Measuring Portfolio Rebalancing Benefits in Equity Markets

Summary:

The Journal of Portfolio Management, Vol. 46, Issue 4, March 2020

The potential source of additional performance because of the simple act of resetting portfolio weights back to the original weights is referred as the rebalancing premium. It is also sometimes known as the volatility pumping effect or diversification bonus because volatility and diversification turn out to be key components of the rebalancing premium. The purpose of this article is to provide a thorough empirical analysis of the volatility pumping effect in equity markets and to examine the conditions under which it can be maximized. The authors’ main contribution to the understanding of the rebalancing premium is an effort to disentangle and separately measure the isolated impact of various components of the total effect. Using the Fama–French–Carhart four-factor model, they find that, after controlling for factor exposures, the average outperformance of the rebalanced strategy with respect to the corresponding buy-and-hold strategy remains substantial at an annualized level above 100 basis points over a 5-year time horizon for stocks in the S&P 500 universe. They also find that size, value, momentum, and volatility are sorting characteristics that have a significant out-of-sample impact on the rebalancing premium. In particular, the selection of small-cap, low book-to-market, past loser, and high-volatility stocks generates a higher out-of-sample rebalancing premium compared to random portfolios for time horizons from 1 year to 5 years. They also show that the initial weighting scheme has a significant impact on the size of the rebalancing premium. Taken together, these results suggest that a substantial rebalancing premium can potentially be harvested in equity markets over reasonably long horizons for suitably selected types of stocks.

Key Findings

• After controlling for factor exposures, the rebalanced strategy generates an average annual outperformance of more than 100 basis points with respect to the corresponding buy-and-hold strategy over a 5-year time horizon for the S&P 500 universe.

• The selection of small-cap, low book-to-market, past loser, and high-volatility stocks generates a higher out-of-sample rebalancing premium compared to random portfolios for time horizons from 1 year to 5 years.

• Serial correlation as a sorting characteristic does not allow maximization of the rebalancing premium out of sample for time horizons greater than 1 year.