Better Rebalancing Strategy for Static Asset Allocation Strategies

An interesting financial academic paper which analyzes an alternative approach to rebalancing of static asset allocation strategies:

Authors: Granger, Harvey, Rattray, Van Hemert

Title: Strategic Rebalancing

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3330134

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.

Notable quotations from the academic research paper:

"A pure buy-and-hold portfolio has the drawback that the asset mix tends to drift over time and, as such, is untenable for investors who seek diversification. However, a stock-bond portfolio that regularly rebalances tends to underperform a buy-and-hold portfolio at times of continued outperformance of one of the assets. Using a simple two-period model, we explain the main intuition behind this effect: rebalancing means selling (relative) winners, and if winners continue to outperform, that detracts from performance.

As stocks typically have more volatile returns than bonds, relative returns tend to be driven by stocks. Hence, of particular interest are episodes with continued negative (absolute and relative) stock performance, such as the 2007-2009 global financial crisis. In Figure 2, we contrast the monthly-rebalanced and buy-and-hold cumulative performance over the financial crisis period, where both start with an initial 60-40 stock-bond capital allocation. The maximum drawdown of the monthly-rebalanced portfolio is 1.2 times (or 5 percentage points) worse than that of the buy-and-hold portfolio, right at the time when financial markets turmoil is greatest.

Rebalanced and not rebalanced portfolio

In earlier work, Granger et al. (2014) formally show that 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. We show that time-series momentum (or trend) strategies, applied to futures on the same stock and bond markets, are natural complements to a rebalanced portfolio. This is because the trend payoff tends to mimic that of a long straddle option position, or exhibits positive convexity.

Trend exposure and portfolio drawdown

We evaluate how 1-, 3-, and 12-month trend strategies perform during the five worst drawdowns for the 60-40 stock-bond portfolio. Allocating 10% to a trend strategy and 90% to a 60-40 monthly-rebalanced portfolio improves the average drawdown by about 5 percentage points, compared to a 100% allocation to a 60-40 monthly rebalanced portfolio. The trend allocation has no adverse impact on the average return over our sample period. That is, while one would normally expect a drag on the overall (long-term) performance when allocating to a defensive strategy, in our sample, the trend-following premium earned offsets the cost (or insurance premium) paid.

An alternative to a trend allocation is strategically timing and sizing rebalancing trades, which we label strategic rebalancing. We first consider a range of popular heuristic rules, varying the rebalancing frequency, using thresholds, and trading only partially back to the 60-40 asset mix. Such heuristic rules reduce the average maximum drawdown level for the five crises considered by up to 1 percentage point. However, using strategic rebalancing rules based on either the past stock or past stock-bond relative returns gives improvements of 2 to 3 percentage points."


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