Rebalancing Risk

34 Pages Posted: 30 Aug 2014 Last revised: 4 Oct 2014

Nicolas M. Granger

Man AHL

Douglas Greenig

Independent

Campbell R. Harvey

Duke University - Fuqua School of Business; National Bureau of Economic Research (NBER); Duke Innovation & Entrepreneurship Initiative

Sandy Rattray

Man AHL

David Zou

Man - AHL

Date Written: October 3, 2014

Abstract

While a routinely rebalanced portfolio such as a 60-40 equity-bond mix is commonly employed by many investors, most do not understand that the rebalancing strategy adds risk. Rebalancing is similar to starting with a buy and hold portfolio and adding a short straddle (selling both a call and a put option) on the relative value of the portfolio assets. The option-like payoff to rebalancing induces negative convexity by magnifying drawdowns when there are pronounced divergences in asset returns. The expected return from rebalancing is compensation for this extra risk. We show how a higher-frequency momentum overlay can reduce the risks induced by rebalancing by improving the timing of the rebalance. This smart rebalancing, which incorporates a momentum overlay, shows relatively stable portfolio weights and reduced drawdowns.

Keywords: fixed weights, 60-40, drift weights, constant weights, rebalanced portfolio, rebalancing, negative skewness, negative skew, short straddle, negative gamma, momentum overlay, negative convexity

JEL Classification: G11, G13

Suggested Citation

Granger, Nicolas M. and Greenig, Douglas and Harvey, Campbell R. and Rattray, Sandy and Zou, David, Rebalancing Risk (October 3, 2014). Available at SSRN: https://ssrn.com/abstract=2488552 or http://dx.doi.org/10.2139/ssrn.2488552

Nicolas M. Granger

Man AHL ( email )

Riverbank House
2 Swan Lane
London, EC4R 3AD
United Kingdom

Douglas Greenig

Independent ( email )

No Address Available

Campbell R. Harvey (Contact Author)

Duke University - Fuqua School of Business ( email )

Box 90120
Durham, NC 27708-0120
United States
919-660-7768 (Phone)
919-660-8030 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Duke Innovation & Entrepreneurship Initiative ( email )

215 Morris St., Suite 300
Durham, NC 27701
United States

Sandy Rattray

Man AHL ( email )

Riverbank House
2 Swan Lane
London, EC4R 3AD
United Kingdom

David Zou

Man - AHL ( email )

Riverbank House
2 Swan Lane
London, EC4R 3AD
United Kingdom
+442071443632 (Phone)

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