March 27, 2012
The Rise of Robo Rebalancing
Tara Siegel Bernard tells us that automatic rebalancing options are becoming common at 401(k) plans, but the service is still a rarity for online brokerages. TD Ameritrade and Fidelity are among the handful of exceptions, she reports in The New York Times. In a perfect world, these options would be standard everywhere. Rebalancing, after all, is crucial for risk management and earning a decent risk premium through time. Making this essential task easier, by putting it on auto pilot, would be a huge plus for investors.
You can, of course, rebalance on your own. The problem is that most of us don't, at least not on a timely basis, perhaps not at all. The price of inaction can be costly because the rebalancing bonus can be substantial. For example, my research shows that a simple regimen of rebalancing a portfolio comprised of the major asset classes improves performance considerably vs. an unrebalanced strategy over the past decade-plus. Optimizing the process holds out the promise of doing even better.
That’s old news, of course. Numerous studies over the years find that rebalancing is the foundation for successful portfolio design and management. A few examples:
"Portfolio Rebalancing in Theory and Practice," by Yesim Tokat (Vanguard)
"Active Portfolio Rebalancing: A Disciplined Approach to Keeping Clients on Track," by John Nersesian (IMCA)
"The Importance of Portfolio Rebalancing in Volatile Markets," by Steven Weinstein, et al. (CCH Inc.)
"The Subtle Art of Rebalancing," by Bill Montague (Consulting Group)
Although the topic of rebalancing is no stranger to financial analysis, it's premature to say that the subject has been exhausted as a research topic. Identifying the ideal set of parameters that govern the rebalancing rules is certainly in no danger of full transparency, as a new paper from Research Affiliates reminds. It's well know and widely documented that the value factor earns a sizable risk premium over growth in the equity market, advises "Rebalancing and the Value Effect," by Denis Chaves and Robert Arnott. "Less well known, however, is how this outperformance is achieved," they note.
Decomposing the total returns of these strategies, we find that (a) value portfolios enjoy higher dividend income and (b) the average growth stock enjoys faster dividend growth than the average value stock; but, surprisingly, (c) value portfolios experience higher growth in dividends than growth portfolios. We argue that the first two findings are expected, but the third one is not completely understood by investors.
This third result is a consequence of the nature of the rebalance rules for growth and value portfolios. Each rebalance replaces lower-yielding value stocks with new higher-yielding replacements, and replaces higher-yielding growth stocks with new lower-yielding replacements. It is, therefore, the act of rebalancing and reconstituting the growth and value portfolios that increases the growth rate for dividend income in value strategies, and rather sharply reduces it in the case of growth strategies.
Another recent study labels the rebalancing effect as "Dynamic Beta: Getting Paid to Manage Risks." That's a fair description of what's going on here, but to borrow a phrase from New York's lottery campaign, you've got to be in it, to win it.
There are no guarantees with rebalancing, of course, but the same caveat applies to every other investment strategy. Everything has risks, and so it's all about managing the risks intelligently. Rebalancing, combined with broad diversification across the major asset classes, offers the most bang for the average investor's portfolio buck. But as several studies have found, relatively few individuals (and perhaps quite a few institutional investors) are mining rebal's gold on a systematic basis. That's probably because the discipline required to rebalance when it's most productive—i.e., when markets soar and crash—is usually in short supply. That also explains why the expected premium from rebalancing is substantial and persistent.
That's another way of saying that if more investors embrace rebalancing, and do so on a timely basis, the expected return from this portfolio technique will decline. Given human nature, however, it's safe to assume that the ex ante rebalancing premium will remain healthy for the foreseeable future.
Nonetheless, it's getting easier to automate the process. Online tools like MarketRiders, for instance, herald a new age for optimizing the rebalancing process. It's anyone's guess how many investors will take advantage of these tools. Rebalancing, after all, has a hard time competing for the average investor's attention in the grand scheme of financial news and information. But maybe that's good news for the few who exploit the strategic opportunities that seem to elude so many of us. In short, the death of the expected rebalancing premium, and the associated benefits that arise from dynamic asset allocation, are greatly exaggerated.
Posted by jp at March 27, 2012 6:35 AM
Outstanding article and spot on. It amazes me how so many advisors and investors pooh pooh broad global diversification WITH systematic rebalancing as passe. Yet working in the industry I know that clients don't do it on their own and advisors often don't as well. Who wants to trim back bonds in 2008 and early 2009 and plow money into reits? Or small cap stocks? But that's exactly what disciplined rebalancing had you do. I get calls to this day about is it time to buy back into reits as an example. And of course reits are up well over 100 percent since 09. Classic.
Posted by: Indo at March 28, 2012 9:42 PM