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Worth the effort.
Our purpose is to demonstrate that specific asset class rebalancing strategies for taxexempt plan sponsors such as pension funds or endowments can add value by controlling risk and increasing returns. We specifically address two questions: Does rebalancing a fund's asset class allocations to the strategic target weights make sense? If it does, what is the best rebalancing strategy? We demonstrate that a disciplined rebalancing strategy that is a function of both asset class deviation interval and monitoring frequency can add value over alternative strategies on a risk-adjusted basis.
Any multi-asset class fund is going to drift from its initial or target allocations over time as some asset classes outperform others. Every plan sponsor has to determine when or whether to rebalance the multi-asset class fund. Current practices among plan sponsors range from haphazard to disciplined rebalancing. Some plan sponsors rebalance only when fund cash inflows or outflows dictate action. Others base their rebalancing strategies on time (such as monthly, quarterly or semiannually) or deviation intervals from target allocations (such as 1%, 5%, or 10%).
Plans typically spend a great deal of time and energy to develop strategic asset allocation target weights employing sophisticated mean-variance efficient optimization techniques. This effort is justified because the selection of the target asset allocation may be the most important aspect in explaining portfolio performance as shown in Brinson, Hood, and Beebower [1986], Brinson, Singer, and Beebower [1991], and Ibbotson and Kaplan [2000]. To let a portfolio's asset mix drift significantly from targets is inconsistent with the care and deliberation that go into establishing these targets.
One of the primary criteria for evaluating alternative rebalancing strategies should be risk control. Plan sponsors typically build diversified portfolios to achieve the risk reduction benefits of combining asset classes with low correlated returns. Portfolios that are not rebalanced can lose some of these risk reduction benefits, drifting toward an unintended large percentage of higher-risk assets or inefficient allocations. Therefore, a primary criterion for evaluating rebalancing alternatives should be risk-adjusted returns. A rebalancing strategy should probably not increase a fund's risk, but if it does it should produce higher risk-adjusted returns. Trading costs and implementation feasibility must also be taken into account.
Given that no plan sponsor can escape making rebalancing...