Optimal Asset Rebalancing in the Presence of Transactions

RPF-261

18 Pages Posted: 1 Feb 1997  

Hayne E. Leland

University of California, Berkeley - Walter A. Haas School of Business

Date Written: August 1996

Abstract

We examine the optimal trading strategy for an investment fund which wishes to maintain two assets in fixed proportions, e.g. 60/40 in stocks and bonds. Transactions costs are assumed to be proportional to the amount of each asset traded. We show that the optimal policy involves a band about the target stock proportion. As long as the actual stock/bond ratio remains inside this band, no trading should occur. If the ratio goes outside the band, trading should be undertaken to move the ratio to the nearest edge of the band. We compute the optimal band and resulting annual turnover and tracking error of the optimal policy, as a function of transactions costs, asset volatility, the target asset mix, and other parameters. We show how changes in transactions costs and other parameters affect the size of the no-trade band, turnover, and tracking error. Compared to a quarterly rebalancing strategy an example demonstrates that the optimal strategy can reduce turnover by almost 50 percent.

JEL Classification: G10

Suggested Citation

Leland, Hayne E., Optimal Asset Rebalancing in the Presence of Transactions (August 1996). RPF-261. Available at SSRN: https://ssrn.com/abstract=1060 or http://dx.doi.org/10.2139/ssrn.1060

Hayne E. Leland (Contact Author)

University of California, Berkeley - Walter A. Haas School of Business ( email )

Haas School of Business
545 Student Services Building
Berkeley, CA 94720
United States
(510) 642-8694 (Phone)
(510) 643-1420 (Fax)

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