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Empirical Analysis of Rebalancing Strategies

Discussion NOTE 3 - 30 March 2012

We review the theoretical foundation for rebalancing regimes and look at the impact of rebalancing on the portfolio’s risk and return based on historical return data from 1970 to 2011. We compare both different calendar based rebalancing regimes and different threshold based regimes with the performance of a drifting mix portfolio. Towards the end of the note we focus on the specific design of a rebalancing regime. In particular, we look at a trigger based regime and examine different designs of the threshold level, persistence requirement and implementation rule.

Main findings

  •  Rebalanced portfolios have had both higher returns and lower risk (volatility and tail risk) than a passive, drifting portfolio. Even if one could argue from a theoretical standpoint that rebalancing involves taking on additional (contrarian) risk, this risk has not materialised in our sample period 1970-2011.

  • There are relatively small differences in the risk/return profile between different specifications of the rebalancing regime. The decision to rebalance the portfolio has been far more important than the specifics of the regime.

  • The current rebalancing regime for the Government Pension Fund Global is one of the bestperforming rebalancing strategies over our sample period. Regional rebalancing has contributed to a higher Sharpe ratio over our sample period. However, the theoretical foundation for regional rebalancing is weak. Rebalancing around any arbitrary dimension such as regions or sectors may add value in a historical analysis if they exhibit mean-reverting tendencies in returns.

  • New portfolio theory points out that an investor’s portfolio should be constructed by allocating to a wide range of different risk premia, where the optimal exposure to the different risk premia is investor-specific, depending on preferences and the nature of any non-tradeable risks that the investor is exposed to. Constructing a rebalancing regime around the equity share in the portfolio will effectively manage the exposure to the equity risk premium, which is the single most important risk factor.

  • We examine a threshold based rebalancing regime focused on keeping the equity share within 3 percentage points of the strategic weight. We also examine the implications of different persistence requirements and compare the impact of different rules for how the index should be adjusted towards the strategic weight after the trigger for rebalancing is met.

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