Rebalancing can help investors tap into alpha, but people can overdo it.
“There are two main traps that constitute what I call detrimental rebalancing,” says Adrian Banner, CEO and CIO of INTECH Investment Management. He manages the Renaissance U.S. Equity Fund.
First, rebalancing isn’t free. So “if you trade too much, or too much in securities that aren’t very liquid, the benefits can be overwhelmed by transaction costs, which drag on portfolio returns.”
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Second, it’s possible to rebalance so much that you start buying high and selling low. How would this work? Well, say Stock X has a target of 5% and Stock Y has a target of 3% in the portfolio.
“You may find after a year you might want to change X’s target to 6% and Y’s to 1%,” says Banner. “But if you adjust these targets too frequently, you may think you’re rebalancing [when you’re] actually trading in the opposite direction of…a true volatility capture.”
The consequence? “You’ve missed an opportunity and paid too much.”
Of the two traps, Banner says high trading costs are more insidious. Still, “the good news is, in practice, transaction costs in developed and even emerging equity markets tend to be low enough that [they don’t] destroy the rebalancing premium,” so long as investors trade carefully.