Strategic Rebalancing

Abstract

A mechanical rebalancing strategy, such as a monthly or quarterly reallocation towards fixed portfolio weights, is an active strategy. Winning asset classes are sold and losers are bought. During crises, when markets are often trending, this can lead to substantially larger drawdowns than a buy-and-hold strategy. Our paper shows that the negative convexity induced by rebalancing can be substantially mitigated, taking the popular 60-40 stock-bond portfolio as our use case. One alternative is an allocation to a trend-following strategy. The positive convexity of this overlay tends to counter the impact on drawdowns of the mechanical rebalancing strategy. The second alternative we call strategic rebalancing, which uses smart rebalancing timing based on trend-following signals – without a direct allocation to a trend-following strategy. For example, if the trend-following model suggests that stock markets are in a negative trend, rebalancing is delayed.

Keywords: Asset Allocation, Smart Rebalancing, Market Timing, Active Management, Buy and Hold, Overlays, 60–40 Portfolio, Balanced Portfolio, Stock-Bond Portfolio, Rebalancing, Drawdowns, Downside Loss, Skewness, Trend, Momentum, Derivatives, Futures, Behavioral Finance

JEL Classification: G10, G11, G12, G13, G15, G20, G22, G32