Opportunistic Rebalancing: A Portfolio Rebalancing Strategy That Times the Market

Do you rebalance your portfolio?

If you do, how often do you rebalance? Once a year? Semi-annually? Or every quarter?

Or maybe you do it whenever you think is necessary.

Why rebalance?

The main reason for rebalancing is to maintain a portfolio’s target asset allocation. As time goes by and market moves, some asset classes may perform better than others during a certain period of time, causing assets drifting aways from the desired allocation. Rebalancing helps restore allocations of assets in a portfolio to their designed percentages so that the portfolio can achieve the balance between risk and reward and provide long-term benefits.

Rebalancing is simply done by reducing asset classes that have grown out of proportion and increasing assets that are under funded, thus the process also invokes the “buy low, sell high” principle. Since the asset classes that exceed their corresponding allocations are those outperforming other classes in the portfolio, bringing these classes down to their target allocations means taking profits from the winning investments. Meanwhile, the allocations of those losing investments shrink as the assets underperform, which, in turn, presents buying opportunities.

How to rebalance?

There’s an interesting article in the January 2008 issue of Journal of Financial Planning with the title, Opportunistic Rebalancing: A New Paradigm for Wealth Managers, that discussed how rebalancing doesn’t have to be done on a predetermined calendar date, but take into consideration the timing of rebalancing, in order to achieve better long-term return. Though the intended audience of the paper is financial planners, In the article, the so-called opportunistic rebalancing is an approach that

not only controls portfolio risk, but also provides significant return improvements by capturing sporadic buy-low/sell-high opportunities as asset classes drift relative to each other.

The argument in the paper against calendar rebalancing is that such method ignores the market condition at the time of rebalaning and chooses an arbitrary point to make buy and sell decision. Instead, the proposed opportunistic rebalancing periodically checks the allocations of a portfolio throughout the year, but only rebalances when the shift of an asset class exceeds a certain range (”tolerance range,” the range which allows the allocation of an asset class to fluctuate). These are two key elements in the new method. The benefits of using tolerance range to determine when to rebalance are quite obvious: If rebalance every time when an asset class drifts away from its target, the number of trades within the portfolio will go up (every class has to be rebalanced at the same time), thus increase the overall costs of the portfolio.

The experiments in the article used data from 1992 to 2004 on a portfolio that has a 60/40 stocks/bonds mix with five asset classes: 25% U.S. large (S&P 500 Total Return), 20% U.S. small (Russell 2000 Total Return), 10% REIT (Dow Jones REIT Total Return), 5% commodities (Dow Jones AIG Total Return), and 40% bonds (Bloomberg 7-10 Total Return). The study results show that superior returns are generated when a wide tolerance range (20%) is used together with more frequent checking of allocations (20-day interval).

My observations

While I think this market condition based rebalaning strategy makes sense as the study results indicated, it may not be easy for individual investors to implement. The main obstacles, in my opinion, are of course the trading frequency and associated costs. I don’t know how practical it is to check allocations every 20 or 30 days and make adjustments accordingly. Besides, most mutual fund companies impose the 90-day holding period to prevent, exactly, market timing, making it difficult to unload winning investments frequently (unless rebalancing is achieved by buying more losing investments). However, the idea of rebalancing when the market is in more favorable conditions to provide long-term benefits to the portfolio is worth exploring.

*Photo from NY Times

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