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Asset Allocation
Determining the Optimal Rebalancing Frequency
By Dave Horan
Financial Advisor, UBS Financial Services
Within the investment consulting community, it has long been preached that periodically
rebalancing a multi-asset class portfolio is a requirement for an effective investment policy.
However, little research is available to help in determining what is the optimal rebalancing
frequency. From an efficiency and simplicity standpoint, rebalancing at a set time period,
such as annually, may be easiest. However, if you consider the taxes and transaction costs
that result from rebalancing, we question whether an investor is better off with such a
simplified structure.
In this analysis we seek to interpret what we believe to be the optimal rebalancing frequency
after considering taxes and transaction costs. In this analysis, we will discuss our rationale
for believing that investors are better off establishing a disciplined rebalancing frequency.
For those investors with taxable assets and an intermediate to long-term investment horizon,
we find a rebalancing strategy that uses a 5 percent rebalance trigger (essentially rebalancing
a portfolio whenever an allocation deviates 5 percent from its target weight) is the most
optimal when considering return, risk and the costs associated with rebalancing.
Costs of Rebalancing
The visible, hard costs of rebalancing are transaction costs and realized taxable gains.
Whether an investor pays transaction commissions or pays for services on a fee basis,
transaction costs occur at some level. Additionally, all clients are affected by the bid/ask
spread that must be paid when selling and purchasing securities in order to rebalance.
While the bid/ ask spread is typically insignificant (often as low as $0.01 a share), this
cost can add up when rebalancing an entire portfolio.
For clients with taxable investments, after-tax returns are just as important, if not more
important, than pre-tax returns. Therefore, controlling the unnecessary recognition of
capital gains is important in maximizing after-tax returns. Due to the nature of rebalancing,
those assets that have appreciated the most, relative to the others within the portfolio, are
sold in favor of increasing the allocation to those assets that have not performed as well
on an absolute basis. This naturally creates a tendency to sell gains, therefore increasing
your tax liability.
Collectively, taxes and transaction costs must be considered when setting a rebalancing
frequency. Taxes may not apply to all investors or all aspects of a portfolio. For example,
investors with tax-deferred investments in annuities, IRAs or 401(k) plans will not have
to consider tax costs when determining a rebalancing discipline. Transaction costs will
always be a constant consideration when determining a rebalancing frequency.
Methods of Rebalancing
There are five basic forms of rebalancing used by individual and institutional investors:
No rebalancing
Rebalancing on demand
Rebalance frequencies
Allocation triggers
Hybrid
With the first method, no rebalancing, an investor essentially is allowing their portfolio
to drift and will allow the market to rebalance the portfolio for them. As large-company
stocks appreciate and bonds decline, the allocation to bonds will fall and the allocation to
large-company stocks will rise.
Rebalancing on demand does not establish a set rebalancing guideline; rather, it gives
the investor the freedom to make tactical decisions on when they believe it is appropriate
to rebalance their portfolio. For example, in 2003, the stock market regained its bullish
position with large-company stocks rising 28.7 percent1 and small-company stocks rising
47.3 percent2. After a year such as that, a natural reaction may be have been to take some
of these gains off of the table and reallocate them to bonds. However, with expectations
of rising interest rates in 2004 and a negative outlook for bonds, an investor rebalancing
on demand may have made the tactical decision to delay rebalancing to bonds until rates
had risen.
Rebalancing frequencies is the most common and most disciplined rebalancing method.
An investor chooses a rate of recurrence to rebalance, such as quarterly, semiannually
or annually. Regardless of market direction or expectations for the market, a portfolio
is rebalanced based on a predetermined frequency.
Allocation triggers set boundaries on an asset allocation, thereby forcing a portfolio to be
rebalanced when a boundary is violated. For example, a 5 percent trigger set on a 50/50
stock and bond allocation would rebalance the portfolio whenever one asset class reached
55 percent or 45 percent. While less disciplined than a set rebalancing frequency, this method
allows portfolios to shift with the market and does not rebalance unless there has been a
significant move.
