Rebalancing With Transaction Costs: Theory, Simulations, and Actual Data

Abstract

In the absence of transaction costs and the presence of independent returns, a buy-and-hold strategy can be shown to generate higher expected returns than a fixed-weight strategy, where the portfolio weights are regularly readjusted/rebalanced to some initial level. This higher expected return comes, however, at a cost: higher volatility. The resulting trade-off leads to different rankings of the Sharpe ratio depending on the statistical moments of the assets. We theoretically discuss causes affecting the ranking of the Sharpe ratio, and we introduce an easy-to-implement methodology to deal with proportional transaction costs. Under transaction costs, the buy-and-hold strategy as the cheaper approach should be the winner. In various simulation experiments, we investigate the relevance of transaction costs on rebalancing strategies. Eventually, we consider a realistic portfolio with a risk-free asset, bonds, and various stock indices that allows us to demonstrate that in practice, as long as transaction costs remain small, rebalancing has value for realistic portfolios.

Keywords: Portfolio rebalancing, Dynamic trading, Portfolio allocation, Buy-and-hold, Transaction costs, Insured portfolio

JEL Classification: G11, G15, C61, C63