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Does rebalancing improve portfolio performance? Yes – but it takes time for the benefits of rebalancing to be fully manifested, at least in the case of a broadly diversified 12-asset portfolio.
The analysis of rebalancing in this article will assume a 12-asset portfolio over a 16-year period from Jan. 1, 1998, to Dec. 31, 2013. Portfolio assets included in this analysis are large-capitalization U.S. equity, mid-capitalization U.S. equity, small-capitalization U.S. equity, non-U.S. equity (developed and emerging), real estate, natural resources, commodities, U.S. bonds, US Treasury Inflation-Protected Securities (TIPS), non-U.S. bonds, and cash. Each of the 12 asset classes is equally weighted at 8.33%. This 12-asset model is known as the 7Twelve® model. (I am the designer of this model.) It represents a diversified, multi-asset portfolio in which to test the merits of rebalancing.
Below in Table 1 is a quick summary of the performance based on various rebalancing assumptions:
- No rebalancing (buy-and-hold)
- Monthly rebalancing
- Quarterly rebalancing
- Annual rebalancing
The performance of 7Twelve® Portfolio is based upon the “passive” model that uses actual exchange-traded funds (ETFs). Performance is net of fees (i.e., the expense ratios of the various ETFs) but has not been adjusted for taxes or inflation. The cost of rebalancing was assumed to be zero – which is possible using a no-trading-fee (NTF) platform, such as that offered by Charles Schwab, Fidelity or Vanguard (if using Vanguard ETFs).
Table 1. Performance under various rebalancing assumptions
(Highest returns shown in bold)
Performance over
Multiple Time Frames |
Multi-Asset Portfolio Performance |
No
Rebalancing |
Monthly
Rebalancing |
Quarterly
Rebalancing |
Annual
Rebalancing |
3-Year Annualized % Return
(2011-2013) |
6.34 |
6.20 |
6.33 |
6.33 |
5-Year Annualized % Return
(2009-2013) |
11.88 |
11.49 |
11.61 |
11.45 |
10-Year Annualized % Return
(2004-2013) |
7.54 |
7.98 |
8.16 |
8.17 |
15-Year Annualized % Return
(1999-2013) |
8.08 |
8.20 |
8.38 |
8.44 |
16-Year Annualized % Return
(1998-2013) |
7.34 |
7.81 |
7.99 |
8.05 |
Table 2. Rebalancing premium over rolling time periods
Numbers in (red) indicate a negative rebalancing premium (i.e., better results without rebalancing)
Rolling
Period Ending
in Year…
|
Rebalancing “Premium”
(Outperformance in basis points due to rebalancing annually versus buy-and-hold) |
Rolling 3-Year |
Rolling 5-Year |
Rolling 10-Year |
Rolling 15-Year |
2000 |
116 |
-- |
-- |
-- |
2001 |
54 |
-- |
-- |
-- |
2002 |
(65) |
83 |
-- |
-- |
2003 |
35 |
38 |
-- |
-- |
2004 |
9 |
(20) |
-- |
-- |
2005 |
(97) |
(11) |
-- |
-- |
2006 |
(71) |
(60) |
-- |
-- |
2007 |
(62) |
(149) |
27 |
-- |
2008 |
99 |
83 |
24 |
-- |
2009 |
140 |
100 |
44 |
-- |
2010 |
153 |
119 |
33 |
-- |
2011 |
12 |
106 |
45 |
-- |
2012 |
2 |
88 |
34 |
71 |
2013 |
(1) |
(43) |
63 |
36 |
When did rebalancing work best?
As can be seen in Table 2 above, there were rolling periods of time in which not rebalancing produced better results (highlighted in yellow). The most distinct time periods in which we saw an advantage for not rebalancing were the three-year rolling periods from 2003-05, 2004-06 and 2005-07, as well as the five-year rolling periods from 2002-06 and 2003-07. As shown below in Table 3, these rolling time periods can be characterized as periods in which nearly all of the 12 asset classes had positive returns each year (shown below in yellow highlighting for the years 2003-07).
Rebalancing did not add value when asset classes were generating positive returns year-after-year. Let winners run – don’t rebalance. The obvious challenge is knowing ahead of time that winners will stay winners. Moreover, if we let runners “run,” the portfolio becomes disproportionately allocated in those winning asset classes – and when they get clobbered it’s painful. Choosing whether or not to rebalance essentially becomes a market-timing decision.
Rebalancing worked best when the time period was characterized by losses and gains among the ingredients in the portfolio. That is why we saw a steady rebalancing “premium” over longer time periods (as shown in Table 2). It is unusual for asset classes (particularly equities and diversifiers) to generate consistent positive year-to-year returns for long periods of time.
