There Is No Rebalancing Debate

Same View, Different Words
I was surprised to see Michael Edesess' article, "Does Rebalancing Really Pay Off??," which questioned the value of Bill Bernstein's oft-cited "rebalancing bonus"--the gain that accrues to investors from periodically selling their winning assets and putting the proceeds into their losers. As neither author is prone to mistakes and rebalancing is a straightforward topic, I didn't see how there could be a serious disagreement.

There isn't. Both parties agree on the salient point: Rebalancing works best if the expected returns on asset classes are similar. As they diverge, so do the benefits of rebalancing.

Consider a portfolio that consists of two assets, stocks and bonds. Assume that stocks and bonds each will gain 6% annualized over the next 10 years. There is no uncertainty about this projection; the two assets will finish the decade in an exact tie. After the first measurement period (one day, one week, one month, one year, whatever), bonds have gained 2% and stocks have lost 2%. At that point, rebalancing by selling bonds to buy stocks mustbe correct. Bonds are currently ahead of stocks, but the two assets will eventually finish at the same place. Thus, the future return on stocks is higher than that of bonds.

The better transaction, of course, would be to liquidate all bonds and hold only stocks. Which illustrates the artificiality of this example--the very reason that rebalancing exists is because investors hold multiple assets, and the very reason that they hold multiple assets is because there are no performance guarantees.  

Nevertheless, the principle is instructive. We don't know an asset's true expected returns, but we can observe its realized risks, and we can reason that assets that are similarly risky should have roughly similar expected returns. Thus, when sifting through assets that have fairly equal levels of risk and return, the odds favor selling the winners to buy the losers. One asset might temporarily look to be higher-returning than another, but the results likely will converge over time.

Implicitly, I've described mean reversion. Which is indeed what researchers find when documenting the behavior of financial markets. Although winners often remain winners over the short term, meaning for a few weeks or months, they tend to slide back when the time period extends past one year. Meanwhile, losers rebound. Intermediate-term mean reversion was initially documented for U.S. stocks over five-year time periods by Werner De Bondt and Richard Thaler in 1985 and has since been expanded to include asset classes as well as individual securities and to use a variety of time horizons.

Thus, it's sensible to rebalance assets that have similar risk levels. One example is different segments of the U.S. stock market, such as value versus growth and large versus small. Another would be between the stocks of different geographic regions, for example, the United States, Europe, and Asia. 

I would extend that advice to include developed-markets versus emerging-markets exposure. While emerging-markets stocks are certainly a riskier bunch, and thus should have superior long-term returns, it's not clear to me that the gap between the two groups is large enough to eliminate the benefits of rebalancing.

Also, the risk-on/risk-off trade that affects emerging-markets performance may be mean-reverting. Central bankers loosen their monetary policies, investors gain confidence and pursue riskier assets, emerging-markets securities flourish, central banks grow concerned about asset inflation and signal that they may tighten, investors become worried, they lose confidence and sell riskier assets, emerging-markets securities decline, central banks grow concerned about asset deflation and signal that they may loosen, and so forth. The theory is more anecdotal than proven, but it strikes me as provisionally correct. 

In contrast, rebalancing reduces performance when assets have markedly different long-term returns. Both Edesess and Bernstein--see, I told you there was no real disagreement--cite U.S. stocks versus U.S. bonds. Whereas the two assets had identical returns in my hypothetical world, in reality it's been a century-long wipeout. As a result, harvesting gains from stocks and reinvesting into them into bonds via rebalancing severely eroded portfolio returns. Investors were much better off letting their stocks ride, because by doing so, they created a portfolio that had a lot more stocks than did the 50/50 rebalanced portfolio. Yes, by not rebalancing they had a higher return, but that return came solely because they owned more equity. Apples, meet oranges. 

Over the decades, without rebalancing, the stocks in an initial 50/50 allocation would have swelled to become more than 90% of the portfolio. What have we learned? Not much. If financial assets behave as expected, so that risky stocks outgain safer bonds, people who hold more stocks will make more money.

That would seem to be pretty obvious. But it's an obvious subject. 

The rules 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).

The first is a free lunch, while the second is a lunch that must be purchased. The price, however, seems fair. Bernstein calculated the average stock position for a portfolio of 50% stocks/50% bonds that ran unrebalanced until March 2014: 82.8%. (The final stock position, of course, was much higher.) That portfolio returned 9.23% annualized over the time period. In contrast, a portfolio that began at 82.8% stocks and was periodically rebalanced to that weighting gained 9.60% annualized. That's a 37-basis-point improvement for the rebalanced portfolio--nothing to complain about, particularly in these days when fund providers battle over a handful of basis points with their index-fund offerings.

As you are unlikely to increase your risk allocation over time, that is not a terribly realistic example. But it does illustrate yet another way that rebalancing can bring a gain by profiting from mean reversion.

Toss in the addendum that taxes must be considered for nonsheltered accounts, and that's it, really. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.