Asset Allocation

CHAPTER 21Rebalancing

THE CHALLENGE

In Chapter 2, we showed how to identify an efficient asset mix given assumptions about the expected returns, standard deviations, and correlations of asset classes. In Chapter 12, we introduced full-scale optimization as a method to construct efficient portfolios when the assumptions necessary for mean-variance analysis do not hold. And, in Chapters 15 and 16, we showed how investors can use multi-goal optimization to construct portfolios that are sensitive to a benchmark or factor profile. Regardless of which method investors use to form portfolios, the portfolios become suboptimal almost immediately after implementation. Why? Price changes are not proportional across asset classes, so the portfolio weights drift away from the optimal targets over time. If there were no transaction costs, investors could trade daily, or even more often, to maintain the optimal weights. In practice, investors face a trade-off: they must balance the transaction cost of restoring the optimal weights against the cost of remaining suboptimal.

Most investors employ simple heuristics to manage this trade-off. Some implement calendar-based rebalancing policies, in which they rebalance each month, quarter, or year. Others impose tolerance bands in which they rebalance when the exposure to any asset class drifts more than two percentage points from its target, for example. These approaches are better than not rebalancing at all. But they are arbitrary. Is total cost ...