Rebalancing is an important topic in asset allocation. Rebalancing refers to adjusting portfolio weights to a level similar with that of strategic asset allocation. Rebalancing is needed since portfolio weights may deviate from the original strategic asset allocation ratio over time and new assets may need to be added into the portfolio when bonds matured.
Besides, rebalancing also need to be conducted timely according to investors’ own conditions, including goals, age, etc. This kind of rebalancing is not only track with the strategic asset allocation, but also need to be conducted under the clients’ monitoring.
Why portfolio rebalancing is required
Firstly, rebalancing can avoid investors taking on unanticipated or unplanned risks. Secondly, rebalancing can ensure that portfolio positions are in the most familiar and professional areas of investment managers.
Advantages and disadvantages of rebalancing
In terms of portfolio management, rebalancing brings both benefits and costs. The benefit is rebalancing can adjust investors’ portfolio weights back to the optimal ratio, achieving the goal of maximization of utility. Meanwhile, rebalancing can prevent portfolios deviating from strategic portfolio allocations, avoiding investors bearing on unanticipated losses. However, investors need to be bear in mind that rebalancing involves transactions, and different transaction costs may be generated depending on various financial instruments.
Apart from the benefits and costs of rebalancing, a disciplined rebalancing portfolio may have lower risk while higher potential returns. Empirical studies have shown that as long as transaction costs are low enough, rebalancing can create a diversified portfolio, in which can take advantage of the different asset correlation coefficients to increase potential returns. Also, additional returns can be gained by using derivatives to construct and rebalance portfolios, such as selling the out-of-the-money options.
Common rebalancing strategies
In practice, there is no optimal rebalancing rule. In general, common rebalancing methods include calendar rebalancing, percentage-of-portfolio rebalancing, and constant proportional portfolio insurance (CPPI). Calendar rebalancing works by returning portfolio’s allocations to target weights on a periodic basis. Generally, the monitoring cost of calendar rebalancing is relatively lower than the other methods. However, the portfolio weights may significantly deviate from the strategic asset allocation under the volatile period.
Percentage-of-portfolio rebalancing is similar with the risk-control measures. Rebalancing is needed when the portfolio’s asset ratio exceeds the width of corridor, the portfolio will adjust the weight of the asset. This strategy helps investors manage their portfolio risk.
CPPI is a strategy that may dynamically adjust the proportion of risk assets and risk-adverse assets based on changes in portfolio values. The criteria of this strategy is less clear than the other two methods. Detailed introduction of CPPI would be discussed in the next article.
How to set the optimal width of corridor
Percentage-of-portfolio rebalancing is worth to learn since it helps to manage portfolio risks. “How to determine the width of corridor?” It is a common query of many investors. In theory, there are several factors that might affect the optimal width of corridor, including transaction costs, risk tolerance, correlation of assets within portfolio, and the volatility of assets in portfolio. Investors can take the below table as a reference to develop their own optimal corridor.
Factors affecting the optimal width of corridor