market factors (signals) that will be followed, how these will be used to make asset allocation decisions for the fund, and the policy controls operating on this decision-making process (frequency, asset bandwidths, etc.). Investors then will be able to analyze and vet these decisions thoroughly prior to approving them. This then allows them to execute what is now a disciplined and systematic set of decisions.
Superiority. This approach is superior to the static/naïve rebalancing approaches because it recognizes the limitations of the SAA, makes implicit decisions explicit (what gets monitored gets managed), and operates in the area where the SAA is of limited value. Further, it is both responsible and responsive to current information, which is always more relevant and up-to-date than that used as an input for the SAA decision. Implementation of SMART rebalancing is very similar to static rebalancing and would be implemented in exactly the same way that a current rebalancing program would. In our experience, both programs are easily implemented using futures contracts, so this performance is very easy to achieve and hence does not have any impact on the rest of the portfolio.
This article has described how the SMART rebalancing approach can meaningfully improve the performance of the investment portfolio. All decisions to change the asset allocation—whether to let the portfolio drift or rebalance on some static policy or to make informed rebalancing decisions—are active asset allocation decisions. Therefore, it is best to make such decisions in an explicit, disciplined, and informed manner by using the various measures that one should constantly be tracking for other investment decisions (economic, valuation, momentum, and market factors). In the current return environment, every bit of performance is needed to meet investment objectives. SMART rebalancing has the advantage of working on the entire asset base, with the added benefit that it can be implemented in addition to other things that may be done in the portfolio.
1 See, for example, Arnott and Lovell (1993), Arnott and Plaxco (2002), Bernstein (2000), Buetow et al. (2002), Masters (2002), and Leland (1996).
2 Leland (1996).
3 Muralidhar (2001), ch. 9.
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