by Richard Phillips, Chief Investment Officer and Kevin Muir, CFA, Market Strategist
Executive Summary
Portfolios need to be periodically rebalanced to ensure they maintain asset allocations dictated by the investor.
These rebalancings have the added benefits of often increasing total return.
Most importantly, regular rebalancing results in a reduction of portfolio volatility.
According to Modern Portfolio Theory (MPT) – a concept pioneered by Harry Markowitz – investors can construct portfolios to optimize maximum expected return for a given level of risk by combining various securities (or asset classes) which have varying degrees of correlation and expected return.
MPT is a large reason why standard portfolio recommendations center around a mix of 60% equities and 40% bonds.
Most investors intuitively understand the benefits of diversification from such a portfolio. It doesn’t take much for them to realize that the volatility will be lower and the outcomes better for the same degree of risk.
Yet how many of those investors allocate based on that model and then fail to recognize that the changes in the market prices of those securities can dramatically alter the portfolio’s composition?
Imagine an investor who chooses the typical 60/40 equity/bond split. Then over the next year stocks rise 10% while bonds decline 1%. Instead of having exposure to the original asset mix, the investor actually has 62.6% equities and 37.4% in bonds. It doesn’t take many years for an un-managed portfolio to drift significantly from the original asset allocation.
Although portfolio management takes patience, neglect is no prescription for success. Systematic rebalancing of portfolios back to an investor’s desired level of risk is an obvious course of action from the perspective of maintaining the proper point along the MPT efficient frontier, but empirical evidence suggests that rebalancing has the added benefit of lowering overall portfolio volatility without giving up any total return, and in fact, often achieving a higher return.
Before we dig into the specific results let’s examine the concept of rebalancing.
Rebalancing is the process of executing security transactions to return the portfolio to the desired percentage allocations. So in the above example, where after a year the 60/40 investor’s portfolio was 62.6% equities and 37.4% bonds, the extra 2.6% equities would be sold and an equivalent dollar value of bonds would be purchased. The investor would then return to their desired 60/40 allocation.
Many large portfolio managers such as pension funds systematically rebalance on a monthly or quarterly basis. In fact, this practice is so prevalent in the institutional money management community that many strategists publish expected market flows from predictable rebalancing transactions.
Why do many institutional money managers rebalance their portfolios so religiously?
Because it yields better results. The volatility of their portfolio is lower without sacrificing return.
There are plenty of great studies that have documented these results. One that we would like to highlight is the professional work of AQR Capital Management in a 2015 paper titled, Portfolio Rebalancing, Part 1: Strategic Asset Allocation.
The following results are reproduced from their work showing the effect of rebalancing the following portfolio:
We encourage readers to look closely at the green row which represents the Net Total Return based on the different rebalancing methods. The first column is the Buy and Hold return which in this case was 8.7%. Then applying different rebalancing frequencies, the hypothetical returns were calculated. They were all higher than the tradtional Buy and Hold strategy.
But what is even more interesting is the row highlighted by the yellow arrow – the Volatility. The simple Buy and Hold strategy’s volatility was 9.0%. But each one of the different rebalancing periods resulted in a significantly lower volatility.
Not only did all rebalancing strategies produce a net higher total return, but it was done with a lower volatility! This lower volatility is a proxy for lower risk.
The benefits from rebalancing differ depending on the market and the time period examined, but most studies come to a similar conclusion.
At East West Investment Management we manage portfolios for high-net worth Canadians so we thought it would be useful to examine the local rebalancing benefits over the past couple of decades in our home country.
We have calculated the returns and volatility using a simple 60/40 equity/bond portfolio over the period from January 1st, 1996 to January 30th, 2019. For the equity portion of the portfolio we used the TSX Composite Total Return Index and for the bond allocation, the S&P Canada Aggregate Bond Total Return Index.
Here is the cumulative portfolio return over this period:
The Buy and Hold strategy returned 376% during this period but all rebalancing strategies outperformed this figure. The quarterly rebalancing period achieved a total return of 408%, and the semi-annual period a total return of 404%.
However, what’s more exciting was that this increase in performance was achieved with less volatility.
The chart of the annualized volatility shows a marked decrease with portfolio rebalancing.
The “sweet spot” for the typical Canadian 60/40 equity/bond portfolio appears to be quarterly rebalancing periods. The investor has picked up the most return with considerably less volatility.
The annualized return during this period for the Buy and Hold strategy was 6.99% with a annualized volatility of 10.56%. This is in contrast to the annualized return of 7.29% with a 9.50% volatility for the strategy of rebalancing every six months. If an investor equally weighted the portfolios for risk, then that would mean that the Buy and Hold strategy would only be able to have $89.96 invested for every $100. This would translate into an annualized return of 6.49% (assuming 2% return on cash). This is 80 basis points less on a risk-equivalent basis.
Rebalancing has worked well in the past – adding returns to portfolios while reducing risk. We believe it will continue to work and in fact has a greater chance of becoming even more consequential as a driver of portfolio returns in the coming years, especially if we are faced with challenging equity and bond markets.
East West Investment Management provides portfolio management advice to Canadians with the objective of substantially increasing a portfolio’s yield while reducing its volatility. To learn more about our services please email invest@eastwestfunds.com or call 1.416.646.9999.