Michael Edesess questions the notion of a rebalancing bonus, wondering if its a ghost in money managements

machine. The concept, he recaps, was formalized in Bill Bernsteins influential 1996 study The Rebalancing Bonus:
Theory and Practice, which found that the actual return of a rebalanced portfolio usually exceeds the expected return
calculated from the weighted sum of the component expected returns. Edesess points out, apparently with Bernsteins
support, that the 1996 analysis is slightly misleading in the sense that the underlying assumptions arent as practical as
they could or should be. Although Edesess number crunching is yet another reminder that you cant count on rebalancing
to boost return, thats still not an argument for shunning rebalancing as a risk-management tool.
Nonetheless, Edesess nails what I think is a critical issue on the topic of rebalancing, namely, recognizing that this
technique requires us to navigate the rocky path between two of the most powerful forces in asset pricing: mean reversion
and momentum. As he explains:
Furthermore, some studies, including particularly one for which I am grateful to Bernstein for supplying, have
concluded that securities prices have historically had a tendency to mean-revert over time, with a half-life of
about three and a half years (i.e., half of them mean-revert by that time). Other studies have shown that for
shorter time intervals, securities prices show signs of mean-reversions opposite: momentum. That is, a high
return over a time interval has increased the likelihood that the return will be higher than average over the
next interval.
These results are in agreement with the theories of Hyman Minsky and behaviorists in finance and economics
that, basically, irrational exuberance and panics do produce bubbles and crashes (i.e., momentum and
mean-reversion, respectively).
However, even if these things are true, does that mean that rebalancing on any particular schedule will
succeed? The rebalancing would have to occur at just the right time to catch a mean-reversion in order to
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A False (But Useful) Debate About Rebalancing
May. 7, 2014 7:41 AM ET | 5 comments | Includes: DIA, IWM, QQQ, SPY by: James Picerno

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succeed and if rebalancing occurred when momentum was in charge, it might even be counterproductive.
Edesess runs some statistical tests of his own and finds that introducing mean-reversion into the returns process did not
cause rebalancing to beat buy-and-hold any more than it did when returns did not mean-revert. Its fair to say that when
it comes to looking at rebalancing as a return-boosting technique, the best you can say is that the record is mixed. Much
depends on the assets and time period under scrutiny, along with the details of the rebalancing strategy. Suffice to say,
theres a wide array of results. But theres also a broad consensus: Just do it. Reviewing a number of studies on the subject
in my book Dynamic Asset Allocation (see Chapter 6), I noted that there was disagreement about how and when to
rebalance. Nonetheless, most analysts agreed that rebalancing as a strategy was likely to be superior to no rebalancing.
Edesess doesnt necessarily disagree, although he argues (rather persuasively) that assuming that rebalancing will always
generate a higher return is more about hope than facts:
Rebalancing is certainly not necessarily harmful, unless it conflicts with another risk management strategy
that better suits the investor. It is better to have an investing discipline than not to have one, and rebalancing
is one acceptable default discipline especially when the investor would fail to adhere to any discipline if his
portfolios volatility exceeded a particular level. It should not, however, be thought of as a strategy that
delivers a returns bonus as compared to other strategies.
John Rekenthaler at Morningstar has read Edesesss critique and decided that two essential lessons emerge in matters of
rebalancing:
1) Rebalancing between assets with similar return levels brings a benefit (higher returns) without cost;
2) Rebalancing between assets with dissimilar return levels brings two benefits (maintaining portfolio risk
level, participating in asset-class mean reversion) and one cost (ultimately lower returns due to owning more
of a lower-performing asset).
Perhaps the most valuable point that Edesess makes is a reminder that any rebalancing analysis needs a robust benchmark.
He recommends (and I agree) that the only meaningful comparison is with a buy-and-hold strategy, i.e., a strategy of not
rebalancing. The reason for choosing that benchmark is that it is the simplest and most straightforward alternative to
rebalancing.
By that standard, its not terribly difficult to find papers that offer encouragement for thinking that you might earn a
rebalancing bonus. Meb Fabers widely cited 2007 study (and an update in 2013), for instance, found that a simple
strategy of tactical asset allocation across multiple asset classes based on moving averages juices returns and lowers risk
vs. buying and holding. Ive generated similar results with the rebalanced version of my Global Market Index compared
with its unmanaged cousin (see here and here, for instance).
Can you count on earning a higher return with rebalancing? No. In fact, you cant even count on reducing risk with
rebalancing. Thats the nature of finance: there are no guarantees. But if you study history intelligently, you can learn a
thing or two. That starts with a basic fact: if you dont rebalance, youre effectively letting Mr. Market run your asset
allocation strategy, i.e., youre favoring a market-value-weighted mix of assets.
You could do a lot worse. History suggests that passively holding a broad set of asset classes, weighted by relative market
values, is competitive with most attempts to do better. But for reasons of risk management and/or earning something
better, you have two basic choices if Mr. Markets not your cup of tea (and he usually isnt, based on choices in the real
world).
First, you can alter his asset allocation: leave out this asset class, overweight that one, etc. Two, you can rebalance. Unless
you go off the deep end on the first choice, which isnt usually recommended, most of your success (or failure) will be
bound up with rebalancing. The details surely matter. For most folks, the lesson is clear: some form of rebalancing is
productive if only to keep the winners from dominating the asset allocation, which inevitably exposes you to painful short
run volatility a la mean reversion. In fact, virtually everyone agrees. Rekenthaler sums it up rather well: There is no
rebalancing debate.
There, is however, plenty of work to do to find an appropriate rebalancing strategy for each investor. Its hard work
because were all forced to make choices based on imperfect information due to a familiar gremlin: an uncertain future. In
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that sense, we can think of asset allocation and rebalancing as the worst set of tools availableexcept when compared with
everything else. In any case, customization is crucial. Andre Perold and Bill Sharpes 1995 paperDynamic Strategies for
Asset Allocationremains the gold standard for summing up the critical challenge:
Ultimately, the issue concerns the preferences of the various parties that will bear the risk and/or enjoy the
reward from investment. There is no reason to believe that any particular type of dynamic strategy is best for
everyone (and, in fact, only buy-and-hold strategies could be followed by everyone). Financial analysts can
help those affected by investment results understand the implications of various strategies, but they cannot
and should not choose a strategy without substantial knowledge of the investors circumstances and desires.
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Comments (5)
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Michael Williamson, CFA
, contributor
Comments (5)