Table 3. Annual performance of 12 asset classes (using ETFs)
Year |
US Large Cap |
US Midcap |
US Small Cap |
Dev Non-US Equity |
Emerging Equity |
Real Estate |
Natural Resources |
Commodities |
US Bonds |
TIPS |
Non-US Bonds |
Cash |
1998 |
28.67 |
16.90 |
4.76 |
19.60 |
-18.00 |
-16.25 |
-14.61 |
-27.98 |
8.56 |
3.74 |
17.66 |
5.34 |
1999 |
20.37 |
15.29 |
3.35 |
26.55 |
61.81 |
-3.95 |
26.63 |
42.81 |
-0.94 |
2.19 |
-6.84 |
5.01 |
2000 |
-9.71 |
17.37 |
21.88 |
-14.46 |
-27.45 |
26.46 |
15.24 |
24.43 |
11.49 |
12.95 |
-3.29 |
6.29 |
2001 |
-11.81 |
-0.90 |
13.70 |
-21.71 |
-2.73 |
12.45 |
-16.00 |
-8.68 |
8.31 |
7.68 |
-4.43 |
4.16 |
2002 |
-21.55 |
-14.37 |
-14.20 |
-15.43 |
-7.29 |
3.85 |
-14.37 |
24.56 |
10.12 |
16.33 |
21.33 |
1.65 |
2003 |
28.16 |
35.14 |
37.19 |
39.68 |
57.88 |
35.77 |
34.73 |
25.84 |
3.98 |
8.18 |
17.64 |
0.90 |
2004 |
10.69 |
15.77 |
23.55 |
18.94 |
26.31 |
30.87 |
24.69 |
37.15 |
4.22 |
8.30 |
11.53 |
1.11 |
2005 |
4.86 |
12.50 |
6.28 |
13.32 |
32.25 |
11.64 |
35.63 |
30.87 |
2.30 |
2.59 |
-9.25 |
3.01 |
2006 |
15.80 |
9.99 |
19.23 |
25.88 |
29.20 |
33.49 |
16.17 |
16.02 |
4.21 |
0.18 |
6.78 |
4.88 |
2007 |
5.12 |
7.12 |
-6.92 |
9.89 |
37.32 |
-16.42 |
33.71 |
31.50 |
6.84 |
11.95 |
10.41 |
5.14 |
2008 |
-36.70 |
-36.34 |
-32.33 |
-41.02 |
-52.29 |
-37.00 |
-42.89 |
-31.74 |
8.49 |
-0.55 |
4.21 |
2.77 |
2009 |
26.31 |
37.49 |
30.98 |
26.84 |
75.29 |
30.07 |
37.07 |
16.19 |
3.70 |
8.94 |
5.44 |
0.53 |
2010 |
15.04 |
26.26 |
25.11 |
8.25 |
19.44 |
28.42 |
23.35 |
11.90 |
6.25 |
6.13 |
3.82 |
0.06 |
2011 |
1.89 |
-2.16 |
-4.20 |
-12.26 |
-18.74 |
8.56 |
-7.80 |
-2.57 |
7.91 |
13.27 |
3.98 |
0.05 |
2012 |
16.02 |
17.82 |
18.97 |
18.82 |
19.20 |
17.62 |
2.02 |
3.50 |
3.92 |
6.39 |
5.86 |
0.04 |
2013 |
32.32 |
33.08 |
36.57 |
21.38 |
-4.92 |
2.31 |
15.54 |
-7.64 |
-2.10 |
-8.50 |
-3.56 |
0.02 |
Two other reasons to rebalance
Two more benefits accrue to those who rebalance, although neither necessarily improves the performance of the portfolio.
A distinct characteristic of rebalancing is that the terminal account values of the fixed-income components are kept in line with the balances in the equity and diversifier asset classes. Without rebalancing, the fixed-income components of a multi-asset model will become relatively smaller over time (as compared to the equity and diversifier asset class balances)
Let me demonstrate using the 7Twelve® over the past 15 years, assuming a starting portfolio value of $120,000, with each component having a beginning value of $10,000. Without rebalancing, cash had a balance of just over $14,000 at the end of the period, whereas commodities had a balance of over $57,000. Emerging-market equity had a balance of more than $45,000, compared to U.S. bonds at $21,337. The account balance discrepancies were considerable. With rebalancing, of course, the account balances in all 12 asset classes are identical at the end of each year.
Ending Balance
After
15-Years
Without
Rebalancing
|
US Large Cap |
US Midcap |
US Small Cap |
Dev Non-US Equity |
Emerging Equity |
Real Estate |
Natural Resources |
Commodities |
US Bonds |
TIPS |
Non-US Bonds |
Cash |
$19,590 |
$40,374 |
$42,406 |
$19,125 |
$45,564 |
$43,160 |
$38,988 |
$57,569 |
$21,337 |
$24,710 |
$17,758 |
$14,174 |
Why does this matter? Inasmuch as fixed income tends to have lower returns than equity and equity-like assets, those assets won’t keep pace with the other portfolio components (in terms of dollar account value). As a result, the account balances become disproportional over time, with the equity components dominating the portfolio. This can be advantageous if, in the latter years of a portfolio, the equity-based assets perform well. But if equity and equity-like assets decline, the investor can experience heavy losses because of their disproportionately large allocations in equity. Furthermore, fixed income and cash generally represent the “safer” asset classes in which many investors prefer to have proportionally larger balances as they age. Without rebalancing, the opposite typically occurs.
Second, rebalancing represents an action on the part of the advisor. During periods of pronounced market volatility, jittery clients often want their advisor to “do something!” Rebalancing represents “doing something” – and it might be enough to keep the client from bailing out at the wrong time. The beauty is this: Rebalancing does not harm the portfolio, whereas a panicked client that sells out at the bottom of a market decline can inflict heavy damage on the portfolio and on the advisor-client relationship. So the next time a client wants you to take action – rebalance. It’s a clever way of selling high and buying low. Even the most novice investor knows that mantra.
Finally, to virtually negate the tax consequences of rebalancing, just use new investment dollars (purchases) to accomplish the rebalance. No selling, just buying. Buying low, that is.
Craig L. Israelsen, Ph.D., is an executive-in-residence in the financial planning program at Utah Valley University. He is the designer of the 7Twelve Portfolio (www.7TwelvePortfolio.com) and author of the book 7Twelve: A Diversified Investment Portfolio with a Plan, published by John Wiley & Sons. .
Read more articles by Craig L. Israelsen, Ph.D.