With rebalancing, less is more

As part of portfolio construction, advisors can help clients develop a rebalancing strategy that addresses the following:

• how frequently the portfolio should be monitored;
• how far an asset allocation should be allowed to deviate from its target before it’s rebalanced; and
• whether periodic rebalancing should restore

a portfolio to its target or a close approximation.

How frequent and far

Our research emphasizes that rebalancing once or twice a year—and only when a portfolio has wandered from its target by at least 5%—produces absolute return/risk results close to those resulting from more frequent, complicated and time-consuming rebalancing.

We reached this conclusion after conducting a historical analysis from 1926 through 2009 on the performance of several hypothetical portfolios (see “Impact of rebalancing,” below). We compared the risk-and-return characteristics produced relative to a target asset allocation of 60% equities and 40% bonds. The target allocation was rebalanced monthly, regardless of the allocation drift (there was a 0% minimum rebalancing threshold).

IMPACT OF REBALANCING: 1926 THROUGH 2009

Monitoring frequency	Monthly	Monthly	Monthly	Monthly	Quarterly	Quarterly	Quarterly	Annually	Annually	Annually	Never
Minimum rebalancing threshold	0%	1%	5%	10%	1%	5%	10%	1%	5%	10%	None
Average equity allocation	60.1%	60.1%	61.2%	61.6%	60.2%	60.9%	62.6%	60.5%	60.7%	63.0%	84.1%
Costs of rebalancing
Annual turnover	2.7%	2.3%	1.7%	1.3%	2.2%	1.7%	1.5%	1.7%	1.6%	1.4%	0.0%
Number of rebalancing events	1,008	389	58	20	210	50	21	72	28	15	0
Absolute framework
Average annualized return	8.5%	8.5%	8.6%	8.8%	8.7%	8.9%	8.6%	8.6%	8.6%	8.7%	8.1%
Volatility	12.1%	12.1%	12.2%	12.2%	12.2%	12.1%	12.3%	11.9%	11.8%	12.1%	14.4%

Notes: This illustration does not represent the return on any particular investment. It assumes a portfolio of 60% stocks/40% bonds. All returns are in nominal U.S. dollars. There were no new contributions or withdrawals. Dividend payments were reinvested in equities; interest payments were reinvested in bonds. There were no taxes. All statistics were annualized.

Sources: Vanguard’s calculations, using data from Standard & Poor’s, Wilshire, MSCI, Citigroup, and Barclays Capital.

A portfolio rebalanced more often, either because it was monitored more frequently or because it had tighter rebalancing thresholds, tracked the target asset allocation more closely. However, the magnitude of the differences in the average annualized returns and volatility was relatively insignificant.

In addition, a rebalancing strategy that included monthly monitoring and 1% thresholds was more costly to implement (an average of 389 rebalancing events, with annual portfolio turnover of 2.3%) than one that included annual monitoring and 10% rebalancing thresholds (an average of 15 rebalancing events and annual portfolio turnover of 1.4%). In our analysis, the number of rebalancing events and the annual turnover were proxies for costs; actual costs depend on a portfolio’s unique transaction costs and taxes.

Although this analysis implies portfolios rebalanced more frequently track the target asset allocation more closely, it also suggests the cost may limit the optimal number of rebalancing events. Transaction costs and taxes detract from the portfolio’s returns, potentially undermining the risk-control benefits of some rebalancing strategies.

Rebalancing once or twice a year can be useful, and for many investors, there’s little value in making it more complicated.

Target asset allocation

The decision to rebalance either to the target asset allocation or to some intermediate allocation short of the target depends primarily on the type of rebalancing cost involved.

When trading costs are mainly fixed and independent of the size of the trade—time spent, for example—rebalancing to the target allocation is optimal because it reduces the need for further transactions.

On the other hand, when trading costs are mainly proportional to the size of the trade—as with commissions and taxes—rebalancing to the closest boundary is optimal, minimizing the size of the transaction. If both types of cost exist, the optimal strategy is to rebalance to some intermediate point.

Setting expectations

A rebalancing plan gives advisors an opportunity to revisit—and potentially reset—client expectations. It offers a good opportunity to discuss how clients concerned about a bond bubble can use bonds to offset stock volatility. It also offers an opportunity to challenge current equities assumptions.

The long-term median nominal return for global equity markets is hovering between 6% and 9%, below historical averages. But after adjusting for potential inflation, we estimate a 50% likelihood that global equities will realize their post-1926 real return average of 9.93% over the next decade. This outlook for the global equity risk premium may surprise some investors in light of the economic outlook and low-rate environment.

Atul Tiwari is managing director of Vanguard Investments Canada.