Portfolio rebalancing is considered to be critical to maintaining investment objectives, yet there is no consensus on the timing, frequency or the out-of-balance threshold that should be used when implementing the common investment strategy.

“Lots of events can trigger the decision to rebalance a portfolio, and different individuals take different views based on their own investment philosophy,” says Robert Marcus, president and CIO of Majorica Asset Management Corp. in Toronto.

In practice, rebalancing to the target asset mix whenever the mix deviates by a defined percentage — a threshold-based policy — appears to be the most prevalent strategy among advisors and other investment professionals. In theory, however, that may not necessarily be the most appropriate strategy.

A recent U.S.-based research paper, entitled Optimal Rebalancing Frequency for Bond/Stock Portfolios, has found that deferring rebalancing to as long as four years was superior to shorter rebalancing frequencies. The paper was written by David M. Smith, associate professor of finance and a research associate at the Center for Institutional Investment Management at the University at Albany, SUNY, in Albany, N.Y., and William H. Desormeau, manager of Strategic Benefit Services in Rensselaer, N.Y.

If a threshold-based policy is used, then superior outcomes are associated with rebalancing only when portfolio weights were 5% or more out of balance, the paper reports. In addition, the best rebalancing policy is dependent upon, and can be planned around, prevailing monetary policy of the U.S. Federal Reserve Board.

In arriving at their findings, the researchers used monthly returns of the S&P 500 composite index with dividends reinvested and the U.S. long-term government bond for the 78-year period 1926-2003. They constructed 19 fixed-weight portfolios, ranging from 5% bonds/ 95% equities to 95% bonds/5% equities, at 5% intervals.

For each of the 19 portfolios, the researchers observed the scaled return under 60 rebalancing policies — from rebalancing every month to rebalancing every 60 months — to determine the existence of an optimum frequency. The scaled return or return/risk ratio is the monthly mean return divided by its standard deviation.

The research showed that, regardless of the asset mix, the maximum scaled return is achieved at a rebalancing frequency of every 44 months; the minimum, at one-month frequencies.

Between 1926 and 2003, the five best rebalancing intervals were found in the 39- to 44-month range, while the lowest scaled returns were more frequent when rebalancing was done every one to six months.

The researchers also found that threshold policies that allowed higher deviations — above 5% — performed better than those with lower deviations in most cases, concluding that returns are less sensitive to threshold-rebalancing decisions than to frequency-based rebalancing decisions.

In addition, it was found that in periods of restrictive monetary policy — rising interest rates — all 19 portfolios benefited from a more patient policy involving a higher rebalancing threshold. Comparatively, in expansionary monetary periods — falling interest rates — more patient monetary policies produced a higher scaled return for 15 of the 19 portfolios.

These findings run counter to the practice of rebalancing among most investment professionals.

The researchers argue that, to the extent that returns are positively correlated in the short run, investors can take advantage of momentum by sitting tight. Given that returns revert to their mean over three to five years, however, rebalancing should correspond to “about that often.”

In practice, Lou D’Aversa, director of business development, at Stratos Wealth Management in Toronto, says rebalancing to the target asset mix is done regularly in keeping with a client’s investment policy statement, based on normal market shifts and outperformance in some areas and asset classes relative to the rest of the portfolio. “A deviation of 5% or more from the target asset mix generally triggers a rebalancing decision,” he adds.

Kevin Chong, a financial advisor with Markham, Ont.-based RGI Financial Services, says he rebalances “as frequently as necessary in a regular market, and at least once a year.” His goal is to maintain a target return and rebalancing is sometimes necessary to achieve it, even though a specific asset class has not deviated from the target asset mix. In such cases, he says, it might be appropriate to rebalance by adjusting the weights of underperforming asset classes based on his view of the market.

@page_break@Moshe Milevsky, associate professor of finance at York University in Toronto, says that investors should try to maintain their asset mix over time by selling some assets that have exceeded their expectations and investing the funds in assets that have disappointed.

“This is not a contrarian strategy [selling winners and buying losers] but a consistency strategy,” he says. “If you don’t rebalance, your allocations will deviate quite widely from your original allocation.”

He cautions, however, that he doesn’t believe one should continuously strive to rebalance a portfolio back to the original allocations, for a number of reasons. First, the transaction costs can be extremely expensive, especially for small investors. Second, investors should give the asset class time to recover.

Milevsky, however, does not go to the extent of Smith and Desormeau in determining an optimal asset mix. His views are more aligned to what is practised: “My preference is to rebalance quarterly, and only if the actual allocations have breached the 5% level. In other words, if you started with a 60/40 mix and by the end of the quarter it became a 65/35 mix, then you should rebalance back to 60/40. But if it only moved to 62/38, don’t bother adjusting. There is a substantial body of academic research that supports this strategy as well.”

He adds: “If your portfolio is relatively large, so that these transaction/trading costs are a relatively smaller fraction of the value of the portfolio, then you might want to check for this rebalancing trigger on a monthly basis — but not more frequently.”

Marcus contends that making switches at the right time can add value to a portfolio. He subscribes to the view that Fed policy can influence rebalancing decisions, but he takes a longer-term view of where interest rates are headed rather than basing his rebalancing decisions on short-term Fed policy.

Both Chong and D’Aversa may also rebalance their clients’ portfolios based on changes in life circumstances. They say periodic rebalancing reduces volatility and enhances returns.

Arguably, the research of Smith and Desormeau is designed for institutional portfolios with a long-term horizons. Many advisors, however, do not subscribe to a rebalancing period as long as almost four years. IE