Rebalancing does give a return benefit, that is not at all disputed. It's just math. For example, read Booth and Fama
(1992), or Wise (1996). You could also take a look at Bouchey, Nemtchinov, Paulsen, & Stien (2012) which gives
an example of how rebalancing coin flips can give you a positive expected return even when the expected return on
each flip is 0.

However, the rebalancing benefit is only captured if the portfolio is continuously rebalanced. Any other strategy
introduces an error that can be positive or negative.

The rebalancing benefit is greater when assets have a low covariance. The rebalancing benefit is maximized when
assets have equal contribution to risk. This is the flaw in the paper you sited; he allocates equal capital, which is far
from equal risk. For the equity and bond portfolio, he should have about double the capital to bonds. If you look at
an equal risk equity/bond portfolio you'll find it handily outperforms either asset on its two. That's the power of
diversification. Owning the highest returning asset does not give you the highest portfolio return.
7 May, 08:08 AMReplyLike2
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User 5842391
, contributor
Comments (258)

I checked Bouchey, Nemtchinov, Paulsen, & Stien (2012).
Not only was the expected return on each flip not 0, but the argument was fallacious. The outcome of their strategy
isn't better on average, it is actually worse with 12.5% expectation instead of 25% per iteration, but with less vol,
meaning the center of distribution (or most probable outcome) will be better. Here is where their argument is bad:
"With a sufficiently large number of flips, the expectation is an equal number of heads and tails. Thus the game has
a zero long-term expected growth.". This is the median outcome, not the mean...
7 May, 12:32 PMReplyLike1
Michael Williamson, CFA
, contributor
Comments (5)

I think you may have misread the example.

In the first case, they are doing buy and hold. In the second case, they are holding a 50% cash, 50% coin flip
portfolio rebalanced after each flip.

As they write "With a sufficiently large number of flops, the expectations is an equal number of heads and tails.
Thus, the game has a zero long-term expected growth.".

They subsequently show that the rebalanced portfolio has a 6% long-term growth rate.

In any case, that's just an example that you may or may not like. Check out the other two papers, they go into the
math. Wise calculates the return (using certain distributional assumptions) that can be expected from rebalancing.

As I mentioned, the problem with the paper sited here is that the portfolios selected are poorly diversified. The
rebalancing return is higher the more diversified the portfolio. The noise may be overwhelming the rebalancing
benefit because it is small.
7 May, 01:31 PMReplyLike1
User 5842391
, contributor
Comments (258)

No sorry I didn't misread... It is a little in between the line I agree but the 6% long term growth rate applies to their
strategy in the median scenario where number of heads=number of tails, which is also the "no growth" scenario for
the all in long strategy. Go up to the 1st paragraph of the experiment: "the expected return of a single flip is 25%",
so not 0% as you mentioned above.
7 May, 02:12 PMReplyLike1
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Learner16
, contributor
Comments (89)

Thanks, James, for a very interesting article.
7 May, 04:05 PMReplyLike0
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