When Rebalancing Creates Higher Returns—and When It Doesn’t

bee

John Rekenthaler articles makes a few important points:

while value and growth stocks might seem the unlikeliest rebalancing opportunity, as they are subsegments of the same investment universe, their fortunes have substantially diverged. In 2022, the Morningstar US Growth Index shed 36.7% of its value, while the US Value index lost less than 1.0%. That was the opportunity that rebalancing seized

At present, do we all have a favorite LCV Fund that we can reallocate LCG outsized gains?

in this universe, as opposed to the alternative world of hypothetical studies, assets don’t regularly record the same long-term returns. Which begs the question: Over that same 9.5-year period, using the same portfolio assumptions, what was the actual benefit of rebalancing?

Not much, as it turns out.

I try to discipline myself to "milk" the cow when I am blessed with a 20% + gain (YTD) in my portfolio...where to put it is the more difficult question.

Swapping between growth and value stocks remained helpful. Otherwise, though, rebalancing reduced the portfolios’ returns.

The rebalanced portfolio may forgo some gains, but it will not surrender its relative safety. Consequently, the risk/return trade-off remains intact. That said, there may, in fact, be a trade-off, rather than an unambiguous benefit. Rebalancing can provide a free lunch—but, as this column has shown, it does not always do so.

when-rebalancing-creates-higher-returns-and-when-it-doesnt?

hank

Thanks @bee.

When I first came on board (actually at FundAlarm in the early 2000 era) regular systematic rebalancing seemed near gospel among the participants of the era. Today the prevailing sentiment is nearly the opposite. A notable change in tenor for whatever reason. (One may speculate it has something to do with the heady outperformance of certain sectors over that long period.)

To each his own. As a very conservative investor with no cash reserve on the side, I like to cull portfolio risk by taking profits from the leaders and plowing the money into the slower moving siblings. But arguments can be made on either side of this coin.

Observant1

Many investors rebalance to reduce risk in their portfolios.
Implementation of intra-asset class rebalancing can potentially
generate higher returns but this possibility should not be the primary motive.

yogibearbull

I posted on it a few days ago and highlighted,
"Morningstar's John Rekenthaler starts with a simple but unusual observation that if 2 assets have the same long-term (LT) TR, then rebalancing will definitely benefit the TR."
In all other cases, rebalancing hurts TR, but does control risk.
https://www.mutualfundobserver.com/discuss/discussion/62512/m-jr-on-rebalancing#latest"

hank

yogibearbull said:

“Morningstar's John Rekenthaler starts with a simple but unusual observation that if 2 assets have the same long-term (LT) TR, then rebalancing will definitely benefit the TR." In all other cases, rebalancing hurts TR, but does control risk.”

Absolutely. Good distinction to make. To myself, and from what I’ve seen over the years, it’s the second reason that receives more of the attention - especially from the financial press. . Every now and than when equity markets appear frothy you’ll get this suggestion to rebalance as part of a lengthier piece on cutting risk, dealing with high equity valuations, planning for the future or some other broader topic. Not new in that sense.

Rekenthaler goes a step farther and dissects the idea into the 2 categories @yogibearbull observes. Good article. Thanks to @bee and Yogi for posting. Great minds think alike.

msf

"Morningstar's John Rekenthaler starts with a simple but unusual observation that if 2 assets have the same long-term (LT) TR, then rebalancing will definitely benefit the TR."
In all other cases, rebalancing hurts TR, but does control risk

That's the inverse of the JR wrote, and inverses are often not true. (See The Fallacy of the Inverse, and Example 41 here.)

JR: If two assets have same LT TR, rebalancing helps portfolio TR.
Inverse: If two assets do not have same LT TR, rebalancing does not help (hurts) portfolio TR.

JR's statement can be understood intuitively. If asset 1 has a good year (relative to asset 2) and the assets have the same long term returns, then in the other years (on average) asset 1 must do worse. Since it will do worse, one would be better off moving some money from asset 1 to asset 2, i.e. rebalancing.

But even if asset 2 has poorer long term returns than asset 1, it could have better returns in the right years so that rebalancing still improves performance.

Suppose we have stocks (asset 1) and bonds (asset 2), and they return 10% and 8% respectively in odd years, and 8% and 9% respectively in even years. On average (long term), stocks return just under 9.0% (10% and 8% compounded), while bonds return just under 8.5% (8% and 9%).

In odd years, stocks do better (10% vs 8%) and rebalancing moves money from stocks to bonds. The next (even) year, bonds do better (9% vs. 8%). So moving money from stocks to bonds (rebalancing) turns out to be the right move. Likewise, in even years, bonds do better; rebalancing moves money from bonds to stocks which then do better the next year. Again, the right move.

The world isn't that neat, and often rebalancing won't improve portfolio performance. But arithmetically, one can't say that rebalancing must hurt total return.

FD1000

I think that most investors would generate similar to better results over time by using up to 5-7 funds, mostly indexes, hardly trade, and rebalance...all based on their goals, style and risk tolerance.
I never believed in any of the above, which is why I became a trader in 2000, when the stock market started to go down. It worked really well for me, using wide range categories
Another observation: markets have long cycles where 1-3 categories are above the rest, so why rebalance?
I started investing in 1995 based on the following:.
1995-2000: US LC tilting growth.
2000-2010: US Value+SC, and international. SPY+QQQ lost money for 10 years.
2010-2024: US LC tilting growth. Since 2018, I'm mostly in bond OEFs.