Finally, the hybrid method combines both a rebalance frequency with an allocation trigger.
An example would be setting an annual rebalance frequency with a 5 percent trigger and
stating that the portfolio will be rebalanced no less than annually. However if the portfolio
deviates by 5 percent from its target during the year, the portfolio will be rebalanced at
that time as well.
Collectively, these methods provide investors with latitude in determining to what
extent they wish to let market movements rebalance their portfolios. In addition,
investors also retain the freedom of determining the discipline they wish to instill within
their investment policy based on their comfort with the markets. The lower the number
of occurrences to rebalance the portfolio, the lower the transaction costs and taxable
effects of rebalancing will be.
Optimal Rebalancing Frequency
At the individual level, investors should set a rebalancing frequency based on what is
optimal to them in order to control risk and enhance return, while at the same time
minimizing their costs (transaction costs and taxes).
Research on the subject of selecting an optimal rebalancing frequency is relatively scarce.
In the research that has been conducted, an overwhelmingly consistent message throughout
is the idea that it doesn’t matter what your method of rebalancing is, all that is important
is that you rebalance.
To test these findings, we conducted our own research on two different scenarios to
determine the optimal rebalancing method and frequency. To construct our conclusions,
we compared (back-tested) a number of rebalancing methods against historical investment
returns. We began this comparison by first looking at a simple portfolio that was invested
60 percent in equities and 40 percent in bonds. The methods considered for this simple
comparison included: not rebalancing, annual rebalancing, quarterly rebalancing and
rebalancing based on a 5 percent trigger. In addition, we ran a second comparison of
a more diversified allocation that included large cap, small cap and foreign stocks along
with bonds. With this scenario we added two additional rebalancing methods: a 10 percent
trigger and a hybrid 5 percent trigger with automatic annual rebalancing.
Analysis of a 60/40 stock and bond mix
In comparing the effects of rebalancing a 60 percent stock/40 percent bond allocation3
from 1979 through 2003 (Figure 1), it was quite apparent that rebalancing alone reduced
volatility by over 18 percent, dropping the long-term standard deviation down from
12.2 percent down to 10.3 percent. The difference in volatility (as measured by standard
deviation) among the three rebalancing frequencies (annual, quarterly and a 5 percent
trigger) was minimal, signaling that it is not the method of rebalancing that matters,
but just the decision to rebalance that makes a difference. When comparing the returns
of these methods, not rebalancing the portfolio provided a marginally better return than
the various rebalancing methods.
Figure 1: Analysis Period January 1979-December 2003
|
Return |
Standard Deviation |
Sharpe Ratio* |
| Annual Rebalance |
12.39% |
10.30% |
1.20 |
| Quarterly Rebalance |
12.33% |
10.22% |
1.21 |
| 5 Percent Trigger |
12.46% |
10.28% |
1.21 |
| No Rebalance |
12.55% |
12.22% |
1.03 |
*Sharpe ratio calculated based on a simple Sharpe calculation (Return/Standard Deviation)
When considering return and risk together, we use a simplified version of the Sharpe
Ratio. This ratio takes the return of the portfolio divided by its risk (standard deviation).
For example, taking the annual rebalancing method, the return (12.39 percent) is divided
by the standard deviation (10.30 percent) to produce a Sharpe Ratio of 1.20. This can
be translated as saying for each unit of risk (standard deviation) an investor earns 1.20
percent in additional return.
Using these results on a risk-adjusted basis (i.e., Sharpe Ratio), an investor is better off
rebalancing. All three rebalancing frequencies produced a Sharpe Ratio that was 16.5 percent
higher than was produced without rebalancing. If you take transaction costs and taxes into
consideration, an investor would be better off selecting the 5 percent rebalance trigger
because it yields the smallest number of rebalancing events. Over the 25-year period
analyzed, a 5 percent rebalance trigger would have created 17 fewer rebalancing events
versus 100 events using quarterly rebalancing.
