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Rebalancing Strategic Portfolios

An evaluation of the efficacy of the annual rebalancing frequency relative to other common approaches.

 

Strategic investors select a diversified portfolio of suitable return and risk from the available set of efficient portfolios. The portfolio's expected return and risk implicitly assume an annual rebalancing frequency because they are derived from annualized capital market forecasts for each asset class in the target asset allocation. We evaluate the efficacy of the annual rebalancing frequency relative to other common approaches to rebalancing.

We use the Sharpe ratio (excess return/standard deviation) as the rebalancing performance metric. It is the standard measure of a portfolio's risk-adjusted return, and maximal Sharpe ratios define the efficient set of portfolios in modern portfolio theory. We test the classic global 60/40 stock-bond portfolio, focusing on the critical balancing point between these two major asset classes, which largely determines a portfolio's return and risk.[1]

We examine 10-year holding periods using two different datasets: historical returns[2] and simulated forward-looking returns.[3] The Annual rebalancing strategy is compared to two other periodic rebalancing frequencies (Quarterly and Monthly), two trigger-based rebalancing bands (5% Trigger and 10% Trigger), and no rebalancing (Buy and Hold).

The Exhibit shows the average Sharpe ratio for each of these rebalancing strategies across all 10-year periods in both the historical (top panel) and simulated (bottom panel) datasets. Across both datasets, the Annual rebalance performs better or as good at generating risk-adjusted portfolio returns, and all rebalancing strategies outperform Buy and Hold. This overall result holds for other stock-bond mixes.

Image: EXHIBIT – AVERAGE SHARPE RATIOS

Rebalancing maintains the intended risk profile while fully capturing the diversification benefit between lowly correlated stocks and bonds. There may be an additional rebalancing premium if returns exhibit mean reversion.

Some taxable investors may choose to postpone rebalancing indefinitely in an effort to avoid incurring a capital gains tax, effectively following a buy and hold approach. However, the Annual rebalancing strategy is highly tax-efficient. The one-year frequency ensures any realized capital gains are taxed at long-term rates. We also found that the annual turnover rate from annual rebalancing is just 3.5% in the historical dataset and 2.9% in the simulated dataset. Assuming turnover is taxed at long-term capital gains rates, we found higher after-tax Sharpe ratios for annual rebalancing than buy and hold for both datasets. This suggests that annual rebalancing is about as tax efficient in practice as buy and hold, while offering improved risk-adjusted portfolio returns.

The overall results show that an annual cycle optimally captures the benefits of rebalancing. It is aligned with modern portfolio theory, tax-efficient, simple to execute, and no other approach is reliably better. These findings are equally relevant to goals-based investors, where goals drive a dynamic asset allocation. Unless goals or risk preferences change, rebalance to the goals-based target asset allocation annually.


[1] The global 60/40 is composed of 60% global equity and 40% U.S. bonds, which are represented by the MSCI ACWI and Bloomberg Barclays US Aggregate indices, respectively.

[2] We use historical monthly return data since MSCI ACWI inception (Jan. 1988) through May 2020 to create 270 rolling 10-year return periods.

[3] We run 5,000 simulations using Northern Trust’s 2019 Capital Market Assumptions. Global equity is represented by MSCI ACWI IMI in the simulations.

 

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