Disentangling Rebalancing Return

Abstract

The use of portfolio rebalancing as a profitable strategy (or “volatility harvesting”) is a hot topic. Indeed, it is interesting to know what the impact of periodic rebalancing is on the growth rate of a portfolio. Unfortunately, the terminology used in the literature is confusing. Terms such as “diversification return” and “rebalancing return” are used interchangeably to indicate the growth rate that a rebalanced portfolio can earn in excess of a buy-and-hold portfolio. The literature is also confused in specifying this excess growth rate from rebalancing. In this paper, we investigate the full return from rebalancing and decompose it into the volatility return and the dispersion discount. We prove some general results regarding these components and present some simple approximations which provide direct insight into the driving forces behind these building blocks. We consider a pro forma US asset portfolio over the period 1974-2013, which allows us to investigate the relative magnitude of the discussed effects and their time variation.

Keywords: rebalancing, buy-and-hold, volatility harvesting

JEL Classification: C58, G11