Abstract

Periodic rebalancing of institutional portfolios is no mere option—it is unavoidable. No manager can allow such a portfolio to drift indefinitely with the market. He or she directs new money somewhere, and withdrawals must have a source.

Failure to confront these obligatory decisions in a disciplined fashion is a functional abdication of the asset mix to the whims of the market. Why, then, do so many portfolios fail to implement a carefully planned rebalancing process?

The asset mix changes constantly, and established policy receives occasional reviews, often at less than propitious times. Interestingly, our work suggests that disciplined rebalancing can boost returns at a much larger margin than the policy mix itself. For instance, the policy choice between 60% or 50% in stocks means less than the decision on how and when to rebalance.

Rational investors set an explicit asset allocation policy incorporating allowable ranges for each major asset class. Suppose, for example, that a pension sponsor decides that the fund’s optimal normal mix is 60% stocks, 30% bonds, and 10% alternative investments. Typically, the sponsor might determine that rebalancing is necessary when any class strays more than five percentage points from its benchmark.

We find this response inadequate. A disciplined framework for rebalancing is demonstrably superior to the laxness implied by this kind of range.