Disciplined Rebalancing

Hi, my name is Chris Nikolich and I’m the head of Glide Path Strategies at AllianceBernstein’s Multi Asset Group. And I’ll be discussing three main topics; exploring why you should rebalance, providing an example based upon 2019 and 2020 markets, and demonstrating how to rebalance.

But before I do that, I just wanted to highlight that there are many ways to manage risk in a multi asset class portfolio. And this applies to defined benefit plans, defined contribution, endowments, foundations, insurance accounts, allocations for individuals, etc. You could employ tactical asset allocation, whereby you actively manage the strategic asset allocation in the portfolio based upon the current market environment. You could change the strategic asset allocation to manage risk. But for those who are long term investors, who don’t employ tactical or maybe have a governance structure that doesn’t permit changes to their strategic asset allocation, rebalancing is a way to manage risk in your multi-asset class portfolio. Why should you rebalance? Well, it helps you maintain the strategic asset allocation, it prevents timing risks and allows you to systematically take advantage of market dislocations to add value.

Rebalancing, however, can be emotionally difficult. The natural inclination is to buy more of what’s doing well, not to sell it. And it may be difficult to add two strategies or asset classes that have underperformed recently. However, if someone lets emotion drive your investment decisions, they’ll actually be buying high and selling low. The exact opposite of what they should be doing. In contrast, systematic or trigger point rebalancing, removes emotion from the decision, it forces you to buy low and sell high. It exploits dislocations between asset classes and it maintains the strategic asset allocation that resulted from a lot of detailed thought and planning. Should you really be abandoning your strategic asset allocation in times of market turmoil?

It’s easy not to rebalance when times are good. As an example, a 60/40 portfolio that was funded with 100 dollars in December of 2018, the equity allocation grew to 61 and 62 and 63 and almost 64 percent, fueled by a nearly 27 percent return of global equities in 2019.

Only three months later, the story was quite different. As you can see, what should be a 60/40 stock bond portfolio, the equity allocation grew to 64 percent, that fell all the way to 54 percent, given a nearly 34 percent selloff in global equities in the first quarter.

However, as you could see in the rebalanced portfolio, rebalancing would’ve maintained those strategic targets and allowed you to exploit market dislocations. That rebalanced portfolio would’ve been selling equities in December of 2019. And because of the severity of the sell off, would have been buying equities on multiple occasions, on March 9th, on March 12th and again on March 23rd. And by the end of March, that rebalancing process would have added nearly a half a percent, 42 basis points to that original hundred-dollar investment.

So how do you rebalance? Employ systematic rebalancing rules. Once you deviate by a certain amount, that’s your trigger to rebalance. As an asset class outperforms in that 60/40 example, stocks outperform and you hit a trigger, which in this case is 3 percent, that’s your signal to rebalance, to sell equities and to buy bonds. Conversely, as equities underperform, and that equity allocation falls from 60 percent to 57 percent, that’s your trigger point to buy more equities.

What inputs determine the trigger point for rebalancing. AllianceBernstein authored a paper a number of years ago, is there a better way to rebalance that’s still relevant today that discusses all of the factors in detail. However, I highlight a few of them for you now.

One is transaction cost. And there’s been a lot of discussion about transaction costs recently. Yes. Transaction costs are higher. And yes, if nothing else had changed but transaction cost, you’re rebalancing tolerance would be wider, or maybe you wouldn’t rebalance it all. But there are other inputs to the rebalancing process. Investor risk tolerance, correlation between asset classes and volatility among the asset classes in your multi asset portfolio.

I’ll touch on one of these factors in a little bit more detail, volatility. Both realized and expected volatility have skyrocketed recently. VIX, a measure of option implied volatility, rose from the high teens to over 80 in March of 2020. And although it’s fallen significantly from there, it’s still three times the normal levels. And all else being equal, higher volatility would lead to lower trigger points or tighter rebalancing bands, than you would see in a normal environment. So, while a number of factors, including trading costs and volatility have risen recently, they tend to offset each other and the framework for rebalancing still holds.

Once a trigger is hit, should you rebalance fully back to target? The answer is no. And as you can see here, the benefit of rebalancing rises geometrically because tracking error is squared. What does that actually mean? Well, if you’re 1 percent off your target and you rebalance back, your benefit in terms of risk reduction is one. If you’re 2 percent off your target and you rebalance back, you benefit in terms of risk reduction is not two, it’s actually four, because tracking error is squared. But costs are purely linear. It costs you twice as much to rebalance back from 2 percent as it does from 1 percent. So, when you combine these two factors together, the benefits of rebalancing fully back to target are not justified by the cost, and the optimal point is rebalancing halfway back.

You may also be wondering about certain asset classes, such as high yield bonds that had the most significantly elevated transaction costs in the current environment. Well, the good news is, in most multi asset class portfolios, high yield represents a pretty small allocation and high yield bonds have had equity like performance. So high yield tends not to be triggering any sort of rebalancing trades and you’re not exposing your portfolio to the most elevated segments of cost today.

In conclusion, rebalancing can help maintain the strategic asset allocation, reduce risks and improve performance. A disciplined, systematic process removes emotion from the decision. And a typical multi-asset class portfolio that has not been rebalanced and is not utilizing tactical asset allocation is underweight equities because of recent market performance. It needs to be rebalanced in order to bring the portfolio back toward the strategic asset allocation, to exploit the current market environment and potentially to improve performance. Finally, despite the rebound that we’ve seen in markets recently, it’s not too late to rebalance.

With that, I’d like to thank you for your time and hope that you stay safe and healthy in the current environment.