Investment managers are taught early in their careers that a basic strategy to mitigate overall portfolio risk is diversification, whether it be by asset category such as stocks, bonds or cash or, in the case of an equity portfolio, by exposure to different sectors, stocks or market capitalizations.
It is possible to construct an equity portfolio that is more efficient than a cap-weighted index, without having to forecast stocks, alphas or any other fundamental inputs. The result is that the weighting of each stock within the portfolio, when compared with the index, is likely to be different. But what happens when the weightings of the individual stocks drift away from their target weights as their prices move up and down in the market?
The portfolio is rebalanced back to those target weights.
Most stock price movements are just natural volatility and not trends. Maintaining a more diversified portfolio by rebalancing accounts for this volatility in the form of a rebalancing premium and ensures that the portfolio remains diversified, helping to mitigate overall portfolio risk. Rebalancing is a mechanism for replenishing diversification. The two concepts are inextricably linked to the point of being nearly symbiotic. Without rebalancing, a portfolio tends to become more concentrated in the assets that have performed well. It is only a matter of time before the benefits of diversification, such as mitigating unintentional exposure risk, start to erode.
Rebalancing also means trading. Rebalancing trades have a buy-low, sell-high quality. They also lock in the gains from diversification that might otherwise be lost. It is important to be cognizant that trading is not free and requires smart implementation.
Is there a return benefit from rebalancing?
There are some academics and practitioners who believe there is no return benefit from rebalancing when a portfolios expected wealth does not increase, or, if a return benefit does exist, it is the result of diversification and not rebalancing. Remember the relationship between rebalancing and diversification; one ties into the other.
Others believe that exploiting the natural volatility of a portfolios individual assets through rebalancing results in pushing up the compound return of the portfolio, as a whole. Many investors overlook the fact that compound returns are more relevant than expected returns, however. The expected return simply indicates how well the portfolio should perform, on average, in a specified time period.
Most often, though, investments do not return what is expected. Compound returns are a vital attribute for any investment whose term length is not known in advance. Even if compound returns are hard to predict, maintaining a diversified portfolio by means of rebalancing nevertheless increases the compound return of the portfolio as a whole relative to the buy-and-hold portfolio.
The correlations and variances of the many stocks that typically comprise a modern, real-world portfolio will vary over time, but the benefits of diversification and rebalancing persist. If there is extreme concentration in a handful of stocks that ends up dominating the other equities in the portfolio, a buy-and-hold approach could work in the long run but with greater overall risk. When no group of assets dominates for long periods even if none of the individual assets are mean-reverting it is likely that the diversified and rebalanced portfolio will outperform a buy-and-hold approach over the long term because of the stability of the market structure.
Richard Yasenchak is client portfolio manager and senior vice president of INTECH Investment Management , a West Palm Beach, Floridabased global institutional investment manager and subsidiary of Janus Capital Group.
Get more on wealth management.