Recent Rebalancing Subsequent Quarter Results

Sep 29, 2011

As we head to the end of the quarter, the idea of re-balancing is back making the rounds in the media and by fund companies.

When treasury bonds outperform the S&P 500, you will often get a rebalancing by large institutions. We saw this at the end of June 2011. Let’s take one type of look at how this rebalancing trade has worked in the subsequent period (quarter).

We used the 5-year treasury bond index and S&P 500 since 2000. 5-Year Bonds have outperformed stocks by at least 3 percentage points in 16 calendar quarters since 2000. In the next quarter, the S&P 500 tended to be very volatile, dropping 9 times with an average -10.6% loss. The other 7 times it rallied on average +11.0%. So in case you weren’t already thinking so --- don’t be surprised to see a big move in Q4 one way or the other.

At the end of June 2011, the story was that funds rebalanced towards stocks. We have always questioned this type of conventional wisdom and wrote instead about the opposite --- that there was relative strength in bonds. As it turns out re-balancing to stocks in June was a poor decision --- stocks suffered significant double-digit losses in Q3 2011 and treasuries continued up. Indeed, the spread between being long ~5 year Treasuries and long S&P 500 is 17.7% since June (with a few days in the quarter left).

Large funds would argue that the trade is not an attempt to be a money-making move --- just a long-term adjustment back to neutral. That is fine -- but others seem to take it and imply its a useful strategy. As we noted previously ( Rebalancing Theory & Nuances ), the value of re-balancing is not a significant source of value-add. The ‘allocate and re-balance’ conventional wisdom is in our view materially overrated by the buy-side community. The results (below) are quite wild so there isn’t a lot to be drawn bearishly either – it’s just more a matter of the fact that this does not have the characteristics of what constitutes good supporting evidence of a strong strategy (lowering risk and/or materially better return relative to that increased risk).


Here is sample of recent results:


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Comments (8) -

Sep 29, 2011 19:44 #

Given all that, how often WOULD you recommend rebalancing?

Jim United States

Sep 29, 2011 21:29 #

I would ignore traditional, time-based re-balancing.   It's not good and it's not bad -- it's just blah.  

Chris United States

Sep 30, 2011 14:24 #

Consider rebalancing based on asset allocation tolerances.

Example, if you're 50/50 something/something else, reinvest dividends (coupons) to their respective category and rebalance when either side hits 55%.  This might be in a month, it might be in a year, it might be in five years.

Further, imagine N assets each with a 1/N allocation.  When any one of those assets exceeds 1/N by 10% or more, rebalance the portfolio.

You could do this a large fixed-income portfolio, too, set your allocation and your ladder length, then just spend your coupons and maturing debt buying at the top of the ladder in whatever class(es) (munis, BBB, corps, sovereigns, Treasuries) was (were) furthest below their planned allocation percentages.

billr United States

Sep 30, 2011 14:39 #

Oh, note that the sample and the post is on "bond return exceeding stocks in one quarter by 3% or more", which is not a very good rebalancing rule and leads to frequent transactions.

For example, a 50/50 in which one side outperformed the other by 3% would then be only 49/51.

A 10% swing in allocation (i.e. 50/50 to 45/55) needs a long, sustained period of outperformance (such as one outperforming the other by 20% or more).  Here, a rebalancing makes sense to me.

billr United States

Sep 30, 2011 14:50 #

FYI, changing to 10% swing pulls 2 of the 4 largest winning quarters out.    Again, I am not big negative on this --- I just think its extremely overrated.

Chris United States

Sep 30, 2011 17:00 #

Start with 50/50 bonds/stocks in 1980.

Run three tests ... never rebalance, rebalance annually, and rebalance when weight equals 55/45 either way.

You won't think it's overrated after looking at that ... you'll see that it's a pretty big positive.

billr United States

Sep 30, 2011 17:15 #

why stop at 3 tests?    we run thousands --- trust me, you can do a lot better than this.


Chris United States

Oct 01, 2011 00:08 #

If you want to really push the envelope, look at what David Swensen does - daily rebalancing of their liquid assets. Rebalancing has always been and always will be about risk control, but given the tendency of markets to exhibit short-term mean reversion, but trending over periods of several months to 3 years, and ver very strong value reversion in the long run, it suggests 3 things:

# frequent rebalancing;
# heavy emphasis on trend-following / momentum strategies; and
# big time Changes in allocations in the long run

I will finish by saying that not rebalancing, or rebalancing infrequently, is an absolutely terrible way to "implement" a momentum strategy - the lack of initiation and exit signals, plus no control over position sizing, says that people who do this are just intellectually lazy.

Capital Markets guy Australia

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