Does rebalancing hurt returns?

Does Rebalancing Hurt Returns?

Rebalancing is a key component of portfolio management, but it often raises questions about its impact on returns. While some investors worry that rebalancing might hurt performance, the truth is more nuanced. The effect of rebalancing depends on various factors such as market conditions, asset💡 Definition:An asset is anything of value owned by an individual or entity, crucial for building wealth and financial security. correlations, and costs associated with implementation. Let's dive deeper into what rebalancing is, how it influences returns, and what investors should consider when applying this strategy.

The Essence of Rebalancing

At its core, rebalancing is the process of adjusting the weights of assets💡 Definition:Wealth is the accumulation of valuable resources, crucial for financial security and growth. in a portfolio to maintain a desired allocation. This can be done through various methods, such as:

• Fixed threshold bands: Rebalancing when asset allocations deviate beyond a set percentage💡 Definition:A fraction or ratio expressed as a number out of 100, denoted by the % symbol., like 3%.
• Calendar-based schedules: Rebalancing monthly, quarterly, or annually.
• Buffer strategies: Allowing a margin💡 Definition:Margin is borrowed money used to invest, allowing for greater potential returns but also higher risk. of drift before rebalancing, which can reduce transaction costs and improve risk-adjusted returns.

Rebalancing is primarily aimed at maintaining a specific risk profile rather than maximizing returns. However, its impact on performance can be significant under certain conditions.

Rebalancing and Returns: What's the Connection?

Rebalancing can have both positive and negative effects on returns, largely depending on market dynamics:

• Return Enhancement Potential: A study over a decade using a 3% fixed threshold found that rebalancing increased annualized returns by 56 basis💡 Definition:The original purchase price of an investment, used to calculate capital gains or losses when you sell. points, adding over $10,000 to portfolio value compared to a buy-and-hold approach. However, these gains aren't consistent across all market environments.

• Modest Gains in Many Scenarios: In many cases, particularly when assets behave similarly, like US stocks and bonds💡 Definition:A fixed-income investment where you loan money to a government or corporation in exchange for regular interest payments., rebalancing adds less than 10 basis points of extra annual returns. The notable benefits occur when asset classes💡 Definition:A group of investments with similar behavior, risk, and regulatory profiles (e.g., stocks, bonds, cash). diverge significantly, as seen in 2022 when US Growth stocks fell 36.7% while US Value stocks remained relatively stable.

Real-World Example

Imagine a portfolio split equally between US Growth stocks and US Value stocks. As Growth stocks fell by 36.7% in 2022, rebalancing would have involved selling some Value stocks (which only lost about 1%) to buy more Growth stocks at lower prices. This action could potentially capture future gains when Growth stocks recover, demonstrating how rebalancing can enhance returns in volatile markets.

Hidden Costs💡 Definition:Small or automatic charges that slip under the radar but add up over time. of Rebalancing

While rebalancing can theoretically boost returns, it also comes with costs:

• Transaction Costs: Every time you rebalance💡 Definition:The process of realigning your investment portfolio back to your target asset allocation by buying and selling assets., you incur trading fees, which can erode gains.
• Market Impact: Large-scale rebalancing by institutions can affect stock💡 Definition:Stocks are shares in a company, offering potential growth and dividends to investors. prices, with equity💡 Definition:Equity represents ownership in an asset, crucial for wealth building and financial security. returns decreasing by 17 basis points the day after rebalancing.
• Front-Running Risks: Predictable rebalancing patterns can lead to market participants exploiting these trades, further impacting returns.

Recent research suggests that these costs might amount to $16 billion annually, or about $200 per U.S. household.

Common Mistakes and Considerations

• Overly Frequent Rebalancing: Too frequent rebalancing can lead to unnecessary transaction costs without significant improvement in returns.
• Ignoring Asset Correlations: Understanding how different assets move relative to each other can help determine the best rebalancing strategy.
• Neglecting Market Conditions: Rebalancing during highly volatile periods might be more beneficial, but it requires careful timing and analysis.

Bottom Line

Rebalancing is a crucial tool for maintaining a portfolio's risk profile and providing discipline. While it doesn't consistently enhance returns, it can be beneficial in volatile markets when asset classes diverge significantly. However, investors must weigh the potential benefits against the costs, such as transaction fees and market impact. For most investors, the primary value of rebalancing lies in risk management💡 Definition:The process of identifying, assessing, and controlling threats to your financial security and goals. rather than return generation. To optimize rebalancing, consider your asset correlations, market conditions, and rebalancing strategy that aligns with your financial goals.