Figure 2
| 2003 |
2002 |
2001 |
2000 |
1999 |
1998 |
1997 |
1996 |
1995 |
| Annual Rebalance |
18.9% |
-9.2% |
-3.8% |
-0.8% |
12.3% |
20.6% |
23.9% |
15.2% |
29.9% |
| Quarterly Rebalance |
18.5% |
-10.1% |
-3.7% |
-1.2% |
12.0% |
20.6% |
23.8% |
15.0% |
29.7% |
| 5 Percent Trigger |
18.8% |
-9.5% |
-3.7% |
-0.9% |
12.3% |
20.8% |
24.0% |
15.3% |
30.1% |
| No Rebalance |
22.9% |
-16.3% |
-8.9% |
-6.5% |
17.8% |
25.2% |
28.6% |
18.5% |
32.7% |
What is intriguing about this analysis is that while the pure returns for not rebalancing
the portfolio are mildly better than the other options, there is a noticeable difference in
the volatility of the rebalanced portfolios versus the non-rebalanced portfolio. A great deal
of the decline in standard deviation comes with less volatility in down markets. The lower
volatility comes from rebalancing back to bonds after stocks have run, therefore creating
a better cushion in a declining stock market. Calendar year performance from 1995–2003
is listed in above (Figure 2).
Analysis of a complete asset allocation
In our second scenario, we took this analysis a step further and compared the performance
of a diversified mix of bonds along with large companies, smaller companies, foreign
stocks and cash. This allocation was a moderate, Growth and Income allocation of
40 percent fixed income, 40 percent large companies, 7 percent small companies and
13 percent foreign stocks.4 This analysis was performed for the period beginning January
1988 and ending in December 2003. In this analysis we compared several rebalancing
methods: quarterly, a 5 percent trigger, a 10 percent trigger and a 5 percent trigger with
an automatic annual rebalancing.
The results of this analysis are displayed in Figure 3 on the next page, with the conclusions
matching those in our first comparison. The choice of rebalancing frequency makes little
impact on overall returns, but the decision to employ a rebalancing discipline meaningfully
diminishes the overall volatility in an investor’s portfolio. More importantly, the volatility
decline results from more steady performance in down markets of 29 percent.5
Although the risk-adjusted results, as measured by the Sharpe Ratio, show all rebalancing
methods to be similar, the use of a 5 percent trigger appears to be the most optimal in our
opinion. After considering transaction costs and taxes, a strong argument could be made
in favor of a 5 percent or 10 percent rebalancing trigger, due to the minor number of
rebalancing events each incurred. As a means of better containing risk within the portfolio,
we recommend a 5 percent trigger, as it will keep the portfolio from gaining a posture that
is too aggressive or too conservative.
Figure 3
|
# of Rebalancing Events |
Return |
Standard Deviation |
Sharpe Ratio |
Average Return in Up Markets |
Average Return in Down Markets |
| Annual |
16 |
11.19% |
4.54% |
2.47 |
4.76% |
-3.29% |
| Quarterly |
63 |
11.34% |
4.60% |
2.46 |
4.81% |
-3.30% |
| 5 Percent Trigger |
7 |
11.44% |
4.61% |
2.48 |
4.84% |
-3.31% |
| 5 Percent Trigger w/ Annual |
18 |
11.41% |
4.60% |
2.48 |
4.83% |
-3.29% |
| 10 Percent Trigger |
3 |
11.40% |
4.65% |
2.45 |
4.85% |
-3.36% |
| No Rebalancing |
0 |
11.56% |
5.44% |
2.12 |
5.18% |
-4.65% |
We also looked at the sensitivity of these results to changes in the initial allocation. As
the asset allocation was tweaked to be more conservative or more aggressive, the results
remained the same.
