Journal Papers

Rebalancing and the Value Effect

By Rob Arnott Denis Chaves

AUGUST 2012 Read Time: 30 min

Executive Summary
The authors investigate the source of outperformance of value over growth investing and determine that it is a side effect of routine portfolio rebalancing. They illustrate the paradox of rebalancing: It can have diametrically opposite effects to help (value) and hurt (growth) performance.

Drawing a crucial distinction between investment performance effects specific to individual stocks and those specific to portfolios, the authors emphasize a novel contrast when examining growth versus value. Namely, after decomposing portfolio returns into three factors—changing valuation, dividend income, and dividend growth—they show that although the valuation factor has varying effects, value-focused portfolios dominate growth on both of the other two components. 

They attribute this surprising finding regarding the dividend growth factor (i.e., value portfolios have consistently superior dividend growth results) to portfolio rebalancing. This customary annual adjustment consistently and strongly undercuts any theoretical advantage claimed by growth stocks, persists for at least five years after the rebalance, and is widely observed in the United States and many other developed markets.

For equity investors, the authors’ findings can be provocative because they also address alternative explanations by prominent theorists who attribute value outperformance either to extra financial risk bearing (Fama and French) or errors in extrapolating earnings growth (Lakonishok, Shleifer, and Vishny). Rather than blaming investor misperceptions, the authors argue that the requisite steps to maintaining an investment discipline and consistently following one’s strategy (value or growth) affect the underlying return drivers (e.g., the dividend growth component) and, therefore, the ultimate results. And with some irony, this result is a consequence of the interplay between investor types because growth holders pare back their holdings with decelerating earnings by selling them to value investors.

This observed rebalancing effect also holds for the market portfolio; indexing to maintain it appropriately (e.g., the top 1,000 stocks ranked by market capitalization) will reduce its dividend-related return components, although not as significantly as it will for pure growth portfolios. The authors also identify rebalancing’s influence on popular current alternative index strategies, such as equal weighting, diversity weighting, maximum diversification, fundamental weighting, and minimum variance. Parenthetically commenting on the optimality of these indexing strategies, the authors note the suitability of each of them for different types of investing, whether it is growth, value, or capitalization focused.

The study is based on two samples and covers U.S. data for 1963–2010 and international data for the 23 countries in the MSCI developed markets ex-U.S. portfolio for 1983–2010. Monthly total and price returns are from CRSP. From a universe of the 1,000 largest stocks—excluding companies without book value data—the authors assign the top 50% by market capitalization to the value portfolio and the remainder to the growth portfolio, which splits in half the third portfolio examined (the market portfolio). All portfolios are capitalization-weighted annually and followed with a six-month lag, with calendar year-end rebalancing to derive annual total and price returns from monthly compounding. They decompose the total returns into the three subclasses of return sources: changing valuation, dividend income, and nominal dividend growth. Dividend growth is further segmented into its trends both before and after rebalancing.

The authors track the contribution to total returns from the three components over time for the market, value, and growth portfolios, as well as the impact of rebalancing, to cover both U.S and international results. They then use, with a further retrospective review of the study’s variables, the Fama–French size and book-to-market portfolios to assess a 1928–2010 data series. They also examine the three-part return components for popular indexing strategies over the period 1964–2009.

By illuminating the potentially substantive effects of a routine, nonjudgmental aspect of portfolio management—annual rebalancing—the authors put a fairly ingenious historical revisionism on a classic question of equity investment: Which is best, growth or value? It can give growth managers pause, with the right to lament that “the fault is not in our stars, but in ourselves,” that by simply doing the mechanics, these managers battle headwinds vis-à-vis their value rivals. And the authors raise the intriguing possibility that rebalancing alphas may extend across all types of markets and their related strategies/indices.


Summarized by Gregory G. Gocek, CFA. Copyright 2012, CFA Institute. Reproduced and republished from the CFA Digest with permission from CFA Institute. All rights reserved.

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