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THERE IS A REBALANCING BONUS ... FALSE

Everyone would love a simple procedural rule that miraculously improves your investment returns. Rebalancing your asset weightings back to a static asset allocation is one of the services that financial advisors sell as just that. The common understanding is that rebalancing is always a good thing. The belief it produces an income gain is now entrenched. This is wrong.

The Evidence

For proof look only at history. While no general rules can be drawn from the one situation that happened to be history, any rule proposed MUST be validated by that one known situation if it is to be correct. The Canadian data for a portfolio of 50:50 debt:equity from 1960 to 2011 shows that rebalancing sometimes increased returns, especially during periods of recession. Other times it decreased returns. In total over the 51 years there has been a 0.37% annualized benefit - assuming zero costs for rebalancing. But the gap may well close again. The data backup can be seen on this spreadsheet's Sheet 15.

You often hear there would be no rebalancing bonus from adjusting your weights between individual stocks because they are too tightly correlated. But compare the graphs of the capital-weighted S&P 500 with the equal-weighted Rydex fund (RSP) that requires rebalancing. Over the long term, as you would expect, RSP tracks a middle path between the SPY and the mid-cap MDY. But in the 200 day period from June 29,2007 the large-cap and mid-cap indexes moved in tandem. In that period the Rydex fund that required rebalancing lost 5% in comparison. A 5% loss over 200 days from rebalancing.

History

This misperception has its roots in academic work that has been mis-represented to the public. The most widely quoted source is William Bernstein. He first presented the 'Rebalancing Bonus' in the 1996 piece, again in a 1997 paper and then again in 2000. Fanning the flames was a quote from David Swensen's 'Unconventional Success' page 198 " In fiscal year 2003, Yale executed approximately $3.8 billion in rebalancing trades, roughly evenly split between purchases and sales. Net profit from rebalancing amounted to approximately $26 million, representing 1.6% return on the 1.6 billion equity portfolio."

The Vanguard Group published a study that showed on Table 3 that average returns were better without rebalancing for some rebalancing schedules, and worse than others:

• 9.655% when never rebalanced
• 9.495% when rebalanced monthly
• 9.669% quarterly
• 9.612% annually

But it is reasonable to question this result. There is a saying that "If you torture data long enough it will confess to anything". Why was the data only from 1970 when Ibbotson's data goes WAY back? Why choose this particular set of assets? This particular result does not 'prove' anything other than exactly what was measured for the time period measured.

The conclusion that Schwab's results could be from chance is validated by the data provided by Sigma Investing. They changed the asset mix to show that rebalancing sometimes increases returns, and sometimes decreases returns.

In 2003 SmithBarney Consulting reviewed the literature and came to the same conclusion - that returns are sometimes better, sometimes worse, and you cannot know ahead of time.

Despite of the lack of evidence, the idea of a rebalancing bonus has found a permanent home in the passive-indexing camp. Once convinced, many people conclude that rebalancing ever-more frequently is ever-more better. Others consider the volatility of an asset a good thing - because it will increase the bonus.

The Generally Accepted Version

What most people agree is that:

• A POTENTIAL rebalancing bonus is determined by two assets' relative variances and covariance. These metrics are developed by averaging historical returns, which are no guarantee of future results in the short term or long term. E.g. debt is traditionally thought to be negatively correlated to equities, but during the 'Great Moderation' they were positively correlated.
• The bonus would be maximized by a 50:50 weighting between the two assets. But that is not to say any particular portfolio SHOULD have that weighting.
• The bonus is greater when each asset's price swings widely, so that each rebalancing creates an entry point at a very low cost relative to the trend. But price volatility is not a desirable attribute of any asset.
• The bonus is greater when the prices of both assets are increasing at roughly the same trend rate of return. If one asset's growth is much lower, each rebalancing would push money from the winning asset into the losing (or lesser return) asset.
• The bonus is greater when returns are negatively correlated and revert to their mean on the same cycle as the rebalancing takes place.
• The big benefit from rebalancing comes from a reduction in risk, not any increased return. Without rebalancing the asset with the largest return will outgrow and take over the whole portfolio. In the data series used in the graph above, the 50:50 allocation degraded to 20:80 debt:equity in 1980 when not rebalanced.

Two securities embodying these qualities would graph as Asset A and Asset B below. Diversification would result in the smoothed orange line. Rebalancing at the exact point of extreme pricing would create a rebalancing bonus and the black line's higher returns.

A fun piece refuting any rebalancing bonus based on pure logic is published in ReoCities. Unfortunately it depends on your acceptance of the Efficient Market Hypothesis that markets always correctly incorporate all public/private information.
A good overview of the different methods for rebalancing is articulated by WiserAdvisor .
Tactical changes to an asset allocation policy are presented by ResearchAffiliates and by James Montier . TAA is not at all what is considered when discussing any rebalancing bonus.

Risk Management

The advice to rebalance comes hand-in-hand with advice to asset-allocate, from advisors looking for a rules-based approach to investing. You should question their objectives. Either they think there is a 'rebalancing bonus' or they think rebalancing reduces risk. Advisors publicly claim to be in the risk-management camp.

Asset allocation positions your portfolio according to your risk tolerance. Without periodically rebalancing back toward that original allocation your portfolio soon becomes heavy in the asset class that has recently outperformed. This is usually (but not always) the more risky asset - common stocks. Rebalancing will reduce risky when you sell some of those outperforming stocks and buy more debt.

But what happens when your 'safe' asset class has outperformed, and now overpowers your portfolio? Rebalancing will not reduce risk because you are INCREASING the risky asset class. A murky argument could be made that holding excessive debt creates a risk of some sort, but really is it credible? Stock markets tank when the economy is in crisis. Debt does well as a 'safe haven'. 2008 is an excellent example.

No one reduced risk by exchanging debt for more stocks at 2008's year end - a time when stocks were the most risky they have been in a living memory. Certainly, advisors later crowed about telling their clients to make the switch. They ridicule the clients that refused. They point to the market's subsequent recovery as proof that markets ALWAYS recover and rebalancing 'works'. (Example).

What exactly worked? What worked was 'market timing' (if they caught the market bottom and did not recommend more stock in (say) September, in time for further drops). They generated excess returns by assuming MORE risk and stepping into stocks at their darkest hour. And yet, when confronted with the reality of the extra risk they put clients in, their response is to deny, deny, deny.

While they SAY they rebalance to reduce risk, in reality they are believers in market timing. They believe that a rules-based approach to rebalancing creates a rebalancing bonus. At the same time, they will ridicule rules such as 'Exit stocks when the index crosses below the 200 DMA.' - a rule explicitly to reduce risk.

Nothing is what it seems.

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