Other Analysis
Other industry research conducted on the topic of optimal rebalancing suggests similar
conclusions to our analysis. In an October 2001 issue of the Journal of Financial Planning,
Cindy Sin-Yi Tsai makes the conclusion that “Once an advisor and client have made the
decision to rebalance, it does not matter much which strategy they adopt.”6 An online article
written by William Bernstein provides a case study on rebalancing. In this analysis, Bernstein
compares rebalancing methods monthly, quarterly, annually, two years and four years.7
Bernstein concludes that monthly rebalancing is too frequent and that there are incremental
benefits in return for stretching out a rebalancing frequency; however, the cost of doing so
is increasing the risk profile of the portfolio.
6Sin-Yi Tsai, Cindy. “Rebalancing Diversified Portfolios of Various Risk Profiles.” Journal of Financial Planning.
October 2001.
7Bernstein,William J. “Case Studies in Rebalancing.” www.efficientfrontier.com November 2002.
Returns calculated in this analysis do not reflect transaction costs and taxes. These costs are specific to a client’s
individual financial situation and cannot be accurately estimated. Transaction costs could occur as an up-front load,
back-end load, quarterly fee or a per transaction cost. Taxes vary based on the individual’s federal, state and local
tax rates. Investors should recognize that transaction costs and taxes would lower the returns shown in this analysis.
Conclusion
The analysis conducted for this research coincides with other industry research suggesting
that the method and frequency of rebalancing is insignificant, as long as an investor employs
a rebalancing discipline. Contrary to popular belief, rebalancing does not appear to enhance
investment returns. However, it has proven to significantly reduce volatility. This reduction
in volatility has tended to occur in down markets.
We believe the most optimal rebalancing discipline, after considering taxes and transaction
costs, is a 5 percent trigger. Based on our study this method has proven to perform in line
with other methods and its smaller number of rebalancing instances (as compared with
a quarterly or annual rebalancing method) will significantly reduce transaction costs and
taxes. When considering taxes, a quarterly or annual rebalancing method is more apt to
recognize short-term gains, a more costly taxable gain, than a 5 percent rebalancing trigger,
which is less likely to recognize short-term gains. The negative side of a 5 percent rebalancing
frequency is that it is not as static or automated and places greater responsibility on the
investor and their financial advisor to periodically review their asset allocation to ensure
a trigger has not been violated.
While we maintain an opinion on an optimal rebalancing frequency, it is important
to recognize that each individual investor is different. Regardless of our opinion, what
matters most is that investors rebalance, with their rebalancing method being only a
secondary consideration.
1As measured by the S&P 500. Source: Zephyr Associates.
2As measured by the Russell 2000. Source: Zephyr Associates.
3Used the S&P 500 as a proxy for equities and the Lehman Aggregate Bond index as a proxy for bonds.
4Data from the Russell 1000 index was used to simulate the performance of large-company stocks. The Russell
2000 was used to simulate results of small-company stocks, with the MSCI EAFE index being used to simulate
the results of foreign stocks. The Lehman Aggregate Bond index was used as a proxy for performance of bonds.
5Assuming that volatility decreased from 4.65 percent with not rebalancing to an average of 3.30 percent with
rebalancing. This decline of 1.35 percent accounts for a 29 percent decrease in volatility as measured by standard
deviation.
6Sin-Yi Tsai, Cindy. “Rebalancing Diversified Portfolios of Various Risk Profiles.” Journal of Financial Planning.
October 2001.
7Bernstein,William J. “Case Studies in Rebalancing.” www.efficientfrontier.com November 2002.
Returns calculated in this analysis do not reflect transaction costs and taxes. These costs are specific to a client’s
individual financial situation and cannot be accurately estimated. Transaction costs could occur as an up-front load,
back-end load, quarterly fee or a per transaction cost. Taxes vary based on the individual’s federal, state and local
tax rates. Investors should recognize that transaction costs and taxes would lower the returns shown in this analysis.
Piper Jaffray does not provide tax advice.
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