(January 25, 2013) — Investors have been warned that paying attention to their asset allocation and general market conditions is as important as maintaining a perfect portfolio split when considering rebalancing activity.
Research from market monitor Factset found there was more to deciding on whether to rebalance a portfolio than merely looking at the the cost in relation to the benefit on the return profile of a portfolio and the frequency with which it was carried out.
Drew J. Cronin, vice president of portfolio analytics at FactSet, said that generally a portfolio will have higher returns without rebalancing during a trending upmarket. This is due to an expanding weighting to an outperforming asset class gathering more good returns.
The reverse is true when markets are oscillating as rebalancing portfolios allows larger allocations to assets that have fallen lower and are more likely to perform, Cronin said.
However, this concept only functions in practice if an investor is certain on where markets are heading – and this is almost never the case, Cronin said.
“Because we don’t know the future with certainty, a big piece of any asset allocation strategy is hedging against that uncertainty,” Cronin said. “If a portfolio’s long-term strategy calls for a particular asset allocation split, then we should focus less on trying to time the market and more on the observable trends that may justify more frequent rebalancing.”
Cronin mapped out how changes in volatility and the correlation within a portfolio’s assets would affect returns and said that these two factors were essential to consider before starting a rebalancing regime.
“Recent market conditions are unlike any other period in recent history, with high volatility, extremely low correlations, and high domestic equity returns,” Cronin concluded. “The benefit of frequent rebalancing should be weighed against the cost (turnover and trading costs) to determine your own optimal rebalance policy and ensure that you’re prepared for future uncertainty in the market.”
To read the full research note, click here.