By Adam J. Smith, CFA, CAIA, Investment Strategist

The last issue of the Nonprofit Minute discussed the perils that can occur when investors unsuccessfully try to time the market (“The Math and Mentalities of Market Timing,” Spring 2010). Another way in which investors unknowingly time the market is through the lack of a disciplined portfolio rebalancing policy. In the absence of such a policy, investment committees are left to rebalance the portfolio at their discretion, which can lead to a form of market timing if there is a reluctance to rebalance because a particular asset class has recently experienced exceptionally good or bad performance. Given this temptation, what are the benefits of a disciplined approach to rebalancing the portfolio, and what should investors do?

Benefits
Simply stated, portfolio rebalancing is the process by which investors increase or decrease their exposure to an asset class so that its actual weighting moves back in line with its target weighting as defined in the strategic asset allocation found in the investment policy statement (IPS). Typically, an asset class moves away from its target weighting because it outperforms or underperforms relative to the other asset classes included in the portfolio. Therefore, the process of portfolio rebalancing serves to capture one of the most powerful concepts within investment management: reversion to the mean. Essentially, reversion to the mean is the tendency for investments or asset classes that have outperformed to experience a period of underperformance, or vice versa. Rebalancing the portfolio forces an investor to reduce its “winners” (i.e. those asset classes that outperformed recently) and add to its “losers” (i.e. those asset classes that underperformed recently). Doing so should have a positive impact on long-term returns, but a question remains: how should investors implement a portfolio rebalancing policy?

Implementation
Investors utilize a number of rebalancing policies. Some choose to rebalance the portfolio systematically, such as quarterly or annually. Others, however, choose to rebalance whenever the actual weighting of an asset class moves outside of an acceptable range relative to its target weighting as defined in the strategic asset allocation. For example, an investor with a 60% target weighting in U.S. equities might rebalance whenever the actual weighting deviates from the target weighting by more than 10% (i.e. the actual weighting is more than 66% or less than 54%). Despite the various triggers for rebalancing a portfolio, a common thread is that rebalancing is implemented throughout the entire portfolio and not just for those asset classes whose actual weightings deviate the most from the target weighting.

Other factors that investors must consider when developing a portfolio rebalancing policy are the impacts of taxes and transaction costs. While taxes are typically not an issue for institutional investors because most are tax-exempt, transaction costs can impact the decision of how frequently the portfolio should be rebalanced; however, transaction costs have come down significantly over the past few decades. Therefore, Lancaster Pollard Investment Advisory Group believes the primary factor that should drive the development of a portfolio rebalancing policy is the policy’s impact on the return and volatility of the total portfolio.

Impact on Returns
Lancaster Pollard Investment Advisory Group measured the impact of various portfolio rebalancing policies on return and volatility. Monthly return data for the following benchmarks were used to create a hypothetical portfolio: 50% in the S&P 500 Index to represent U.S. stocks; 10% in the MSCI EAFE Index (Net) to represent international stocks in developed markets; and 40% in the Barclays Capital Intermediate Government / Credit Index to represent investment-grade U.S. bonds. Using a start date of Jan. 1, 1973, (the inception of the Barclays bond index) the impact on the return and volatility of the total portfolio was analyzed using the following four rebalancing policies: never; quarterly; annually; and whenever the actual weighting deviated by more than +/- 10% relative to the target weighting.

Based on this analysis, never rebalancing the portfolio is clearly the most inferior option, generating both the lowest return and the highest volatility of the four options tested; however, there is very little difference between the return and volatility for the three different portfolio rebalancing policies (see Figure 1 above).

Although the return percentage and volatility impact on the total portfolio among the various rebalancing policies is minimal, the actual dollar impact can become meaningful, especially as the investment period becomes longer. For example, an investment portfolio with a beginning value of $10 million on January 1, 1973, and no rebalancing policy would have grown to about $226 million as of June 30, 2010. Using the same starting value for the portfolio and implementing a rebalancing policy of quarterly or +/- 10%, the resulting portfolio would have grown to about $259 million, or an additional $33 million versus never rebalancing (see Figure 2). The best result, however, would have been achieved using an annual rebalancing policy, which would have resulted in an ending portfolio value of $263 million as of June 30, 2010, or $37 million more than never rebalancing the portfolio. Therefore, an annual rebalancing policy, while generating a minimal advantage in percentage terms, can create a meaningful advantage in dollar terms when compounded over a long period. Additionally, an annual rebalancing policy should lead to lower transaction costs versus a quarterly rebalancing policy.

Conclusion
Given the combination of higher returns, lower volatility, and lower transaction costs compared to other rebalancing policies, investors should include an annual rebalancing policy as part of their IPS. Including specific rebalancing language in the IPS makes the decision policy-driven rather than at the discretion of the investment committee. As noted earlier, discretionary rebalancing is a form of market timing, as it could be difficult for an investment committee to decide to reduce its position in an outperforming asset class and add to its position in an underperforming asset class. Therefore, implementing a policy of annual rebalancing, which can be done in conjunction with the annual review of the IPS, is appropriate for many investors in that it is systematic, disciplined, and should lead to better long-term performance within the investment portfolio.

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