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Since September, we've seen markets in turmoil, with considerable emotion in play. Equity classes no longer have the correlations that were used to allocate assets efficiently. As a result, the bases for asset allocations may no longer be valid. Nevertheless, the fundamentals remain. Equities have dropped in value, but eventually they're likely to revert to pre-Sept. 15 values. They appear undervalued now, making this an opportune time to rebalance.
How do you rebalance in these turbulent times? I've devised an approach, called "opportunistic rebalancing," that squeezes more alpha out of rebalancing. This article first describes the process, then applies it to periods of volatility.
Let's start with some basic concepts. "You're in the Band" (see page 25) shows five asset classes with allocation targets and their rebalance bands. Any asset whose allocation has drifted outside the rebalance band is now "out-of-band," which means the portfolio needs to be rebalanced.
In the chart, assets A and B are out-of-band. A is so far above its allocation that we anticipate a reversion to the mean-a drop in value. Rebalancing would have us sell A before it reverts. This is the sell-high concept. Similarly, B has dropped so low that we anticipate it will revert to the mean by rising in value. Rebalancing would have us buy B before the reversion-the buy-low concept.
Thus, the rebalance band we have defined is an implicit statement of the line above or below which we anticipate a reversion to the mean. Advisors commonly use a 20% relative band, so if an asset class allocation is 10%, the rebalance bands are 8% and 12%. Generally, if the asset class is above 12% we will sell high, if below 8% we will buy low. My research has shown that 20% relative bands are optimal.
TOLERANCE BANDS
You don't need to rebalance exactly to the target-the dotted line. The reasoning: Suppose asset A is above the target by $1; there is no need to rebalance, even if trading costs are free. Similarly, if C is off just a bit, we don't know if it is headed north or south. It's in what we call the "noise band," or the "tolerance band." There is a noise band near the target, inside which we can't...